Friday, November 29, 2013

Senator Warren Gains Glass-Steagall Allies in U.K. Parliament

The efforts of Senator Elizabeth Warren (D-MA) to bring back the Glass-Steagall Act gained some adherents in the U.K. Parliament. During recent debate on the U.K. legislation on ring-fencing retail from investment banks, legislators had some nice things to say about Glass-Steagall.

Lord Lawson, a key member of the joint Banking Standards Commission, said that the Glass-Steagall Act worked in the United States for many, many years and it is no accident that serious problems emerged after it was repealed. Indeed, the Glass-Steagall Act would have worked for a great deal longer, he said, had not successive American Administrations been lobbied by the banks to introduce loopholes in one place and another. Similarly, Lord Barnett said that Glass-Steagall, which he called the separation regime in the United States, did not fail but succeeded for more than 60 years. It failed when the lobbyists in the banks eventually won, he noted. However, he continued, ``if we managed to introduce a UK form of Glass-Steagall, strengthened to prevent lobbyists succeeding, we will have achieved something that has never been achieved before.’’

Friday, November 22, 2013

Securities and Banking Industries Request Extension of FATCA Deadlines

The securities and banking industries have asked for an additional extension of the phased-in timeline for the Foreign Account Tax Compliance Act (FATCA). In a letter to the Treasury and IRS, SIFMA and the American Bankers Association, as well as the  Institute of International Bankers, said that a number of significant gaps in guidance remain, as well as numerous unanswered implementation questions that must be addressed by the IRS. While banks and securities firms are working diligently to implement FATCA, noted the letter, without the Final Guidance firms cannot complete their implementation plans, finalize budgets, prepare needed written procedures, hire and train internal personnel, educate clients, and develop and test the systems changes required for compliance with FATCA.  The industry associations believe that it would be appropriate to extend further certain milestone dates in order to help ensure a smooth transition to the FATCA regime and minimize the prospects of over withholding and, more broadly, the potential for significant disruption to the financial markets.
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.

SIFMA and ABA extension requests. Specifically, SIFMA and the ABA request an additional six-month extension for withholding that is scheduled to take place beginning on July 1, 2014, so that withholding begins with payments made after December 31, 2014. In addition, the definition of a grandfathered obligation, including associated collateral, should be extended to obligations outstanding as of January 1, 2015.
Similarly, they request an additional six-month extension for withholding documentation set to expire on June 30, 2014, so that such documentation would expire on December 31, 2014. Since information reporting and withholding systems are based on the calendar year, the banking and securities industries have a strong preference for January 1 effective dates. The mid-year effective date for withholding and due diligence procedures, as well as the mid-year expiration date for Forms W-8, presents an additional and unexpected challenge for FATCA implementation teams.
Draft Form W-8BEN-E is a highly complex 8-page form that will require significant employee training on how to validate the form, said the associations. Banks and securities firms, as requesters of withholding certificates, will play an integral part in the education of their non-U.S. clients and will need time to educate clients on the completion and use of the new Form W-8 series once the forms and instructions are issued in final form. 
They also request that FATCA reporting for 2014 (via Form 8966) should apply only to accounts designated by a participating foreign financial institution as held by a U.S. citizen or resident on December 31, 2014, and identifiable via electronic search. In addition, reporting for calendar year 2014 should be delayed one year so that reporting for calendar years 2014 and 2015 would be provided by March 31, 2016. Under this approach, firms would be permitted to voluntarily report earlier in order to test the reporting systems. All other FATCA-related reporting requirements7 should be postponed to be effective for payments made beginning in calendar year 2015.
IGAs. SIFMA and the ABA also emphasized that FATCA implementation has been further impacted by the lengthy process of negotiating IGAs between Treasury and foreign governments. Not only will global financial institutions doing business in IGA jurisdictions be required to implement certain aspects of FATCA under IRS regulations, said the groups, they will also be required to comply with varying IGA requirements in the approximately 80 jurisdictions expected to enter into IGAs.

Moreover, of the ten IGAs that have been executed to date, only the United Kingdom has issued comprehensive guidance for implementation. While it is helpful that signed IGAs can be recognized as being in effect, banks and securities firms still are faced with the prospect of being required to program their systems for the FATCA regulations and then having to subsequently reprogram these systems and revise their procedures on a country-by-country basis as IGAs are implemented and local guidance is released. Therefore, the associations believe that additional time is needed for the Treasury and foreign jurisdictions to conclude the new IGAs and enable financial institutions operating in those countries to implement FATCA just once.

FCA’s Wheatley Emphasizes Judgment and Ethics in Approach to Securities Regulation

While regulations and guidance are important for securities regulators, noted Financial Conduct Authority Chief Executive Martin Wheatley, they become a blunt instrument if used as a substitute for good judgment and are not enough, in and of themselves, to regulate effectively. The FCA’s solution to this has been to use a broader array of judgment-based tools and techniques, including competition, behavioral economics and more sophisticated modeling, to get under the hood of the financial services industry and ensure that consumers in all financial markets are treated fairly. Mr. Wheatley delivered his remarks at the recent CFA European Investment Conference.

Britain’s new Financial Conduct Authority came into being on April 1, 2013 as part of the new twin peaks regulatory regime under which the Financial Services Authority was replaced by the Financial Conduct Authority and the Prudential Regulation Authority, two new regulators with discrete remits. This has effectively meant that prudential regulation, the safety and soundness of firms, has been separated from conduct regulation, noted Mr. Wheatley, which is about the broader behavior of firms. There is also the Financial Policy Committee, with a remit to manage risks to the financial system and build its resilience.

According to the Chief Executive, the FCA’s focus on conduct regulation means there is much greater regulatory emphasis on integrity and ethics in the U.K. financial markets today. Recognizing that culture is notoriously difficult to measure, let alone change, the FCA is developing a deeper understanding of the sectors that it regulates, and the consumer experiences within them. The agency is also probing on sources of revenue, trying to divine how a firm makes its money. Similarly, it wants to understand how a firm’s business model delivers against the expectations of consumers.  
The Chief Executive said that the FCA’s toolkit is more sophisticated and more in tune with the changing political and societal context. It is fair to financial firms, he continued, and reflects where the financial industry is now and where it is going. Mr. Wheatley believes that effective judgment-based, forward looking financial regulation should actually and ultimately translate into reduced enforcement activity and more confidence in the financial industry.
In earlier remarks, he indicated that the main duty or Government remit of a securities regulator is to ensure that the financial markets work well for all the market participants. He noted that the FCA has developed a forward-looking and judgment-based philosophy of financial regulation to ensure the well-functioning of the markets. The FCA will employ real time regulation  and eschew box-ticking and regulation based on historic data collection. The FCA espouses regulation that is outcome-based and employs the tactic of early intervention.

ESMA issues guidance on when shareholders act in concert

At the request of the European Commission, the European Securities and Markets Authority (ESMA) has issued a list of activities that shareholders can cooperate on without being considered to be acting in concert under the Takeover Directive. The ESMA guidance provides that shareholders will not be acting in concert when they enter into discussions with each other about possible matters to be raised with the company’s board. Similarly, they will not be acting in concert when they make representations to the company’s board about corporate policies, practices or particular actions that the company might consider taking.  Shareholders will not be acting in concert when they agree to vote the same way on a particular resolution put to a general meeting, other than in relation to the appointment of board members.

The ESMAS list does not include any activity relating to cooperation on board appointments, due to differences in Member State approaches towards determining whether shareholders who cooperate in relation to board appointments are acting in concert. ESMA pointed out that if shareholders cooperate in an activity not included on the list, this will not result in an automatic assumption that they are acting in concert. Rather, each case will be determined on its own particular facts and circumstances.

National competent authorities will have regard to the ESMA list when determining whether shareholders are persons acting in concert under national takeover rules, but will also take into account all other relevant factors in making their decisions.

ESMA Chair Steven Maijoor said that the issuance of the list means that shareholders can be confident that regulators will take a consistent approach across the E.U. to shareholder cooperative activities. In turn, the Chair believes that this consistency will provide shareholders with the reassurance they need for the effective, sustainable engagement that is one of the cornerstones of sound corporate governance, allowing them to hold their boards to account.

German Central Bank Calls for Strong Risk Management at Derivatives Central Counterparties

A report by the German central bank found that the close and opaque ties in the over-the-counter derivatives markets are a potential source of danger to the stability of the financial system. The antidote to this potential threat to financial stability is the creation of derivatives central counterparties, who bear the default risks. Thus, the Deutsche Bundesbank views as a positive development the ever greater use of central counterparties for clearing under both the Dodd-Frank Act and EMIR.  The report noted that, in the case of new index credit default swaps arranged between major derivatives traders, more than half are now being cleared through central counterparties.
However, the central bank cautioned that as central counterparties assume this systemically important role the need for safety barriers arises. In this regard, regulators must adopt and ensure strict requirements globally for risk management at central counterparties. In addition, suitable recovery and resolution regimes for central counterparties must be established. Regulators and policy makers must not allow new systemic risks to build up at central counterparties.
Central counterparties. The Bundesbank report observed that a primary goal of the regulation of the derivatives markets is to reduce systemic risk mainly by involving central counterparties, which act as a contractual counterparty for derivatives buyers and sellers. They thus assume default risk in the derivatives market, which will, it is hoped, allow them to dampen the shock waves sent out by the default of a large market participant by acting as a breakwater. In addition, trade repositories are to ensure greater transparency with a view to facilitating the timely identification of risk concentrations.

However, the report cautioned that the regulation of the OTC derivatives markets is advancing only slowly. While international standard-setting, national implementation and the application of the regulations are making definite progress, acknowledged the central bank, the aim of having the new regulations fully in place by the end of 2012 has not been achieved.

It would have been desirable, said the Bundesbank, for the international agreements to have been implemented close to simultaneously in all countries. But this did not happen, and there are marked differences in the national implementation to date.

Requirements for central counterparties in the various jurisdictions should not be contradictory, cautioned the central bank, and must not be permitted to trigger regulatory arbitrage and a concomitant race to lower standards. In addition, as derivatives central counterparties are assigned a systemically important role, their risk management should be subject to strict rules at the global level. Indeed,  every central counterparty should have robust risk management structures in place.

All that said, the central bank noted that progress is being made in the field of central clearing of derivatives. The entry into force of various obligations to use central counterparties in Japan in November 2012 and in the United States in March 2013 provided a catalyst. 

Judge Rakoff Speaks on Intent and Lack of Prosecutions in Wake of Financial Crisis

In remarks before the New York City Bar Association, federal district judge (SDNY) Jed Rakoff noted that, in striking contrast with past prosecutions engendered by past financial crises, not a single high level executive has been successfully prosecuted in connection with the recent financial crisis, and given the fact that most of the relevant criminal provisions are governed by a five-year statute of limitations, it appears very likely that none will be. One possibility, already mentioned, is that no fraud was committed, a possibility that should not be discounted.

While he has no opinion as to whether criminal fraud was committed in any given instance, Judge Rakoff remarked that the Financial Crisis Inquiry Commission, in its final report, uses variants of the word fraud no fewer than 157 times in describing what led to the crisis, concluding that there was a systemic breakdown, not just in accountability, but also in ethical behavior. The Commission found that the signs of fraud were everywhere to be seen. Without multiplying examples, the point is that, in the aftermath of the financial crisis, the prevailing view of many government officials was that the crisis was in material respects the product of intentional fraud.

Examining the issue of the difficulty of proving intent, Judge Rakoff noted that willful blindness or conscious disregard are a well-established basis on which federal prosecutors have asked juries to infer intent, in cases involving complexities, such as accounting treatments, at least as esoteric as those involved in the events leading up to the financial crisis. And while some federal courts have occasionally expressed qualifications about the use of the willful blindness approach to prove intent, the Supreme Court has consistently approved it.

He had no idea whether the financial crisis was the product, in whole or in part, of fraudulent misconduct. But if it was, he continued, the failure of the government to bring to justice those responsible for 

U.S. Supreme Court will Examine Fraud-on-the-Market Doctrine and Presumption of Reliance

The U.S. Supreme Court has agreed to review the fraud-on-the-market doctrine and its attendant presumption of reliance in securities fraud actions. The grant of certiorari gives the Court the opportunity to examine its 1988 ruling in Basic, Inc, v. Levinson, 485 U.S. 224. The vehicle for the Court’s review of fraud-on-the-market is Halliburton v. Erica P. John Fund, Dkt. No. 13-317.

In the BasicInc. decision, the Court endorsed the fraud-on-the-market theory under which a plaintiff in a securities fraud action can invoke a rebuttable presumption of reliance on misrepresentations regarding securities trading in an efficient market. This action poses the question of  whether the Court should overrule or substantially modify its 1988 holding in Basic Inc. v. Levinson, to the extent that it recognizes a presumption of class-wide reliance derived from the fraud-on-the-market theory.

Fraud-on-the-market. The fraud-on-the-market presumption is generally invoked to establish reliance. Under the presumption, when a company makes public material misstatements in an efficient market, the misstatements are reflected in the price of the stock and it is presumed that the investor relied on the misstatements when he or she purchased the stock at the market price.

In an earlier amicus brief the National Association of Manufacturers and the U.S. Chamber of Commerce had urged the Court to grant the petition for certiorari (which it has now done) and overrule or modify the fraud-on-the-market theory endorsed in the Basic Inc. decision. 

This theory, explained the Chamber, allows investors to establish the reliance element in a securities fraud class action merely by showing that they traded stock around the time of the public misrepresentations. This approach, argued the Chamber, has led to doctrinal confusion among the lower courts and enabled a wave of frivolous class action litigation. The Chamber also noted that the presumption of reliance is based on an efficient-market theory, which today's economists increasingly reject.

House Panel Marks Up Legislation to Enhance Capital Formation

The House Financial Services Committee has marked up and reported out three pieces of legislation that would ease the regulation of business development companies, create a tick size pilot program for emerging growth companies, and reform the regulation of M&A brokers. All three are part of an initiative to enhance capital formation. Committee Chair Jeb Hensarling (R-TX) said that these three bills, combined with other bills the Committee will soon consider in a subsequent mark up, will be bundled together to comprise a JOBS Act 2.0.

Business development companies. Business development companies are closed-end investment companies that invest in and lend to small- and medium-sized private companies rather than large public companies, thereby filling a market niche that some commercial banks have abandoned. As a result, many small and medium-sized businesses have been able to obtain financing, which has supported their growth and which might not otherwise have been available to them.

In 1980, Congress authorized the creation of business development companies by amending the Investment Company Act, but Congress has not updated the statute since 1980. In the intervening years, the regulatory framework has created challenges for business development companies seeking to raise and deploy capital and, in turn, to satisfy their Congressional mandate to lend to small and medium-sized companies.

In an effort to reform the regulation of business development companies, the Committee approved the Small Business Credit Availability Act, H.R. 1800. Introduced by Rep. Michael Grimm (R-NY), H.R. 1800 would amend Section 60 of the Investment Company Act to allow business development companies to purchase, acquire, or hold securities or other interests in investment advisers or advisors to investment companies, and allow them to issue more than one class of senior security which is a stock. H.R. 1800 also amends Section 61(a) of the Investment Company Act to reduce the ratio of assets to debt that business development companies are required to maintain from 200% to 150%. Finally, H.R. 1800 directs the SEC to revise its rules and forms to allow business development companies to use the streamlined securities offering provisions available to other registrants under the Securities Act.

Much of the modernization of securities regulation that occurred in 2005 by way of Securities Offering Reform largely did not apply to business development companies. As a result, SIFMA noted in recent testimony before the Committee that many unnecessary obstacles remain in place today so that business development companies are unable to efficiently access the markets and, in turn, provide much needed capital to middle market companies. SIFMA supports efforts to align the regulation for business development companies more closely with that of other public companies.

Most business development companies are RICs (Regulated Investment Companies) under the federal tax code and as a result are required to dividend out substantially all of their net income for tax purposes. Thus, business development companies are required to come to the public markets more regularly to raise capital in order to grow. The inability to utilize some of the built- in efficiencies in securities regulation for frequent corporate issuers, such as incorporating previously filed information  by reference, creates unnecessary burdens.

Tick size pilot program. The Committee also unanimously marked up and approved the Small Cap Liquidity Reform Act, H.R. 3448., which would allow small emerging growth companies to enter a five year pilot program that would give them the ability to quote and trade stocks in 5 and 10 cent increments instead of just pennies. The increased tick size maximizes their liquidity, giving them access to capital that the penny tick size does not foster.

Introduced by Rep. Sean Duffy (R-WI), and co-sponsored by Rep. John Carney (D-DE), H.R. 3448 would  provide for an optional pilot program administered by the SEC allowing certain JOBS Act emerging growth companies with a stock price above $1.00 to increase the tick size at which their stocks are quoted and traded from $.01 to $.05, or, if the company’s board of directors so elects, $.10. The bill allows covered emerging growth companies to change the tick size of their stock from $.05 to $.10 or from $.10 to $.05 one time during the pilot program. It also allows companies to opt out of the program.

By providing flexibility in tick size for smaller issuers, the bill aims to improve market quality and increase liquidity in their shares, thereby promoting capital formation.

An amendment offered by Rep. Duffy, and approved during the mark up, provides that if an emerging growth company opts out of program, the SEC must notify all venues on which the company is traded. Another Duffy Amendment approved in the mark up would give the SEC discretion to determine where in the 5 and 10 cent increments the stock may be traded. An amendment offered by Rep. Carney would clarify that the intent is to apply the safe harbor provision in the bill solely to the decision to expand the tick size for the company. The intent is to ensure that the safe harbor is not too broad, while at the same time sufficient to protect the company from shareholder suits.

Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act, The Committee also approved by a unanimous 57-0 vote,  H.R. 2274, the Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act, which would amend Section 15(b) of the Securities Exchange Act to establish a streamlined and commonsense approach that allows for the sale of small and mid-size businesses while maintaining the necessary safeguards, protecting jobs and allowing for continued economic growth. Sponsored by Rep. Bill Huizenga (R-MI), H.R. 2274 would reform the regulation of M&A brokers.

Rep. Huizenga noted that current federal law treats the sale of a small privately held business, as if it were a Wall Street investment firm selling securities of a public company. The legislation establishes a streamlined and commonsense approach that allows for the sale of small and mid-size businesses while maintaining the necessary safeguards, protecting jobs and allowing for continued economic growth.

Sunday, November 17, 2013

European Commission Report Says Transform EFRAG to Have More Say in IFRS Standard Setting

The European Commission has issued a report offering suggestions on how the E.U. could have a more active role in setting international accounting standards in a world where more and more non-E.U. countries are adopting IFRS and the IASB acknowledges the major of influence of FASB positions  even though the United States has no intention of adopting IFRS in the foreseeable future. The report, prepared by Phillpe Maystadt at the behest of Commissioner for the Internal Market Michel Barnier, centers on a transformed European Financial Reporting Advisory Group (EFRAG) as the vehicle for enhancing E.U. influence on international accounting standard setting.

A former Belgian Finance Minister and President of the European Investment Bank, Mr. Maystadt was named a Special Adviser to Commissioner Barnier with the role of reinforcing the E.U.’s contribution to IFRS.

The report concludes that EFRAG is currently an imperfect vehicle for the job because it is a technical body composed of experts mainly from the private sector, with no mandate from the Member States. While ideally EFRAG should be Europe’s voice in the accounting debate, noted the report, it is a technical committee with views that do not always take appropriate account of broader policy perspectives, such as market stability and shadow banking. In addition, the influence of EFRAG is weakened by tense relations with the national standards setters of the largest Member States, which wish to gain more
influence in the debates.

The report offers three options: 1) transform EFRAG; 2) transfer EFRAG’s duties to the European Securities and Markets Authority (ESMA); or 3) replace EFRAG with an agency of the E.U. Noting the  opposition to Option 2 and the budgetary constraints working against Option 3, the Maystadt report recommends the adoption of Option 1.

Option 1: Transform EFRAG. The transformation of EFRAG would aim at reinforcing its structure and maintaining, at the same time, its mixed composition that covers both public and private interests at the European level. The new structure would fulfill its current technical role, but would also be able to carry out a strategic analysis of the economic impact of the accounting standards under scrutiny, relying on adequate conceptual and technical means.

The new structure would allow EFRAG to provide the IASB and the Commission with analyses on both technical and economic considerations. Under this first option, EFRAG would remain a private organization and the Commission, as a guardian of the European public interest, would still be responsible for making decisions on the strategic and political issues involved in the accounting debate, under the control of the Council of the European Union and of the Parliament.

Option 2: Fold EFRAG into ESMA. The interest of ESMA is to ensure that the IASB produces standards which are sufficiently clear to allow for the consistent application of IFRS but also to protect markets. ESMA has solid expertise in the field of implementation and the interpretation of accounting standards at the European level. As part of its duty to coordinate at the E.U. level the enforcement activities performed by national regulators on the consistent application of IFRS, ESMA identifies cases where standards have been implemented in diverse ways and, if necessary, submits them to the interpretations committee of the IASB.

The report said that this would present the possibility to integrating EFRAG into ESMA. Mr. Maystadt emphasized the advantages of this option, while also recognizing the strong opposition to it. The option would merge two European organizations, EFRAG and ESMA, active in the field of IFRS and allow for the rationalization of human and financial resources, as well as the integration of the endorsement and enforcement processes, thus making the overall process of IFRS development more coherent.

It would also endow the European Union with a structure more similar to the SEC. Moreover, the role of spokesperson for the European Union and the influence over the strategic guidelines in the field of international accounting standards would no longer belong to a private entity.

However, this option has run into massive opposition from stakeholders. They claim that ESMA has a restrictive view on accounting standards and considers IFRS only from the perspective of informing and protecting investors, without taking into consideration macro-economic impacts, prudential aspects and the concerns of preparers of financial statements. In addition, certain Member States are reluctant to give more power to ESMA.

Noting that the development of standards and enforcement should not be mixed, some people fear that ESMA would grow into a stock market watchdog similar to the SEC. Further, sentiment has been expressed that the IFRS standards are based on principles (unlike US GAAP), and that therefore the regulatory influence should remain moderate in order to maintain this characteristic and to avoid IFRS becoming more rules-based.

For all if these various reasons, the report concludes that Option 2 cannot be adopted. But Mr. Maystadt still wants ESMA to have an enhanced role in the European accounting standard setting  process. For this reason, in Option 1, the report recommends that ESMA propose a member for the Board of the new and transformed EFRAG. ESMA could also share with the Commission the role of observer at the International Financial Reporting Standards Interpretations Committee.

Option 3: Replace EFRAG with a public agency. The major advantage of this option is the fact that it would no longer be necessary to entrust the roles of advisor to the Commission and of spokesperson in relations with the IASB to a private entity (EFRAG). This would clearly show that European public interest must prevail in these matters.

However, this option is unrealistic in the current budgetary context. In particular, the scope of this agency would seem to be too limited to justify the creation of such a structure, especially because it would inevitably generate costs, not only for salaries, but also for bigger pensions.

Friday, November 15, 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.

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

E.U. concerns.
In an earlier letter to the CFTC, the European Commission said that, while the doctrine of substituted compliance set forth in the proposed guidance is similar to the E.U. equivalence approach, a decision by the CFTC determining substitute compliance will not apply to jurisdictions, which is the case under the European Market Infrastructure Regulation (EMIR), but will apply only to specific firms and can be withdrawn from a firm at any time.

The Commission urged the CFTC to adopt a similar approach to that of the E.U. based on the recognition of equivalent jurisdictions and not of individual firms. The Commission warned that the approach taken in the proposed guidance would introduce legal uncertainty. Also, the broad definition of U.S. person in the proposed guidance poses a significant risk of the duplication of U.S. regulatory requirements with those of the E.U., said the Commission.

ESMA Publishes List of non-E.U. Central Counterparties Applying for Recognition under EMIR

The European Securities and Markets Authority has listed central counterparties established in non-E.U. countries that have applied for recognition under Article 25 of the European Market Infrastructure Regulation (EMIR) and which expressly agreed to have their name mentioned publicly. ESMA noted that this list is not necessarily exhaustive and remains subject to further updates.

Eight U.S. central counterparties have applied: Chicago Mercantile Exchange, ICE Clear U.S., LCH.Clearnet LLC, National Securities Clearing Corp. New York Portfolio Clearing LLC, The Options Clearing Corporation, Fixed Income Clearing Corp, and ICE Clear Credit LLC. Other central counterparties that have applied include the Canadian Derivatives Clearing Corp., the Tokyo Financial Exchange, Inc., and the Hong Kong Securities Clearing Company, Ltd.

Senate Legislation Would Give States Standing to Challenge Federal Regulations

Senator Roger Wicker (R-MS) has introduced legislation that would enable states to dispute federal regulations. The Restoring the 10th Amendment Act, S. 1632, stipulates that any regulation proposed by federal agencies is subject to constitutional challenge if state officials determine that it infringes the 10th Amendment. Senator Wicker said that enacting the legislation would be a step towards greater accountability. The bill is co-sponsored by Senator Mike Crapo (R-ID), the Ranking Member on the Banking Committee and Senator Charles Grassley (R-IA), the Ranking Member on the Judiciary Committee.
S. 1632 provides that during the comment period for a proposed regulation state officials may submit to the head of the agency proposing the regulation, if the SEC the SEC Chair, a legal brief challenging the constitutionality of the proposed regulation under the 10th Amendment. The SEC Chair, continuing the example, would then have to prominently post on the front page of the agency’s website, in such a manner that it is immediately noticeable to individuals who visit that website, a link to the brief. Within 15 days of posting the link to the state’s brief, the SEC Chair must certify in writing that, in the opinion of the Chair, the regulation does not violate the 10th Amendment and include in the certification the full legal reasoning supporting that opinion. The certification must be prominently posted on the front page of the agency’s website next to the links to the brief.  At any time after the head of an agency posts a certification that a rule does not violate the 10th Amendment, the legislation authorizes a designated state official to commence a civil action against the agency on the grounds that the rule of the agency violates the 10th Amendment.

U.K. Appeals Court Allows LIBOR Claims against Global Banks in Action on Swaps Agreements

A three-judge panel of the U.K. Court of Appeal ruled that investors in an action with global financial institutions involving derivatives agreements could amend their pleading to allege that the firms made implied representations as to the efficiency of or the non-manipulation of LIBOR. The financial institutions did propose the use of LIBOR, said the court, and it is arguable that, at the very least, they were representing that their own participation in the setting of the rate was an honest one. If  the LIBOR scandal had occurred before these cases were begun and what are now the proposed pleas had been incorporated in original pleadings, they would not, in the view of Lord Justice Longmore writing for a unanimous panel, be amenable to a strike out application. (Graisley Properties Limited & ORS v. Barclays Bank PLC and Deutsche Bank PLC, Court of Appeal (Civil Division), EWCA Civ 1372, Nov. 8, 2013.

LIBOR. LIBOR is a benchmark used to gauge the cost of unsecured borrowing in the London interbank market and sets the price for derivatives and other financial contracts worldwide. LIBOR is an integral part of the modern financial system, referenced in a huge number and variety of derivatives and other financial contracts. Although LIBOR is calculated in London, it is based on daily submissions from a number of international banks and is used as a global benchmark.

Swaps agreements. The appeals resulted from the distortion or manipulation of LIBOR in the calculation of interest in the swap agreements. In the appeals, the financial institutions are endeavoring to recover sums due under such agreements and the borrowers sought permission to amend their pleadings to allege that the banks made implied representations as to the efficiency of or the non-manipulation of LIBOR.

The court rejected the idea that doing nothing cannot amount to an implied representation. The banks did not do nothing in that they proposed transactions which were to be governed by LIBOR. The court reasoned that is conduct just as much as a customers’ conduct in sitting down in a restaurant amounts to a representation that they are able to pay for their meal. The banks' submissions boiled down to saying that they were prepared to accept that they would do nothing dishonest or manipulative during the term of the contract and that should be enough for any counterparty. But in the court’s view, that is arguably not enough.

If the day after the contracts had been made, the banks had told their counterparties that they had been manipulating LIBOR in the past and intended to do so in the future, but would be happy to pay any loss that their borrowers could prove, the borrower would arguably be sufficiently horrified so as to think he would be entitled to rescind the deal. The law should strive to uphold the reasonable expectations of honest men and women, emphasized the court, and, if in the end it cannot do so, that should only be after a proper trial.

Sunday, November 10, 2013

U.K. FCA Will Engage in Reform of the Asset Management Sector at Domestic and E.U. Levels Says Martin Wheatley

The current U.K. asset management regulatory regime is neither sufficiently transparent nor accountable, noted Martin Wheatley, Chief Executive of the Financial Conduct Authority. In recent remark at an asset management seminar, he noted two persistent problems. First, services are being bundled together, with eligible and non-eligible services being mixed. Second, when this information is provided back to the client, there is a lack of clarity or adequate transparency around how their commissions have been spent. Almost concomitantly, the FCA issued a report on outsourcing in the asset management business.

The asset management industry is plagued by an outdated bundled charging system, noted the FCA official, and the use of dealing commissions to purchase research lacks transparency, distorts competition, and supports unsustainable business models. Moreover, the link between volume of trading and research expenditure appears to be flawed. It creates pots of research commissions that the fund manager is then incentivized to spend regardless of the added value of the services, he said, thereby creating a potential conflict of interest.

The system is not working as intended, he emphasized, and thus wider reform is now required to address flaws that cannot simply be addressed by incremental improvements to existing rules.

The FCA is greatly concerned that firms are pushing the definition of research by using client commissions to cover non-eligible costs and services, including a significant chunk of clients’ commission being paid for corporate access services from investment banks and brokers. The FCA estimates that up to £500 million of dealing commission was spent in 2012 to facilitate corporate access. This averaged out to each individual investment manager paying over £100,000 just to gain access to the management of companies they wanted to invest in. The FCA believes that this is just one area where firms are allocating commission to ineligible services and paying more for services than they would if they had to pay for them out of their own money.

This practice transfers the firm’s costs onto the client, he noted, which clearly works against the client’s interests. It additionally raises a concern because asset managers do not control costs indirectly borne by the client with the same rigor as costs they incur directly. On the other side of the transaction, chief executives and investor relations officers have learned that their time is being billed to the industry by brokers.

While the FCA has no particular concerns with the purchase of corporate access, it believes that asset managers should be using their own funds if they wish to purchase access. Investment banks appear to sell or provide additional services such as corporate access to the highest bidder. In the view of the FCA, this practice favors high degrees of trading, distorts the market, and causes asset managers to pay increasingly more for research even if they receive very little value from it.

Moreover, the prevalence of bundled services, combining eligible with non-eligible services, can also disguise overpayments for eligible services. This cross-subsidizes services that asset managers should pay for from their own funds, observed Mr. Wheatley, and, in turn, sustains business models that would quickly fail under increased global competition

As a result of these findings, industry members and representatives, including the Investment Management Association, have recognized that certain practices need to change. While acknowledging that reform must ultimately and ideally be at the E.U. level, the FCA chief opened a domestic debate on the need to reform the asset management sector. He said the FCA will issue a Consultation Paper in November seeking views on how to improve the current regime. Specifically, the Consultation will focus on providing clarity around how ``research ‘’ is defined and what is eligible and non-eligible when purchasing goods and services from clients’ dealing commissions.

At the same time, the FCA will continue to engage at a European level. The changing E.U. asset management regulatory regime is in development and the FCA has engaged and influenced the Markets in Financial Instruments Directive (MiFID), for example, from the outset, which Mr. Wheatley views as the main vehicle for E.U. reform.

In principle, the FCA supports an approach that applies across Europe so if the end destination becomes un-bundling, for example, then this would apply unilaterally across asset management in Europe. The advantage of progressing this at the E.U. level is that it will ensure a level playing-field and allow firms to adapt their business models before implementation.

The key findings of the report on outsourcing in the asset management industry is that asset managers were largely unprepared for the failure of a service provider undertaking critical activities, as firms’ contingency plans had not considered how to maintain operations and service to their customers. An asset manager is engaged in outsourcing if it appoints a service provider to conduct an activity which the asset manager would otherwise complete itself while conducting its regulated business.

The report also found reassurance that asset managers had oversight arrangements in place to oversee their service providers. But the effectiveness of oversight arrangements varied from firm to firm, with only some asset managers able to demonstrate high standards of oversight consistently across all outsourced activities. Where oversight of an activity was lacking, the main cause was insufficient internal expertise to carry out the oversight.

In light of the findings, the FCA urged asset managers to review their own outsourcing arrangements and, where appropriate, enhance their contingency plans for the failure of a service provider providing critical activities, taking into account industry-led guiding principles where applicable; and assess the effectiveness of their oversight arrangements to oversee critical activities outsourced to a service provider, ensuring that the required expertise is in place.

Enforcement Action Alleging Insider Trading and Fraud by Two Magic Circle Solicitors Can Proceed Says Hong Kong Court

An enforcement action by the Hong Kong Securities and Futures Commission against two solicitors for insider dealing and fraud will proceed after the Court of First Instance dismissed an application by the solicitors to strike out the proceedings. The action was brought under Section 213 of the Securities and Futures Ordinance (SFO). The allegations concern conduct in relation to two confidential deals which the two solicitors became privy to as a result of their employment by two different law firms in Hong Kong. The solicitors were employed at the relevant time by Slaughter & May and Linklaters, but are no longer employed by these firms. The court found that the solicitors owed fiduciary duties, including a duty of confidentiality, to their firms and its clients. They were also subject to the firms’ restrictions on trading securities and had to obtain approval before doing so. (SFC v. Fung, et al., HCMP 2575/2010, Oct 28, 2013, Chan, J.)

The SFC is seeking injunctions and remedial orders under Section 213 of the SFO. The defendants argued that the court had no jurisdiction under Section 213 of the SFO to seek court orders against them and that the SFC had no reasonable cause of action or the action was unlikely to succeed. The Court of First Instance found that the arguments to strike out the proceedings were misconceived and dismissed the application.

The first deal involved a proposed takeover of Hsinchu International Bank Company Limited (Hsinchu), a company listed on the Taiwan Stock Exchange, by Standard Chartered Bank (Standard Chartered). Shortly before the deal was announced, the defendants purchased shares in Hsinchu. The SFC alleges that at the time one solicitor was working on secondment within Standard Chartered on the proposed takeover.

The second deal involved a proposed privatization of Asia Satellite Telecommunications Holdings Limited (Asia Satellite) by CITIC Group and General Electric Capital Corp. The other solicitor was working for a different law firm which had been engaged to advise CITIC Group on the proposed transaction; and worked within the department of the law firm that was working on the deal. On the morning before trading in Asia Satellite shares was to be suspended for the proposed privatization, the solicitors began buying shares in Asia Satellite. The SFC alleges their trading accounted for 73% of the total trading on that day.

The SFC alleges that the defendants, who made a total profit of $2.9 million from the two transactions, contravened Section 300 of the SFO which prohibits the use of fraudulent or deceptive schemes in securities transactions in relation to the Hsinchu matter; and Section 291, which prohibits insider dealing in relation to the trading in shares of Asia Satellite. The SFC is unable to allege that the Hsinchu trades constituted insider dealing as well because the prohibition on insider dealing in the SFO does not apply to shares traded on the Taiwan Stock Exchange.

The main grounds claimed for dismissal concern the viability of the Commission’s causes of action based on Section 300, which provides that a person must not in a transaction involving securities or futures contracts employ any device, scheme or artifice with intent to defraud or deceive; or engage in any act, practice or course of business which is fraudulent or deceptive, or would operate as a fraud or deception. According to the court, it is reasonably clear from the natural meaning of Section 300 that it is intended to outlaw two types of conduct in transactions involving securities. First, fraudulent or deceptive conduct, which is relatively straightforward; and second, any device, scheme or artifice employed with intent to defraud or deceive.

The court rejected the contention that the person being defrauded or deceived must be a trading party in a transaction involving securities. There is nothing in Section 300 which suggests that the victim of the fraud or the device, scheme or artifice must be a party to the securities transactions, noted the court, and such limitation should not be read into the section since it would severely curtail its scope.

In Wake of LIBOR Scandal, German Regulators Increase Requirements for Quotation Process

In view of the allegations of manipulation relating to quotation processes for LIBOR and other reference rates, the German Federal Financial Supervisory Authority (BaFin) has specified in more detail its requirements in respect of financial institutions reporting associated data. In a letter, which was agreed to with the Bundesbank, the financial regulators calls on the financial institutions to strengthen their internal control processes.

In the summer of 2012, BaFin had already informed certain individual financial institutions of mandatory requirements for quotation processes. The current letter is designed to ensure that the quotation processes are uniformly applied at the firms. At the same time it aims to increase awareness of supposedly low-risk audit areas. BaFin’s requirements with respect to the quotation process include, among other things, the principle of dual control, transparent documentation and the clear allocation of responsibilities. The documentation must at least show who is responsible for the quote, and include a justification for each quote and an explanation of deviations from the previous day quotations.

An escalation procedure must be resorted to in cases of uncertainty that at least goes to upper management, ie the vice presidential level, so that they will be informed of actual implausibilities.

In addition, financial institutions must perform regular checks and risk audits. The amounts stated in the quotations must be verified independently on a regular basis, at least monthly. The quotation process must be given greater prominence within the internal auditing function, which must monitor compliance with the audit measures and perform regular checks to establish whether the quotations that have been reported are correct, and whether the original risk classification assigned to audit areas is still appropriate

Friday, November 08, 2013

U.S. and Global Regulators Urge Uniform Derivatives Contracts to Aid Cross-Border Resolution

In a joint letter to the International Swaps and Derivatives Association (ISDA), U.S. and global financial regulators in charge of resolution authorities for failing financial institutions urged the adoption of uniform language in derivatives contracts to delay the early termination of those instruments in the event of the resolution of a global systemically important financial institution (G-SIFI). In the letter, the resolution authorities expressed support for the adoption of changes to ISDA's standard documentation to provide for short-term suspension of early termination rights and other remedies in the event of a G-SIFI resolution. The letter to ISDA was signed by FDIC Chair Martin Gruenberg, Bank of England Governor Mark Carney, Patrick Raaflaub, CEO of the Swiss Financial Market Supervisory Authority, and Elke Konig, President of the German Federal Financial Supervisory Authority.

In the view of the regulators, the adoption of such changes would allow derivatives contracts to remain in effect throughout the resolution process following the implementation of a number of potential resolution strategies. By minimizing the disorderly unwinding of such contracts, reasoned the regulators, these changes would place resolution authorities in a better position to resolve G-SIFIs in a manner that promotes financial stability while providing market certainty and transparency.

According to the regulators, a key challenge in the development and implementation of resolution authorities for failed financial firms and accompanying strategies is the risk of the disorderly termination of derivatives contracts, particularly in the cross-border resolution context, arising out of the exercise of termination rights following the commencement of an insolvency or resolution action.

Thus, the regulators believe it essential for standard ISDA documentation to provide for a short-term suspension of early termination rights and other remedies on the basis of the commencement of an insolvency or resolution proceeding or exercise of a resolution power with respect to a counterparty or its credit support provider. Such a provision would allow the exercise of all applicable types of resolution powers, especially the transfer of the derivative contracts and associated guarantee obligations to a third party, including a bridge entity, on an expedited basis, the bail-in of a failing institution through the write-down of liabilities, or the conversion of liabilities into equity.

The international regulatory community continues to work closely to harmonize statutory approaches, noted the regulators, and a change in the underlying contracts for derivative instruments that is consistently adopted is a critical step to provide increased certainty to resolution authorities counterparties, and other market participants, particularly in the cross-border resolution context. As resolution regimes arc developed and implemented in an increasing number of jurisdictions, continued the authorities, ISDA is in a unique position to link these regimes by providing consistent and enforceable contractual provisions related to termination and other remedies with respect to derivatives transactions.

E.U. Council Approves Changes to Financial Reporting and Mandates Disclosure of Resource Extraction Payments

The Council of the European Union has approved amendments to the Transparency Directive that eliminate the need for company management to publish quarterly financial information. Thus, Member States will not be allowed to impose in their national legislation the requirement to publish periodic financial information on a more frequent basis than annual financial reports and half-year financial reports. However, Member States will be able to require companies to publish additional periodic financial information if such a requirement does not constitute a significant financial burden, and if the additional information required is proportionate to the factors that contribute to investment decisions. In particular, Member States can require the publication of additional periodic financial information by financial institutions. Moreover, a regulated market can require issuers which have their securities admitted to trading thereon to publish additional periodic financial information in all or some of the segments of that market.

In order to provide additional flexibility and reduce administrative burdens, the amended Directive also extends the deadline for publishing half-year financial reports to three months after the end of the reporting period.

The legislation also requires companies whose securities are admitted to trading on a regulated market and who have activities in the resource extractive or logging of primary forest industries to annually disclose in a separate report payments made to governments in the countries in which they operate. The report should include types of payments comparable to those disclosed under the Extractive Industries Transparency Initiative (EITI).

The intent of the legislation is that disclosure of payments to governments should provide civil society and investors with information to hold governments of resource-rich countries to account for their receipts from the exploitation of natural resources.

There is a materiality threshold such that payment, whether made as a single payment or a series of related payments, need not be taken into account in the report if it is below EUR 100 000 within a financial year.

According to E.U. Internal Market Commissioner Michel Barnier, the amendment puts the E.U. on a level playing field with the U.S., which mandated similar payments by resource extraction companies in Section 1504 of the Dodd-Frank Act. The Directive goes further than Section 1504 in that, in addition to oil gas and mining companies, it brings logging companies within its scope.

Wednesday, November 06, 2013

In Form 10-Q, Avon Products, Inc. Details Efforts to Reach Settlements with SEC and DOJ on FCPA Issues

In its most recently filed Form 10-Q, Avon Products, Inc. detailed efforts to reach a settlement with the SEC and the Department of  Justice on compliance with the Foreign Corrupt Practices Act (FCPA). As previously reported in October 2008, the company voluntarily contacted the SEC and DOJ to advise both agencies of its internal investigation, overseen by the audit committee, focused on FCPA compliance issues and reviews.  The company said that has cooperated and will continue to cooperate with investigations of these matters by the SEC and the DOJ. The company has, among other things, signed tolling agreements, responded to inquiries, translated and produced documents, assisted with interviews, and provided information on its internal investigation and compliance reviews, personnel actions taken and steps taken to enhance corporate ethics and compliance program.

As far as the internal investigation and compliance reviews, the company noted that they have focused on reviewing certain expenses and books and records processes, including, but not limited to, travel, entertainment, gifts, use of third-party vendors and consultants and related due diligence, joint ventures and acquisitions, and payments to third-party agents and others, in connection with our business dealings, directly or indirectly, with foreign governments and their employees. The internal investigation and compliance reviews of these matters are substantially complete. In connection with the internal investigation and compliance reviews, certain personnel actions, including termination of employment of certain senior members of management, have been taken, and additional personnel actions may be taken in the future. In addition, the company said that it continues to enhance its ethics and compliance program, including FCPA compliance-related training and FCPA third-party due diligence programs.

As previously reported in August 2012, the company is in talks with the SEC and the DOJ regarding resolving the government investigations. As previously reported in its Form 10-Q for the period ending June 30, 2013, the company made an offer of settlement to the DOJ and the SEC in June 2013. Although that offer was rejected by the DOJ and the staff of the SEC, the company accrued the amount of its offer in the second quarter of 2013. In September 2013, the SEC staff proposed terms of potential settlement that included monetary penalties of a magnitude significantly greater than the company’s earlier offer.

The company disagrees with the SEC staff's assumptions and the methodology used in its calculations; and believes that monetary penalties at the level proposed by the SEC are not warranted. The firm anticipates that DOJ also will propose terms of potential settlement, although they have not yet done so. If the DOJ’s offer is comparable to the SEC’s offer, and if the company were to enter into settlements with the SEC and the DOJ at such levels, observed the 10-Q, the company’s earnings, cash flows, liquidity, financial condition and ongoing business would be materially adversely impacted.

Although the company said it is working to resolve the government investigations through settlement, these discussions are at early stages and at this point the success of these efforts is uncertain, as is the timing or terms of what such settlements would be. The company expects that any settlements with the SEC and DOJ will include civil and/or criminal fines and penalties, and may also include non-monetary remedies, such as oversight requirements and additional remediation and compliance requirements. The company may be required to incur significant future costs to comply with the non-monetary terms of any settlements with the SEC and the DOJ.

There can be no assurance that the company’s efforts to reach settlements with the government will be successful. If settlements are not reached with the SEC and/or the DOJ, the company cannot predict the outcome of any subsequent litigation with the government; but added that any such litigation could have a material adverse effect on corporate earnings, cash flow, liquidity, financial condition and ongoing business.

Finally, the third quarter 10-Q noted that the company has not recorded an additional accrual beyond the amount recorded in the second quarter of 2013 because at this time, in light of the early stages of discussions of possible settlement terms with the government, the magnitude of the difference between the earlier offer and the amount proposed by the SEC and the absence of a proposal from the DOJ, and the inability to predict whether the company will be able to reach settlements with the government, the firm cannot reasonably estimate the amount of additional loss above the amount accrued to date.

Until these matters are resolved, either through settlement or litigation, the company expects to continue to incur costs, primarily professional fees and expenses, which may be significant, in connection with the government investigations. Furthermore, under certain circumstances, the company may also be required to advance and/or reimburse significant professional fees and expenses to certain current and former company employees in connection with these matters.

Monday, November 04, 2013

On Question from Ninth Circuit, Delaware Supreme Court Reaffirms Narrow Fraud Exception to Continuous Ownership Rule for Derivative Actions

Answering a question from the Ninth Circuit Court of Appeals, the en banc Delaware Supreme Court ruled that shareholders cannot maintain a derivative action under the fraud exception to Delaware’s continuous ownership rule after a merger that divests them of their ownership interest in the corporation on whose behalf they sue by alleging that the merger at issue was necessitated by, and is inseparable from, the alleged fraud that is the subject of their derivative claims. At the same time, the Court, in an opinion by Justice Holland, reaffirmed the continuous ownership rule, and the limited fraud exception to that rule, recognized by its 1984 holding in Lewis v. Anderson. (Arkansas Teacher Retirement System, et al. v. Countrywide Financial Corporation, et al., Delaware Supreme Court, No. 14, 2013, September 10, 2013, Holland, J.)

The derivative action was brought in federal court by five institutional investors asserting state and federal derivative claims for breach of fiduciary duty and securities law violations. While the suit was pending in the federal district court, the company merged into a wholly-owned subsidiary of Bank of America Corporation in a stock-for-stock transaction that divested the plaintiffs of their shares.

Continuous ownership rule. In Anderson, the Court held that for a shareholder to have standing to maintain a derivative action, the plaintiff must not only be a stockholder at the time of the alleged wrong and at the time of commencement of suit but must also maintain shareholder status throughout the litigation. These two conditions precedent to initiating and maintaining a derivative action are referred to as the contemporaneous ownership and the continuous ownership requirements. The contemporaneous ownership requirement is imposed by statute, noted the Court, while the continuous ownership requirement is a matter of common law. But the Court also recognized a narrow exception to the loss-of-standing rule when the merger itself is the subject of a claim of fraud, being perpetrated merely to deprive shareholders of their standing to bring or maintain a derivative action.

Fraud exception. The Court emphasized that Lewis v. Anderson is settled Delaware law and has been consistently followed since 1984. The Court said that its 2010 decision in Arkansas Teacher Retirement Systems v. Caiafa, which arose from the same underlying facts and involved the parties to this appeal, did not change the Lewis v. Anderson equation.

Moreover, in Arkansas Teacher, the Court unequivocally stated that the company’s merger with BofA had extinguished the plaintiffs’ standing to pursue derivative claims. After that ruling, the Court discussed, in dictum, certain direct claims that the plaintiffs could have brought, but did not. But the Court emphasized here that that dictum did not overrule sub silentio more than twenty-five years of precedent that consistently held that the fraud exception applies only where the sole purpose of a merger is to extinguish shareholders’ derivative standing.

U.K. Opinion Says Directors Have No Fiduciary Duty to Avoid Tax

The Tax Justice Network, an independent organization launched in the British Houses of Parliament dedicated to analysis and advocacy in the field of tax regulation recently sent a letter to the CEO of every company in the UK's FTSE100 opining that company directors have no fiduciary duty to their shareholders to avoid tax. A director's duty to exercise reasonable care, skill and diligence is not a duty to avoid tax, particularly in view of the role generally played by external advisers. Although the opinion in itself only directly applies to the UK, it potentially has wide international relevance. The opinion was prepared for the Network by the law firm Farrer & Co.

Delaware decision. Company directors have no general independent fiduciary duty to minimize taxes, ruled the Delaware Chancery Court, and a failure to minimize taxes is not per se a waste of corporate assets. There are a variety of reasons why a company may choose or not choose to take advantage of certain tax savings, reasoned Vice Chancellor Glasscock, and a company’s tax policy typifies an area of corporate decision-making best left to management’s business judgment, so long as it is exercised in an appropriate fashion. (Seinfeld v. Slager, Del Chan Ct, No. 6462, June 29, 2012)

While not foreclosing the theoretical possibility that under certain circumstances overpayment of taxes might be the result of a breach of a fiduciary duty, the Vice Chancellor noted that a decision to pursue or forgo tax savings is generally a business decision for the board of directors. Vice Chancellor Glasscock observed that a company’s tax policy may be implicated in nearly every decision it makes, macro or micro, including about its capital structure, when to purchase capital goods, where to locate its operations and whether to rent or buy real property.

House Panel Reports Out Legislation Reforming Federal Litigation

The House Judiciary Committee has reported out legislation designed to reform the federal litigation system by reducing frivolous lawsuits. Introduced by Rep. Lamar Smith (R-TX), the Lawsuit Abuse Reduction Act, H.R. 2655, was reported out of the Committee by a vote of 17-10. House Judiciary Committee Chairman Bob Goodlatte (R-VA) said that H.R. 2655 is an important step in reducing unnecessary and abusive litigation in the judicial system. Attorneys should not be rewarded for filing baseless lawsuits, he noted, and the Act would provide sanctions against such abuse. The bill now heads to the floor for a full vote by the House of Representatives.

According to Rep. Smith, the measure would restore accountability to the legal system by imposing mandatory sanctions on attorneys who file meritless suits in federal court. Specifically, the bill would reinstate sanctions for the violation of Rule 11 of the Federal Rules of Civil Procedure, which was originally intended to deter frivolous lawsuits by sanctioning the offending party. H.R. 2655 would reverse the 1993 amendments to Rule 11 that allow parties and their attorneys to avoid sanctions for making frivolous claims by withdrawing them within 21 days after a motion for sanctions has been served. The legislation would also ensure that judges impose monetary sanctions against lawyers who file frivolous lawsuits, including the attorney’s fees and costs incurred by the victim of the frivolous lawsuit. 

Senate companion bill. There is a companion bill in the Senate, S. 1288, sponsored by Senator Charles Grassley (R-Iowa), the Ranking Member of the Senate Judiciary Committee. Senator Grassley noted that federal rules mandating sanctions for frivolous suits were watered down in 1993, resulting in widespread lawsuit abuse. The Lawsuit Abuse Reduction Act restores the mandatory sanctions which hold attorneys accountable for lawsuit abuse.