Thursday, September 26, 2013

US Hedge Fund Industry Asks for Revision of ESMA Proposed Guidance on Hedge Fund Directive

The U.S. Hedge Fund Industry has asked the European Securities and Markets Committee to revise and clarify its proposed guidance under the E.U. Alternative Investment Fund Managers Directive. In a comment letter to ESMA, the Managed Funds Association asked that the proposed guidance be amended with respect to master/feeder funds, funds of funds, and other tiered funds to avoid duplicative reporting requirements. The MFA also requests that hedge fund managers be permitted to report information on the basis of the best data available, given the short time periods for filing quarterly reports.

The MFA also asks for clarification whether the definition of position or instrument should be an individual security or whether it should refer to a group of securities that have the same risk profile. For example, if a hedge fund owns 5 separate U.S. Treasury bills with similar maturity dates should those 5 positions be aggregated as one instrument or should they each be treated as a separate instrument. In this regard, the MFA also noted that the Annex IV templates in the Directive appear to use certain terms
interchangeably such as “principal instruments”, “important instruments”, “principal exposures”, “main instruments”, “important markets” and “most important concentrations."

Indeed, Items 13 ( principal exposures) and 14 ( most important concentrations) in the Directive seem duplicative by requiring information on both principal exposures and most important portfolio concentrations as the two concepts may overlap significantly. To the extent that ESMA does not see significant differences between them, the MFA suggested that these two be combined into one.

The draft guidelines states that investors that are part of the same group should be considered as a single investor. However, it is not clear what “group” means for this purpose.

Master-Feeder Funds. The draft proposes that hedge fund managers managing non-EU master hedge funds that are not marketed in the EU should report for such master funds the information requested by Article 24(2) of the AIFMD if one of the master fund’s feeder funds is marketed in the EU. In this regard, the Article 24(2) Reporting Template contains various line items requiring investor-related information. In the view of the MFA, this gives rise to a number of issues as to how such investor-related information should be reported.

For example, when reporting for a master fund, presumably the fund manager would need to look-through to the feeder fund that is marketed in the EU. If so, the MFA asked if these investor-related questions are to be answered only with respect to those class(es) of the units/shares of the feeder fund that are marketed in the EU or would they need to be answered in relation to the entire feeder fund.

If the relevant information on the master fund needs to be reported on a look-through basis, reasoned the MFA, it would seem duplicative to require that fund-specific information under Article 24(2) of the AIFMD must also be reported individually for each feeder fund. In order to avoid duplicative reporting in the case of master-feeder structures, the hedge fund association suggests that hedge fund managers should be allowed to report, at their option, either at the individual feeder fund level or at the aggregate master fund level. This would also harmonize the reporting requirements between the EU and the US as the SEC’s Form PF reporting requirements in the US allow this option.

Fund of Funds. Hedge funds that are funds of funds typically have only three types of assets: cash, derivatives, and investments in underlying hedge funds. As a result, said the MFA, for such hedge fund, a significant amount of information as required under Articles 24(1) and 24(2) of the AIFMD is either duplicative or inapplicable.

For example, Item 13 (annual investment return) in the Article 24(2) Reporting Template appears to be inapplicable since a fund of funds does not have information on the portfolios of the underlying hedge funds in which it invests. Item 14 (trading and clearing mechanisms) in the Article 24(2) Reporting Template requires clarification regarding whether investments in underlying hedge funds should be considered “securities” for the purposes of this section, and if so, since such investments are not traded on a regulated exchange, confirmation that OTC should be selected. In addition, information on such fund’s exposures, positions and main instruments will largely be the same since it typically has a concentrated portfolio.

In any event, the underlying hedge fund manager would already be obliged to provide information to the relevant regulators for those underlying hedge funds that are marketed in the EU, reasoned the MFA, so having the fund manager report information again on the fund-of-funds would appear to be duplicative.

To avoid duplication, the MFA suggests that hedge fund manager managing funds of funds should be permitted to disregard any investments made by such funds in underlying hedge funds. In this regard, the MFA noted that, by allowing hedge fund managers managing fund-of-funds to disregard investments in underlying hedge funds This would make the EU reporting requirements consistent with the requirements under SEC Form PF.

Collateral. Hedge fund managers may post collateral in various situations, e.g., collateral on short term borrowing facilities, or collateral on facilities for the purposes of leveraged exposure. The MFA assumes, and suggests, that this item only covers collateral posted on facilities utilized to gain exposure. Further, a hedge fund’s entire prime brokerage account may be subject to a lien in the event of a default by the fund and the value of such prime brokerage account may significantly exceed the value of borrowings. The hedge fund association asked ESMA to clarify whether there are any assets potentially subject to a lien that should not be considered collateral for the purpose of this section.

Value at Risk. The draft guidelines propose that hedge fund managers should report the value at risk (VaR) of the relevant hedge fund. Due to some of the inherent weaknesses of VaR as a risk metric for strategies transacting in less liquid asset classes, many managers do not calculate VaR as part of their risk management processes. As such, the MFA does not believe that the reporting of VaR should be a mandatory requirement. Rather it should be an option for hedge fund managers to decide.

In letter to SEC, Senator McCain Says "London Whale" Enforcement Incomplete Until Individuals Charged

In a letter to SEC Mary Jo White, Senator John McCain (R-AZ) urged the government to hold individuals accountable for their role in JPMorgan Chase’s $6 billion loss associated with the “London Whale” trading debacle in 2012. While the senator acknowledged that the $920 million settlement constitutes a significant rebuke to the financial institution, he believe that the government must hold accountable those individuals who compromised the integrity of the financial markets. Senator McCain, Ranking Member on the Investigations Subcommittee, said that the government’s incomplete enforcement actions to date fail to achieve that goal.

Senator McCain asked Chairman White to promptly respond to a number of questions, including whether the SEC considered requiring admissions of wrongdoing on the part of any individuals within the bank as part of the settlement negotiations. He also wants to know what factors led to the decision to not address individual misconduct in the settlement. The Senator also asks if the global settlement agreement precludes either civil or criminal enforcement action against individuals at JPMorgan. The SEC Chair is also queried whether anyone within the SEC referred any individuals to the DOJ for criminal prosecution and, if so, to explain the situation. Finally, the Senator asked the SEC Chair to describe how each of the following were considered, determined, and structured in the settlement: penalties, fines, disgorgement, compensatory damages and/or restitution, and admissions of wrongdoing.

In a separate statement, Senator Carl Levin (D-MI), Chair of the Subcommitee, said that the whole issue of misinforming investors is missing from the SEC findings and settlement. He noted that the Subcommittee’s investigation showed that senior bank executives made a series of inaccurate statements that misinformed investors and the public as the London Whale disaster unfolded. Other civil and criminal proceedings are unfolding, he said, so there is still time to determine any accountability on that matter.

Mutual Fund Directors Forum Asks for SEC Guidance on Valuation of Securities

In a letter to SEC Investment Management Director Norm Champ, the Mutual Fund Directors Forum asked the Commission to issue principles-based guidance on fund valuation of securities recognizing the authority of fund directors to delegate valuation. The Fourm believes that principles-based guidance is the most effective and comprehensive way to address the wide variety of funds, boards, securities and investment instruments and product innovation and evolution in the dynamic mutual fund industry.

The statutory requirement that fund directors fair value securities in their portfolios that do not have readily available market values envisions an informed, engaged and independent board acting in good faith with respect to the valuation of portfolio securities, noted the forum, but it does not require that boards themselves directly value portfolio securities. Boards also have the flexibility to determine how involved they would like to be in the valuation process.

Because mutual funds must calculate their NAVs daily, most boards adopt policies and procedures to govern the method in which the NAV is to be determined on a day-to-day basis. Those procedures generally delegate to the adviser the determination of fair value for portfolio securities and other assets for which market quotations are not readily available. Delegation is appropriate both because the adviser generally has the required expertise to make judgments about fair value prices and has the resources available to make daily valuation determinations.

Fund directors do not abdicate their statutorily imposed responsibility to fair value securities by adopting policies and procedures that require the adviser to determine on a day to day basis the fair values of fund securities for which market quotations are not readily available. Rather, fund boards use the adviser to carry out the fair value function while fulfilling the board’s responsibilities to shareholders by reviewing and approving those procedures and then monitoring their implementation and ongoing effectiveness.

In the view of the Forum, boards, consistent with their business judgment, should have the flexibility to use experts (whether within the organization or outside) to provide the information necessary to perform their duties with respect to fair valuation. Just as in other areas, the board will approve the parameters of the relationship with the expert and establish a mechanism to review the expert’s performance.

The Forum urged that any guidance issued by the Commission should clarify that boards can adopt policies and procedures that require the adviser or other third party to assign values to a fund’s portfolio securities consistent with their Investment Company Act responsibility to fair value securities so long as the board provides effective oversight of the process. Boards should understand the policies and procedures regarding valuation of fund securities and the adviser’s day to day process in making necessary fair valuations. An understanding of the policies does not require, however, that fund directors be familiar with the intricacies of particular fair value pricing models.

Typically the adviser is the expert with the knowledge most relevant to assigning fair values to securities. Directors can be expected to understand the process that the adviser will use to value securities, particularly the identity of the parties making the determinations. Further, the board should understand how the adviser handles exceptions to the policies, including any overrides of prices received from third parties.

A board has many resources at its disposal to gain helpful insight into how well the fair valuation process is functioning, including the chief compliance officer and outside auditors. Boards should, however, be able to work with those parties in ways most appropriate for the particular facts and circumstances of the funds they oversee.

In developing guidance on valuation, the fund directors asked the Commission to focus on the principles that underlie and drive the valuation process, rather than on attempting to develop prescriptive approaches to valuing specific classes or types of securities. Doing so will permit the Commission to issue succinct guidance that is of real value to independent directors rather than a lengthy compendium of prior guidance and a list of potential approaches to various types of securities that would both be inflexible and be liable to become quickly outdated.

Given the rapid development of new types of securities, reasoned the Forum, guidance that focuses on how to value specific currently existing securities will not be helpful in the long run to funds or their investors. Moreover, the methods of valuing securities that exist today may change as well, as the manner in which those securities are traded and the liquidity of those securities may change rapidly over time.

Therefore, even relatively high-level guidance with respect to specific types of securities risks rapidly becoming outdated and potentially problematic. In contrast, principles-based guidance that focuses broadly on what funds should attempt to achieve when fair valuing portfolio securities is likely to lead to a better result, more accurate individual security valuations and, most importantly, more accurate daily NAVs.

ESMA Reaches Cooperation Agreements with US and Other non-EU Jurisdictions for Hedge Fund Regulation

The European Securities and Markets Authority has approved seven co-operation arrangements between EU securities regulators and their global counterparts with responsibility for the regulation of alternative investment funds, including hedge funds, private equity and real estate funds. ESMA approved Memoransum of Understanding with authorities from the Bahamas, Japan, Malaysia, Mexico and the United States, including the Commodity Futures Trading Commission.

The co-operation agreements allow for the exchange of information, cross-border on-site visits and mutual assistance in the enforcement of respective supervisory laws. The agreements cover third-country hedge fund and other alternative investment fund managers that market alternative investment funds in the EU and EU fund managers that manage or market hedge funds outside the EU. The agreements also cover co-operation in the cross-border supervision of depositaries and hedge fund managers’delegates.

Hedge Fund Regulation. National securities regulators in the EU, as hedge fund regulators, are in the process of signing MoUs with those jurisdictions relevant to their market. The existence of co-operation arrangements between the EU and non-EU authorities is a precondition of the Alternative Investment Fund Managers Directive (AIFMD) for allowing managers from third countries access to EU markets or to perform fund management by delegation from EU managers by July 22, 2013.

The co-operation arrangements are applicable from 22 July, and will enable cross-border marketing of AIFs to professional investors between jurisdictions. This is subject to the non-EU jurisdiction not being listed as a non-cooperative jurisdiction by the Financial Action Task Force and, as from the entry into force of the passport for non-EU managers, having co-operation agreements in place with EU Member States regarding the exchange of information on tax matters.

The content of the ESMA MoUs follow the IOSCO Principles on Cross-Border Supervisory Co-operation of 2010, and complements the terms and conditions of the IOSCO Multilateral MoU Concerning Consultation and Co-operation and the Exchange of Information of 2002 (MMoU).

Monday, September 23, 2013

House Passes Legislation Requiring Congressional Approval of Major Federal Regulations

During this first session of the 113th Congress, the House has passed legislation, by a vote of 223-183, increasing the accountability for and transparency in the federal regulatory process. The Regulations from the Executive in Need of Scrutiny Act (REINS), H.R. 367, would require Congress to take an up-or-down, stand-alone vote on all new major regulations adopted by the SEC, CFTC and other federal regulatory agencies before they can be enforced. Major regulations are defined as those that have resulted in or are likely to result in an annual effect on the economy of $100 million or more; a major increase in costs or prices, or significant adverse effects on competition, employment, investment, productivity, innovation, or U.S. competitiveness.

However, HR 367 allows a major rule to take effect for 90 calendar days without such approval if the President determines that the rule is necessary because of an imminent threat to health or safety or other emergency, for the enforcement of criminal laws, for national security, or to implement an international trade agreement.

H.R. 367 essentially replicates the text of the REINS Act as passed by the House during the 112th Congress. As a result, it includes revisions to the legislation, made during the Rules Committee's markup of the bill, which post-date the Committee's last review and markup of the legislation. These revisions principally refine the parliamentary procedures for introduction of, and consideration and floor action on, REINS Act approval resolutions. They serve to maximize the efficiency of the Act's parliamentary procedures and prevent undue incursions on floor time needed for other legislative business.

The Act provides that no determination, finding, action, or omission under the legislation will be subject to judicial review. The measure does allow a court to determine whether a federal agency has completed REINS Act requirements necessary for a rule to take effect, a determination which would enable a court to determine if a suit concerning the rule is ripe.

In addition, the enactment of a joint resolution of approval cannot be interpreted to serve as a grant or modification of statutory authority by Congress for the promulgation of a rule, and cannot extinguish or affect any claim, whether substantive or procedural, against any alleged defect in a rule, and cannot form part of the record before the court in any judicial proceeding concerning a rule except for purposes of determining whether or not the rule is in effect.

Presidential Veto Message. The Obama Administration is strongly opposed to the passage of S. 367. In a Statement of Administration Policy, the President said that the legislation represents a radical departure from the longstanding separation of powers between the Executive and Legislative branches that would delay and, in many cases, thwart implementation of statutory mandates and execution of duly-enacted laws, create business uncertainty, undermine much-needed protections of the American public, and cause unnecessary confusion.

German Legislation Implements EU Hedge Fund Directive

On July 22, 2013, the Act Implementing the Alternative Investment Fund Managers (AIFM) Directive entered into force in Germany. This legislation effectively implements the European Union hedge fund Directive regulating hedge funds and private equity funds in the EU. By virtue of the Act Implementing the AIFM Directive, the Investment Act was repealed and replaced by the Investment Code.). The implementation of the AIFM Directive brings significant administrative burdens and new rules for all German fund providers, noted the German Federal Financial Authority (BAFin)

The Investment Code extends the AIFM Directive on UCITS depositaries. This concerns in particular the provisions for custody under the strict liability of the depositary. The legislature was in response to the request of the German Fund Association (BVI) reinforced by investor protection. The qualification of sub-custodians are clearly defined, and the liability for the loss of the sub-custodian of securities is exacerbated.
The legislature has halved the time to examine the distribution indicator for domestic funds by the BaFin from 40 to 20 days. Thus, the BVI members can more quickly than originally anticipated sell newly launched mutual funds.   

The new Investment Code regulates both open-end and closed-end funds and the fund managers.. Regulation on risk management and risk measurement with the use of derivatives, securities lending and repurchase transactions in investment companies are covered under the Investment Code.
The Investment Code distinguishes between investment funds, known as the Undertakings for Collective Investment in Transferable Securities (UCITS), and those that are considered alternative investment funds, such as hedge funds and private equity funds. Many stock and bond funds are UCITS. Different registration and reporting requirements apply to UCITS and hedge funds and other alternative investment funds.

Thursday, September 19, 2013

Big Four Firm Seeks Guidance from SEC and FASB on Audit Implications of SEC Money Market Fund Proposals

In a letter to the SEC, the Ernst & Young firm commented on the accounting and auditing implications of the Commission’s proposed reform of the regulation of money market funds. US GAAP explicitly states that money market funds are commonly considered cash equivalents. The main characteristics for an investment to be classified as a cash equivalent is that it is short term, highly liquid, readily convertible to known amounts of cash and presents insignificant risk of changes in value because of changes in interest rates

The audit firm urged the SEC to inventory a number of practice-related questions that have been raised by auditors, and users and preparers of financial statements on the cash equivalent topic and consider issuing, along with FASB, guidance to address these questions, perhaps through the Emerging Issues Task Force (EITF). One key question is whether an unexpected deterioration in the value or liquidity of a money market investment after the balance sheet date would be treated as a non-recognized subsequent event. Another question being raised by auditors is whether the occurrence of an event triggering fees and gates would preclude the continued classification of an investment in a money market fund as a cash equivalent.

In its proposed Release on money market reform, the SEC is considering two alternatives that could be adopted alone or in combination: 1) Floating NAV—Prime institutional money market funds would be required to transact at a floating NAV, while Government and retail money market funds would be allowed to continue using stable NAV. 2) Liquidity fees and redemption gates—Non-government money market funds would be permitted to use liquidity fees and redemption gates to reduce run risks in times of stress.

The audit firm agrees with the Commission that investments in money market funds with a floating NAV under amended SEC Rule 2a-7 would continue to meet the definition of a cash equivalent because the fluctuations in value would be expected to be insignificant. Ernst & Young also concurred with the Commission that the evaluation of whether an investment in a money market fund meets the requirements of a cash equivalent should be performed periodically

The firm also agreed with the Commission that investments in money market funds with both a floating NAV and fees and gates under the proposed amendments would continue to meet the definition of a cash equivalent. The potential suspension of redemptions for up to 30 days in contingent circumstances would not violate the requirement that a cash equivalent be “readily convertible to known amounts of cash.” Moreover, the potential imposition of a liquidity fee of up to 2 percent in contingent circumstances would not violate the requirement that a cash equivalent present “insignificant risk of changes in value.”

The proposal requests comment on whether sponsors of money market funds should be required to publicly disclose their financial statements in order to permit an evaluation of the sponsor’s capacity to provide support. The audit firm noted that the Commission has existing rules and practices that address the provision of financial statements when a guarantee or explicit credit enhancement exists. When there is merely implied or potential financial support, reasoned the firm, there should be no reason to require financial statements of the sponsor unless it is required to consolidate the money market fund as a variable interest entity under US GAAP. Otherwise, requiring sponsors to provide financial statements would not appear to be cost-justified when their financial support is not legally enforceable.

In Letter to House Ways and Means Committee, Fund Industry Comments on Taxation of Financial Products

In a letter to the House Way and Means Committee as it considers an overhaul of the U.S. tax code, the Investment Company Institute focused on two areas of intense importance to the fund industry that were part of a Committee discussion draft on the taxation of derivatives and other financial instruments. The first proposal would mark all derivatives to market, while the second proposal would require investors to compute gain or loss using the average cost basis method. The ICI understands that these proposals will be included in a comprehensive legislative tax reform package.

While more uniform taxation of derivatives generally would benefit both funds and their investors, noted the ICI, the Committee draft raises concerns. If a mark-to-market approach for derivatives is advanced, the Institute suggests changes to several provisions, including the broad scope of the definition of derivative, the decision to treat marked gains and losses as ordinary, and the application of the straddle rules.

While forcing all investors onto a single basis methodology might appear to simplify gain/loss calculations, noted the ICI, the proposal raises significant complexities and would not improve tax compliance. Because of these concerns, the ICI urged that Congress drop the mandatory average cost proposal from any reform legislation.

Derivatives. Funds and their investors generally would benefit from more uniform tax treatment of derivatives, acknowledged the ICI, since this area of tax law is particularly complex and the Internal Revenue Code has not kept pace with financial product development, which means that new financial products must be pigeon-holed into existing tax regimes that were not designed for them.

The lack of clear and cohesive rules for the taxation of derivatives also complicates accounting compliance for regulated investment companies under SEC rules requiring them to follow FIN 48 (now FASBAccounting Standards Codification Topic 740). This has increased the resources that funds must spend to support accounting for the tax effects of their investments in derivatives. Working with their outside legal advisors and accounting firms, funds must document that their tax treatment of derivatives will be sustained upon examination, based on a more-likely-than-not standard. Meeting the FASB standard would be considerably easier if the rules for taxing derivatives were clarified.

But the draft’s broad definition of “derivative” is expansive enough to encompass a number of instruments and transactions that are not typically thought of as derivatives, noted the ICI, including securities loans and repos. The Institute asked the Committee to narrow the definition to exclude such instruments and transactions, which are frequently used both by funds and by ordinary investors. The ICI also asked Congress to exempt embedded derivatives, such as the option component in a convertible bond, from a mark-to-market regime. It is difficult to see how the Internal Revenue Service could fairly and efficiently administer the proposed rules regarding embedded derivatives, opined the ICI.

The derivatives draft proposal would treat any mark-to-market gains or losses as ordinary. The ICI urged the Committee instead to treat any mark-to-market gains or losses as having the same character as the underlying security. In most cases, the assets underlying derivatives are capital assets. There are some assets, however, that are ordinary, such as currency. Thus, although mark-to-market gains and losses from most derivatives should be treated as capital, it would be appropriate to treat mark-to-market gains from derivatives such as currency forwards as ordinary.

Ordinary income treatment would also create unique difficulties for regulated investment companies. One such difficulty arises because funds cannot carry forward net operating losses (NOLs). As most funds typically have ordinary income in excess of their ordinary losses and expenses, noted the ICI, the absence of carryforward treatment has not been particularly problematic. If mark-to-market losses were ordinary, however, funds would be more likely to experience NOLs more frequently and in greater dollar amounts.

Funds therefore would need the ability to carry forward NOLs indefinitely to prevent fund investors from being unfairly whipsawed. Mutual funds also would be subject to an additional whipsaw in that they would not be able to offset capital losses on their portfolio securities, such as stocks or bonds, with ordinary gains on their derivatives.

Mandatory Average Cost. The Institute strongly urged the Committee to drop the proposal to require all investors to compute gain or loss using the average cost basis method. This proposed change to current law would provide little, if any, benefit, said the ICI, but substantial burdens would be imposed on funds, their shareholders, and reporting brokers. Importantly, average cost basis is not nearly as simple to apply as it may appear and would result in additional locked-in investment.

The mutual fund industry has substantial experience with reporting cost basis to investors, noted the ICI. Most of the industry began providing this information voluntarily about twenty years ago. For the past five years, because of federal legislation mandating cost basis reporting, funds and brokers have spent considerable time and resources addressing cost basis reporting requirements. The expended effort has included revising cost basis reporting systems to, among other things, accommodate shareholder elections to choose any available cost basis method and educating shareholders about the methods available to them. The ICI warned that changing the rules now will create additional confusion for shareholders and negate much of the work done already. Investors should retain their ability to choose their cost basis methodology for all securities.

The ICI rejected the argument that the average cost method is appropriate because securities are fungible. All tax attributes in the Code, such as holding periods and adjustments for wash sales and market discount, are calculated at the lot level. The lots therefore are not fungible for tax purposes, reasoned the ICI, different lots may have very different tax. attributes associated with them. Moreover, investors certainly do not view their lots as fungible, as different lots may have been purchased at different times for different amounts. It has long been a fixture of the federal tax system that taxpayers are able to control the timing of their gains and losses by choosing which lots to sell. It is not clear why this tenet of the U.S. tax code should be replaced by such a fundamental change.

Monday, September 16, 2013

US and Global Hedge Fund Groups Comment on CFTC Cross-Border Exemptive Order on Cross-Border Swaps

In response to the CFTC’s Exemptive Order on compliance with swap regulations issued at the time it adopted final guidance on cross-border swaps regulation, the U.S. and global hedge fund industries explained how the intersection and sequencing of the CFTC’s final cross-border interpretive guidance, the Exemptive Order and the final reporting rules creates problems for funds because, for certain swaps with non-U.S. dealers, it would unintentionally cause funds, rather than dealers, to be responsible for reporting those swaps entered.

Therefore, in a
letter to the CFTC, the Managed Funds Association and the Alternative Investment Management Association requested that, where a fund’s non-U.S. dealer counterparty will register as a swap dealer on December 31, 2013, the CFTC not deem the fund to be the reporting party for the period prior to when such dealer registers as an swap dealer, and thereby, becomes the reporting party with respect those swaps.
In the letter, the MFA and AIMA also urged the CFTC to confirm that, for a non-U.S. fund that becomes a U.S. person at some point after October 10, 2013, the non-U.S. Fund and its affected non-U.S. counterparties will have a 75-day phase-in period from the date the non-U.S. Fund’s status changes to comply with the applicable Dodd-Frank requirements.

On July 12, 2013, the CFTC voted 3-1 to adopt final guidance to provide greater legal certainty and clarity to U.S. and non-U.S. market participants regarding obligations under the Commodity Exchange Act (CEA) with respect to cross-border swaps activities. The guidance embodies the concept of substituted compliance, under which the CFTC would defer to comparable and comprehensive foreign derivatives regulatory regimes. The CFTC also approved by a 3-1 vote an exemptive order giving market participants time to phase in to this new market reality by providing temporary conditional relief from certain swap provisions of the Dodd-Frank Act to non-U.S. swap dealers, as well as foreign branches of U.S. swap dealers.

Under the Exemptive Order, market participants may continue to apply the swap dealer and MSP calculation provisions contained in the January Order, from July 13, 2013 until 75 days after the
Guidance is published in the Federal Register. Accordingly, during this time period, a non-U.S. person may exclude (from its swap dealer de minimis and its MSP threshold calculations) any swap where the counterparty is not a U.S. person, or any swap where the counterparty is a foreign branch of a U.S. person that is registered as a swap dealer.

The hedge fund associations generally support the SEC’s decision to issue the Exemptive Order to provide further transitional relief with respect to its final guidance on cross-border swaps regulation in order to avoid unnecessary market disruptions and to facilitate market participants’ transition to the new Dodd-Frank Act derivatives regulation regime. However, the associations urge the Commission to provide appropriate guidance or relief with respect to reporting party obligations that, in certain limited circumstances, inadvertently fall upon commodity pools, pooled accounts, collective investment vehicles and funds and would complicate unnecessarily achieving the goals of the reporting rules.

ESMA advises European Commission that U.S. Derivatives Regulatory Regime is Broadly Equivalent to EMIR, but SEC-CFTC Funding Is a Concern

The European Securities and Markets Authority (ESMA) advised the European Commission that the SEC and CFTC have erected a broadly equivalent derivatives regulatory regime for central counterparties and trade repositories to that put in place by the EMIR. While describing the U.S. financial supervisory regime as a robust one with a significant track record and decades-long experience in financial markets, ESMA is concerned that neither the SEC nor the CFTC currently has sufficient funding, and the method of funding does not provide sufficient assurance of continuing funding levels, to be able to commit to long-term capital projects, such as building new market surveillance systems, which are necessary to keep pace with changes in the industry.

In conducting its equivalence assessment, ESMA used an objective approach, where the capability of the regime in the U.S. or any other third country to meet the objectives of EMIR is assessed from a holistic perspective. The European Commission is expected to use ESMA’s advice to prepare implementing acts concerning the equivalence between the legal and supervisory framework of the U.S. under EMIR. Where the Commission adopts such an implementing act, ESMA may then recognize a central counterparty or a trade repository authorized in the U.S. or other third country.

Entities providing clearing services as a central counterparty in the U.S. are required to be registered with either the SEC or the CFTC, or both, depending on the type of asset being cleared.

ESMA advised the Commission that central counterparties authorized in the U.S. are subject to effective supervision and enforcement on an on-going basis and that the U.S. legal framework provides for an effective equivalent system for the recognition of central counterparties authorized under third-country legal regimes. However, ESMA noted that U.S. authorities do not use the equivalent system on a long-term basis and highlighted to the Commission that in practice the U.S. authorities require that central counterparties authorized outside of the U.S. become subject to the direct jurisdiction of the SEC and CFTC and the application of two sets of rules. ESMA further noted that this represents a departure from the third country central counterparty regime prescribed in EMIR.

More specifically, ESMA advised the Commission that U.S. legal and supervisory arrangements ensure that central counterparties authorized in the U.S. comply with legally binding requirements which are equivalent to the requirements laid down in Title IV of EMIR in respect of central counterparties that have adopted internal policies, rules, and methodologies that constitute legally binding requirements and where they incorporate provisions which, on a holisitic basis, are broadly equivalent to the legally binding requirements for central counterparties under EMIR.

On this basis, ESMA would only grant recognition to central counterparties authorized in the U.S. which have in fact adopted internal policies and methodologies which, on a holistic basis, incorporate provisions that are broadly equivalent to the legally binding requirements for central counterparties under EMIR in the specific areas identified and where ESMA has assessed that the relevant internal policies and methodology do constitute legally binding requirements.

If a central counterparty authorized in the U.S. that was granted recognition by ESMA subsequently made changes to its internal policies and methodologies in a way which meant that it no longer complied with standards that were broadly equivalent to the legally binding requirements under EMIR, then that central counterparty would no longer qualify for recognition, and would be subject to the withdrawal of its recognition pursuant to Article 25(5) of EMIR.

Similarly, ESMA advised the Commission that trade repositories authorized in the U.S. comply with legally binding requirements which are equivalent to the requirements laid down in EMIR, where such trade repositories have adopted internal policies and methodologies that constitute legally binding requirements and where they incorporate provisions which are broadly equivalent to the legally binding requirements for trade repositories under EMIR in the areas of operational separation and collection of data on valuation and collateral.

Advocate General for E.U. Court of Justice Rules Invalid ESMA Authority under Short Selling Regulation

In a proceeding instituted by the United Kingdom, the Advocate General for the European Court of Justice found invalid Article 28 of the E.U. Short Selling Regulation for vesting in the European Securities and Markets Authority (ESMA) the power to make legally binding decisions and adopt measures directed at individual entities that must prevail over any previous measure taken by a competent national authority, which power does not contribute to internal market harmonization. The Advocate General therefore proposed that the Court should annul Article 28 of the Short Selling Regulation. United Kingdom of Great Britain and Northern Ireland v. Council of the European Union and European Parliament, No. 270/12, September 12, 2013, Opinion of Advocate General Nillo Jääskinen.

The powers vested in ESMA under Article 28 go beyond internal market harmonization because the effect of Article 28 is to elevate to the EU level, and more precisely to ESMA, an intervention competence that operates in circumstances that are equivalent to those that trigger the intervention powers of the competent authorities of the Member States. By definition, ESMA will be forming a judgment on a matter on which the relevant competent authority has formed a different judgment. Further, under Article 28(4), the only entity ESMA is bound to consult before imposing these measures is the European Systemic Risk Board.

The AG pointed out that the objections raised by the United Kingdom do not constitute an all-out assault on the legal basis for the establishment of ESMA. It concerns instead the powers with which ESMA has been endowed by Article 28 of the Regulation. The U.K. formulated its challenge under Article 114 TFEU on the basis that this Treaty provision cannot authorize individual measures directed at particular natural or legal persons so that, to the extent to which Article 28 purports to allow such measures it is ultra vires.

The opinion described ESMA as a regulatory agency which assists with the task of regulation at the E.U. level related to the expansion of the internal market. As such, ESMA mainly provides common rules and services and operates under a management or supervisory board composed of Member States’ representatives and some representatives of the Commission.

Short Selling Regulation. In 2012, in order to harmonize its response to short selling in light of the financial crisis, the E.U. adopted the Short Selling Regulation. Short selling is a practice whereby assets and securities, which are not owned by the seller at the moment of sale, are sold with the intention of profiting from a decline in the price of the assets before the transaction is settled. The Regulation was adopted on the basis of Article 114 TFUE, which allows for the adoption of harmonizing measures where necessary for the achievement and functioning of the internal market.

While in principle there can be no objection to using Article 114 TFUE as a legal basis for E.U. agencies which adopt legally binding decisions, noted the Advocate General, the determining factor is whether the decisions of the agency in question either contributes to or amounts to internal market harmonization. The AG determined that the powers vested in ESMA under Article 28 of the Regulation go beyond these limits.

The Advocate General emphasized that ESMA is uniquely empowered to make legally binding decisions in substitution for those of a competent national authority, which may well disagree with the decision of ESMA, which decision will prevail over any previous measure taken by the national authority. In the Advocate General’s view, the effect of this is to create an E.U. level emergency decision-making mechanism that becomes operable when the national authorities do not agree on a course of action. It follows that this outcome is not harmonization but the replacement of national decision-making with EU level decision-making, which goes beyond the limits of Article 114.

If the Court should decide, contrary to his proposal, that Article 114 TFUE is an appropriate legal basis for Article 28 of the Regulation, the Advocate General urged the rejection of the other arguments advanced by the United Kingdom. In his view, the powers vested in ESMA are in line with the relevant E.U. constitutional rules in relation to the delegation of powers to an agency and do not leave too wide a margin of discretion to EMSA. He points out that Article 28 imposes specific procedural safeguards as to the measures that ESMA is empowered to take, including express definitions of the content of measures, the procedure for their adoption, and their temporal effect. Article 28 stems from a basic policy choice by the EU legislature in that the essential value judgments have been made by the latter and have not been left to ESMA.

The Advocate General’s opinion is not binding on the Court of Justice. It is the role of the Advocates General to propose to the Court, in complete independence, a legal solution to the cases for which they are responsible. The judges of the Court are now beginning their deliberations in this case. Judgment will be given at a later date.

Saturday, September 14, 2013

Federal Reserve Bank Presidents Support SEC Proposal of Floating NAV for Money Market Funds

In a letter to the SEC, the Presidents of the 12 Federal Reserve Banks expressed their support for a floating NAV for money market funds as the best avenue for reform of this vital sector. The central bankers urged the SEC to pursue this option and consider ways in which the benefits of a floating NAV could be enhanced, such as continuing to monitor funds’ procedures for determining that amortized cost accurately reflects fair value and eliminating the retail exemption. More broadly, the Fed senior officials accept the principle that the disruptions in the ability of money market funds to function as credit intermediaries can have a significant negative impact on the broader financial system and that, despite the SEC’s meaningful 2010 amendments, such funds remain a significant risk to financial stability. Thus, they urged the SEC to proceed with these additional reforms.

In its proposed Release on money market reform, the SEC is considering two alternatives that could be adopted alone or in combination: 1) Floating NAV—Prime institutional money market funds would be required to transact at a floating NAV, while Government and retail money market funds would be allowed to continue using stable NAV. 2) Liquidity fees and redemption gates—Non-government money market funds would be permitted to use liquidity fees and redemption gates to reduce run risks in times of stress.

The Federal Reserve Bank presidents do not believe that the liquidity fees and temporary redemption gates alternative would constitute meaningful reform since this alternative bears many similarities to the status quo. In their view, investors would still have an incentive to be the first to redeem and the price of those early redemptions, before the trigger is breached, may still be inaccurate and unfair to remaining shareholders if such redemptions occur under a fixed NAV regime.

Liquidity fees and temporary redemption gates notwithstanding, however, the Fed officials recognize the importance of maintaining a fund board’s ability to suspend redemptions in order to liquidate a fund as specified in the 2010 amendments to SEC Rule 2a-7.

Floating NAV. If properly implemented, noted the officials, a floating NAV requirement could recalibrate investors’ perceptions of the risks inherent in a fund by making gains and losses a more regularly observable occurrence. Further, the floating NAV alternative reduces investors’ incentives to redeem by tempering the “cliff effect” associated with a fund “breaking the buck.” The first mover advantage is reduced, they explained, because redemptions would be processed at a NAV reflective of the market-based value of the fund’s underlying securities.

The SEC proposes to exempt prime retail money market funds, defined as those with a daily shareholder redemption limit of $1 million or less, from the floating NAV requirement. But the central bankers asked the Commission to make all prime money market funds, including those characterized as retail, subject to the floating NAV requirement. They posited that a structural incentive would remain for investors in retail money market funds that are exempt from the floating NAV requirement to be the first to redeem during times of stress.

While acknowledging that retail investors did not en masse act on this incentive during the crisis, the central bankers cautioned that it cannot be assumed that investor behavior in the future will be the same as in the past. They are also concerned that the $1 million redemption threshold may not fully exclude institutional investors from retail funds, as services might emerge to spread large cash balances across numerous money market funds eligible for the retail exemption. In that event, the entry of institutional investors into retail funds would likely increase the run risk to which the retail investors are exposed.

Liquidity fees and redemption gates. Under this alternative, non-government money market funds would be permitted to transact at a stable share price under normal market conditions, but would be required to impose a stand-by liquidity fee of no more than two percent on all redemptions if a fund’s weekly liquid assets were to fall below 15 percent of total assets, unless a majority of the fund’s independent directors determined that such action was not in the best interest of the fund. In addition, the directors may opt to “gate” the fund upon breaching the weekly liquid assets threshold, if they determine that such action is in the best interest of the fund.

The letter to the SEC flatly states that stand-by liquidity fees and temporary redemption gates do not meaningfully address the risks to financial stability posed by money market funds. This option does not eliminate run risk as investors could have an incentive to redeem before their fund breaches the weekly liquid assets threshold. Because investors are unable to predict how other investors would react once a fund’s weekly liquid assets level begins to deteriorate, noted the central bankers, their safest option may be to run in advance of the fund breaching the trigger. Further, because of the relative homogeneity in many money market fund holdings, the imposition of a liquidity fee or redemption gate on one fund may incite runs on other funds which are not subject to such measures.

Enhanced disclosure. The central bankers strongly support the enhanced disclosure requirements contained in the SEC proposal, under which money market funds would be required to disclose current and historical instances of sponsor financial support; daily liquid assets and weekly liquid asset levels; current NAV rounded to the fourth decimal place; and daily net flows. The SEC also proposes to require money market funds to promptly file (within one business day) a new Form N-CR when certain significant events occur, such as a portfolio security default or insolvency, and weekly liquid asset levels falling below 15 percent under the liquidity fees and redemption gates alternative.

The senior officials also urged the SEC to implement additional steps to enhance disclosure, such as requiring weekly or even daily disclosures of portfolio holdings. During times of stress, uncertainty regarding portfolio composition could cause money market fund investors to redeem if they believe the fund could be exposed to distressed assets. More frequent disclosure alleviates this uncertainty.

The Fed officials also suggested that the SEC consider requiring money market funds to publicly disclose their ten largest investors on a weekly or monthly basis. But they hastened to add that the identity of individual shareholders need not be disclosed, just the size of their investment in the fund. Under current requirements, all mutual funds disclose shareholders that own five percent or more of the outstanding shares of a class of funds.

This information is reported annually in mutual funds’ Statement of Additional Information (SAI) with a significant lag. In their view, enhanced disclosure would allow investors to better assess the shareholder concentration risk in the fund. A fund with a small number of large investors is more likely to experience large redemptions, they reasoned, and is thus more exposed to liquidity risk compared to a less concentrated fund.

Australian Securities and Investments Commission Report Says Hedge Funds Do Not Pose Systemic Risk

Hedge funds do not appear to pose a systemic risk to the Australian economy, according to a report issued by the Australian Securities and Investments Commission. The report found that the surveyed hedge funds appear to use low levels of borrowing, implying that their leverage is unlikely to generate or contribute to systemic risk issues. The majority of the hedge funds use multiple prime brokers, diversifying their counterparty exposure among generally large financial institutions. Further, responses suggested that counterparty exposures and collateral practices are unlikely to contribute to any concerns of systemic risk.

Aggregated information sourced from commercial data providers indicates that the Australian hedge funds sector is mainly made up of funds with less than $50 million assets under management. Therefore, while the survey is representative of a substantial proportion of assets controlled by single-strategy hedge funds, a great majority of smaller funds are not represented by the survey. The Commission said that it might consider lowering the assets under management threshold for qualifying hedge funds in its next survey to capture more funds.

The main investors in the surveyed qualifying hedge funds are Australian wholesale investors. The scale of their investment in hedge funds relative to their total investments is minimal, noted the Commission, which will tend to reduce the likely systemic impact of any problems in the sector. Indeed, nearly 90 percent of investors in surveyed qualifying hedge funds are wholesale investors, with retail investors accounting for slightly over 10 percent.

Wednesday, September 11, 2013

German Central Banker Says Regulation of Shadow Banking Must be Cross-Border to Prevent Arbitrage

The regulation of the non-bank entities in the shadow banking system, including money market funds, must be harmonized across jurisdictions in order to avoid regulatory arbitrage, emphasized Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank. In remarks at the Alpbach Financial Market Symposium, he said that regulatory measures must be developed and agreed upon in international cooperation. As the regulation of banks tightens, he continued, there is a real risk of regulatory arbitrage as activities shift to the shadow banking system, which he predicted would constantly challenge policy makers because it adapts very quickly in order to evade regulatory measures.

In addition, as regulations are developed, policymakers need to have a thorough understanding of their implications. For example, the repo markets are an important source of leverage and pro-cyclicality. In order to thoroughly assess the effects of envisaged numerical floors on haircuts for the securities lending and repo market, a quantitative impact study is just being launched, an approach he strongly supports. It facilitates early recognition of inadequate measures and unintended side-effects, he said, thereby allowing for the introduction of effective measures.

As an aside, the central banker noted that he does not favor the commonly used expression of shadow banking, since the activities of the shadow banking system are not bad per se. He would prefer to call it non-bank banking. However, the term shadow banking has become something of a term of art. The European Commission recently observed that many respondents to its Green Paper on shadow banking expressed displeasure with the term "shadow banking," which they felt has negative connotations. While noting these concerns, the Commission said that it uses the term neutrally and free of connotations. At this stage, concluded the Commission, it is very difficult to introduce alternative terminology, since this is by now a well-established term in the international debate.

The Commission defines shadow banking as a system of credit intermediation that involves entities and activities outside the regular banking system. The shadow banking system includes ad hoc entities such as securitization conduits, money market funds, investment funds that provide credit or are leveraged, such as certain hedge funds or private equity funds and financial entities that provide credit or credit guarantees. Shadow banking also includes activities, in particular securitization, securities lending and repurchase transactions, which constitute an important source of finance for financial entities.

European Commissions Outlines Drive to Regulate Shadow Banking System to Contain Systemic Risk

Concomitant with a proposed Regulation on money market funds, the European Commission issued a statement outlining other reform initiatives in the drive to regulate parts of the shadow banking system that may contribute to systemic risk. In addition to the proposal on money market funds, the Commission indicated that an enhanced framework for certain investment funds could be implemented by strengthening the UCITS framework. In addition, the Commission has been working on a project to reduce the risks associated with securities financing transactions, with a proposal expected in the coming months. The Commission also desires to complete the prudential rules applied to banks in their operations with unregulated financial entities in order to reduce contagion risks and extend the scope of application of prudential rules in order to reduce arbitrage risks.

The Commission defines shadow banking as a system of credit intermediation that involves entities and activities outside the regular banking system. Shadow banks are not regulated like banks, though their operations are like those of banks. The shadow banking system includes ad hoc entities such as securitization conduits, money market funds, investment funds that provide credit or are leveraged, such as certain hedge funds or private equity funds and financial entities that provide credit or credit guarantees. Shadow banking also includes activities, in particular securitization, securities lending and repurchase transactions, which constitute an important source of finance for financial entities.

While the notion of shadow banking has only recently been formally defined in the G20 discussions, the risks related to it are not new. The Commission has already implemented, or is in the process of implementing, a number of measures to provide a better framework for these risks, such as harmonized rules applying to hedge fund activity under the Alternative Investment Fund Managers Directive (AIFMD); and reinforcing the relationship between banks and unregulated actors under, for example, the provisions related to securitization exposures in the revised Capital Requirements Directives.

The European Systemic Risk Board (ESRB) and the Financial Stability Board have shed light on the lack of reliable and in-depth data on repurchase agreements and securities lending transactions. In the Commission’s view, this data is essential to observe the risks associated with interconnectedness, excessive leverage and pro-cyclical behaviors. It will permit the identification of risk factors such as excessive recourse to short-term funding to finance long-term assets, high dependence on certain types of collateral and shortcomings in assessing them.

These gaps are a concern, said the Commission, particularly in view of the opacity of collateral chains which increases the risk of contagion. While actively contributing to international discussions on this issue, the Commission is closely following the current European Central Bank initiative to establish a central repository to collect detailed data on securities repurchase transactions in the E.U. in real time. This work will identify the data necessary for monitoring these transactions and analyze the data already available, particularly in infrastructure.

The ECB recently reiterated the need for a reporting framework at the E.U. level, while the ESRB has concluded that setting up a central repository at the E.U. level would be the best way to collect data on securities financing transactions. The Commission will pay specific attention to this work within the framework of the FSB recommendations. In the light of these developments, it will assess whether transparency at the E.U. level has improved, while reserving the right to propose any appropriate measures to remedy the situation.

The Commission also pointed out that shadow banking entities can, to some extent, be monitored through their relationships with banks. Two sets of requirements are particularly important in this respect: requirements related to transactions concluded between banks and their financial counterparties and the accounting rules on consolidation.

Measures have been taken to ensure that the interests of the persons initiating securitization transactions are firmly aligned with those of the end investors. Since CRD II entered into force at the end of 2010, credit institutions are obliged to check that the originator or sponsor institution of a transaction has an economic interest equivalent to at least 5 percent of the securitized assets. CRD III then reinforced the capital requirements for the risks associated with securitization transactions, particularly when these structures involve several levels of securitization, and increased the prudential requirements for support given to securitization vehicles.

Accounting requirements regarding transparency also play an important role insofar as they allow investors to identify the risks borne by banks and their exposures to the shadow banking sector. The accounting standards on consolidation, in particular, determine whether or not an entity must be included on a bank's consolidated balance sheet. The amendments made by the IASB to the provisions of IFRS 10, 11 and 12, which will enter into force in Europe in 2014, will develop the accounting consolidation requirements and increase disclosure regarding unconsolidated structured entities. Further, the Basel Committee has embarked on a review of prudential consolidation practices and will publish its conclusions by the end of 2014. The Commission is following these developments closely.

Also, in 2010 the IASB strengthened disclosure requirements relating to off balance sheet exposures in the case of transfers of financial assets, which came into effect in Europe on July 1, 2011 pursuant to IFRS 7. During the crisis, observed the Commission, the lack of information on this type of commitment meant that investors and banking authorities were unable to correctly identify all the risks borne by banks.

G20 Leaders Pledge to Complete Derivatives Regulation, End Too-Big-to-Fail, and Finish Reform of the Shadow Banking System

While lauding the substantial progress that major jurisdictions have made in implementing internationally consistent reforms to their financial systems, the G20 Leaders in a final communiqué from the St. Petersburg, Russia Summit urged these jurisdictions to not lose momentum and to finish the job of financial regulatory reform. The G20 were pleased to note that all major jurisdictions have implemented new global capital standards under Basel 3; have completed frameworks for OTC derivatives to be traded on exchanges or electronic trading platforms, centrally cleared, and reported; have identified globally systemically financial institutions and subjected them to heightened prudential standards to mitigate the risks they pose; have set up orderly resolution procedures for large, complex financial institutions without taxpayer loss; and have begun to address potential systemic risks to financial stability emanating from the shadow-banking system. This regulatory effort is unprecedented, said the Leaders, but there is still more work to be done.

The G20 took a strong stand to end too-big-to-fail. In this regard, they fully endorsed the implementation of the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for all parts of the financial sector that could cause systemic problems. They pledged to remove obstacles to cross-border resolution of globally significant financial firms.

The Leaders asked the FSB, in consultation with standard setting bodies, to assess and develop proposals by the end of 2014 on the adequacy of global systemically important financial institutions' loss absorbing capacity when they fail. Recognizing that structural banking reforms can facilitate resolvability, they called on the FSB, in collaboration with the IMF and the OECD, to assess cross-border consistencies and global financial stability implications, taking into account country-specific circumstances, and report to the next Summit. Similarly, they asked the FSB, in consultation with the International Organization of Securities Commissions (IOSCO), to develop methodologies for identifying global systemically important non-bank financial institutions by the end of 2013. They also asked the Committee on Payment and Settlement Systems and IOSCO to continue their work on systemically important market infrastructures.

The G20 Leaders welcomed the FSB's report on progress in OTC derivatives reforms, including members' confirmed actions and committed timetables to put the agreed OTC derivatives reforms into practice. They also praised the recent set of understandings by key regulators on cross-border issues related to OTC derivatives reforms, as a major constructive step forward for resolving remaining conflicts and inconsistencies globally, and look forward to the speedy implementation of these understandings once regimes are in force and available for assessment.

The Leaders endorsed the principle that jurisdictions and regulators should be able to defer to each other when it is justified by the quality of their respective regulatory and enforcement regimes, based on similar outcomes, paying due respect to home country regulation regimes. The G20 asked the regulators, in cooperation with the FSB and the OTC Derivatives Regulators Group, to report on their timeline to settle the remaining issues related to overlapping cross-border regulatory regimes, and regulatory arbitrage.

The G20 called for accelerated progress in reducing reliance on credit rating agencies, in accordance with the FSB roadmap. They encouraged further steps to enhance transparency and competition among credit rating agencies and look forward to IOSCO's review of its Code of Conduct for credit rating agencies.

The Leaders support the establishment of the FSB's Official Sector Steering Group to coordinate work on the necessary reforms of financial benchmarks. And, they endorsed IOSCO's Principles for Financial Benchmarks and look forward to reform as necessary of the benchmarks used internationally in the banking industry and financial markets, consistent with the IOSCO Principles.

The Leaders welcomed the progress achieved in developing policy recommendations for the oversight and regulation of the shadow banking system, as an important step in mitigating the potential systemic risks associated with this market. At the same time, they recognized that nonbank financial intermediation can provide an alternative to banks in extending credit to support the economy.

The Leaders pledged to work towards timely implementation of the recommendations while taking into account country specific circumstances. They welcomed the respective FSB reports in this area and agreed on a straightforward roadmap for work on relevant shadow banking entities and activities with clear deadlines and actions to progress rapidly towards strengthened and comprehensive regulation appropriate to the systemic risks posed.

As part of the growing global consensus on tax evasion and tax avoidance, the G20 Leaders commended the progress recently achieved in the area of tax transparency and fully endorsed the OECD proposal for a truly global model for multilateral and bilateral automatic exchange of tax information. Calling on all other jurisdictions to join them by the earliest possible date, the G20 committed to automatic exchange of tax information as the new global standard, which must ensure confidentiality and the proper use of the information exchanged.

They fully support the OECD work with G20 countries aimed at presenting such a new single global standard for automatic exchange of tax information by February of 2014 and to finalizing technical modalities of effective automatic exchange by mid-2014. In parallel, they expect to begin to exchange information automatically on tax matters among G20 members by the end of 2015.

They called on all countries to join the Multilateral Convention on Mutual Administrative Assistance in Tax Matters without further delay; and look forward to the practical and full implementation of the new standard on a global scale.

The Leaders asked the Global Forum to establish a mechanism to monitor and review the implementation of the new global standard on automatic exchange of tax information.

Sunday, September 08, 2013

Executive Orders on Financial Regulatory Process Reform Shine Light on Path to Legislation

As Congress considered a number of bills that would reform the regulatory process, the two Executive Orders issued by President Obama during his first term in office remain fixed stars to navigate towards teh final enactment of regulatory reform legislation. President Obama has been a strong champion of reform of the federal regulatory process. This is evidenced by the 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. To facilitate the periodic review of existing significant regulations, EO No.13579 said that independent regulatory agencies should consider how best to promote retrospective analysis of  rules that may be outmoded, ineffective, insufficient, or excessively burdensome, and to modify, streamline, expand, or repeal them in accordance with what has been learned.

One of the more promising pieces of legislation to emerge in the 113th Congress is the  Independent Agency Regulatory Analysis Act, S. 1173, would require independent federal agencies, such as the SEC and CFTC, to conduct a cost-benefit analysis of new regulations and tailor new regulations to minimize unnecessary burdens on the economy. The bill would provide for review by the Office of Information and Regulatory Affairs (OIRA) of every proposed and final economically significant regulation, pegged at economic impact of $100 million or more, followed by a public exchange of views between OIRA and the independent agency concerning the quality of the agency’s cost-benefit analysis. Although OIRA would not have the power to reject a regulation, it would place its evaluation of the agency’s cost-benefit analysis in the public record. 

S. 1173 is strongly bi-partisan and is sponsored by Senators Mark Warner (D-VA), Susan Collins (R-ME) and Rob Portman (R-OH). It contains a key role for OIRA, an office in OMB which the Administration has elevated into a new prominence.

Saturday, September 07, 2013

In Supreme Court Amicus Brief, National Whistleblower Center Urges Deference to DOL

In a case reviewing a First Circuit panel’s ruling that only employees of public companies are covered by the whistleblower provisions of the Sarbanes-Oxley Act,  the National Whistleblower Center filed an amicus brief urging the Supreme Court to give Chevron deference to the Department of Labor’s holding that contractors and subcontractors are also covered under the term employee under the provisions. The case is set for oral argument on November 12, 2013. Lawson v. FMR, LLC,. No. 12-3.

Congress vested exclusive jurisdiction in the DOL to administer the whistleblower provisions in Section 806 of Sarbanes-Oxley, said the brief. Within the context of this authority, the DOL has consistently interpreted the term employee broadly to encompass contractors and subcontractors. Further, noted the brief, this interpretation has been in place for decades and has not been challenged by Congress or overturned judicially.

If the Court did not give deference to the DOL interpretation of employee and decided that the whistleblower protections do not extend to contractors and subcontractors, the brief warns that this would create a massive loophole that was not intended by Congress when it passed Sarbanes-Oxley. Even more, not giving deference to the DOL in this matter would create dubious incentives for companies engaged in misconduct to hire contractors and subcontractors to handle some of their more legally questionable work. 

European Commission Reaffirms Support for Mandatory Audit Firm Rotation

In a letter to the U.K. Competition  Commission on its audit tendering proposal, the European Commission took the opportunity to reaffirm its strong commitment to audit firm rotation as the best way to bring diversity to the highly concentrated outside audit of financial statements market. While noting that the Competition Commission proposed mandatory tendering on a five-year basis, the European Commission said that it was addressing a wider range of issues involving enhancing auditor independence and improving audit quality.

In this regard, the Commission views mandatory audit firm rotation as an essential step for ensuring independence and professional skepticism. Audit firm rotation is needed to ensure a ``fresh pair of eyes’’ and avoid the relationship between management and auditors becoming too close. There is a real risk that incumbent auditors would be unwilling to challenge their own past judgments where such an act would be likely to either inflict reputational damage or where restatements might result in potential legal liabilities. When an audit firm knows that it will be replaced, reasoned the Commission, it will be incentivized to maintain skepticism in its judgments since the incoming auditors will be reviewing those judgments in detail.

Hong Kong Regulators Issue Proposals on OTC Derivatives Regulation

The Hong Kong Monetary Authority and the Securities and Futures Commission have, after consultation, issued additional proposals on the regulation of OTC derivatives and the oversight of systemically important participants (SIP).  Two new regulated activities were proposed to be regulated involving the activities of dealers and advisers in relation to OTC derivatives transactions, as well as clearing agents in OTC derivatives under the OTC derivatives regime.
In order to manage counterparty risk arising from a bilateral OTC derivatives transaction, market participants have started clearing their OTC derivatives transactions through a central counterparty. They can do so directly by becoming a member of the central counterparty or indirectly by clearing with a central counterparty through a third party. Due to the stringent admission criteria of central counterparties, noted the authorities, not every market participant may become member of a central counterparty and clear directly. They may instead engage third parties who provide clearing agency services so that they can clear indirectly through a central counterparty. As the regulators implement mandatory clearing obligations to cover more market participants, the demand for indirect clearing is likely to increase.

It was also proposed that market participants in Hong Kong whose OTC derivatives positions exceed a prescribed notification level should notify the SFC, and their name and details should then be entered in the SIP register. Additionally, the HKMA and SFC should have the power to require registered SIPs to provide information and take certain action in respect of their OTC derivatives positions and transactions as may be required.

The authorities proposed that penalties for breach of a notification requirement by an SIP should be set at the same level as penalties for unlicensed activities. They also proposed to give SIPs a right of appeal in respect of agency decisions on various matters, including registration and de-registration by the SFC and directions by the SFC or the HKMA for the SIP to take specified action.

Hong Kong Monetary Authority Advises on FATCA Compliance

With the issue of tax evasion assuming increasing prominence within the international community and various countries having introduced or contemplating changes to their tax regimes, the Hong Kong Monetary Authority advised financial institutions to ensure compliance with FATCA and other applicable overseas  regulatory requirements by critically assessing the implications of such changes for their customers and operations, taking into account their scale and nature of business and geographical areas of operation. As a case in point, the HKMA specifically mentioned FATCA, which requires foreign financial institutions to report to the IRS certain information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest. To properly comply with these reporting requirements, noted the Authority, foreign financial institutions will have to enter into a special agreement with the IRS. Non-participating foreign financial institutions may be subject to withholding taxes on relevant payments received by the firms.

In a letter to CEOs of financial institutions authorized to operate in Hong Kong, the HKMA advised that, if the financial firms conclude that any overseas tax regime changes may have implications for their customers and operations, they should put in place process and controls to ensure compliance and develop good practices through industry collaboration if appropriate. In the case of  FATCA, the financial firms should ensure compliance by implementing necessary process and controls, which among other things may include legal, compliance and operational implications, including customer communication, of the foreign financial institution agreements with the IRS, and resources implications, for FATCA implementation.

The agreements require foreign financial institutions to perform additional due diligence and provide information about customers who are U.S. taxpayers or foreign entities in which U.S. taxpayers hold a substantial ownership interest. During this process, advised the HKMA, financial firms may obtain further information from their customers to identify those accounts maintained by U.S. persons. Whenever there is a need, advised the Authority, foreign financial firms should inform customers and obtain their specific consent before reporting the requested information to the IRS. At all times, they should ensure that they comply with all provisions of the Hong Kong Personal Data (Privacy) Ordinance and adequate preparation should be made to respond to customer enquiries, taking into account the Ordinance.

Hong Kong SFC Advises on Investment in Collective Investment Schemes

Responding to enquiries concerning the regulation of collective investment schemes, the Hong Kong Securities and Futures Commission outlined the relevant provisions in the Securities and Futures Ordinance (SFO) governing the offer and promotion of collective investment schemes, and reminded those intending to market a collective investment scheme that breaching the provisions may constitute a criminal offense.

Under the SFO, generally a collective investment scheme has four relevant elements. First, it must involve an arrangement in respect of property. Second, participants cannot have day-to-day control over the management of the property even if they have the right to be consulted or to give directions about the management of the property. Third, the property is managed as a whole by or on behalf of the person operating the arrangements, and/or the contributions of the participants and the profits or income from which payments are made to them are pooled. Fourth, the purpose of the arrangement is for participants to participate in or receive profits, income or other returns from the acquisition or management of the property.

A collective investment scheme may cover any property, including real estate, whether located in Hong Kong or overseas. It is an offense under the SFO to issue any marketing material which contains an offer to the Hong Kong public to acquire an interest or participate in a collective investment scheme unless it has been authorized by the SFC or an exemption applies. In addition, promoting a collective investment scheme may, in addition, constitute a business in a regulated activity which requires a license from the SFC, failing which may lead to an offense under the SFO.

Finally, and more generally, the Commission cautioned any person who wishes to offer or promote any investment arrangement to Hong Kong investors to be aware of the restrictions under the SFO, and seek professional advice if in doubt to ensure compliance with the law. At the same time, investors in doubt about the nature and regulatory status of any investment arrangement are also advised to seek professional advice prior to making an investment. 

Thursday, September 05, 2013

IOSCO Secretary General to Address NASAA's Annual Conference

NASAA has announced that IOSCO Secretary General David Wright will address NASAA's annual conference next month in Salt Lake City. Prior to his appointment as head of IOSCO in 2012, Wright spent more than 34 years working for the European Commission at the highest levels of the European Union's political and regulatory system.

During his service with the European Commission, Wright played key roles in designing and finding political agreements on the major European securities legislation such as the Markets in Financial Instruments Directive (MIFID) and the Transparency, Prospectus and Market Abuse directives. Wright also acted as rapporteur on the De Larosière Committee on financial services reform and represented the European Commission in international fora such as the FSB and G20.

SIFMA CEO and former U.S. Senator Judd Gregg will deliver the conference's keynote address at a luncheon on October 7. Conference registration forms and the full schedule of events are available on the NASAA website. Regular conference registration ends on September 27.

Monday, September 02, 2013

German Central Banker Warns against Interconnectedness of Derivatives Central Counterparties in EMIR-Dodd-Frank Age

While praising the compromise agreement between the CFTC and the European Commission on cross-border derivatives regulation as evidence that global policymakers are pulling together, Andreas Dombret, the member of the Deutsche Bundesbank Executive Board with oversight of financial stability, cautioned that Dodd-Frank Act and EMIR regulatory requirements could turn central counterparties into “juggernauts” of the international financial system that must be closely monitored.  As such, he advised that every central counterparty must have robust risk management structures in place. As competition among central counterparties grows more and more intense, a race to the bottom could ensue as they undercut each other in terms of the size and quality of their margin requirements. Regulators and policymakers must prevent this from happening by, among other things, assuring that the central counterparties’ models for calculating margin requirements are sufficiently conservative.

In the board member’s view, the main problem with central counterparties is that losses could only be distributed among clearing participants, which is usually a small group of market participants, in particular, global financial institutions, giving rise to potential contagion risks and domino effects. More broadly, the central banker said that financial stability cannot be subordinated to the efficiency of central counterparties. While recognizing that it would be desirable for derivative users if the central counterparties became interconnected because the users would not need to join a number of different central counterparties in order to settle contracts with counterparties that use other central counterparties, the board member warned against the contagion dangers that interconnected central counterparties would represent. All of this serves to illustrate why regulators must continue to keep a close watch on the future development of the derivatives markets. In Europe, he noted, EMIR offers a good starting point for regulators to ensure that the changes now under way help achieve greater stability in the financial system.

Finally, the central banker said that appropriate recovery and resolution regimes need to be available for central counterparties in case of emergencies. The envisaged loss allocation rules are one core element in designing these regimes.

European Commission Supports SEC Proposed Cross-Border Derivative Regulations

In a letter to the SEC, the European Commission generally supported the SEC’s proposed cross-border derivatives regulations, especially praising the Commission’s use of substituted compliance for firms and exemptive relief for market infrastructure. The European Commission is encouraged by the holistic approach that the SEC proposes to take when assessing a foreign regime with a view to awarding substituted compliance. The Commission supports the consideration of regulatory outcomes as the standard for permitting substituted compliance, as well as the consideration of particular market practices and characteristics in individual jurisdictions.

This flexible approach recognizes the differing approaches that regulators and legislators may take to achieving the same regulatory objectives in the derivatives markets. The European Commission did suggest, however, that the review of a foreign regime should be conducted in cooperation solely with the relevant foreign regulators or legislators, as opposed to firms. In particular, the initiation of the review should be left to the relevant foreign regulator or legislator in order to avoid duplication or confusion.

The European Commission is also supportive of a definition of a US person that is territorial in scope, which does not capture entities incorporated in foreign jurisdictions. Within this meaning, the proposed definition of a US person is primarily territorial in nature. But there is one notable exception, in the form of the inclusion of any partnership, corporation, trust, or other legal person having its principal place of business in the United States.

While recognizing that the purported capture of firms incorporated outside of the US but operating principally within the US is designed to ensure the non-evasion of obligations by firms that essentially conduct their core business within the US but that are notionally incorporated in non-regulated jurisdictions, the European Commission urged the SEC to clarify the type of businesses that it intends to capture through this notion, either within the operative text of its rules or through accompanying guidance.

The Commission suggested that the SEC may wish to consider adding criteria to establish whether a non-US entity meets the definition of US person in this respect, such as quantitative thresholds such as a percentage of business conducted in the US and whether the seat of incorporation of the firm is a non-regulated jurisdiction. Indeed, the Commission feels that it is essential that further clarity be provided on this aspect of the definition in order to enable firms to establish whether they or their counterparties would be classified as US persons by the SEC.

The Commission observed that the notion of transactions conducted within the US runs throughout the proposal and is a trigger point for the application of US rules transacted with or between non-US firms. The result is that transactions involving non-US firms may be caught by SEC rules by virtue of being deemed to be concluded on US territory, although either one or both of the legal counterparties to the transaction  may be non-US persons. The proposal would require non-U.S firms to comply with U.S. rules on reporting and trade execution in two instances: 1) when a transaction executed by a non-US firm with a US firm where the non-US firm transacts via a US branch but where the non- US firm is the legal counterparty to the transaction; and 2) a transaction executed between two non-US firms through US branches but where the non- US firms are the legal counterparties to the transaction.

The European Commission asked the SEC not to apply its rules in the case where the legal counterparty to a transaction deemed to be conducted in the US is a non-US firm since no US firms are exposed to counterparty credit risk under such transactions and in particular where those non-US firms are subject to comparable rules in its domestic jurisdiction.