Friday, August 30, 2013

Australian Securities Regulator Adopts High Frequency and Dark Trading Regulations

After extensive internal analysis and consultation with industry, the Australian Securities and Investment Commission adopted market integrity rules on dark liquidity and high-frequency trading. Commissioner Cathie Armour said that the ASIC expects the new rules will quickly lead to changes in the behavior of market participants.

With regard to dark liquidity, crossing system operators must publish on a website information about their crossing system and make disclosures to clients on the operation of the crossing system. They must also identify in trade information for wholesale clients the crossing system and whether they traded as principal.

In addition, the tick sizes that apply to exchange markets will also apply to crossing systems. Crossing system operators must have a common set of procedures which do not unfairly discriminate between users and allow clients to opt out of using their crossing system. If suspicious activity is identified in a crossing system, it must be reported to the ASIC. Further, market participants must protect confidential client information and deal with client orders fairly and in due turn.

Regarding high frequency trading, market participants must consider additional circumstances in considering whether a false or misleading market has been created. They must also consider the frequency with which orders are placed, the volume of products that are the subject of each order, and the extent to which orders made are cancelled or amended relative to the orders executed.

Int’l Working Group Finds Risk of Regulatory Arbitrage amid Economic Benefits in Derivatives Regulatory Reforms

An IOSCO-Basel Committee-Financial Stability Board working group found a net economic benefit from the OTC derivatives regulatory reforms being implemented in the wake of the financial crisis. The working group’s report also found that the derivatives reforms increased transparency and enhanced risk management. However, as the reforms are playing out across different jurisdictions, the report found a risk of regulatory arbitrage.

The Over-the-counter Derivatives Coordination Group, composed of the Basel Committee, IOSCO, the Committee on Payment and Settlement Systems (CPSS), the Financial Stability Board, commissioned a quantitative assessment of the macroeconomic implications of OTC derivatives regulatory reforms to be undertaken by the Macroeconomic Assessment Group on Derivatives (MAGD), chaired by Stephen G
Cecchetti of the Bank for International Settlements. The Group comprised 29 member institutions of the Financial Stability Board, working in close collaboration with the IMF.

In its report, the MAGD focused on the effects of mandatory central clearing of standardized OTC derivatives,  margin requirements for non-centrally-cleared OTC derivatives and bank capital requirements for derivatives-related exposures. In its preferred scenario, the group found economic benefits worth 0.16% of GDP per year from avoiding financial crises. It also found economic costs of 0.04% of GDP per year from financial institutions passing on the expense of holding more capital and collateral to the broader economy. This results in net benefits of 0.12% of GDP per year.

In response to the financial crisis, policymakers are implementing reforms aimed at reducing counterparty risk in the OTC derivatives market. These include requirements for standardized OTC derivatives to be cleared through central counterparties, requirements for collateral to be posted against both current and potential future counterparty exposures, whether centrally cleared or non-centrally cleared, and requirements that banks hold additional capital against their uncollateralized derivative exposures.
While these reforms have clear benefits, noted the working group, they do entail costs. For example, requiring OTC derivatives users to hold more high-quality, low-yielding assets as collateral lowers their income. Similarly, holding more capital means switching from lower-cost debt to higher-cost equity financing. Although these balance sheet changes reduce risk to debt and equity investors, risk-adjusted returns may still fall. As a consequence, financial institutions may pass on higher costs to the broader economy in the form of increased prices.
This report assesses and compares the economic benefits and costs of the planned OTC derivatives regulatory reforms. The focus throughout is on the consequences for output in the long run when the reforms have been fully implemented and their full economic effects realized. The main beneficial effect is a reduction in forgone output resulting from a lower frequency of financial crises propagated by OTC derivatives exposures, while the main cost is a reduction in economic activity resulting from higher prices of risk transfer and other financial services.
The main benefit of the reforms arises from reducing counterparty exposures, both through netting as central clearing becomes more widespread and through more comprehensive collateralization. The working group estimates that in the central scenario this lowers the annual probability of a financial crisis propagated by OTC derivatives by 0.26 percentage points. With the present value of a typical crisis estimated to cost 60% of one year’s GDP, this means that the reforms help avoid losses equal to (0.26 x 60% =) 0.16% of GDP per year.
The benefit is balanced against the costs to derivatives users of holding more capital and collateral. Assuming this is passed on to the broader economy, the working group estimates that the cost is equivalent to a 0.08 percentage point increase in the cost of outstanding credit. Using a suite of macroeconomic models, the group estimates that this will lower annual GDP by 0.04%. Taken together, this leads to the group’s primary result: the net benefit of reforms is roughly 0.12% of GDP per year.
Regulatory arbitrage risk. As the regulatory regimes are gradually put in place, the report found indications of potential differences in the scope and application of OTC derivatives regulation across jurisdictions. There is a risk that overlaps, gaps or conflicts in the frameworks, if not properly addressed, could create the potential for regulatory arbitrage as trading migrates to certain jurisdictions.
Among the cross-border issues in this category is the regulatory treatment of central counterparties. For example, the European Market Infrastructure Regulation (EMIR) and the Commodity Exchange Act (CEA), as modified by the Dodd-Frank Act, contain prescriptive rules that may prevent European/US banks from participating in third-country central counterparties that are not currently recognized by the European Securities and Markets Authority (ESMA) or that are not currently registered as a derivatives clearing organization under CFTC regulations.
The potential non-recognition of third-country central counterparties could negatively affect Asian OTC derivatives markets, said the report, as it could affect market liquidity, restrict participation and undermine price discovery. The extraterritorial application of regulatory frameworks could affect European and US banks’ participation as these banks are already clearing members in Asian clearing houses and may be potentially shut out of certain business lines.
Non-recognition could imply that some central counterparties would be treated as non-qualifying, thereby attracting a much higher regulatory capital requirement for trade exposures and default fund contributions, which could act as a disincentive for OTC derivatives trading. Thus, the working group concluded that there is a risk that significant contributors to market liquidity may be forced to withdraw, thereby making those markets shallower. The resulting impact on the price discovery process could also influence hedging decisions, which would adversely affect the ability of financial institutions and companies to manage interest rate and other risks, thereby potentially increasing systemic risk.
Transparency. The report found that enhanced transparency could be a likely benefit of the reforms in that greater standardization of products and lower counterparty risk will facilitate the comparison of pre-trade prices, which should improve competition and lead to more accurate price differentiation. The increased posting of collateral and use of central clearing also means that detailed information about individual counterparties becomes less important. In contrast, as more trades are moved onto central counterparties it will become increasingly important to ensure that market participants have ongoing access to reliable information about the positions, risk management practices and financial health of the central counterparty.
Risk Management. The regulatory reforms will not only reduce the risk of systemic financial crises, said the working group, they are also likely to reduce the risk of less severe episodes of financial turbulence and of the failure of single financial institutions. They do this in two ways. First, minimum margin requirements are likely to make it less likely that risks build up within a financial institution without all main departments, including risk management, realizing it. The reforms may also indirectly lower the risk of financial instability due to poor internal controls at financial institutions.

Second, by reducing counterparty risk embedded in OTC derivatives, the reforms can help reduce price model risk. Currently, pricing models for derivatives take counterparty risk into account, but these risks are difficult to measure or calibrate and often call for subjective judgment. Therefore, reducing counterparty risk lowers this modeling risk, making it less risky to price and value derivatives.

Thursday, August 29, 2013

House Legislation Would Reduce Regulations Two for One

Legislation introduced in the House would require any federal agency issuing a new regulation to repeal two existing regulations before the new one takes effect. The One In, Two Out Act, HR 2997,  is sponsored by Rep. Michael McCaul (R-TX), who said that it is modeled on a successful U.K. policy. Specifically, requires a federal agency to assess the net cost of complying with any proposed new regulation. For major regulations with an annual economic cost of more than $100 million, a deregulatory measure must be found that reduces the net cost by at least the same amount before the new regulation may take effect.
Specifically, a federal regulatory agency may not issue a major rule unless it has repealed two or more rules that, to the extent practicable, are related to the major rule; and the cost of the new major rule is less than or equal to the cost of the rules repealed. The bill is cosponsored by, among others, Rep. K. Michael Conaway (R-TX), Chair of the Commodities and Risk Management Subcommittee and Rep. Randy Neugebauer, Chair of the Housing and Insurance Subcommittee.

When this policy was enacted in the UK, related Rep. McCaul, agencies proposed a total of 157 regulatory measures of which 119 would have imposed a burden on business. After six months, only 46 regulations remained, only 11 of which imposed a net cost on business. Under the U.K ``one in, two out’’ rule, when policymakers need to introduce a new regulation, and where there is a cost to complying with that regulation, they have to remove or modify an existing regulation with double the cost to business.

Wednesday, August 28, 2013

Dr. King's Call for Justice Touched the Better Angels of our Nature

The historic speech by Dr. Martin Luther King Jr. whose 50th anniversary we celebrate today had justice as its overarching theme. In a rather short address, Dr. King uses the word justice nine times, ultimately calling on a shaking of the foundation of this nation until the bright day of justice emerges. This call was appropriate. In his seminal encyclical, Pacem in Terris, Pope John XXIII quoted St, Augustine that ``Take away justice, and what are kingdoms but mighty bands of robbers.’’ Dr. King understood this profound truth. His call for justice rang out fifty years ago and rings out just as strongly today. His message of social justice is compelling and eternal as we honor his dream today. Thank you Dr. King for doing as President Lincoln did and touching the better angels of our nature.

Monday, August 26, 2013

Business Groups Ask for Expedited Appeal in DC Circuit of District Court’s Conflict Minerals Ruling

The U.S. Chamber of Commerce and a consortium of business groups have filed a notice of appeal and a motion for expedited appeal with the DC Circuit of a federal district judge ruling that upheld SEC regulations implementing the conflict minerals provisions of the Dodd-Frank Act. The district court was convinced that the Commission discharged any potential responsibility to consider whether the regulations will promote efficiency, competition, and capital formation, and that the Commission appropriately considered the impact on competition more generally. The court emphasized that the regulations were not promulgated by the Commission on its own accord, but rather the conflict minerals regulations were promulgated pursuant to an express, statutory directive from Congress, which was driven by a Congressional determination that the due diligence and disclosure requirements it enacted would help to promote peace and security in the DRC. As a result, said the court, the SEC rightly maintains that its role was not to “second-guess” Congressional judgment as to the benefits of disclosure, but to, instead, promulgate a rule that would promote the benefits Congress identified and that would adhere closely to that congressional command. (National Assoc. of Manufacturers, Chamber of Commerce and Business Roundtable v. SEC, CA-DofC, August 12 and 14, 2013)

The final regulations became effective on November 13, 2012, and the first reports and disclosures it requires are due to be filed with the SEC by May 31, 2014. Ultimately, the Commission declined to adopt any categorical de minimis exception as part of the final rules. In the district court’s view, the SEC’s de minimis determination was rationally based upon the evidence before it. While it may be true that the adoption of some type of de minimis approach could also have been a reasonable, alternative option, noted the court, this does not render the SEC’s contrary determination arbitrary or unreasonable.

In their motion for expedited appeal, the business groups proposed an expedited review schedule, with briefing concluding in November of 2013, that they believe will greatly increase the possibility that the case can be decided before the first disclosures and reports under the Rule would be due in May of 2014.

The appellants are a trade association, a business federation, and an association of chief executive officers, collectively representing thousands of publicly traded companies, many of which are burdened with what they said are the astronomical costs of the conflict minerals rule. They argued that delay will cause irreparable injury because the conflict minerals rule will impose extraordinary costs upon them which cannot be recovered. If their challenge is successful, noted the business groups, expedited consideration would help spare them at least some of the costs of preparing, auditing, and filing the reports, as well as the costs of ongoing compliance in 2014.

Thursday, August 22, 2013

Senators Warner and Corker explain their mortgage securitization bill at policy forum

At a forum sponsored by the Bipartisan Policy Center, Senators Mark Warner (D-VA) and Bob Corker (R-TN) discussed their legislation to reform the mortgage securitization process. Senator Corker said that the bill strikes the appropriate competitive balance, with 10 percent capital up front and a reliance on the market. It also separates issuers from guarantors. Senator Warner said that the status quo of private sector gains and public sector losses is neither palatable nor sustainable. He noted that reform of housing finance was a bridge too far in the Dodd-Frank Act, but the time to do it is now. The Senator expects the Banking Committee to take up the bill in September.

Senator Corker is reasonably optimistic that there is a five-month window of time in which to get a bi-partisan bill done. The legislative calendar is fairly open right now, he said, adding that he and Senator Warner are working closely with the Obama Administration to get legislation enacted. Senator Warner emphasized that a bill rebranding and recapitalizing Fannie and Freddie is not the way to go and, in any event, could not get through Congress. Many senators are moving to support the bill, he noted.

The Housing Finance Reform and Taxpayer Protection Act, S. 1217, would create the Federal Mortgage Insurance Corporation (FMIC) as an independent federal agency to capitalize the housing finance system by separating credit risk from interest rate risk, and bringing in private capital to take on both. All of these risk sharing options will have a minimum of 10 percent equity. In addition to this capital buffer, FMIC will also leave the securitization and insurance functions to private market participants. Every mortgage-backed security issued through FMIC will have a private investor bearing the first risk of loss and holding at least 10 cents in equity capital for every dollar of risk.

Senator Corker noted that the 10 percent capital buffer is the right balance and sends the right signal to the financial markets. He noted that SIFIs will be close to a 10 percent buffer when all is said and done. In addition, the 10 percent piece in the legislation is appealing to Democratic co-sponsors. Senator Warner noted that the 10 percent may be tranched into different components and the market could price it appropriately. He added that the current system of no private capital is dramatically underpriced.

Senator Warner pointed out that the legislation would create a common securitization platform with a front-end process with sound underwriting standards. All secuitizers will pass through a common securtization platform and will drive us towards a single security

The House Financial Services Committee has reported out the Protecting American Taxpayers and Homeowners (PATH) Act, H.R. 2767. Senator Warner described the House bill as an ideologically pure exercise that will not get Democratic support. While the PATH Act represents a coherent approach, he acknowledged, it would completely upend the existing housing finance system, destroy the 30-year fixed mortgage, and chill purchasers of securities, particularly foreign purchasers of securities. Senator Warner said that S. 1217 represents a balance between the status quo and a rigidly ideological and disruptive approach. S. 1217 starts with a good structure, and he believes that the Senate process will improve it.

House legislation would refocus Dodd-Frank SIFI definition towards risk

A key member of the House Financial Services Committee has proposed legislation that would refocus the definition of a systemically important financial institution in Title I of the Dodd-Frank Act to base the designation of a SIFI more on interconnected risk than some arbitrary asset size. Rep. Blaine Luetkemeyer (R-MO) introduced the Systemic Risk Designation Improvement Act (H.R. 3036) so that the heightened regulation of some financial institutions will be based on risk rather than on arbitrary asset size. He noted the importance of creating regulatory standards that appropriately account for risk and the varying structures of small, mid-size and large financial institutions, adding that federal financial regulation should not treat interconnected, global financial institutions with complex lines of business the same as financial institutions focused on traditional, retail and commercial banking.

The Systemic Risk Designation Improvement Act would enhance the criteria used to make SIFI designations to ensure that those with the SIFI designation, and therefore subject to stricter regulatory standards, are those institutions that are not only large in size, but also globally interconnected and complex. In turn, the legislation free traditional retail and commercial banks so that they are able to focus on making loans to customers, enhancing economic recovery. The Dodd- Frank Act used a numeric threshold of $50 billion to subject all financial institutions, regardless of business lines or complexity, to enhanced regulatory assessment through the SIFI designation. According to Rep. Leutkemeyer, Dodd-Frank does not consider the fact that community banks, mid-size banks and large banks often have completely different business models, resulting in regulatory scrutiny of companies based on size rather than activity. Ultimately, he believes that the legislation would support economic growth by allowing community and regional banks to lend without being burdened by the required regulation of reaching the $50 billion threshold.

Wednesday, August 21, 2013

European Parliament Issues Report on Collateral Haircuts in Securities Financing Transactions

European Parliament issues report on haircuts applied to the collateral used in securities financing transactions, principally repurchase agreements (repos) and securities lending, assessed the recommendations of a Financial Stability Board working group on their effectiveness as a tool to enhance stability in the financial market. A haircut is intended to hedge the credit, liquidity and other risks on a security being used as collateral by adjusting its value to reflect the potential loss arising from liquidation during a time of funding need or after a possible default by either a counterparty or the issuer of the asset. However, the report noted that haircuts create problems. They represent the share of a security which cannot be funded in the repo market and requires a firm to draw on its own funds or unsecured borrowing, which increases the overall cost of funding. They also expose the borrower to the credit risk of the lender.

The FSB is concerned that changes in haircuts fuel pro-cyclicality. In buoyant markets, firms may narrow haircuts, which would amplify the expansion of credit. But in a depressed market, they may widen them, which would amplify the tightening of credit. The working group has proposed a dual approach to stabilizing and controlling the level of haircuts. First, it would introduce minimum standards for the methodologies for the calculation of collateral haircut. Second, it is considering placing a floor under firms’ calculations in the form of a mandatory minimum haircuts.

The FSB is also considering the use of haircuts to control the build-up of leverage, in a manner similar to the use of reserve requirements in a fractional banking system. The recommendations set out appropriate methodological approaches to calculating haircuts, and various adjustments and additional risk factors to be taken into account. These approaches do indeed reflect best practice in the market, noted the report, at least where haircuts are being applied, although some further risk factors have been identified for consideration. However, haircut practices vary very widely in the European market and the need for haircuts is not accepted in low-risk transactions such as short-term interdealer repos of government securities. The role of haircuts reflects the fact that collateral is considered secondary in importance in risk management to counterparty credit risk.

Another recommendation makes the case for mandatory minimum haircuts for collateral that exhibits material pro-cyclicality. The FSB recognizes the possible unintended consequences for market liquidity and efficiency, and asks for comments on whether mandatory minimum haircuts would be effective and workable.

The European Parliament welcomes the intention to introduce minimum standards for the methodologies for the calculation of collateral haircuts, adding that the detail of the proposal accords with best practice in the market. However, better market data will be required to support such calculations. This should become available through initiatives to improve market transparency; but the market should process such data into risk statistics to avoid the perception of official approval.

Financial Stability Board proposes guidance for resolution regimes and principles for information sharing

The Financial Stability Board has proposed guidance outlining the key attributes for effective resolution regimes, such as those represented by Title II of the Dodd-Frank Act and the proposed E.U. Recovery and Resolution Directive. The proposed guidance focuses on resolution regimes for hedge funds, securities firms, central counterparties and other non-bank significant financial institutions and financial market infrastructures. The proposed key attributes set out the core elements considered necessary to make feasible the resolution of financial institutions without severe systemic disruption and without exposing the taxpayers to loss. They constitute an umbrella standard that applies for all parts of the financial sector that could cause systemic problems. The FSB also proposed principles governing information sharing for resolution purposes.

FSB Chair Mark Carney, also Governor of the Bank of England, said that the draft guidance on the resolution of non-bank financial institutions represents further significant progress in international efforts to develop the powers and tools that authorities need to manage the failure of any type of systemic institution without taxpayers bearing the costs. He noted that resolution of firms from other financial sectors has lagged behind the progress made in relation to banks. Further, in light of the move towards mandatory clearing of OTC derivatives, the Chair said that robust resolution regimes for central counterparties are particularly important to ensure that greater reliance on central counterparties does not result in a new category of TBTF institution.

In the wake of the global financial crisis, the FSB has been established, and has a mandate from the G-20, to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory policies in the interest of financial stability.

Client assets. A key attribute is that effective resolution regimes should allow for the rapid return of segregated client assets. The legal framework governing the segregation of client assets should be transparent and enforceable during a crisis or resolution of firms and should not hamper the effective implementation of resolution measures Given the significant variations in national regimes for client asset protection, the draft guidance is intended to specify outcomes rather than prescribe methods or mandatory rules by which those outcomes should be achieved. Whatever national arrangements apply, client assets should be shielded from the failure of the firm and, to the extent possible, of any third party custodian. The legal status of client assets and the clients’ entitlement to them should not be affected by entry into resolution of the firm.

Financial market infrastructures. The key attributes are also calibrated to apply to the resolution of components of the financial market infrastructure, which are defined to include payment systems, central securities depositories, securities settlement systems, central counterparties and trade repositories. The presumption is that all financial market infrastructures are systemically important or critical, at least in the jurisdiction where they are located, typically because of their critical roles in the markets they serve. However, the presumption is rebuttable. Thus, authorities may determine that a financial market infrastructure in its jurisdiction is not systemically important or critical and, therefore, not subject to the key attributes.

Generally, an effective resolution regime for financial market infrastructures should pursue financial stability and allow for the continuity of critical functions without exposing taxpayers to loss. From the point at which a financial market infrastructure enters resolution pending the restoration of its ability to perform those functions as a going concern, their performance by a successor to the financial market infrastructure or their performance through an alternative mechanism, the use of resolution powers should aim to achieve continuity of critical functions, including, continuity and timely completion of critical payment, clearing, settlement and recording functions, as well as the timely settlement of obligations.

The resolution of a financial market infrastructure may be carried out by the resolution authority directly or through a special administrator, conservator, receiver or other official with similar functions. The resolution authority or an appointed administrator, conservator, receiver or similar official should have the power and the capacity to ensure the continued provision of critical functions in resolution and to fulfill the payment and settlement obligations on time.

Information sharing for resolution purposes. The FSB also proposed principles for the design of national legal gateways and confidentiality regimes to allow the sharing of non-public information between domestic and foreign authorities that is necessary for planning and carrying out resolution. The principles also include the provisions on information sharing and confidentiality that should be included in the institution-specific cross-border cooperation agreements that are required for all global systemically important financial institutions by the key attributes.

Paul Tucker, Deputy Governor of the Bank of England and Chair of the FSB Resolution Steering Group, said that the lack of information sharing is one of the key obstacles authorities face when preparing for and dealing with a crisis. Unless authorities are legally permitted and positively willing to share firm-specific non-public information, he noted, both within jurisdictions and across borders, and to protect its confidentiality, they will not be able to cooperate effectively in a crisis, nor will they be able to plan together effectively. In that spirit, the draft guidance aims to ensure that information-sharing and confidentiality regimes are fit for purpose and truly used in practice.

Under the principles, jurisdictions should ensure that their legal framework establishes clear legal gateways authorizing national authorities to disclose information in a timely fashion to other domestic and foreign authorities with functions relating to resolution where that information is necessary for the receiving authority to carry out functions relating to the resolution of the firm to which the information relates. The term legal gateways refers to provisions set out in statute or other instruments with the force of law that enable the disclosure of non-public information to specified recipients or for specified purposes. Legal gateways may be contingent on, or supported by, memoranda of understanding or other forms of agreement between the providing and recipient authorities

Jurisdictions should also ensure that their legal framework establishes a regime for the protection of confidential information that imposes adequate confidentiality requirements on authorities and their current and former employees and agents that receive confidential information, and provides for effective sanctions and penalties for breach of confidentiality requirements.

The legal gateways should permit authorities that do not have functions relating to resolution, such as purely supervisory authorities, to disclose information to domestic and foreign authorities where that information is necessary for the recipient authority to carry out functions relating to resolution. More granularly, they should permit commercially and legally sensitive information, such as information relating to customers or the counterparties of a firm, to be disclosed to domestic and foreign authorities if it is necessary for the recipient authority to carry out functions relating to resolution.

Disclosure under those legal gateways should always be conditional on the recipient authority being subject to adequate confidentiality requirements and safeguards that are appropriate to the nature of the information and the level of sensitivity.

The legal framework should be clear about the conditions under which information received from a foreign authority may be disclosed to another domestic or foreign authority for resolution-related purposes. The legal framework should protect the authorities and their current and former employees and agents against criminal and civil actions for breach of confidentiality based on the disclosure of information if the disclosure was made in accordance with the legal gateways, including any applicable conditions or safeguards.

Where legal gateways are conditional on reciprocity, meaning that disclosure of information is only permitted if the jurisdiction of the recipient authority has comparable gateways that permit disclosure to the jurisdiction of the providing authority, the legal framework should set out clear criteria and procedures for determining comparability. Legal gateways should not prevent or restrict the reasonable and effective use of information by a recipient authority. Rather, the legal gateways should be sufficient to permit disclosure to authorities for the purposes of the full range of resolution-related purposes with regard to a firm, including the assessment of resolvability; the development of resolution strategies; the development of recovery plans and operational resolution plans; early detection of financial stress; and, more generally, the exercise of resolution powers.

In letter to SEC and CFTC Chairs, U.S. Senators Urge Closing of Swaps Loophole in Dodd-Frank Rulemaking Proposals

In a letter to the SEC and CFTC, eight U.S. Senators urged the Commissions not to allow a U.S.-based financial firm to escape U.S.-mandated swaps oversight simply because its swaps trading is conducted through an offshore affiliate or branch. If the current SEC and CFTC proposals are adopted, warned the senators, U.S. financial firms could easily arrange their affairs to produce that outcome. The letter, which was addressed to CFTC Chair Gary Gensler and SEC Chair Mary Jo White, was signed by Senators Jeff Merkley (D-OR), Carl Levin (D-MI), Tom Harkin (D-IA), Elizabeth Warren (D-MA), Jeanne Shaheen (D-NH), Barbara Boxer (D-CA), Richard Blumenthal (D-CT), and Dianne Feinstein (D-CA).

If the current proposals are adopted, they noted, foreign firms doing business with the foreign affiliate of a U.S.-based derivatives dealer would likely opt to forego an express guarantee from the U.S.-based entity in return for more favorable pricing and the ability to avoid U.S. trading regulations and any attendant costs. If those arrangements were to become widespread, feared the senators, Title VII of Dodd-Frank would be rendered inapplicable to that derivatives trading activity, at the same time placing U.S,. businesses at a competitive disadvantage to their foreign counterparts. Some proposals also appear to allow swaps between U.S. guaranteed foreign affiliates and some non-U.S. persons to be outside U.S.-mandated oversight, including the doctrine of substituted compliance. The senators emphasized that this would be unacceptable for the same reasons. Regulating conduits to capture these risks is important, said the senators, but is ultimately insufficient.

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

The senators reminded the SEC and CFTC that they have a statutory obligation to ensure that the liabilities of unregulated, risky foreign swaps trading truly cannot flow back to the U.S. To achieve that goal, it is important to understand the contexts in which these issues of liability would likely arise. For example, the liabilities of an offshore affiliate may come back to the U.S.-based entity if a foreign court, following foreign law, were to determine that the U.S.-based entity is liable. It could also happen under U.S. law, if a U.S. court were to elect to pierce the corporate veil, and find that the U.S.-based entity is liable for the actions of its affiliate.

The senators explained that another way the liabilities may come back to the U.S.-based entity is if the U.S.-based entity is placed under market pressure into effectively guaranteeing the liabilities of an offshore affiliate. Protecting the firm’s reputation and customer base has proven to be a powerful motivator when a U.S. parent has been asked to stand behind its affiliates.

This pressure to absorb liabilities of an offshore affiliate may be particularly acute if the U.S.-based entity and the foreign entity share a common name or valued customers or counterparties; if the entities have a business reliance on one another for an essential business or service; if the entities share employees or executives; or if the counterparties to the foreign entity believe that the U.S.-based entity is likely to bail out the liabilities of the foreign entity or press it to do so

The senators urged the SEC and CFTC to revise their proposals to apply U.S. oversight and regulation to offshore affiliates and branches of U.S.-based firms whose liabilities could flow back to the United States. They allowed that in appropriate limited circumstances the doctrine of substituted compliance may stand in for direct U.S. supervision.

House FSC Chair explains PATH Act in key address, commends Corker-Warner Effort

In a key address on the PATH Act, House Financial Services Chair Jeb Hensarling (R-TX) explained that the Protecting American Taxpayers and Homeowners (PATH) Act principally relies upon private capital and market discipline and includes four fundamental goals essential to the development of any free market. First, the role of government is clearly defined and limited. Second, artificial barriers to private capital are removed to attract investment and encourage innovation. Third, market participants are given clear, transparent, and enforceable rules for transactions to foster competition and restore market discipline. Fourth, consumers are afforded informed choices in determining which mortgage products best suit their needs.

Chairman Hensarling said that the reform legislation introduced by Senators Mark Warner (D-VA) and Bob Corker (R-TN) is an important element in the debate. He commended Senator Corker and Senator Warner for their leadership. As someone who has worked for years on the complicated and contentious issue of housing finance reform, Chairman Hensarling salutes anyone who works hard and produces an actual plan. The Corker-Warner legislation, the Housing Finance Reform and Taxpayer Protection Act, S. 1217, would, among other things, create the Federal Mortgage Insurance Corporation (FMIC) as an independent federal agency to capitalize the housing finance system by separating credit risk from interest rate risk, and bringing in private capital to take on both.

Specifically, continued Chairman Hensarling, the PATH Act would end the costly Fannie Mae and Freddie Mac bailout; protect and restore the FHA by defining its mission; increase mortgage competition; enhance transparency and maximize consumer choice; and break down barriers for private investment capital. At the end of the day, noted the FSC Chair, the best arguments for perpetuating the GSEs are that they were standards-setters through their underwriting purchase requirements and also provided a conduit for smaller originators to access mortgage investors through the issuance of mortgage-backed securities.

According to Chairman Hensarling, these are indeed functions worth preserving in some form in a new regime. Thus, the PATH Act ushers in a new system of housing finance that separates out these functions, providing clear and transparent disclosure of mortgage data, giving certainty to contracts and their enforceability, utilizing the knowledge and networks of the Federal Home Loan Bank system, and creating an open-access utility for the issuance of mortgage-backed securities that is decoupled from the holding of long-term mortgage risks.

To ensure a smooth transition to the new system, he noted, the PATH Act implements several reforms to Fannie and Freddie in the interim. These reforms include repealing their affordable housing goals that helped precipitate the crisis; shrinking their portfolios of mortgage-backed securities and other assets; and eliminating their government-granted competitive advantages over the private sector.

Covered bond regime. The PATH Act also allows for a new-but-old method for financing mortgage lending by creating a regulatory framework for covered bonds financing. The Chair referred to a U.S. covered bond regime as ``new-but-old’’ because covered bonds have existed and been successfully used in Europe for more than 200 years, where they offer a third path to mortgage financing beyond traditional portfolio lending or securitization.

Covered bonds help to resolve some of the difficulties associated with the originate-to-distribute model of securitization. The on-balance-sheet nature of covered bonds means that issuers are exposed to the credit quality of the underlying assets, a feature that better aligns the incentives of investors and mortgage lenders than does the originate-to-distribute model of mortgage securitization. The cover pool assets are typically actively managed, thereby ensuring that high-quality assets are in the cover pool at all times and providing a mechanism for loan modifications and workouts. Also, the structure used for such bonds tends to be fairly simple and transparent.

Covered bonds have been used in Europe to help provide additional funding options for the issuing institutions and are a major source of liquidity for many European nations’ mortgage markets. The House legislation is a thorough framework that seeks to provide the same benefits to the U.S. market According to an earlier FDIC policy statement, covered bonds originated in Europe, where they are subject to extensive regulation designed to protect the interests of covered bond investors from the risks of insolvency of the issuer. By contrast, the U.S. does not currently have the extensive statutory and regulatory regime designed to protect the interests of covered bond investors that exists in European countries.

Saturday, August 17, 2013

ESMA Proposes to Delay Reporting Date for Exchange-Traded Derivatives

The European Securities and Markets Authority (ESMA) has asked the European Commission to allow for a later start date for reporting of exchange-traded derivatives trades to trade repositories. In a letter to the Commission, ESMA Executive Director Verena Ross proposed rescheduling the reporting start date for exchange-traded derivatives from January 2014 to January 2015 so that ESMA can provide additional guidance on this complex subject. ESMA is acting under Article 9 of the European Market Infrastructure Regulation (EMIR) to develop draft implementing standards.

Currently, ESMA is working on ensuring the consistent application of EMIR and its regulatory standards and implementing standards. The implementation work has revealed to ESMA the complexity of the reporting of trades subject to the rules of a trading venue and executed in compliance with those rules, including the processing by the trading venue after execution and the clearing by a central counterparty within one working day of execution.

The current reporting start dates to trade repositories contained in the implementing standards do not distinguish the methods of trading OTC derivatives and exchange-traded derivatives. ESMA believes that such specification would be necessary as there is otherwise a material risk that reporting of exchange-traded derivatives would not be harmonized. Thus, there is a need for further guidance to be issued. Without further guidance, exchange-traded derivatives reporting would neither be consistent nor would it serve the purposes for which it was conceived.

In this respect, ESMA proposes to develop guidelines and provide sufficient time for stakeholders to implement them. ESMA believes the guidelines are needed for a variety of reasons, including to clearly identify the counterparties of exchange-traded derivatives and to achieve consistent application of reporting requirements under EMIR and the Markets in Financial Instruments Directive (MiFID), to the extent possible.

The main obligations under EMIR are central clearing for certain classes of OTC derivatives; application of risk mitigation techniques for non-centrally cleared OTC derivatives; reporting to trade repositories; application of organizational, conduct of business and prudential requirements for central counterparties; application of requirements for trade repositories, including the duty to make certain data available to the authorities.

Federal Appeals Panel Rules Private Equity Fund Not Passive Investor in Bankrupt Company

A First Circuit panel ruled that a private equity fund was not a passive investor in, but sufficiently operated, managed, and was advantaged by its relationship with, a company that went bankrupt. The fund’s controlling stake in the company placed it in a position where it was intimately involved in the management and operation of the company. The case presented important issues of first impression as to withdrawal liability for the pro rata share of unfunded vested benefits to a multiemployer pension fund of a bankrupt company. (Sun Capital Partners III, LP, et al. v. New England Teamsters & Trucking Industry Pension Fund, CA-1, No. 12-2312, July 24, 2013).

The fund argued that it cannot be a trade or business within the meaning of ERISA because that would be inconsistent with two Supreme Court decisions, Higgins v. Commissioner of Internal Revenue, 312 U.S. 212 (1941), and Whipple v. Commissioner of Internal Revenue, 373 U.S. 193 (1963) which interpreted that phrase. The fund contended that cases interpreting the phrase "trade or business" as used anywhere in the Internal Revenue Code are binding because Congress intended for that phrase to be a term of art with a consistent meaning across uses. But the appeals court rejected the proposition that, apart from the provisions covered by 26 U.S.C. § 414(c), interpretations of other provisions of the Internal Revenue Code are determinative of the issue of whether an entity is a "trade or business" under ERISA. The panel cited a Third Circuit opinion explaining that a term used for tax purposes does not have to have the same meaning for purposes of a pension fund plan.

The fund also made a policy argument that Congress never intended such a result in the control group provision in ERISA because the purpose of that provision is to prevent an employer from circumventing ERISA obligations by divvying up its business operations into separate entities. It is not, said the fund, intended to reach owners of a business so as to require them to dig into their own pockets to pay withdrawal liability for a company they own.

These are fine lines, remarked the court, adding that the various arrangements and entities meant precisely to shield the fund from liability may be viewed as an attempt to divvy up operations to avoid ERISA obligations. The panel recognized that Congress may wish to encourage investment in distressed companies by curtailing the risk to investors in such employers of acquiring ERISA withdrawal liability. If so, however, Congress has not been explicit, and it may prefer instead to rely on the usual pricing mechanism in the private market for assumption of risk.

Thursday, August 15, 2013

House Financial Services Committee Hearing Examines Dodd-Frank Orderly Liquidation Authority and TBTF

Congress is not nearly done examining the contentious question of whether the Dodd-Frank Act ended too big to fail. At a hearing during the First Session of the 113th Congress held before the August recess examining Titles I and II of the Dodd-Frank Act and the attendant orderly liquidation authority for systemically important financial institutions, House Financial Services Committee Chair Jeb Hensarling (R-TX) said that there is a growing consensus that Dodd-Frank did not end too big to fail (TBTF) as applied to large, complex financial firms. Indeed, he noted that the Dodd-Frank Act codifies the TBTF doctrine. In this regard, he pointed to Section 113 of Dodd-Frank, which authorizes the Financial Stability Oversight Council to designate financial firms as systemically important financial institutions. In essence, said Chairman Hensarling, by designating a financial firm as a systemically important financial institution, the FSOC is designating the firm as TBTF.

The Committee’s Ranking Member, Rep. Maxine Waters (D-CA), noted that Title II of Dodd-Frank includes provisions that are supposed to prevent taxpayer-funded bail-outs. She pointed to Section 214(a), which provides that no taxpayer funds may be used to prevent the liquidation of any financial company under Title II. Section 214(b) requires that all funds expended in the liquidation of a covered financial company be recovered from the disposition of assets or through assessments on the financial sector. Section 214(c) provides that taxpayers shall bear no losses from the exercise of any authority under Title II.

Rep. Mick Mulvaney (R-SC) said that, despite Section 214, it appears that taxpayer funds could still be used in a Title II orderly liquidation. Asked by Rep. Mulvaney for his view, Dallas Fed President Richard Fisher noted that, if the reorganized firm cannot repay the Treasury for its debtor-in-possession financing, Section 214 says that the repayment should be clawed back via a special assessment on the company’s SIFI competitors. Since that assessment is then written off as a tax-deductible business expense by the assessed firm, thereby reducing revenue to the Treasury, Mr. Fisher contends that it is at taxpayer expense.

Rep. Patrick McHenry (R-NC) flatly stated that the Dodd-Frank Act did not end TBTF. He also noted that the FSOC has not identified new risks to the economy and the Federal Reserve Board has not made public how it would employ its new authorities to prevent a financial crisis. He also pointed out that the DOJ is reluctant to prosecute large financial institutions.

Rep. Carolyn Maloney (D-NY) emphasized that Dodd-Frank properly gave regulators a third option outside the previous binary choice for a failed financial firm of bankruptcy or a taxpayer bailout. This third option is the orderly liquidation authority in Title II, allowing the FDIC to wind down large financial firms.

Dodd-Frank and TBTF. In his testimony, Mr. Fisher argued that the Dodd–Frank Act, despite its best intentions, imposes a prohibitive cost burden on the non-TBTF financial institutions and needs to be amended. As soon as a financial institution is designated systemically important as required under Title I of Dodd–Frank, he noted, it is viewed by the market as being the first to be saved by the first responders in a financial crisis. In other words, said the Dallas Fed leader, these SIFIs occupy a privileged space in the financial system

In reality, rather than fulfill Dodd–Frank’s promise of no more taxpayer-funded bailouts, the Treasury will likely provide, through the FDIC, debtor-in-possession financing to the failed companies, he continued, thereby artificially keeping alive operating subsidiaries for up to five years, and perhaps longer. Under the single point of entry method being espoused by Treasury, the operating subsidiaries remain protected as the holding company is restructured. President Fisher described Title II of Dodd–Frank as a disguised form of taxpayer bailout that promotes and sustains an unnatural longevity for zombie financial institutions.

Dallas Fed Reform Proposal. The Dallas Fed has a three-prong reform proposal to address the situation. First,  roll back the federal safety net of deposit insurance and the Federal Reserve’s discount window to where it was always intended to be, that is, to traditional commercial bank deposit and lending intermediation and payment system functions. Thus, the safety net would only be available to traditional commercial banks and not to the nonbank affiliates of bank holding companies or the parent companies themselves.

Second, customers, creditors and counterparties of all nonbank affiliates and the parent holding companies would sign a simple, legally binding, unambiguous disclosure acknowledging and accepting that there is no government guarantee backstopping their investment. Third, the largest financial holding companies would be restructured so that every one of their corporate entities is subject to a speedy bankruptcy process.

Former FDIC Chair Bair. In her testimony, former FDIC Chair Shelia Bair strongly disagreed with the notion that Title II’s orderly liquidation authority enshrines the government bailout policies of 2008 and 2009. Dodd-Frank has abolished the implicit and explicit TBTF policies that were in effect before its enactment. To the extent that TBTF remains, she noted, it is because regulators have more work to do to ensure that financial firms go into orderly liquidation if they do fail and because markets continue to question whether government will follow through on Title II and allow a systemically important firm to fail.

There are some things that could be done to improve the orderly liquidation process, said the former FDIC Chair. For example, regulators should ensure that large, complex financial institutions have sufficient long-term debt at the holding company level. The success of an orderly liquidation authority using the Treasury’s single point of entry approach depends on the top level holding company’s ability to absorb losses and fund recapitalization of the surviving operating entities,   reasoned the former FDIC head. Currently, nothing requires that firms hold sufficient senior debt to meet this need.

FDIC Vice Chair Hoenig. In his testimony, FDIC Vice Chair Thomas Hoenig expressed concern that government support of large financial institutions, combined with their outsized impact on the broader economy, gives them important advantages and encourages them to take on ever-greater degrees of risk. Short-term depositors and creditors continue to look to governments to assure repayment, he noted, rather than to the strength of the firms' balance sheets and capital. As a result, these companies are able to borrow more at lower costs than they otherwise could, and thus they are able increase their leverage far beyond what the market would otherwise permit. Their relative lower cost of capital also enables them to price their products more favorably than firms outside of the safety net can do. These advantages translate into a subsidy that represents a sizable competitive advantage and which leads to a more concentrated industry.

The FDIC official noted that the Dodd-Frank Act was intended to address the build-up of systemic risk and, if necessary, the management of its fallout on the economy. However, there remain systemically important financial firms that are of a size and complexity that would expose the broader economy to overwhelming consequences should they encounter problems. The Dodd-Frank Act does not change the fundamental incentive of the safety net's subsidy, he said, which continues to encourage these firms to leverage and take on excessive risk for higher returns. As long as the subsidy exists, there will be highly leveraged, highly vulnerable institutions that will negatively impact the national economy.

SEC Chair Responds to Concerns of House Leaders Around Rulemaking Implementing JOBS Act Lifting of Ban on General Solicitation under Regulation D

Responding to the concerns of House oversight leaders, SEC Chair Mary Jo White said that issuers and market participants can use the new Rule 506(c) exemption permitting general solicitation once it becomes effective on September 23, 2013 as long as they comply with the conditions of that exemption. In a letter to Rep. Patrick McHenry (R-NC), Chair of the House Oversight and Investigations Subcommittee, Chairman White also assured that issuers are not required to comply with any aspect of the Commission's July 10th rule proposal set forth concomitantly with the adoption of the exemption until such time as the SEC may approve a final rule and such rule becomes effective. Should the Commission ultimately decide to adopt final rules, the Chair expects that these rules would consider the need for transitional guidance for ongoing offerings that commenced before the effective date of any final rules, as it did when it adopted the Rule 506(c) exemption.

On July 10, the SEC adopted regulations implementing Title II of the JOBS Act to end the ban on general solicitation under Rule 506 of Regulation D. Concomitant with the adoption of regulations lifting the general solicitation ban, the Commission proposed rules intended to enhance its ability to assess developments in the private placement market now that the rule to lift the ban on general solicitation has been adopted.

Specifically, under the proposal, issuers that intend to engage in general solicitation as part of a Rule 506 offering would, in addition to the current requirements, be required to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. In their letter to the SEC, Rep. McHenry and Rep. Scott Garrett (R-N.J.), Chairman of the Subcommittee on Capital Markets, said that the rule proposals unnecessarily burden private issuers by increasing regulations and disclosure requirements that effectively preserve the ban on general solicitation. They reasoned that, since Title II of the JOBS Act lifted the ban on general solicitation for Regulation D Rule 506 offerings to accredited investors, the proposed Form D filing requirements would effectively violate Title II.

In her response, Chairman White pointed out that the JOBS Act required a significant change in the Rule 506 marketplace by mandating that the Commission eliminate the ban on general solicitation in Rule 506 securities offerings. She reaffirmed her statement at the open meeting that the Commission had a responsibility to implement this Congressional mandate expeditiously, while at the same time closely monitoring and collecting data on the changes to the Rule 506 market to assess whether non-accredited investors are participating in this market, to observe the practices that issuers and market participants are using, and to evaluate whether the changes are creating new capital raising opportunities, and assess whether and to what extent the changes in the private offering market lead to additional fraud. The proposal is designed to provide the Commission with additional tools to assist in this effort.

In their letter to the Chair, the House leaders asked the Commission to modify certain aspects of this proposal or withdraw it entirely. With the comment period on the proposal underway, noted Chairman White, it would be premature to discuss the actions that the Commission may take with respect to the proposal generally or any specific aspect of it. The Administrative Procedure Act requires the Commission to give the public an opportunity to comment on a rule proposal for a period of time after it is published. The Commission is very interested in reviewing the comments that it receives on the proposal, said the SEC chief, adding that that the SEC will also give very careful consideration to the views of the House oversight chairs. Further, Chairman White pledged that any final rule is adopted will include a robust economic analysis, including consideration of the cost and benefits of the regulation.

The House leaders also requested information about staff time and related expenses dedicated to the Commission's rule proposal. Chairman White responded that the staff estimates that approximately 3,538 staff hours were spent on the proposal at an estimated labor cost of approximately $315,574. The labor cost reflects salary, but does not include other components of the Commission's labor cost, such as healthcare and other benefits.

Given that the rule proposal was part of a group of Rule 506-related rulemakings considered by the Commission on the same day, noted Ms. White, it was difficult for staff to isolate the time spent working on each of the rulemakings. Thus, she cautioned that, while the staff attempted to be as comprehensive as possible, some of the estimates may be overstated or understated.

In addition, the estimates do not include time spent by the Commissioners and their staff reviewing and considering the proposal, and do not include time by staff providing administrative support in connection with the proposals. In addition, the estimates do not include time spent either before or after the adoption of the JOBS Act in connection with the consideration of matters relating to the regulatory approach to lifting the restriction on general solicitation.

Normally, related Chairman White, staff do not track and record their time by specific project and, as a result, this information cannot be generated automatically from existing records. Nonetheless, the staff gathered certain information in an effort to provide the House oversight chairs with an estimate of the staff time spent on this project. To create the estimate, the Commission asked staff who worked on the rule proposal to provide their best estimates of their time spent on it. These staff estimates were based on the recollections of individuals of the approximate hours spent working on the proposal.

In addition, the time recorded in connection with this response only includes the time spent on the specific proposal considered and approved by the Commission on July 10, 2013. It does not include time spent either before or after the adoption of the JOBS Act in connection with the consideration of matters relating to the regulatory approach to lifting the restriction on general solicitation.

Wednesday, August 14, 2013

New OIRA Administrator to Conduct Retrospective Review of Federal Regulations

Howard Shelanski, the new Administrator of the Office of Information and Regulatory Affairs, said that his Office will launch a regulatory retrospective review, or look back, initiative to identify outdated and unnecessary federal regulations. While it is the job of OIRA to review federal agency regulations before they are issued, he noted, some regulations that were well crafted when first issued can become unnecessary over time as conditions change. Regulations that are not providing real benefits to society need to be streamlined, modified, or repealed. No one should be filing paperwork just for the sake of filing paperwork, he emphasized.

According to the OIRA chief, review of existing regulations is a crucial part of ensuring that protecting the nation’s health, safety, and environment remains consistent with creating jobs and prosperity. He pledged that this Administration will expand and institutionalize regulatory look back efforts to ensure the identification of rules that need to be modified, streamlined, or repealed. His Office wants and will carefully consider ideas and input from the public as it make these regulatory changes.

The initiative is in line with President Obama January 2011 Executive Order that called on federal agencies to streamline, modify, or repeal regulations on the books that impose unnecessary burdens or costs. The President has followed up with additional orders asking federal agencies to report regularly on their progress in reviewing existing rules, and asking independent federal agencies to perform a similar review of regulations on their books.

The look back initiative was presaged at Mr. Shelanki’s nomination hearing before the Senate Homeland Security and Governmental Affairs Committee. Asked by Committee Chairman Tom Carper (D-DE) to list his top priorities as OIRA Administrator, among the three priorities he listed was that OIRA would conduct retrospective reviews and look backs of adopted regulations even as the Office moves forward with new regulations. OIRA will look back to ensure that the regulations already on the books are not overly burdensome and are doing what they were intended to do. The Administrator added that, regarding retrospective review, the primary duty is with the agency heads since they best know their regulations. To Chairman Carper’s query if such retrospective review will be ongoing, he replied that it would be.

Executive orders. President Obama issued two significant Executive Orders on the federal regulatory process during his first term: Executive Order No. 13563, 76 Fed. Reg. 3,821 (Jan. 21, 2011) and Executive Order No. 13579, 76 Fed. Reg. 41,587 (July 14, 2011). EO No. 13563 set out general requirements directed to executive agencies concerning public participation, integration and innovation, flexible approaches, and science. It also reaffirmed that executive agencies should conduct a cost-benefit analysis of regulations. EO No. 13579 states that independent regulatory agencies should follow EO No. 13563. At his conformation hearing, Mr. Shelanski assured the Senate that he would faithfully follow these Executive Orders.

Monday, August 12, 2013

UK Audit Overseer Updates Guidance for Audits of Financial Instruments

The U.K.’s oversight authority for accounting and auditing issued updated guidance for the outside financial audits of entities of all sizes that may be subject to the risks associated with using financial instruments. The Financial Reporting Council said that the guidance is designed to enhance investor confidence in the depth and reliability of the audit of financial statements. Nick Land, FRC Chair of the Audit and Assurance Council, noted that financial instruments is an area of financial reporting involving complex issues, which came under particular focus in the financial crisis. The updated guidance is intended to assist auditors in understanding the nature of, and risks associated with, financial instruments, the different valuation techniques and types of controls that may be used by entities in relation to them, and identifies the important audit considerations.

For a regulated firm in the financial sector, it may be appropriate for the auditor to discuss matters related to the firm’s use and disclosure of financial instruments directly with the regulator in bilateral and/or trilateral meetings (the latter involving representatives of the regulated firm. Here, the FCA referenced its July 2013 Code of Practice for the relationship between the external auditor and the regulator. The Code of Practice sets out principles that establish, in the context of a particular regulated firm, the nature of the relationship between the regulator and the auditor.

It may be appropriate for the auditor’s understanding of relevant industry and regulatory factors in accordance with ISA 315 to include inquiry of management as to whether there have been discussions with regulators during the year about its policies in respect of financial instruments, and whether management has reviewed its processes in the light of those discussions, for example if the regulator has expressed a view that the firm’s valuations appear out of line with those of other firms or are not sufficiently prudent. The auditor should review any relevant correspondence with regulators.

The FRC guidance also noted that the application of professional skepticism is required in all circumstances and the need for professional skepticism increases with the complexity of financial instruments, for example with regard to evaluating whether sufficient appropriate audit evidence has been obtained. Thus can be particularly challenging when models are used in determining the fair value of a financial instrument or in determining if markets are inactive.

There should also be heightened professional skepticism when the auditor evaluates management judgments, and the potential for management bias, in applying the firm’s applicable financial reporting framework, in particular management’s choice of valuation techniques, use of assumptions in valuation techniques, and addressing circumstances in which the auditor’s judgments and management’s judgments differ. Professional skepticism also comes into play when drawing conclusions based on the audit evidence obtained, for example assessing the reasonableness of valuations prepared by management’s experts and evaluating whether disclosures in the financial statements achieve fair presentation.

In any event, continued the guidance, evaluating audit evidence for assertions about some financial instruments requires considerable judgment because the assertions, especially those about valuation, may be based on highly subjective assumptions or be particularly sensitive to changes in the underlying assumptions. For example, valuation assertions may be based on assumptions about the occurrence of future events for which expectations are difficult to develop or about conditions expected to exist a long time. Accordingly, competent persons could reach different conclusions about valuation estimates or estimates of valuation ranges. Considerable judgment also may be required in evaluating audit evidence for assertions based on features of the financial instrument and applicable accounting principles, including underlying criteria, that are both extremely complex

A firm’s policies for accounting for financial instruments must take into account the different purposes for which they can be transacted, such as trading, hedging or investment. Relevant accounting standards may be under review and entities need to monitor developments to ensure the correct accounting requirements, including possible transitional arrangements, are complied with. Having regard to disclosure requirements is important as they can play a key role in making the levels of holdings of financial instruments, their purpose and the underlying risk profile transparent

A key consideration in audits involving financial instruments, particularly complex financial instruments, is the competence of the auditor. International audit standards require the audit engagement partner to be satisfied that the engagement team, and any auditor’s experts who are not part of the engagement team, collectively have the appropriate competence and capabilities to perform the audit engagement in accordance with professional standards and applicable legal and regulatory requirements and to enable an auditor’s report that is appropriate in the circumstances to be issued.

Use of Experts. The guidance recognizes that auditing financial instruments may require the involvement of one or more experts or specialists to assist in understanding the operating characteristics and risk profile of the industry in which the company operates and in understanding the business rationale for the particular financial instruments used by the firm, the related risks and how they are managed.

Senate Legislation Would Repeal Anti-Privacy Provisions of FATCA

Senator Rand Paul (R-KY) introduced legislation, S. 887, to repeal the anti-privacy provisions of the Foreign Account Tax Compliance Act (FATCA), which, in his view, infringe upon basic constitutional rights. He pointed out that, under FATCA, private data of anyone considered a U.S. Person under FATCA would have details of their financial assets provided to the IRS without a warrant requirement, suspicious activity report (SAR), or any allegation of wrongdoing.

FATCA would require every non-U.S financial institution, such as banks, credit unions, pension funds, stock and investment firms, to register directly with the IRS and agree to provide specified financial data on the accounts of any U.S. Person.

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

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.

The U.S. Treasury has entered into intergovernmental agreements 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.

Senator Paul is troubled that the implementation of FATCA has allowed the Treasury Department to make independent decisions with respect to the sovereignty of foreign nations and the privacy of United States citizens. In order to implement FATCA, Treasury has initiated intergovernmental agreements, citing the intent to engage in reciprocal information sharing with other nations. Senator Paul believes that the Treasury Department, without the consent and authority of Congress, will force U.S. financial institutions to provide the bank account information of private customers to foreign nations. In his view, FATCA violates important privacy protections, disregards the sovereign laws of other nations and will cost the U.S. economy hundreds of billions of dollars in compliance costs.

Council of Institutional Investors Endorses Comply or Explain Approach to Audit Firm Rotation

At a time when audit oversight authorities and policymakers are considering mandatory audit firm rotation, the Council of Institutional Investors took a comply or explain approach to the issue. The CII revised its corporate governance policy on auditor independence to require company boards that retain the independent outside auditor of the company’s financial statements beyond ten years to explain why doing so is in the best interest of the company’s shareholders. As with any other comply or explain provision, the explanation should be fact-specific and meaningful; and should avoid  boilerplate.

The CII also adopted a best practice standard calling on audit committees of public companies to consider several factors when deciding whether to retain their external auditor. The CII emphasized that both the audit committee and the auditor should recognize the principle that investors are the customers and end users of financial statements in the public capital markets.

Among the factors the audit committee should consider in deciding whether to retain the external auditor are inspection results and fines levied by the Public Company Accounting Oversight Board or other regulators and the quality and frequency of communication from the auditor to the audit committee. Another key factor to consider is the availability of a replacement for the existing auditor with the requisite experience and staffing required by professional standards to perform a quality audit.

Other factors that should be considered are the auditor’s tenure as independent auditor of the company, the directors’ relationships with the auditor, and the proportion of total fees attributable to non-audit services, and a determination of why these services could not have been provided by another party to safeguard the auditor’s independence.

Importantly, the audit committee should also consider the expertise and professional skepticism of the audit partner, manager and senior personnel assigned to the audit, and the extent of their involvement in performing the audit, as well as the incidence and circumstances surrounding the reporting of a material weakness in internal controls by the auditor. 

Friday, August 09, 2013

House Legislation Would Provide Exemption for Brokers Assisting Private M&A Activities

House legislature has been introduced to provide for a notice-filing registration procedure for brokers performing services in connection with the transfer of ownership of smaller privately held companies and to provide for regulation appropriate to the limited scope of the activities of such brokers. Sponsored by Rep. Bill Huizenga (R-Mich), the Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act, HR 2274,  is designed to scale federal regulation of securities broker-dealers with respect to privately negotiated business sales, mergers, and acquisitions.

At a recent hearing on capital formation conducted by the House Capital Markets Subcommittee, Rep. Huizenga noted that an SEC working group has been studying this issue for a number of ways, but the Commission has not moved with recommendations. Thus, Rep. Huizenga concluded that a legislative tool is needed.

H.R. 2274 would add a new subsection to Section 15 of the Exchange Act, which governs broker-dealer registration, to reduce the regulatory costs incurred by sellers and buyers of small and midsized privately held companies for professional business brokerage services, while enhancing their protection through well defined, appropriately scaled, and cost effective federal securities regulation. The legislation would direct the SEC to create a simplified system of registration through a public notice filing, publicly available on the SEC’s website, and would require appropriate client disclosures, pertaining to M&A brokers and their associates. The legislation would also direct the SEC to tailor its rules governing M&A brokers in light of the limited scope of their activities, the nature of privately negotiated M&A transactions, and the active involvement of buyers and sellers in those transactions.

In testimony at the hearing Shane Hansen, Warner, Norcross & Judd, noted that H.R. 2274 would preserve important investor protections by allowing federal law to continue to control the capital, custody, margin, financial responsibility, recordkeeping, bonding, and financial or operational reporting requirements applicable to M&A brokers, tailored by the SEC to their circumstances. Statutory disqualifications would continue to apply. The SEC, in coordination with state securities regulators, would establish the content of the notice registration and disclosures, and could establish uniform and consistent standards of training, experience, competence, and qualifications for the associates of M&A brokers, presently prescribed by FINRA.

M&A brokers would be exempt from membership in and regulation by FINRA. Existing state securities laws would continue to apply. Being SEC-registered, an M&A broker could exchange client referrals with fully registered broker-dealers, noted Mr. Hansen thus better assuring that small business clients could be cost effectively served by appropriately regulated brokers. M&A brokers could not have custody of  the funds or securities exchanged by the parties. An M&A broker could not be involved in capital-raising beyond the context of M&A transactions and could not be engaged by an issuer in a public offering of its securities.
At the hearing, Mr. Hansen testified that the public policy considerations supporting H.R. 2274 began in 2005 with the American Bar Association, Business Law Section, Report and Recommendations of the Private Placement Broker-Dealer Task Force. A similar recommendation was made the next year in the Report of the Advisory Committee on Smaller Public Companies. Following the issuance of these independent reports, working drafts of proposed rules to accomplish these recommendations were developed by the Alliance of Merger & Acquisition Advisors with the support of the International Association of Business Brokers, and submitted to the SEC and NASAA in 2007 and 2008. A proposal to appropriately scale federal regulation of M&A intermediaries and business brokers has been among the top recommendation at the Government-Industry Forum on Small Business Capital Formation hosted by the SEC.

The SEC has been studying these issues, as acknowledged by former SEC Chairman Schapiro, but has not engaged in rulemaking. In December 2011, a bipartisan group of eight House members wrote to then SEC Chairman Schapiro asking about the status of the recommendations from past SEC-Government Small Business Capital Formation Forums. Chairman Schapiro’s response of Jan 11, 2012 was that the Forum recommended that the SEC adopt a rule providing an exemption from federal broker-dealer registration and FINRA membership for M&A intermediaries and business brokers involved in the purchaser and sale, exchange and transfer of ownership of privately-owned businesses, subject to the states exercising primary regulatory supervision over these activities under state law. Chairman Schapiro directed SEC staff to carefully analyze the Forum’s recommendation and develop options for the Commission to consider in revising regulations applicable to M&A intermediaries serving small businesses.

House Legislation Would Stiffen Penalties for High Frequency Trading

A bill introduced in the House would empower federal regulators to tap the brakes on some High Frequency Trading (HFT) practices where they pose a threat to market integrity or to companies seeking to use the futures markets to hedge business risks. The legislation would give the CFTC the power to put in place some common sense rules of the road that are aimed at controlling excesses that have occurred in connection with this kind of trading.

The Protection from Rogue Oil Traders Engaging in Computerized Trading (PROTECT) Act, HR 2292, would authorize the CFTC to issue regulations on HFT in the commodity futures markets. Earlier this year, Rep. Markey called on the SEC to use the Market Reform Act of 1990 to oversee HFT in the stock markets. The Market Reform Act authorized the SEC to prohibit or limit practices which result in extraordinary levels of volatility. The SEC is currently considering using this and other authorities to strengthen oversight over HFT trading of stocks, noted Rep. Markey, meanwhile his bill would give the CFTC new authorities to take similar actions in the futures markets.

The PROTECT Act would require traders involved in HFT in commodities to register with the CFTC and to establish trading safeguards. The Act would ban simultaneous buy and sell orders by traders using HFT in commodities. The CFTC would be authorized to set business standards to limit fraud, manipulation, and other disruptive practices in HFT.

Similarly, the CFTC would be authorized to fine HFT traders based on the amount of time of their violation. For example, a trader violating the regulations for more than a second or two could receive a higher fine than one violating a regulation for just a microsecond. In addition, penalties for market manipulation would be increased from $140,000 to the greater of $1,000,000 for individuals and $10,000,000 for entities, triple the monetary gain to the actor, or triple the total amount of proximate losses. Thus, a high frequency trader causing $100,000,000 in damages via manipulation could be fined up to $300,000,000.

Through HFT, he noted, traders are able to buy and sell stocks and futures at microsecond speed using automated systems that have the ability to destabilize markets. The Executive Director of Financial Stability at the Bank of England estimated in 2010 that HFT firms account for 70 percent of all trading volume in U.S. equities, noted Rep. Markey, and HFT is believed to have represented more than 50 percent of global futures trading volume in 2011.

Similar trading practices have now spread to oil and other commodities markets. On September 17, 2012, oil futures plummeted and recovered over the course of a few minutes. According to Rep. Markey, it is believed that HFT played a role in this flash crash market occurrence.The legislation establishes safeguards which he believes would help protect investors and the financial markets against the potential dangers of HFT in commodities and futures markets.

Sprint 10Q reveals closing of SEC investigation into sales tax collection

In its 2013 second quarter Form 10-Q, Sprint Corporation revealed that on July 2, 2013, the SEC notified the company that it was closing its investigation into the company’s sales tax collection activities and did not intend to recommend an enforcement action against the company. On July 23, 2012, the SEC had issued a formal order of investigation relating to the company's sales tax collection.

State Action. The Form 10-Q also disclosed that on April 19, 2012, the New York Attorney General filed a complaint alleging that Sprint has fraudulently failed to collect and pay more than $100 million in New York sales taxes on receipts from its sale of wireless telephone services since July 2005. The complaint seeks recovery of triple damages as well as penalties and interest. The company moved to dismiss the complaint on June 14, 2012. On July 1, 2013, the court entered an order denying the motion to dismiss in large part, although it did dismiss certain counts or parts of certain counts.

New York law allows for an immediate appeal and the company indicated in the filing that it intends to appeal this order. The company believes that the complaint is without merit and intends to defend this matter vigorously. The company does not expect the resolution of this matter to have a material adverse effect on its financial position or results of operations.

Thursday, August 08, 2013

House Members urge SEC and CFTC to Harmonize Derivatives Regulations both Domestically and Globally

With the United States set to continue international financial reform discussions with G-20 partners in September 2013, 35 members of the House of Representatives urged the SEC and CFTC to harmonize cross-border derivatives regulations with each other, as well as with their appropriately regulated global counterparts. In a letter to CFTC Chair Gary Gensler and SEC Chair Mary Jo White, the House members cautioned that the unilateral application of U.S. derivatives regulations to other countries that are presently working on their own complementary derivatives regulatory regimes will result in a flight of swaps activity away from U.S. banks overseas and further away from U.S. oversight. Further, while ensuring a proper level of regulatory compliance abroad is imperative, the failure to agree on a common regulatory framework poses risks and distortions. For one thing, regulatory gaps would encourage regulatory arbitrage, warned the House members, as market participants seek inappropriately regulated markets.

Other deleterious effects of inconsistent derivatives regulation would be competitive imbalances among market participants based upon the home jurisdiction of the participants and inadvertent violations as market participants are forced to choose which regulatory regime to follow. Other harmful effects would be isolating risk inside countries or jurisdiction because of regulatory balkanization, which could create instabilities in the risk profiles of individual countries’ markets. An overarching goal of the harmonization of regulation is to provide for a sound and competitive international derivatives marketplace, rather than merely just a safe U.S. market.

The House members referenced a letter recently sent to Treasury Secretary Jacob Lew by nine Finance Ministers and Michel Barnier, E.U. Internal Market Commissioner, expressing concern at the lack of progress in developing workable cross-border regulation of the OTC derivatives markets. Left unaddressed, the failure to harmonize rules between the SEC, the CFTC, and their global counterparts will have substantial negative effects on domestic businesses operating abroad as well as the safety and soundness of the U.S. and international financial systems.

More broadly, the House members pointed out that OTC derivatives remain a crucially important financial tool for corporations, agriculture providers, investors, and financial services firms attempting to manage their risk. The Dodd-Frank Act enacted critical reforms to this marketplace, formerly rife with regulatory gaps. Implementation of these reforms, including clearing, trade reporting, higher capital levels, margin for uncleared swaps, business conduct requirements, and periodic regulatory reviews, will provide increased transparency and reduced risk in the OTC swaps market.

Senate confirms Howard Shelanski as OIRA Administrator in Voice Vote

Against the backdrop of two Executive Orders on federal agency rulemaking, and at a critical moment when legislation is pending to require independent federal agencies to conduct a cost-benefit analysis of regulations, the U.S. Senate confirmed by voice vote Howard Shelanski to be the next Administrator of the Office of Information and Regulatory Affairs.

Mr. Shelanski is the Director of the Bureau of Economics at the Federal Trade Commission, a position he has held since 2012. He is currently on leave from the Georgetown University Law Center, where he has been a professor since 2011. Mr. Shelanski was the Deputy Director for Antitrust in the FTC’s Bureau of Economics from 2009 to 2011. He served as Chief Economist of the Federal Communications Commission from 1999 to 2000 and as Senior Economist for the President’s Council of Economic Advisers from 1998 to 1999.

At his nomination hearing before the Senate Homeland Security and Governmental Affairs Committee, Mr. Shelanski noted that OIRA plays an essential role in developing and overseeing the implementation of Government-wide policies on regulation, information collection, information quality and technology, statistical standards, scientific evidence, and privacy. He believes that public involvement and transparency in regulation is critically important as we tackle the complex issues of regulation both domestically and globally.

Asked by Committee Chairman Tom Carper (D-DE) to list his top priorities as OIRA Administrator, he listed three. The first is to ensure that regulatory review occurs in a timely manner and that it is a high quality review. Second, he intends to form good working relationships with agency heads and with Congress, as well as with public stakeholders. Third, OIRA will conduct retrospective  reviews  and look backs of adopted regulations even as the Office moves forward with new regulations. OIRA will look back to ensure that the regulations already  on the books are not overly burdensome and are doing what they were intended to do. The Administrator added that, regarding retrospective review, the primary duty is with the agency heads since they best know their regulations. To Chairman Carper’s query if such retrospective review will be ongoing, he replied that it would be.
Executive Orders. President Obama issued two significant Executive Orders on the federal regulatory process during his first term: Executive Order No. 13563, 76 Fed. Reg. 3,821 (Jan. 21, 2011) and Executive Order No. 13579, 76 Fed. Reg. 41,587 (July 14, 2011). EO No. 13563 set out general requirements directed to executive agencies concerning public participation, integration and innovation, flexible approaches, and science. It also reaffirmed that executive agencies should conduct a cost-benefit analysis of regulations. EO No. 13579 states that independent regulatory agencies should follow EO No. 13563. Mr. Shelanski assured the Senate that he would faithfully follow these Executive Orders.