Jim Hamilton’s World of Securities Regulation

Audit Committee Chairs of Global Companies Inform PCAOB that Mandatory Auditor Rotation Would Undermine the Committee

2012-01-29T13:21:00.002-06:00

Comment letters on the PCAOB’s concept release on auditor independence and audit firm rotation reveal a growing consensus among the audit committee chairs of complex global corporations that mandatory audit firm rotation would undermine the audit committee as overseer of the company’s relationship with its outside auditor in the post-Sarbanes-Oxley era. Peter V. Ueberroth, audit committee chair of Coca-Cola, Inc. noted that, since the passage of the Sarbanes-Oxley Act in 2002, independent audit committees have had the primary responsibility for engaging, overseeing, and terminating the outside auditor. In passing Sarbanes-Oxley, he noted, Congress clearly recognized that the audit committee brings a unique and informed perspective to consideration of which firm is best positioned to serve as a company’s outside auditor.

The audit committee chair at the Louisiana-Pacific Corporation said that, in the Sarbanes-Oxley Act, Congress explicitly rejected mandated audit firm rotation. Instead, the Act strengthened the role of audit committees, which enhanced the communication between the independent auditors and the audit committee, increased the discussion around independence and provided more transparency to the services provided by the audit firms.

Mr. Ueberroth, a former chair of the United States Olympic Committee board of directors, also posited that imposing a mandatory rotation requirement would inevitably interfere with the audit committee’s responsibility for assessing the effectiveness of the auditor and choosing whether to retain the auditor based on this assessment. That key responsibility would be subordinate to a mandate to choose a new firm, he said, even when that firm, in the judgment of the audit committee, may not be as qualified as the current auditor to serve the company. Further, requiring a company to rotate audit firms would presents serious risks related to the effective functioning of the audit process and, consequently, could lead to a deterioration in audit quality, particularly in the years leading up to, and after, a rotation. Mandatory audit firm rotation also would create a host of practical difficulties for Coca-Cola and similar companies with complex global business operations.

The chair of the Exxon Mobil audit committee, Michael Boskin, former Chair of the Council of Economic Advisers under President George H. W. Bush, emphasized that mandatory auditor rotation could have a detrimental effect on the quality of the independent audit function and would diminish the important role of the board audit committee, a primary function of which is to promote the independence of the audit function. The chair explained that the audit committee accomplishes this through exercising direct responsibility for appointing, compensating, retaining and overseeing the work performed by the independent auditor. Mandating rotation of the audit firm would diminish the audit committee’s responsibility to appoint and retain the independent auditor.

Mr. Boskin also noted that an auditor can achieve a profound understanding of a complex, multinational company only through active engagement over an extended period of time. Attaining this deeper understanding of the company, its philosophy, policies, standards, and systems is critical to audit effectiveness, he remarked, and takes many years to achieve. Mandatory rotation undermines the process for developing this holistic view of a company, he said, and would make audits less effective and more vulnerable to error.

The audit committee chair at AT&T observed that mandatory audit firm rotation would be ineffective in increasing audit quality and protecting investors. It would also diminish the audit committee’s oversight role. The audit committee is best positioned to select the company’s outside auditor, emphasized the chair, and industry expertise combined with institutional knowledge gained over time significantly enhances the quality of the audit.

Echoing the comments of other audit committee chairs, the Union Pacific Corp. audit committee chair noted that mandatory audit firm rotation may lead to increased audit costs as a newly engaged audit firm may require additional staff and time to ensure a comprehensive audit.

The chair of the audit committee at New York Life Insurance Co. said that mandatory audit firm rotation would result in no meaningful improvement in auditor independence, objectivity and professional skepticism and would come with significant cost and risk. The chair stressed the importance of the continued autonomy of the audit committee to choose the right auditor, based on the audit firm's experience and industry knowledge, instead of being forced to choose an auditor due to a mandated requirement. Any
requirement to adopt mandatory rotation would take away discretion from the audit committee to do what is in the best interest of the company. The audit committee is in the best position to evaluate whether the company’s outside auditors are independent, objective and are exercising an appropriate level of professional skepticism.

The chair of the audit committee at Imperial Oil said that mandatory rotation of the audit firm effectively supersedes the board audit committee's important responsibility to appoint and retain the independent auditor. Further, since there are only a limited number of audit firms large enough to audit companies like Imperial Oil, mandatory rotation, based on arbitrary points in time could limit the availability of qualified firms, placing the audit committee in an unacceptable position.

House Ag Committee Approves Legislation Clarifying Dodd-Frank Swap Execution Facility Provisions

2012-01-28T14:30:00.001-06:00

The House Agriculture Committee approved by a voice vote bi-partisan legislation providing certainty and direction with regard to the Dodd-Frank definition of swap execution facility. Sponsored by Rep. Scott Garrett (R-NJ), Chair of the Capital Markets Subcommittee, the Swap Execution Facility Clarification Act, HR 2586, is designed to implement congressional intent reflected in the heavily negotiated language of the swap execution facility definition in Dodd-Frank. H.R. 2586 directs regulators to provide market participants with the flexibility they need to obtain price discovery in the market and in the method of execution they use.

The Act would clarify that a swap execution facility cannot be required to have a minimum number of participants, receive or respond to quote requests, or display quotes for a certain period of time. Further, the SEC and CFTC would not be permitted to limit the means of contract execution or require trading systems to interact with each other.

In addition to allowing voice execution on a swap execution facility for any trade, HR 2586 prohibits ‘the 15 second rule,’ restrictions on the request for quote (RFQ) model and a sweep the book requirement. Chairman Garrett believes that the specific nature of this direction is necessary to promote the conditions for a competitive regulated swaps market to thrive in the U.S.

An amendment to HR 2586 offered by Ag Committee Ranking Member Collin Peterson (D-MN) was approved by voice vote. The Peterson Amendment is designed to send a signal to not gut CFTC powers on swap market transparency. In this spirit, the amendment preserves CFTC authority to promote greater transparency. Rep. Peterson noted that swap execution facilities must be open transparent marker places where competition governs. The Peterson Amendment was strongly support by Ag Committee Chair Frank Lucas (R-OK), who described it as a targeted amendment that will give swap execution facilities the flexibility to evolve naturally without hindering liquidity or choice for market participants. ‘

Chairman Garrett praised the Ag Committee’s approval of HR 2586, noting that regulating the execution of swap transactions as mandated by the Dodd-Frank Act is the most significant market structure undertaking since 1934. If Congress and the regulators don’t get it right, he warned, there is a risk of putting the U.S. at a competitive disadvantage with foreign counterparts. While for some the goal is to have swaps trade with continuous pricing like the equity and futures markets, he said, because many swaps are illiquid products with sporadic pricing, that goal simply isn’t practicable at this time. H.R. 2586 is specifically designed to promote the transparent evolution of swaps trading on swap execution facilities and help to ensure that a vibrant swap market develops in the U.S. Importantly, it also protects the confidential trading strategies of asset managers, pension funds, insurance companies, farm credit banks and the ability of commercial end-users to access the swap market to fund long-term projects necessary to create jobs.

During the markup of HR 2586 in the Financial Services A technical amendment offered by Chairman Garrett, and suggested by the SEC, would strike ``trading system or platform’’ from the bill and insert ``method of trading system functionality.’’ According to Chairman Garrett, this is term of art that keeps the congressional intent of allowing different methods of trading while obviating the need for new definitions in the legislation.

FinCEN to Work with SEC in Developing Regulations Requiring Investment Advisers to Set Up AML Programs and Report Suspicious Activities

2012-01-28T11:56:00.002-06:00

The Financial Crimes Enforcement Network is working on a regulatory proposal that would require investment advisers to establish anti-money laundering programs and report suspicious activity. In remarks at a recent American Bankers/American Bar Association seminar, FinCEN Director James Fries, Jr. said that FinCEN looks forward to working with the SEC as well as the States in developing the proposed regulations. FinCEN is a bureau within the Treasury Department charged with administering and enforcing compliance with the Bank Secrecy Act and associated regulations.

Although investment advisers are not expressly included within the definition of financial institution under the Bank Secrecy Act, the Act authorizes the Treasury Secretary to include additional types of entities within the definition of financial institution if it is determined that they engage in an activity similar to, related to, or a substitute for an activity of an enumerated entity. FinCEN regulations currently apply to broker-dealers and mutual funds.

On May 5, 2003, FinCEN published a notice of proposed rulemaking in the Federal Register proposing that investment advisers, because of the types of activities they engage in and the services they provide, should be defined as financial institutions for the purpose of requiring them to establish anti-money laundering programs. Many investment advisers provide investment advice to clients who have granted the adviser the power to manage the assets in their accounts, frequently on a discretionary basis, reasoned FinCEN, and thus engage in activities that are similar to, related to, or a substitute for financial services that are provided by other Bank Secrecy Act financial institutions.

Further, advisers managing clients’ assets work so closely with other financial institution, such as by directing broker-dealers to purchase or sell client securities or by directing banks to transfer client funds, that the advisers’ activities are related to those of the other financial institutions. Advisory services can also be a substitute for products offered by investment companies or insurance companies, for example, when clients seek to have advisers manage their assets through other forms of pooled investment vehicles.

Given the amount of time that had elapsed since the initial publication without further regulatory action, on November 4, 2008, FinCEN withdrew the proposed regulations and said that it would not proceed with regulations for investment advisers without publishing new proposals and allowing for industry comments. Since then, there have been significant changes in the regulatory framework for investment advisers with the passage of the Dodd-Frank Act and SEC rules implementing Dodd-Frank. Based on passage of Dodd-Frank and other changes, FinCEN revisited the topic of investment advisers.

According to the Investment Advisers Association, the number of investment advisers registered with the SEC totaled 11,539 in 2011, and the total assets under management reported by all investment advisers increased 13.7% to $43.8 trillion in 2011, from $38.6 trillion in 2010. According to the SEC, there are more than 275,000 state-registered investment adviser representatives and more than 15,000 state-registered investment advisers. Approximately 5% of SEC-registered investment advisers are also registered as broker-dealers, and 22% have a related person that is a broker-dealer. Additionally, approximately 88% of investment adviser representatives are also registered representatives of broker-dealers.

NY Senator Says SEC and CFTC Should Uniformly Enforce the Volcker Rule

2012-01-27T16:16:00.000-06:00

The SEC, CFTC and banking agencies must achieve a uniform approach to enforcement of the Volcker Rule so as not to favor certain entities with an advantage and not to create opportunities for regulatory avoidance, emphasized Senator Kirstin Gillibrand (D-NY). In a letter to the regulators, the Senator also questioned how granular the enforcement level would be and said that the market making so crucial to the financial markets must continue under the Volcker regulations.

The proposed regulations implementing the Volcker provisions in Section 619 of Dodd-Frank call for enforcement at the smallest unit of organization. The Senator queried if this meant individual traders or trading desks. In her view, granular enforcement at that level would create a substantially different standard than one focused on a larger picture. In addition, such a standard may require added build time to develop the reporting mechanisms to enable such a standard to function. At the very least, the Senator urged the regulators to clarify the unit of enforcement needed to assess the level at which the standards proposed will be applied.

Further, the Senator pointed out that Congress sought to balance the need of financial institutions to hold assets in order to maintain market liquidity with the Volcker Rule restrictions. The ability of firms to make markets is critical to the competitiveness of the US financial industry and to the maintenance of deep and liquid financial markets that undergird the economic system. The Senator emphasized that the final regulations should strike this important balance in order to ensure the competitiveness and safety of financial institutions.

Securities Industry and Corporate Secretaries Ask SEC to Use Negotiated Rulemaking in Adopting Dodd-Frank Pay Ratio Regulations

2012-01-27T10:14:00.007-06:00

The securities industry and the Society of Corporate Secretaries and Governance Professionals have urged the SEC to employ a negotiated rulemaking process when adopting pay ratio regulations under Dodd-Frank that will allow a representative group of stakeholders on a rulemaking advisory committee to join with the Commission in developing a balanced rule that achieves the legislative intent of Section 953(b).

In a letter to the SEC, SIFMA and the Society also asked the Commission to hold a roundtable discussion of experts and stakeholders to better understand the potential issues and unintended consequences of implementing the pay ratio disclosure requirements. The letter was also signed by, among others, the Financial Services Roundtable and the US Chamber of Commerce.

The groups also urged the SEC to submit the proposed regulations to the Office of Information and Regulatory Affairs (OIRA) review process. OIRA is located within the Office of Management and Budget and was created by Congress with the enactment of the Paperwork Reduction Act of 1980 to review federal regulations. In the view of the trade groups, a thorough OIRA review will allow for increased scrutiny to better understand the cost and benefits of the pay ratio rules and aid the SEC in choosing the least burdensome means of implementing Section 953(b). This will ensure that the best and most practical approaches can be included in a proposed regulation that will balance the perceived benefit of this disclosure against the implementation costs.

Moreover, the groups urged the SEC to follow the requirements outlined in Executive Orders 13563 and 13579 to identify alternative approaches and choose the least burdensome means of implementation.

Section 953(b) requires disclosure of the median of the annual total compensation of all employees of an issuer, except the CEO, as calculated in accordance with Item 402(c)(2) of Regulation S-K, the annual total compensation of the CEO, and the ratio of the median annual compensation of all employees to the CEO’s compensation. Recently, the House Financial Services Committee reported out a bi-partisan bill that would repeal Section 953(b). The Burdensome Data Collection Relief Act, HR 1062, is currently awaiting action by the full House of Representatives.

The corporate disclosure regime is designed to provide information that is useful to investors when making investment decisions, noted the groups. While pay ratio disclosure may be of general interest to some investors, they conceded, it is unclear how this disclosure will be material for the reasonable investor when making investment decisions. The ratio will inevitably vary widely among industries or businesses without any relevance to the financial performance of a company. Thus, additional consideration of any possible benefit to be provided by this disclosure must be considered in the rulemaking process and weighed against the costs.

According to the groups, there are significant hurdles and burdens faced by the business community in attempting to comply with Section 953(b). There is a widespread misperception that this information is readily available at the touch of a button, noted the letter, but this could not be further from the truth. Companies may have tens of thousands of employees stretched out over dozens of countries, especially the largest companies with operations around the world. Obtaining the data will be difficult and time-consuming as the definition of compensation among countries will vary widely, and companies will face difficulties attempting to rationalize compensation with currency fluctuations.

The requested SEC roundtable could gather information from the people that will handle the practical compliance with this rule. The groups asked that this roundtable discussion, if it occurs, be designated part of the rulemaking record.

Given the lack of discussion about the practical implications of Section 953(b) prior to its enactment, continued the groups, it is of utmost importance during difficult economic times that implementing regulations are carefully and thoughtfully proposed. Further, the SEC should use caution during the rulemaking process to ensure that the economic consequences do not outweigh the objectives of the rule.

Noting that Section 953(b) does not include a deadline for promulgating regulations, the trade associations urged the SEC to resist rushing into proposing regulations, given the substantial cost and implementation burdens that are likely to be imposed on companies. While acknowledging that Section 953(b) is more prescriptive than many Dodd-Frank requirements, the groups said that the SEC has been afforded the time to thoroughly analyze the economic impacts that different alternatives will have on the U.S. economy at large. Thus, the SEC should consider how to provide the most flexibility for the least cost and minimize the disadvantages of unnecessary regulatory expenditures.

Finally, the groups urged the SEC to submit the proposed regulations to the Office of Information and Regulatory Affairs (OIRA) review process. In the view of the trade groups, a thorough OIRA review will allow for increased scrutiny to better understand the cost and benefits of the pay ratio rules and aid the SEC in choosing the least burdensome means of implementing Section 953(b). This will ensure that the best and most practical approaches can be included in a proposed regulation that will balance the perceived benefit of this disclosure against the implementation costs.

Senator Hagan Urges SEC and Other Regulators to Adhere to Legislative Intent in Crafting Dodd-Frank Volcker Regulations

2012-01-26T19:57:00.003-06:00

The proposed regulations implementing the Volcker Rule provisions of the Dodd-Frank Act may unintentionally narrow the scope of permitted activities, such as market making, that Congress preserved and could siphon liquidity from capital markets and harm US capital formation, said Senator Kay Hagan (D-NC). In a letter to the SEC and CFTC, the Senator noted that, in crafting Section 619(d), Congress acknowledged that market-making, underwriting, and asset management are critical to capital formation and essential to preserving robust liquidity in U.S. capital markets. The Volcker Rule prohibitions were never intended to restrict or prohibit legitimate structures, she continued, including foreign funds, joint ventures, venture capital funds, loan funds, securitization vehicles, and structured notes, that are not usually thought of as private equity or hedge funds and do not relate to trading the firm's own capital.

Senator Hagan is also concerned that the proposed regulations could inadequately clarify the treatment of certain investments made by insurers. Section 619(d)(I)(F) of Dodd-Frank includes trading in an insurance company's general account as a permitted activity and, by its terms, exempts permitted activities from the proprietary trading ban. While the proposed regulations do provide an exemption from the proprietary trading restrictions for the general account of an insurer, she noted, the section that provides this exemption does not address covered funds.

Further, the covered funds section does not expressly extend the exemption that permits proprietary trading activities on behalf of the general account to allowing the general account to hold an ownership interest in a covered fund. The Senator urged the regulators to conform the rule to Section 619's directive to accommodate the business of insurance and include investments in covered funds within the exemption for insurers.
In Section 619(d)(I)(B) of Dodd-Frank, Congress explicitly permitted market making.

While acknowledging the difficulty in distinguishing market making from prohibited activities, the Senator emphasized the importance of ensuring that regulatory limits on proprietary trading do not unnecessarily prevent firms from engaging in the accepted and legitimate activities necessary to preserve orderly markets and service clients.

Restrictions that impede the ability of firms to make markets could reduce liquidity and trigger unintended consequences, said the Senator. Moreover, the complex monitoring regime proposed by the regulators has the potential to reduce liquidity in secondary markets by causing dealers to limit the size of the positions that they purchase for fear of tripping prohibitions. A reduction in liquidity could limit the ability of mutual funds, pension funds, and other institutions to adequately serve investors, including many US retail customers. Senator Hagan urged regulators to carefully evaluate the impact of the proposal on the ability of firms to make markets and to avoid regulations that could reduce market liquidity, discourage investment, limit credit availability, and increase the cost of capital for companies.

Corporate Secretaries Oppose PCAOB Suggestions of AD&A and Auditor Assurance Outside Financial Statements

2012-01-26T18:22:00.001-06:00

The possible revisions to standards on the reports of outside auditors on company financial statements suggested by a PCAOB concept release would fundamentally change the role of the auditor from an independent analyst to an original source of information for investors, said the Society of Corporate Secretaries and Governance Professionals. In a comment letter to the PCAOB, the Society said that the net effect of many of the suggestions in the concept release would make the auditor a guarantor of the accuracy and completeness of the financial statements and, indeed, of the company’s historical results of operations and financial condition.

While the PCAOB would retain the outside auditor’s pass/fail opinion on a company’s financial statements, the Society believes that the pass/fail approach would be vitiated by the alternatives set out in the release. Depending on the nature and extent of the auditor’s comments in the proposed Auditor’s Discussion and Analysis (AD&A), and in any required assurance on disclosures outside the financial statements, the audit would yield the equivalent of high pass, medium pass, low pass, and similar grades, which would add complexity and uncertainty for investors that does not exist with the current pass/fail system.

The Society strongly disagrees with requiring an AD&A because it would be counterproductive to the PCAOB’s goal of providing greater transparency to investors and would substitute the auditor’s judgment for management’s judgment, which could ultimately undermine the auditor’s independence and management’s responsibility for the financial statements and related disclosures. Management is ultimately responsible for the preparation of the financial statements and related disclosures and is in the best position to understand its business and discuss its financial results. If an auditor were required to provide its own analysis of critical audit risks and close calls, reasoned the Society, the auditor would essentially be taking ownership of the financial statements.

Moreover, providing more detailed disclosure by the auditor of the matters considered and underlying considerations with regard to an issuer’s financial statements would not meet the PCAOB’s stated objectives of increasing transparency and making financial statements more relevant to users, noted the Society, rather it would likely increase confusion and the length of disclosure documents without a corresponding benefit. In addition, the nature and process of review and approval of the AD&A would greatly increase the difficulty of meeting tight time frames for filings under the securities laws, particularly filings of large, accelerated filers whose financial statements are generally complex.

According to the Society, even if the AD&A does not become boilerplate, which is a fear, the lack of consistency and comparability among different issuers’ AD&As would cause confusion. In the Society’s view, to add a discussion on difficult and contentious issues, particularly including close calls on the application of complex accounting standards, would create an unproductive situation where there are two potentially competing views on accounting matters.

The Society also disfavors the proposed assurance on items outside of the financial statements. While auditors are familiar with the figures and disclosure upon which the MD&A, earning releases, and non-GAAP measures are based, the cost of requiring an auditor opinion on MD&A or these other disclosures would provide relatively little benefit compared to the cost. Auditors already routinely comment on these matters and issuers routinely take such comments into account, noted the Society, and their responsibilities include consideration of whether such information is materially inconsistent with the financial statements.

Thus, the scope and nature of these other disclosures is unlikely to materially change as a result of requiring a more formal assurance on the part of auditors, reasoned the Society, but would only increase the cost. The illustration of a possible attestation in the release appears to suggest that such an attestation would have to contain a legal opinion that the MD&A satisfies SEC regulations, as well as assurance or comfort regarding the amounts and numbers contained therein. The Society cautioned that these requirements would be well beyond the scope of auditors’ duties and would require an auditor to develop expertise in areas not currently associated with auditing responsibility.

House Ag Committee Approves Legislation Clarifying End-User Exemption from Dodd-Frank Derivatives Margin Requirements

2012-01-26T13:43:00.003-06:00

The House Agriculture Committee has approved bi-partisan legislation clarifying that commercial end users would not be subject to margin requirements for uncleared swaps under derivatives provisions of the Dodd-Frank Act. The Business Risk Mitigation and Price Stabilization Act, HR 2682, sponsored by Rep. Michael Grimm (R-NY) and Gary Peters (D-MI), passed the committee by voice vote with strong support from Chairman Frank Lucas (R-OK) and Ranking Member Colin Peterson (D-MN). The legislation has already been approved by the Financial Services Committee on a voice vote.

The Dodd-Frank Act does not require regulators to impose margin requirements on end users and the legislative history clarifies that Congress did not intend to impose margin requirements on non-financial end users. Nonetheless, the legislation was driven by end user uncertainty about whether they will be subject to margin requirements.

At the markup of the bill, Chairman Lucas said that, while the CFTC has followed congressional intent, the banking regulators have proposed to require margin in the form of cash or highly liquid securities from non-financial end users, thereby ignoring congressional intent. Thus, he viewed this legislation as critical to reaffirming congressional intent to expressly and clearly provide an end-user exemption. In this regard, Chairman Lucas noted a letter sent by Senators Chris Dodd (D-CT) and Blanche Lincoln (D-AK) to House oversight chairs stating that the Dodd-Frank Act does not authorize federal regulators to impose margin on end users that use swaps to hedge or mitigate commercial risk.

Rep. Grimm said that HR 2682 clarifies the intent of Congress to provide an explicit exemption on the posting of margin by end users. He emphasized that the legislation ensures that federal regulators will not impose margin requirements on true ends users that use swaps to manage their business risks, like to lock in the cost of raw materials.

True end-users are companies that use derivatives to manage an actual business risk, he noted, generally to hedge against fluctuating prices, currency rates, or interest rates, and not to speculate. Forcing true end-users to post margin can have several negative consequences, he noted, such as the costs of hedging could be become so high that they stop hedging, resulting in a detrimental rise in prices for consumers. Also, capital would be restricted that would otherwise be used for job creation or reinvestment to make US companies more competitive in the global economy. Further, the high costs of hedging could drive business overseas to foreign derivatives markets and could also increase regulatory arbitrage.

UK Financial Conduct Authority Product Intervention Powers Explained by Martin Wheatley

2012-01-25T18:20:00.002-06:00

The product intervention powers of the new UK Financial Conduct Authority will be exercised around a strong governance framework in a flexible and proportionate manner assured Martin Wheatley, designated CEO of the FCA. In remarks to the British Bankers Association, he said that the power to ban a financial product will not be used either lightly or indiscriminately and pledged that regulatory intervention will not prevent innovation and product development. In addition, the FCA will set out principles for when it will use these types of powers. While the intervention powers will be a useful regulatory tool for protecting investors, he noted, it will not be the first tool the FCA reaches for and it will not be the norm. He does not envision FCA staff walking around offices ``with clipboards waiting to jump in and stop’’ the next good financial product idea.

The UK is in the process of fundamentally reforming its domestic financial regulatory regime. The Financial Services Authority is being abolished in its current form. The new Financial Conduct Authority will oversee the conduct of financial services firms, the operation of markets and the protection of consumers, with new powers to ban the sale of toxic products. Martin Wheatley is currently the Managing Director of the FSA Consumer and Markets Business Unit; and is slated to be the first CEO of the FCA. He was formerly CEO of the Hong Kong Securities and Futures Commission.

With regard to product intervention, the official set out some scenarios where intervention could be used. The FCA could intervene to ban inherently flawed products, such as products that offer such poor value or have such disadvantageous features that most consumers are unlikely to benefit from them. Also, intervention could be proper when there is widespread promotion or selling to customers for whom the product is unsuitable. Another example could be products where there is a strong incentive for a mis-sale, such as instances where profitability is so great that the product is just being sold to everyone, regardless of whether it is appropriate for them, and the usual regulatory measures will not put a stop to it.

Mr. Wheatley also detailed a number of forms of product intervention that the FCA could employ. For example, the FCA could intervene to ban the sale of a particular type of product to all customers, or to certain categories of customer. Moreover, intervention could be used to mandate the inclusion or exclusion of specific product features. Or sales could only be allowed in certain specified situations, such as only selling the product if it includes or excludes specified features, and if sales are limited to particular categories of customer, or through particular distribution channels.

On a separate point, the official urged people to follow the FSA guidance for creating structured financial products that was published last year. The guidance sets out four steps the FSA expects people designing and selling such products to go through. First, identify the target audience and design a product that meets their needs so it is clear who you are aiming it at, and that your high risk, high return investment is not meant for ``the 80 year old widow who visits your branch looking for a way to save without losing her money. ‘’

Second, test the products to ensure that they can deliver fair outcomes. This can involve looking to see how the product would fare under different scenarios. Third, have in place a robust approval process before the products go on sale. This means that the sales process gets the product in the hands of the right people. Fourth, monitor the product to see who is buying it and how it is performing. This is not just about selling it and moving on, said the official, but taking an interest in how it is actually working in practice.

NASAA Proposes Model Crowdfunding Exemption

2012-01-25T14:44:00.005-06:00

The Small Business Capital Formation Committee of the North American Securities Administrators Association (NASAA) has released for internal comment a proposed new NASAA Model Crowdfunding Exemption. The proposed model rule would create a transactional exemption at the state level for the sale of securities through an Internet-based offering to numerous small investors, a procedure known as "crowdfunding."

As discussed in the Request for Member Comments, the key elements of the proposed exemption include the following:

- Issuers are limited to an aggregate offering amount of $500,000 over a 12-month period.

- Individual investments are limited to $1,000 per year, per offering, with a multi-investment limit of eight percent or less of annual income.

- Issuers must make a one-stop filing in the state of the issuer’s principal place of business, using proposed new Form CF.

- Issuers must disclose certain information, including their business plans and proposed use of proceeds, on a website accessible to all state securities regulators.

- Cautionary language has been developed to provide investors with important information about the general investment risks of crowdfunding.

- Issuers must escrow investor proceeds until they reach the target offering amount.

- Individuals and companies with prior disciplinary history will be disqualified from using the exemption.

- Offerings must be conducted through an intermediary that is registered as a broker- dealer, but the intermediary is exempted from certain rules applicable to traditional broker-dealers.

The proposed exemption will not become viable at the state level unless a corresponding exemption is created under federal law. The Committee noted that the proposed model rule contains a lower aggregate offering limit than the current proposals that have been introduced in Congress in H.R. 2930, S. 1791, and S. 1970, but the Committee believes that the model rule otherwise represents a compromise between the competing federal proposals.

In the Committee's view, the most important aspect of the proposed rule may be the requirement that intermediaries register as broker-dealers, presumably because intermediaries would thus fall within the current definition of a "broker-dealer" by accepting transaction-based compensation. The rule, however, sets up a framework for exempting the intermediary from some of the rules that apply to traditional broker-dealers, provided the intermediary’s activities are limited to crowdfunding. In particular, the proposed rule exempts the intermediary from the normal rules related to SRO membership, short sales, penny stocks, suitability, and prospectus delivery requirements. The Committee observed that this approach is similar in some respects to the treatment of security futures dealers in Section 15(b)(11) of the Securities Exchange Act of 1934.

NASAA members will have until February 7, 2012 to comment on the proposed exemption.

US Hedge Fund Industry Comments on EU Derivatives Regulation, Supports Sound Central Counterparty Governance

2012-01-25T14:10:00.002-06:00

The US hedge fund industry strongly supports the European Union Regulation promoting central clearing designed to increase transparency of the derivatives market and reduce counterparty and operational risk in trading. In a comment letter on the proposed Regulation, the Managed Funds Association broadly posited that balanced central counterparty governance is critical to promoting competition in the derivatives market and that clients have an interest in sound governance requirements that foster fair and objective risk-based access, broad product offerings and competitive pricing.

In that spirit, the MFA said that EMIR (European Market Infrastructure Regulation) should affirmatively mandate the inclusion of non-dealer, client representatives on central clearing counterparty boards and risk committees. As a significant proportion of the trading volume in the OTC derivatives market, clients are important stakeholders. Thus, the MFA reasoned that they should have their views reflected in the critical decisions of these bodies and should be entitled to attend and vote at meetings, not merely consulted.

The MFA feared that, without such a mandate, narrow interests will dominate and central counterparties may not adequately take into account the views of all market participants. In addition, in order to completely effect fair representation and balanced governance of central counterparties, no single group of market participants should constitute a controlling majority of any boards or risk committees.

The MFA also suggested that the Regulation allow central counterparty employees to have representation on risk committees. Such employees are motivated to expand the scope of central counterparty products and services, offer optimal capital, margin and cost management and maintain risk management procedures, which prevent losses to the central counterparty, clearing members and the market. Moreover, such employees provide further counterbalance to the potential conflicts of interest of other constituencies represented on risk committees.

The MFA also supports portability measures facilitating a client’s ability to transfer freely all or part of its portfolio and related margin between clearing members. Clients should be able to negotiate transfers of their positions to another clearing member at any time, whether prior to or following the default of their current clearing member.

The Regulation should clarify that ceding clearing members must effect such transfers as promptly as technologically feasible and without imposing fees or other conditions that could act as a barrier or deterrent to portability and competition in the provision of clearing services. If a central counterparty transfers only part of a portfolio, the untransferred portion must be appropriately margined, in accordance with the margining methodology agreed to by the clearing member and client, or absent express agreement, as previously applicable to the client’s portfolio.

It is also important for the Regulation to permit netting arrangements allowing parties to net initial and variation margin amounts across a broad range of exposures and assets, including across cleared and uncleared exposures, as well as across related legal entities. Such netting will reduce aggregate counterparty credit risk, lower trading costs, allow for efficient use of capital, provide better transparency as to counterparty risk and reduce complexity and settlement risk. Without permitting robust netting arrangements, liquidity will drain from the derivatives market as participants seek other execution strategies to prevent over-collateralization.

The European Securities and Markets Authority (ESMA) will draft technical standards specifying the minimum margin standards, including the percentage of margin that central counterparties must collect as well as the related time horizons. The MFA urged ESMA to be mindful of the increased costs that margin regulation may impose on clients both in terms of the margin amount and of the increased administrative costs associated with collecting margin and verifying calculations.

Praising real time clearing, the MFA urged that the Regulation require immediate acceptance or rejection of a trade upon submission for clearing by both central counterparties and clearing members. Providing open access to real-time clearing of trades will promote market efficiency by enabling participants to reduce their counterparty credit risk without delay, said the hedge fund group, and by ensuring unrestricted access to the broadest range of executing counterparties, more liquidity and competitive pricing.

Real-time clearing will also enhance market transparency and protect the anonymity of a client’s executing counterparties and will avoid the imposition of additional credit limits, fragmentation of liquidity, delays in acceptance of trades and/or the imposition of barriers to access to clearing such as inappropriate execution documentation.

The MFA has consistently advocated for the protection of client collateral in cleared and bilateral trades based on its belief that segregation protects investor positions and margin from clearing member insolvency. The EU Parliament Text of the Regulation provides greater protections for clients than the EU Council Text as there is a positive segregation requirement with an opt-out in the Parliament Text as opposed to a requirement to offer an opt-in. Specifically, the Parliament Text requires that a clearing member must distinguish in separate accounts with the central counterparty the positions of the clearing members from those of its clients. The MFA strongly supports providing clients with a robust level of protection for both their positions and assets that also promotes efficient portability.

The hedge fund group supports the recognition of third country central counterparties. The three criteria for the recognition of third country central counterparties set out in the Commission’s proposal remain in the Council and Parliament texts but with certain amendments. In particular, the Council Text reflects the MFA’s suggestion that coordination with non-European regulators on the approval procedures would ensure that the equivalency test applied is reasonable and not unduly restrictive towards the regulatory frameworks of third countries.

In addition, both the Council Text and the Parliament Text contain a reciprocity requirement, which provides that ESMA may only recognize a central counterparty established in a third country when ESMA deems the legal framework of that third country to provide for an effective equivalent recognition of central counterparties authorized in the EU.

In the MFA’s view, this restriction would be difficult to implement in practice, does not significantly increase the protections available to EU entities, and is likely to have the effect of unduly restricting the ability of EU entities to access third country central counterparties. As a result, the MFA recommends eliminating this reciprocity requirement.

Cordray Outlines to House Panel His Vision for a CFPB with Full Enforcement Authority

2012-01-24T12:53:00.001-06:00

Director Richard Cordray’s vision is that the new Consumer Financial Protection Bureau will make consumer financial markets operate fairly in order to protect consumers, support honest businesses, and play a crucial role in helping to safeguard the overall economy. In testimony before a House oversight panel chaired by Rep. Patrick McHenry (R-NC), he said that the Bureau will benefit consumers by clarifying the prices and risks of consumer financial products and services.

When consumers know the true costs, benefits, and risks of competing products, he reasoned, they will be better able to make informed decisions. It will also help people avoid being ambushed by costly surprises buried in the fine print, he continued, so that they can have proper confidence that the terms of the deal stated today are the terms they will actually be living with down the road. The Bureau will benefit honest businesses by leveling the playing field and ensuring that financial institutions play by the same set of rules.

He also noted that Bureau has launched the first federal nonbank supervision program, one of the central new authorities provided by the Dodd-Frank Act. There are thousands of nonbank providers of financial products and services that make up a significant portion of the consumer financial marketplace, including mortgage lenders, mortgage servicers, mortgage brokers, payday lenders, consumer reporting agencies, debt collectors, and money services corporations.

The Director said that the nonbank supervision program will include conducting individual examinations and may also include requiring reports from businesses to determine what areas need greater focus. The Bureau will determine what degree of supervision to perform based on an analysis of the risks posed to consumers, including factors such as the nonbank’s volume of business, types of products or services, and the extent of state oversight for consumer financial protection.

Now that the CFPB has a Director, the Bureau has full authority to investigate and bring enforcement actions to ensure that financial providers are held accountable if they violate the law, and that the rules of the road governing banks and nonbanks are applied evenhandedly to all participants. In this area, observed Director Cordray, the Bureau is also cooperating closely with other law enforcement agencies to avoid any duplication of work and to coordinate limited resources. The Bureau has many tools to address problems in the financial markets, he said, including supervision, rulemaking, and enforcement. The Director emphasized that filing lawsuits or administrative actions will be necessary at times to ensure that the law is followed and respected, and that harm to consumers from unlawful conduct is remedied.

Massachusetts Provides Guidance on Social Media Use by Investment Advisers

2012-01-24T11:02:00.011-06:00

Investment advisers that discuss business with existing or prospective clients on any of the 21st Century Internet platforms for socializing, e.g., facebook, twitter or LinkedIn, must be aware that their communications may be subject to state regulation, according to the Massachusetts Securities Division. Investment advisers do not violate Massachusetts' investment adviser rules per se by using the new social media but must be particularly mindful of the State's advertising, recordkeeping and supervisory requirements because of the risk for harming a large number of investors by virtue of the media's ability to reach an immensely wide audience.

An adviser's web page on facebook, twitter or LinkedIn, for example, would likely be "advertising" if it can be accessed by the general public. Moreover, a web page is "advertising" in Massachusetts if the page is created or maintained in the adviser's name, or contains business-related content about the firm, or solicits advisory services. Even a sole-proprietor adviser's web page is "advertising" if the adviser discusses services in the name of the adviser's representative. And the long-standing restrictions against using testimonials or making misleading statements apply to an adviser's web pages on social media. Similarly, the prohibition against advertising an adviser's past specific profitable recommendations applies to posting those recommendations on a web page unless the adviser posts a list of all the adviser's recommendations made within the last one-year period. Now, new restrictions on the use of social media hold advisers responsible for web page content even if the advisers did not create the content, if the advisers were somehow "entangled" or involved in its creation or preparation by another person, or if the advisers explicitly or implicitly "adopted" or approved or endorsed the content after it's creation by another person.

As for recordkeeping, SEC Rule 204-2 requires advisers to retain their advertisements, and Massachusetts, in addition, requires advisers to maintain a correspondence file or log. Regarding supervision, the long-standing requirement that advisers create and enforce written procedures for supervising their investment adviser representatives applies to supervising their representatives' use of social media and, moreover, instructs state investment advisers to consider recently released SEC guidelines for federally-registered investment advisers on the proper use of social media by their representatives.

Securities and Derivatives Groups Must First Challenge CFTC Position Limits Regulations in District Court Says DC Circuit

2012-01-23T14:09:00.000-06:00

A three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit dismissed a challenge by securities and derivatives industry associations to rules establishing derivatives position limits adopted by the Commodity Futures Trading Commission. Citing circuit precedent, the court stated that the “normal default rule” is that “persons seeking review of agency action go first to district court rather than to a court of appeals.”

According to Judges Rogers, Garland and Brown, “Initial review occurs at the appellate level only when a direct-review statute specifically gives the court of appeals subject-matter jurisdiction to directly review agency action …There is no express congressional authorization of direct appellate review applicable to the petition for review in this case.”

SIFMA and ISDA filed a petition for review of the CFTC’s position limits regulations in the DC Circuit. Simultaneously, noting that there may be a question as to the proper forum for the challenge due to lack of direct precedent, the associations also filed a complaint in the District Court for the District of Columbia.

In Letter to House Leader, SEC Chair Details Work of Economists on Potential Regulations on Broker-Adviser Fiduciary Standard

2012-01-22T14:40:00.004-06:00

There are currently three economists working within the Division of Risk, Strategy and Financial Innovation on the topic of retail financial advice and the differences between the broker and investment adviser regulatory regimes, said SEC Chair Mary Schapiro in a Jan. 10, 2012 letter to Rep. Scott Garrett, Chair of the House Capital Markets Subcommittee. The letter was in response to Chairman Garrett’s recent questions on the progress of SEC economists in gathering and analyzing data necessary for a meaningful consideration of potential standard of conduct regulations for brokers and investment advisers providing retail investment advice.

In the letter, Chairman Schapiro also said that the SEC staff is drafting a public request for information to obtain specific data on the provision of investment advice and regulatory alternatives. She noted that, in addition to the work of the SEC economists, it is especially important to ask the public for additional data and empirical analysis.

Although SEC employees do not track their time by specific projects, the SEC Chair assured Chairman Garrett that the Risk Fin economists spend a significant amount of their time on the issues of the standard for brokers and advisers providing retail investment advice. Specifically, they have reviewed and catalogued the publicly available data, including academic articles, reports and surveys and opinion pieces discussing the market for retail financial advice. The search encompasses information describing differences between regulatory regimes based on fiduciary and suitability standards, the economics of the financial advice industry, the quality of financial services, conflicts of interest, consumer disclosure, and retail investment behavior.

In December of 2011, Risk Fin communicated a summary of the available literature to the SEC and the Risk Fin economists discussed the evidence and its relevance to potential regulation. Risk Fin economists are also conducting an ongoing dialogue with financial economists at other agencies and from academia. The SEC believes that this interaction will give Commission economists a useful and different perspective on how to conduct an economic analysis in this area.

According to Chairman Schapiro, the Risk Fin economists have also proactively reached out to industry groups and finance and law academics to ascertain the availability of data important to any future economic analysis and also to obtain additional points of view. Similarly, Risk Fin economists are working with other SEC staff to develop focus group and survey questions to obtain additional information and insights through investor testing.

In moving forward with regulatory action, the SEC will follow its usual practice of including its economic analysis for review and public comment as part of any proposal. This process has the important benefit of providing a mechanism for refining the economic analysis by seeking feedback on specific issues and making requests for private data, she said, especially in this area where the data needed to conduct an analysis may not be publicly available.

Based on its review of the broker-dealer and investment adviser industries pursuant to a study mandated by Section 913 of the Dodd-Frank Act, in 2011 the SEC staff recommended the adoption of a uniform federal fiduciary standard for brokers and advisers that would be no less stringent than the standard currently applied to investment advisers under Advisers Act Sections 206(1) and (2). The new standard would apply uniformly to both brokers and investment advisers when providing personalized investment advice about securities to retail customers

In her letter to Chairman Garrett, Chairman Schapiro noted that two Risk Fin economists were members of the interdivisional drafting team responsible for publishing the study. These economists continue to regularly meet with staff from the Division of Investment Management and the Division of Trading and Markets to collectively discuss the topic and meet with outside interest groups. Investment Management and Trading and Markets staff also contribute to the economic analysis by providing industry insights and legal analysis.

In a letter sent to Chairman Schapiro on March 17, 2011, Chairman Garrett said that, while Section 913 of Dodd-Frank Act gives the SEC the discretion to adopt a uniform fiduciary standard for brokers and investment advisers, the statute does not mandate the adoption of such a standard, and in no way suggests a congressional intent that the SEC move forward on such a rulemaking without a sufficient basis. The letter was also signed by 13 members of the Financial Services Committee.

The Garrett letter also notes that the SEC has not identified and defined clear problems that would justify a rulemaking and does not have a solid basis on which to move forward. The SEC should conduct a thorough cost benefit analysis that considers customer preferences while evaluating the specific impact that any market changes would have for investors, as well as assessing the broader practical impact that such changes might have throughout the entire financial marketplace. For example, if the SEC’s activities should involve a relationship with the Department of Labor’s incipient changes to the existing definition of fiduciary under ERISA, advised Chairman Garrett, this should factor into the SEC’s analysis and subsequent activities in order to minimize disruption to the provision of financial services to investors.

Mainland Has Potential for Significant Derivatives Market Says Hong Kong Securities Regulator

2012-01-22T14:25:00.001-06:00

While the current focus of Mainland China’s financial sector is the stock and bond markets, noted a Securities and Futures Commission senior official, there is an even greater potential for derivative products. In recent remarks, SFC Executive Director Alexa Lam urged the creation of a cooperative venture by Shanghai and Hong Kong in the derivatives markets, especially in derivatives involving precious metals and base metals, where Europe is neither the most important producer nor one of the biggest users. Expressing optimism for the future development of the global derivatives markets, she urged full use of Shanghai's large customer base and Hong Kong’s international standards of technology and regulation as a key to good cooperation and development. The official noted that, as of June 2011, the global outstanding notional amount of derivatives was over 700 trillion U.S. dollars.

The Deputy Chief Executive also noted that derivatives are risk management tools. Derivatives allow financial institutions, entities, businesses, investors and consumers to conduct risk management Since risk is continuous, she reasoned, as long as companies continue to operate there will be risk management needs. This dynamic will fuel global demand for derivatives products. But she also cautioned that the financial crisis revealed the risk of derivatives, including leverage and price volatility. At the same time, regulatory reform is underway, including importantly central clearing and central settlement for standardized derivatives. Not only does the settlement system itself need to have a sound risk management system, she emphasized, regulators must be able to conduct strict supervision.

UK Finance Minister Cautions that Transparency and Position Limit Reforms Must Be Calibrated for Derivatives Markets

2012-01-21T11:54:00.001-06:00

Transparency and market position reform of the derivatives markets must proceed deliberately based on rigorous impact assessments to fully understand the costs and benefits, said UK Finance Minister Mark Hoban in remarks to the London Stock Exchange. While greater transparency has clearly had a positive effect in equity markets, he noted, the same measures may not be directly transferrable to the derivatives markets.

Derivative markets are considerably less liquid than equity markets, he said, and extreme care is needed to ensure that transparency requirements are carefully designed to work for each asset class. For example, while the component bonds that make up Markit’s iBoxx bond indices are some of the most actively traded bonds in Europe, a review of over 9000 of these bonds revealed that only 52 percent actually traded at least once in a six month sample period in 2010.

The European Commission must also undertake a rigorous analysis when it comes to updating MiFID to reflect changes in the commodities market. He urged the Commission not to succumb to knee jerk reactions which may only serve to increase costs for EU citizens.

The Minister emphasized that it is vital to remember that the commodities derivatives market serves a critical economic function in allowing end users to mitigate commercial risk. That is why the Minister is skeptical about blanket position limits across all markets, while acknowledging that they have a role to play in defined circumstances. In his view, active position management by exchanges and authorities will be much more effective in tackling market abuse, and will also provide a more rigorous approach. He said that it is incorrect to think that blanket limits will enable governments to control prices, as some would seem to suggest.

More broadly, he urged the Commission to resist pressure to use the ongoing MiFID reforms to raise barriers against third countries seeking to trade with the EU. Across EU dossiers there has been an increasing and worrying tendency to try to implement strict equivalence or reciprocity provisions through EU legislation. The Minister cautioned that this approach could effectively close EU financial markets to third country firms.

For instance, it seems that no third country would meet the standards as set out under the current MiFID proposal. From the moment that it is passed and until equivalence decisions are taken, it would close the EU market entirely to any new third country firm. Barriers would also be placed in the way of outward investment flows, for example restricting access to emerging markets. At a time when it is vital to attract more investment both within and without the EU, it is an approach that undermines growth.

Federal Magistrate Says Negative Dodd-Frank Say on Pay Vote Did Not Overcome Business Judgment Presumption

2012-01-20T10:41:00.001-06:00

A federal magistrate (DC Ore) ruled that a shareholder derivative action alleging that board members breached their fiduciary duty of loyalty with regard to executive compensation failed to show the futility of pre-suit demand on the board because, despite a negative shareholder say on pay vote, the challenged action was protected by the business judgment rule. The shareholder advisory vote on executive compensation, mandated by the Dodd-Frank Act, resulted in 62 per cent of the shareholders rejecting the pay package. (Plumbers Local No. 137 Pension Fund, et al. v. Davis, et al, DC Ore, Civ. No. 03: 11-633-AC, Jan. 11, 2012)

The shareholders’ allegations did not dispel the presumption that the board’s compensation decisions could be attributed to a rational purpose. Specifically, the allegation that the board violated the company’s pay for performance policy was not sufficient to overcome the business judgment presumption. The fact that the board’s compensation decision does not square with the shareholder’s interpretation of the pay for performance policy is not the equivalent of an allegation that the board intentionally misled shareholders that it would follow the policy when it actually had no intention of doing so.

Compensation determinations are typically within the business judgment of the board and the allegations here were not sufficient to overcome the presumption that the board exercised business judgment. The board’s actions did not directly defy or violate any company by-law, any shareholder agreement, or any legally mandated disclosure or reporting requirement, noted the magistrate. The shareholders rely on a pay for performance policy that does not establish a binding standard for compensation.

Citing Delaware precedent, the magistrate noted that futility of demand can be shown in one of two ways. First, demand is futile when the directors are not independent or disinterested. Second, demand is futile when there is a reasonable doubt that the challenged transaction was not the product of a valid exercise of business judgment. The shareholders failed to satisfy either test.

In this situation, only one director, the CEO, stood to personally benefit from the compensation decision. Thus, a majority of the board was not interested in the decision. The magistrate rejected the contention that the interest needed to excuse demand existed because the board members face a substantial likelihood of liability.

The court similarly rejected the contention that the board lacked independence because it was subject to the outsized influence of the CEO, the only director with a personal interest in the compensation package. To accept that contention, reasoned the magistrate, would effectively erase the demand requirement and negate its purpose.

Securities and Banking Industries Respond to DOL Request for Data in Drafting Reproposed Fiduciary Definition

2012-01-19T13:34:00.002-06:00

Securities and banking trade groups have responded to a Department of Labor request for assistance in developing an expanded regulatory impact analysis of a proposed change to the DOL’s long-standing definition of fiduciary. In a letter to DOL, SIFMA and the American Bankers Association expressed the hope that this expanded analysis will help provide appropriate direction to the Department as it develops the re-proposed regulation defining an ERISA fiduciary. The trade groups believe that DOL, plan participants, plan sponsors and plan service providers will all benefit from a comprehensive and supportable regulatory impact analysis.

While the trade groups do not have the particular information requested, they do have access to providers who may be able to assist. The trade groups asked for a meeting with DOL to discuss clarifying and perhaps refining the requested information. Through an expanded dialogue on these issues, they noted, the securities and banking industry can fully understand the information and data needs of DOL and, in turn can then reach out to their respective members to determine what information the industry is able to provide.

In September of 2011, DOL said it would re-propose its rule on the definition of a fiduciary consistent with the President's January 2011 Executive Order on regulation. Thus, the re-proposal is designed to inform judgments, ensure an open exchange of views and protect consumers while avoiding unjustified costs and burdens. Consistent with the Executive Order, the extended rulemaking process also will ensure that the public receives a full opportunity to review the agency's updated economic analysis and revisions of the rule. DOL pledged to continue to coordinate closely with the SEC and CFTC to ensure that this effort is harmonized with other ongoing rulemakings.

Specifically, DOL will clarify that fiduciary advice is limited to individualized advice directed to specific parties, and respond to concerns about the application of the regulation to routine appraisals. DOL will also clarify the limits of the rule's application to arm's length commercial transactions, such as swap transactions.

The reproposed regulation will also contain exemptions addressing concerns about the impact of the new regulation on the current fee practices of brokers and advisers, and clarify the continued applicability of exemptions that have long been in existence that allow brokers to receive commissions in connection with mutual funds, stocks and insurance products. The DOL said it would craft new or amended exemptions that can best preserve beneficial fee practices, while at the same time protecting plan participants and individual retirement account owners from abusive practices and conflicted advice.

Last year, the securities industry asked DOL to coordinate with the SEC on redefining the term “fiduciary” under the Employee Retirement Income Security Act (ERISA), effectively changing 35 years of established regulatory certainty. In testimony before the House Education & Workforce Committee, SIFMA executive vice president for public policy and advocacy Ken Bentsen said that the proposed original regulation had far broader impact than the problems it sought to address. It would reverse 35 years of case law, enforcement policy and the understanding of plans and plan service providers as well as the manner in which products and services are provided to plans, plan participants and IRA account holders, without any legislative direction.

SIFMA asserted that the proposed rule was in conflict with Section 913 of the Dodd-Frank Act, which authorizes the SEC to establish a uniform fiduciary standard of care for brokers and advisors providing personalized investment advice. While current exemptions to the prohibited transaction rules of ERISA permit fiduciaries to select themselves or an affiliate to effect agency trades for a commission, there is no exemption that permits a fiduciary to sell a fixed income security or any other asset on a principal basis to a fiduciary account.

Lack of exemptive relief in this area is contrary to what Congress explicitly stated in authorizing the SEC to promulgate a uniform fiduciary standard of care for brokers and advisers providing personalized investment advice under Section 913 of Dodd-Frank. In SIFMA’s view, the result of that conflicting prohibition is that the broker would not be able to execute a customer’s order from his or her own inventory, but rather must purchase the order from another dealer, adding on a mark-up charged by the selling dealer.

SEC Issues Small Entity Compliance Guide for Reporting on Form PF

2012-01-18T11:23:00.002-06:00

The SEC has published a small entity compliance guide on reporting by investment advisers to private funds, certain commodity pool operators and commodity trading advisers. The SEC and the CFTC jointly adopted new reporting requirements on October 31, 2011 and new Form PF for filing the information with the SEC. The reporting requirements affect SEC-registered investment advisers with at least $150 million in private fund assets under management. The information that is collected by the SEC will be shared with the Financial Stability Oversight Council.

Private fund advisers that are also registered with the CFTC as commodity pool operators or commodity trading advisers will satisfy the CFTC's reporting obligations by filing Form PF. These advisers also may consolidate their reporting on Form PF with respect to private funds and non-private fund commodity pools.

The data that is reported to the SEC on Form PF will not be made publicly available in a manner that would identify a particular adviser or fund, but it may be used in an enforcement action.

The SEC-registered advisers that must report on Form PF are divided into two groups, with one for large and one for small advisers. Large private fund advisers are those with at least $1.5 billion in assets under management attributable to hedge funds; liquidity fund advisers with at least $1 billion in combined assets under management attributable to liquidity funds and registered money market funds; and advisers with at least $2 billion in assets under management attributable to private equity funds. All others will be considered smaller private fund advisers.

An investment adviser generally is a small business for purposes of the Investment Advisers Act and the Regulatory Flexibility Act if it has assets under management with a total value of less than $25 million; did not have total assets of $5 million or more on the last day of its most recent fiscal year; and does not control, is not controlled by, and is not under common control with another investment adviser that has assets under management of $25 million or more, or any person (other than a natural person) that had total assets of $5 million or more on the last day of its most recent fiscal year. Investment advisers that are defined as small businesses have no obligation to report on Form PF.

Advisers that have at least $150 million in private fund assets under management and do not exceed a large adviser threshold must file Form PF once a year within 120 days of the end of the fiscal year. These advisers will report only basic information about their size, leverage, investor types, concentration, liquidity and fund performance. Smaller advisers that manage hedge funds must report hedge fund-specific information about strategy, counterparty credit risk and the use of trading and clearing mechanisms.

Large private fund advisers have to provide more detailed information more frequently. Large hedge fund advisers must file Form PF to update information within 60 days of the end of each fiscal quarter. They must provide aggregated information with respect to their exposures by asset class, geographical concentration and turnover by asset class. For each managed hedge fund with a net asset value of at least $500 million, the advisers must report information about each fund's exposures, leverage, risk profile and liquidity.

Large liquidity fund advisers must file Form PF to update information about the funds they manage within 15 days of the end of each fiscal quarter. The information must include the types of assets in each of the liquidity fund's portfolios, risk profile information and the extent to which the fund has a policy of complying with Investment Company Act Rule 2a-7.

Large private equity fund advisers will file Form PF annually within 120 days of the end of the fiscal year. These funds must respond to questions about the extent of the leverage incurred by their funds' portfolio companies, the use of bridge financing and investments in financial institutions.

The guide outlines the two-stage phase-in period for the Form PF filing requirements. Most private fund advisers will begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, that ends on or after December 15, 2012.

Advisers with at least $5 billion in assets under management attributable to hedge funds; liquidity fund advisers with at least $5 billion in combined assets under management attributable to liquidity funds and registered money market funds; and advisers with at least $5 billion in assets under management attributable to private equity funds must begin filing Form PF after the end of their first fiscal year or fiscal quarter that ends on or after June 15, 2012.

This post was contributed by my colleague Jacquelyn Lumb.

UK Legislation Would Provide Mandatory Vote on Executive Compensation and Otherwise Unlock Shareholder Power

2012-01-17T16:26:00.001-06:00

The UK government is readying a legislative package that would increase the transparency of financial statements and give shareholders a mandatory vote on executive compensation. The legislation will introduce binding shareholder votes on executive pay as part of a package of measures to moderate boardroom behavior and will overhaul the way shareholders can access information.

In recent remarks, Deputy Prime Minister Nick Clegg said that the legislation is designed to give company shareholders the proper tools to behave like owners of the business rather than absentee landlords. The government does not want unhappy shareholders to sell their shares and move on, but rather to stay and throw their weight around so that the company improves.

One reason investors are passive, reasoned the official, is because they cannot see the reasons to act. Shareholders should be able to use annual reports as a kind of report card so they can see how well their money is being spent. But, he noted, many annual reports are impenetrable texts that obscure the financial statements rather than illuminate them.

Hundreds and hundreds of pages of facts, figures, charts and graphs are provided, but nowhere is there a clear single figure showing who gets paid what or a simple summary of where the money goes, such as how much is spent on directors, how much on dividends, or how mush is re-invested in the business. This type of information is absolutely essential for any investor trying to calculate value for money, posited the Minister, and not enough companies make it transparent.

The legislation will require companies to present financial information so that investors don’t need an accountancy degree to decipher them, he noted. For example, shareholders would only need to look at one number, not a dozen, to see how senior executives are being compensated. Companies must implement a clear policy for departing CEOs so that, if they deviate from that policy, and if a hefty payment is made for failure, that decision is illuminated. Also, the way the money is spent will need to be crystal clear. So if a company is spending too much on boardroom pay compared to the amount being reinvested in the business, noted the official, they will have to explain why and show investors where their money is going.

Key Senators Suggest Enhancements to SEC Proposed Regulations on Securitization Conflicts of Interest

2012-01-16T17:22:00.002-06:00

The Senate authors of the securitization conflict of interest provisions of the Dodd-Frank Act codified in Section 621 have suggested enhancements to the proposed SEC regulations implementing those provisions. In a letter to the SEC, Senators Carl Levin (D-MI) and Jeff Merkley (D-Ore) said that securitization transactions rife with conflicts of interest demonstrate not only the importance of investor safeguards, but also the need to strengthen aspects of the proposed regulations.

The proposed regulations would apply to an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of such entity, of an asset-backed security. While recognizing that such parties typically have substantial roles in the assembly, packaging and sale of asset-backed securities, the Senators noted that this language simply repeats the statutory terms without adding needed clarification to ensure that key asset-backed securities participants are prohibited from engaging in conflicts of interest damaging to the securitization markets.

The Senators said that the regulations should define the terms used to describe who is a covered person, and those persons should, in the aggregate, cover any party that has made a material contribution to the economic structure or composition of an asset-backed security, its management, or the sale of interests in the product to investors. The SEC should clarify that the test for whether a person is covered by the conflict of interest regulations will depend not just on the person's job title, but the party's economic involvement in the securitization transaction.

For example, collateral managers typically have significant influence in the structure, composition, and management of an asset-backed security, observed the Senators, adding that they are typically the main driver behind the selection and purchase price of the securitized assets. According to the Senators, to leave collateral managers out of a regulation intended to limit conflicts of interest in securitizations would make no sense in the context of industry norms and unduly restrict regulatory scope and impact.

The proposal suggests adopting the narrow definition of "sponsor" used in Regulation AB as a type of catchall phrase to encompass a variety of securitization participants. In the view of the Senators, adopting the Regulation AB definition of sponsor risks using a term that is both under-inclusive and confusing in the context of Section 621. A better approach, suggested the Senators, would be to define sponsor broadly for purposes of Section 621 to include any person (including a collateral manager, servicer, or custodian) who, for a fee or other remuneration or benefit, participates in the design, composition, assembly, sale, or management of the asset-backed security.

Similarly, in order to restore confidence in U.S. securitization markets, the proposed regulations must apply broadly to the wide variety of asset-back securities products that exist today as well as those that will be designed in the future. The proposal follows the statutory mandate that it cover asset-backed securities as that term is defined by Section 3(a)(77) of the Securities Exchange Act, as well as synthetic asset backed securities. In using the newly-created definition under Section 3(a), said the Senators, Congress explicitly rejected the more narrow definition used in Regulation AB.

Because the Section 3(a)(77) definition is so new, noted the Senators, its contours are still somewhat fluid. The success of the proposed regulations will thus partially rely on the Commission's interpretation of Section 3(a)(77). Since that definition explicitly applies to securities, including collateralized debt obligations, they observed, it already encompasses both registered and unregistered asset-backed securities products, which is important given that the collateralized debt obligations at the center of the financial crisis were unregistered securities.

The proposed regulations also encompass synthetic asset-backed securities products, a term that currently has no statutory definition. The proposal does not offer its own definition of synthetic asset-backed securities, instead noting that the term is commonly understood by market participants. While conceding that may be true, the Senators said that the regulations should not rely exclusively on the understandings of market participants, as those may vary and shift over time.

Instead, the Senators urged the SEC to provide a regulatory definition broad enough to cover any synthetic product that creates an economic exposure equivalent to one or more asset-backed securities. The lawmakers suggested that a possible definition in line with Section 3(a)(77) would be a fixed-income or other security that references any type of financial asset, including a loan, a lease, a mortgage, a secured or unsecured receivable, or index, and allows the holder of the security to receive payments that depend primarily on the value or performance of the referenced assets. The rule should also explicitly cover so-called hybrid products containing a mix of cash and synthetic assets.

In order to ensure that financial innovation does not render the definition under-inclusive, the SEC should add a catchall provision to its definition of covered products to ensure that the regulations will apply to any financial product that is the economic equivalent of a cash, synthetic, or hybrid asset-backed security. Without that added provision, cautioned the Senators, the regulations would not be able to restrain conflicts of interest affecting products important to the asset-backed securities markets.

Section 621 prohibits securitization participants from designing and selling asset-backed securities and then profiting from transactions in which the participants' interests materially conflict with the interests of persons being sold the securities. The proposal appropriately limits the scope of covered conflicts of interest to those arising out of transactions related to the asset-backed securities, said the Senators, and not unrelated activities.

Similarly, the proposed regulations wisely avoid a precise definition of material conflict of interest, which is a concept backed by years of administrative determinations and case law, and in which federal securities regulators already have significant expertise. Capturing that experience in a concise regulatory definition is neither feasible nor wise, reasoned the Senators, since the concept needs to remain flexible and adaptable to ensure its effectiveness.

In place of a precise definition, the proposal offers interpretive guidance to determine when a material conflict of interest exists. The guidance appears to prohibit securitization participants from engaging in a transaction through which they would have the potential to benefit if the related asset-backed securities perform poorly and there is a substantial likelihood that a reasonable investor would consider that fact important.

The Senators allowed that this approach seems to best capture the intent of Section 621. The guidance would also determine that a material conflict of interest exists when securitization participants benefit from allowing a third party to structure an asset-backed security in a way that permits a third party to benefit from a short transaction and there is a substantial likelihood that a reasonable investor would consider that fact important. Put simply, a securitization participant could not get paid for enabling a third party to engage in a conflicts-ridden transaction that the securitization participant itself could not.

The Senators urged the SEC to enhance the test by replacing ``structure an asset-backed security’’ with ``influence the structure of an asset-backed security.’’ They reasoned that it is more typical for third parties to "influence" rather than "structure" an asset-backed security.

Both conflict of interests tests would incorporate the well-established judicially-inspired standard of a substantial likelihood that a reasonable investor would consider the conflict important to his or her investment decision. In other words, the conflict must be big enough for a reasonable investor to want to know about it before investing. While this standard is backed by a significant body of court interpretations, noted the Senators, the incredibly complex nature of asset-backed securities and the sheer number of roles that may be performed by various securitization participants may make its application difficult.

Thus, the Senators urged the SEC to make it explicit that the reasonable investor standard should be applied broadly to evaluate, not only obvious conflicts of interest arising from asset selection issues, but also hidden conflicts of interest that may arise from inappropriate fees, ministerial arrangements, or other actions taken by securitization participants. In addition, the regulations should clarify that application of the reasonable investor standard must assume that investors have all of the relevant facts to perform a fair evaluation of the securitization, including facts that may have actually been concealed from them at the time of the transaction.

Treasury Official Assures Congressmen Concerned about FATCA’s Impact on Capital Markets

2012-01-16T17:07:00.005-06:00

A senior US Treasury official has assured four Members of the House of Representatives that their concerns about the impact of FATCA on the U.S. capital markets will be kept in mind during the drafting of FATCA regulations. In a letter to Rep. Blaine Leutkemeyer (R-MO), Emily S. McMahon, Acting Assistant Secretary (Tax Policy), said that Treasury and the IRS are working assiduously to provide further guidance that will help to implement FATCA in an efficient, effective and commercially reasonable manner. This guidance will reflect careful consideration of the comments that they are receiving from the financial industry. The four concerned Members are Rep. Luetkemeyer,Rep. Ron Paul (R-TX), Rep. John Campbell (R-CA), and Rep. Donald Manzullo (R-Il).

Passed 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 will 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.

In their letter to Treasury, the Members said that FATCA's damage to the markets could appear in many forms. The most immediate impact, as foreign investors abandon US markets before 2013, could be rapidly deteriorating stock and bond prices. Any sharp drop in stock and bond prices, in turn, could impair consumer confidence, they noted, and the combined effect of these results could decimate any fragile economic recovery. The long-term impacts of FATCA could include reluctance by foreign firms to enter U.S. markets or conduct business domestically and the relocation of U.S. firms offshore.

In its response letter, Treasury shared the Members’ commitment to maintaining strong U.S. capital markets and said it has been closely consulting with U.S. and foreign financial institutions in developing guidance to implement FATCA. In addition, Treasury and the IRS issued a Notice on July 14, 2011, providing for phased implementation of the obligations imposed by FATCA over a transition period lasting through 2015, in order to provide financial institutions sufficient time to adapt their procedures and information technology systems.

New IASB Oversight Chair, a Former Securities Regulator, Is Fully Committed to Global Adoption of IFRS

2012-01-16T17:05:00.001-06:00

The new Chair of the IFRS Foundation, the overseer of the International Accounting Standards Board, is strongly committed to the adoption of IFRS as the set of global accounting standards. Michel Prada said that IFRSs have become the internationally accepted standards for high quality financial reporting. They are recognized by most major economies, starting with the EU in 2005, and have contributed hugely to the transparency and comparability of financial information for listed companies.

The ongoing financial crisis should not slow down the collective effort towards global accounting standards, he emphasized, but rather the recent market turmoil shows how important it is to deliver sound, transparent and consistent information to market participants in order for them to make informed decisions. Uncertainty and ambiguity are fundamentally detrimental to efficient markets and to sound risk management, he noted, which can trigger irrational and herd-like behaviors.

Chairman Prada is fully committed to the collective effort of promoting the goal of the global adoption of IFRSs as issued by the IASB, including the process of convergence, which he described as a tool for dealing with transition towards full adoption rather than being an end point in itself. This is of the essence when considering the relationship between the IASB and the US-based FASB, he noted. While appreciating the challenges faced by the largest economy in the world when considering the possibility of fully endorsing the global standards in a strategic domain, he said that significant progress has already been achieved in that direction and work continues.

A former securities regulator, Mr. Prada was Chairman of the Autorité des Marchés Financiers, the French markets and securities regulator, where he was an outspoken advocate for investor protection and global standards. He also served as Chairman of the Executive and Technical Committees of IOSCO and was a founding member of the Financial Stability Forum (now the Financial Stability Board). More recently, Mr Prada was a member of the Financial Crisis Advisory Group, formed to advise the IASB and FASB on their response to the financial crisis. And most recently he served as Chairman of the International Valuation Standards Council, which has established excellent working relations with the IASB in the field of valuation of all sorts of assets.

Abraham, Martin and John

2012-01-16T09:37:00.002-06:00

I thought I saw him walkin' up over the hill,
With Abraham, Martin and John (Dion)

Abraham Lincoln made the pledge a reality and one hundred years later Dr. Martin Luther King, Jr. redeemed it. That took far too long. How foolish the doctrine of Interposition seems today, how misguided was Massive Resistance and, as to the Southern Manifesto, I will leave that to history and, as John F. Kennedy said, move on to New Frontiers.

We hear a lot of talk today about job creation. Dr. King was one of the greatest job creators in US history. We must never forget that a great legacy of Dr. King is the new Toyota plant in Mississippi, the new VW plant in Tennessee, the new Siemens plant in North Carolina, and the new Hyundai plant in Alabama, because no international company would have ever built gleaming new facilities in a segregated South. So, in addition to everything else, thank you Dr. King for all the jobs you helped create in the New South.

Fed Gov. Duke Calls for Guidance on Accounting for Troubled Debt Restructurings and Sets Goal for Loan Loss Accounting

2012-01-15T14:29:00.001-06:00

Federal Reserve Board Governor Elizabeth Duke favors the issuance of guidance clarifying the regulatory and accounting treatment of troubled debt restructuring, non-performing assets, and classified loans which, while they have different definitions, time frames, and regulatory consequences, often seem to be used interchangeably. In remarks before the California Bankers Association, the Fed official also sees a need to clarify expectations, improve transparency, and heighten consistency around accounting for loan losses.

With regard to troubled debt restructuring, Gov. Duke noted that some bankers are reluctant to offer modifications that would help struggling borrowers and enhance the potential for ultimate repayment because they are concerned that the loan would be classified as a TDR and remain classified even after performance under the modified terms is demonstrated.

She also noted that a factor contributing to uncertainty is the intersection of Generally Accepted Accounting Principles (GAAP) and regulatory requirements. In her view, nowhere is this more evident than in the accounting for the allowance for loan and lease losses. The current accounting standard requires provisions only to cover losses that have already been incurred.

The central banker observed that conflicting views of the range of likely losses sometimes leads to a perception that the regulatory evaluation of the adequacy of accounting for loan loss levels involves something of a black box. To further complicate things, the accounting standard generally requires estimation, using statistical analysis, of a bank's unique past loss patterns, but most community banks have neither the rich data nor the capability to perform such analysis.

Gov. Duke said that the Federal Reserve staff is currently investigating whether there is any way to use available supervisory data to publish loss rate ranges that could be used as a starting point for any bank to calculate allowance amounts in a way that is simple to understand and not inconsistent with GAAP. Even if development of such a tool does not turn out to be feasible, she continued, the staff is still working to amend its approach to clarify expectations, improve transparency, and heighten consistency.

Hedge Fund Industry Asks CFTC to Approve ICE Petition on Portfolio Margining and Calculating Margins for Cleared Swaps

2012-01-15T12:46:00.004-06:00

The ICE portfolio margining program will benefit customers and the U.S. credit default market by facilitating systemic risk reduction, providing capital efficiencies, and encouraging greater clearing and facilitating the transition to clearing and should thus be approved by the CFTC, said the hedge fund industry. In a letter to the Commission, the Managed Funds Association also noted that approval of the ICE petition will improve buy-side access to clearing and remove economic barriers to customer clearing, promote competitive equality, and improve risk management. Without the exemptive relief requested in the ICE petitions, the MFA believes that none of these benefits will be realized.

The ICE petition is also supported by the Futures Industry Association. In a letter to the CFTC, the FIA said that a commingled portfolio margining account will allow ICE Clear Credit to offer the greatest benefit to the market and market participants by providing its broker dealer and futures commission merchant clearing members and their customers with greater operational efficiencies and a more comprehensive offering of products that can be cleared.

In particular, continued the FIA, because many market participants hedge index credit default swap positions with a single-name credit default swap, in the absence of portfolio margining, a trader will have to post full margin for both assets, which will require a significant capital outlay that will discourage participation in the US swap market and potentially add to systemic risk during times of stress. Portfolio margining will provide participants in the credit default swap market with the incentive and capital efficiency necessary to make the central clearing of credit default swaps, as contemplated in the Dodd-Frank Act, economically feasible.

Similarly, the MFA strongly believes that by granting the requested exemptive relief in the ICE petitions, the CFTC will provide customers in the credit default swap market with the economic incentives and capital efficiencies necessary to promote clearing of a broader scope of swap contracts. The requested exemptive relief would thus facilitate the achievement of the systemic risk reduction goal of the Dodd-Frank Act. Customers will be able to expend less capital on margin by virtue of the ability to net customers’ offsetting positions in security-based credit default swaps and index credit default swaps in cleared swaps customer accounts under ICE Clear Credit’s margin methodology.

Moreover, without portfolio margin treatment, many customers may determine that clearing their security-based and index credit default swaps will be prohibitively expensive. This would have a limiting effect on both the volume of voluntary clearing prior to the clearing mandate becoming effective, said the MFA, and the breadth of credit default swap clearing after the clearing mandate becomes effective. In the association’s view, these results would be inconsistent with a key Dodd-Frank Act goal to promote greater central clearing of swaps to reduce systemic risk.

Without the exemptive relief requested in the ICE Petitions, noted the MFA, ICE Clear Credit and its broker-dealers and futures commission merchants would be required to maintain separate accounts subject to the different margin rules of the CFTC and SEC to hold customer collateral relating to index and security-based credit default swaps. Separate accounts would make clearing significantly more expensive for customers because they would be required to fully margin both accounts.

For example, a customer that sells single-name credit default swaps to offset the risk of a correlated index credit default swap will, without the ability to net margin under a portfolio margining program, have to post full margin for both assets. The resulting inability of broker-dealers and futures commission merchants clearing such transactions on behalf of customers to net the margin of correlated index and security-based credit default swaps held in separate accounts would eliminate the economic efficiencies that can be gained from portfolio margining and that are inherent in a wide range of hedging strategies.

The MFA believes that these inefficiencies will act as an economic disincentive, not only to customers’ efficient portfolio risk management, but also to moving the US credit default swap marketplace to central clearing. Further, such a significant disincentive would severely undermine a fundamental objective of the Dodd-Frank Act to reduce systemic risk through promotion of greater clearing of swaps and the reduction of systemic risk. In addition, the Dodd-Frank Act encourages portfolio netting for systemic risk management reasons, charging the CFTC and the SEC with issuing exemptive orders under Section 713(a) in support of portfolio margining.

The FIA noted that Section 713 amends the Securities Exchange Act to provide that cash and securities, including security-based swaps, that are carried in a segregated account in accordance with an approved portfolio margining program will be subject to the commodity broker liquidation provisions of Subchapter IV of Chapter 7 of title 11 of the Bankruptcy Code. With this amendment, said the FIA, a major impediment to implementation of portfolio margining has been removed.

US Hedge Fund Industry Asks EU Securities Regulator to Provide Guidance on Short Selling Regulation

2012-01-14T16:36:00.001-06:00

The European Securities and Markets Authority (ESMA) was urged by the US hedge fund industry to provide clarifying guidance on aspects of the recently approved EU Regulation restricting transactions in short sales and credit default swaps. The Regulation, (2010) 0482, is intended to harmonize the rules on short selling and credit default swaps and thereby ensure that the EU internal financial market functions correctly. ESMA is the pan-European securities regulator.

In a letter to ESMA, the Managed Funds Association asked ESMA to provide examples, for purposes of the restriction on uncovered sovereign credit default swaps, in which the value of a particular portfolio of assets is correlated to the value of the particular sovereign debt, and adopt clear requirements for investors and other market participants to locate shares prior to engaging in a short sale. In addition, the MFA requested that the Regulation include convertible bonds in the calculation of a net short position. The letter was signed by Richard H. Baker, MFA CEO, and former Chair of the House Capital Markets Subcommittee.

Article 3(3) of the Regulation requires that any position held by a person indirectly, including through an index or basket of securities, must be included in the calculation of short and long positions. The association noted that Article 3(3) refers to the position holder having regard to publicly available information as to the composition of the index or basket. The MFA urged ESMA to clarify that publicly available information means information that can be obtained without payment so that position holders do not have to pay significant fees to index owners for data licenses.

Otherwise, said the MFA, it would be extremely expensive for market participants to include broad-based indices in their calculations. Typically, trades on indices are used for hedging purposes rather than to take a directional view on a particular name on the index, so market participants do not currently track the detailed information in relation to underlying stock in an index.

The MFA is especially concerned about the practical effect of requiring disaggregation of all positions in indices. Unlike existing short selling disclosure rules that apply mainly to financial institutions, the disclosure obligation under the Regulation applies to all companies admitted to trading in the EU. This means, said the MFA, that the reporting burden will be significantly greater than is currently the case under the existing regime.

This is particularly problematic in relation to broad-based indices. In this regard, the MFA believes that Article 3(3) should be interpreted such that a position in an index should be considered only if an individual stock represents more than a certain percentage, such as 20 percent, of the index, or the position holder through its holding in the index holds more than 1 percent of the relevant stock. This approach is used, for example, by the UK Financial Services Authority in its existing rules on the disclosure by holders of long positions. The FSA rule includes an anti-avoidance provision so that a person could not utilize this approach in order to avoid having to make the relevant notification.

The MFA also believes that a person calculating a net short position should be permitted to net long positions held by means of convertible bonds against short positions in the same issuer. Excluding convertible bond positions, reasoned the MFA, would mean excluding what is legitimately a long position from the calculation and giving an inaccurate result. The MFA noted that the definition of “issued share capital” in the Regulation refers to the total of ordinary and any preference shares issued by the company, but does not include convertible debt securities.

Thus, the definition does not exclude convertible bonds from the calculation of long positions under Article 3(2) of the Regulation, reasoned the MFA, it simply states which of the issuer’s securities should be aggregated to determine the denominator of the calculation of a person’s net short position. Thus, the association urged ESMA and the European Commission to clarify that investors should include long positions through convertible bonds in the calculation.

The MFA also posited that, when calculating long and short positions for purposes of the disclosure obligation, investment managers should be permitted (but not required) to aggregate the positions of funds managed by them where appropriate, such as for funds which adopt similar investment strategies. Noting that the broad definition of “sovereign goes beyond a reference simply to each EU Member State, the MFA sought the clarity of a specific list of entities which are considered to be sovereign issuers for purposes of the Regulation; with such a list to be published on the ESMA website. Importantly, the MFA urges that financial instruments be accounted for on a delta-adjusted basis rather than a notional basis, which more accurately reflects the relevant person’s economic exposure to the underlying shares and is consistent with existing short selling rules.

Uncovered Positions in Credit Default Swaps

The main issue raised by Article 4 of the Regulation is whether for purposes of the restriction on uncovered sovereign credit default swaps in Article 14 the value of a particular portfolio of assets or financial obligations is correlated to the value of the particular sovereign debt so that one could show that the credit default swap was entered into to hedge an exposure. The MFA encouraged ESMA to take a broad view of correlation, recognizing that correlation can be present in a wide range of circumstances.

The MFA also asked the EU regulators not to impose a strict requirement for the sovereign credit default swap protection buyer to hold the exposure it is hedging for the life of the swap. This is important, explained the MFA, because under English law and New York law, which together govern the majority of credit default swaps, a requirement that a credit default swap protection buyer always hold the reference obligation could result in that swap contract being characterized as a contract of insurance.

This would result in the protection seller being required to have a license to write insurance, noted the MFA, adding that protection sellers in most cases do not have such licenses. The MFA urged ESMA to clarify that the reference to “insurable interest” principle should be taken as merely indicative of the policy behind the rule in Article 14 of the Regulation, rather than an expression of what the rule requires.

Consistent with the insurance recharacterization issue, the MFA asked that there be no strict requirement for a sovereign credit default swap to be unwound upon the protection buyer no longer holding the reference asset, provided that the protection buyer entered into the swap contract in good faith with the intent of holding the asset for a reasonable period of time and hence was hedging an exposure. In addition, a protection buyer under a sovereign credit default swap should have the flexibility to reallocate the hedge to another asset by redesignating what the relevant swap covers for purposes of Article 4 of the Regulation.

In Comments to PCAOB, Large Audit Firms Oppose Mandatory Audit Firm Rotation

2012-01-13T12:13:00.001-06:00

In letters to the PCAOB, large audit firms said that the costs of mandatory audit firm rotation outweighs the benefits and that implementation of an audit firm rotation regime could undermine the critical role of audit committees and detract from sound corporate governance. The firms were commenting on a concept release issued by the PCAOB on auditor independence and audit firm rotation.

In its comment letter, KPMG said mandatory audit firm rotation could present risks to audit quality as well as significant costs and practical problems for auditors and public companies. There is some evidence that mandatory audit firm rotation could decrease audit quality and that fraudulent financial reporting is more likely to occur in the early years of the audit-client relationship.

In addition, KPMG believes that it would be arbitrary under applicable legal standards for the Board to move forward with a proposal that would dramatically change the fundamental principle that the audit committee is in the best position to decide which is the best external audit firm to audit the company’s financial statements without more empirical evidence that the perceived problem can be solved by the proposed solution. Moreover, mandatory audit firm rotation likely would place significant burdens and costs on auditors and public companies. For example, mandatory audit firm rotation would present audit firms with significant uncertainty regarding audit capacity needs and where best to locate talent with particular skill sets, and also inhibit longer-term investment in the development of specialized industry sectors.

Mandatory audit firm rotation also presents many practical implementation problems that could significantly increase costs to public companies and their shareholders, noted KPMG, costs which have not been fully quantified in any study. Most obvious is that companies would suffer increased costs as new auditors are appointed and seek to understand fully the work of the company and the prior auditor. Also troubling from the perspective of a public company is that mandatory audit firm rotation would undermine the audit committee’s ability to always select the best auditor for the job and determine whether changing auditors is in the best interests of the company and its shareholders.

Mandatory rotation divorces decisions about auditor appointment from the circumstances of the individual company and does not allow for situations in which it may be important not to change the auditor, such as when there are major changes underway at a company like a merger or acquisition or implementation of new financial reporting software.

Similarly, Ernst & Young said that mandatory audit firm rotation is neither a necessary nor a constructive means to promote auditor skepticism. E&Y was aware of no evidence suggesting that mandatory firm rotation will improve audit quality. Moreover, there are many identifiable and known downsides to such a policy with little to no certain benefit. A mandatory audit firm rotation model would not only give rise to substantial costs and disruptions, posited E&Y, it would also impair audit quality, undermine sound corporate governance, and detract from the ability to maintain a robust accounting profession.

In the view of PricewaterhouseCoopers, mandatory audit firm rotation does not pass a cost-benefit test. The most significant cost relates to diminished audit quality and less reliable financial reporting. Mandatory audit firm rotation may not be the most efficient way to enhance auditor independence and audit quality considering the additional financial costs and the loss of institutional knowledge of a public company’s previous auditor of record. The potential benefits of mandatory audit firm rotation are harder to predict and quantify.

Mandatory audit firm rotation also would involve considerable disruption, said PwC, which could further impact audit quality and the financial reporting process. In the initial years of an auditor's tenure, there is a significant effort from all parties in the financial reporting process to assist the audit team in understanding the business and internal control over financial reporting. PwC also believes that mandatory audit firm rotation would diminish audit committee effectiveness by preventing the audit committee from making the judgment to retain its existing firm in some circumstances and require it to choose a firm which it does not believe would be in the best interest of its company’s shareholders.

There will no doubt be many circumstances in which the audit committee determines that retaining the existing audit firm beyond the statutory period would be the best alternative for achieving the highest quality audit. In turn, mandatory audit firm rotation also presents significant corporate governance implications since a principle of sound governance is that the audit committee is in the best position to determine whether auditor rotation is appropriate. Since the passage of the Sarbanes-Oxley Act, audit committees on the whole have embraced their responsibility as independent stewards of the auditor relationship and function effectively in discharging those responsibilities.

While Deloitte & Touche said that mandatory audit firm rotation is not as effective as would be making improvements in the existing system, the firm allowed that a limited form of mandatory rotation, what Deloitte called remedial rotation, should be considered. For example, the PCAOB might recommend to the audit committee an auditor change as a result of serious adverse inspection findings that the Board believes cannot be resolved otherwise. In appropriate circumstances, the PCAOB or the SEC also could seek agreement from an audit firm to resign from an engagement, or a company to change auditors, as a condition for resolving an enforcement investigation. These measures would allow for change in specific auditor-company relationships, reasoned Deloitte, without mandating audit firm rotation for the entire system.

In its comment letter, BDO noted under mandatory audit firm rotation the audit learning curve would be significantly steeper because an entire audit firm is being replaced, rather than just the lead partner and engagement quality reviewer. Thus, the institutional knowledge a firm gains during its tenure is lost, reasoned BDO, and the successor firm would need to devote substantial time in building an appropriate level of knowledge.

While acknowledging that companies do change auditors in the normal course of business, BDO pointed out that these voluntary changes are effectively managed. In contrast, the exponential increase in the rate of audit firm changes under a mandatory rotation regime would place excessive burdens on management, the audit committee, and the new audit firm in implementing a smooth transition, with the potential negative effect on audit quality.

Securities Industry Urges Clarification of Proposed FINRA Whistleblower Rules

2012-01-13T06:04:00.002-06:00

The securities industry has asked that FINRA rule proposals addressing disputes arising under a whistleblower statute be changed by replacing ``dispute” with “claim” in every instance in new section (b) of Rule 13201 and new item (3) of Rule 2263. In a letter to the SEC, which must ultimately approve the rule change, the Securities Industry and Financial Markets Association said that as a practical and definitional matter there can be no “dispute” until the parties join issue in an ongoing legal proceeding by disagreeing about the facts or the law. But a “claim” is the mere assertion of a right, in this case under a statute. To the extent that the proposal simply aligns FINRA’s rules with Dodd-Frank Act Section 922, and other federal statutes that do not require parties to arbitrate whistleblower claims, SIFMA supports the proposed changes.

According to SIFMA, using the term “dispute” creates a risk that a party could raise a whistleblower retaliation defense or otherwise assert some counterclaim under a whistleblower statute in an effort to improperly remove the entire case from arbitration. The proposal should clarify that it applies only to a bona fide whistleblower claim, that such a claim may be severed and removed from securities arbitration, and by doing so, the proposal is not intended to allow parties to avoid arbitrating other claims in the case that are properly subject to securities arbitration. SIFMA believes that replacing “dispute” with “claim” would help provide necessary clarity and certainty on this point.

SIFMA also urged that the word “federal” be inserted before “whistleblower statute” in new section (b) of Rule 13201 and new item (3) of Rule 2263 to clarify that the rule’s application is limited to federal whistleblower claims which are not subject to arbitration. As currently drafted, the proposed rule would seemingly apply to all whistleblower statutes, both federal and state (if any) that carve-out whistleblower claims from arbitration. The Federal Arbitration Act, however, generally preempts state statutes that invalidate arbitration agreements and thus would preempt state statutes that remove whistleblower claims from arbitration. As a result, the proposal could be read to expand upon U.S. Supreme Court jurisprudence and current law, and frustrate federal preemption under the FAA. The proposal should be amended to clarify that such is not the purpose or intent.

Hedge Fund and Securities Industries Urge SEC and CFTC to Allow Hedge Funds and Commodity Pools to Qualify as Eligible Contract Participants

2012-01-12T15:09:00.003-06:00

The hedge fund and securities industries are concerned that the proposed definition of eligible contract participant under the Dodd-Frank Act will cause substantial disruptions to financial markets. In a joint letter to the SEC and CFTC, the Managed Fund Association and SIFMA urged the Commissions to adopt changes to the definition allowing private funds and other commodity pools to qualify as eligible contract participants, provided that the funds and pools were not formed for the purpose of evading the definition.

The associations believe that private funds and commodity pools should be able to rely on Section 1a(18)(A)(v)(I) of the Commodity Exchange Act without the need to look through to determine whether every direct or indirect investor/participant is an eligible contract participant. Thus,they urge the Commissions to clarify that a hedge fund or traditional commodity pool will continue to qualify as an eligible contract participant by relying on Section 1a(18)(A)(v)(I), which, as amended by Section 721(a)(9) of Dodd-Frank permits a hedge fund having assets exceeding $10,000,000 to qualify as an eligible contract participant.

The scope of the eligible contract participant definition is critically important because Sections 723(a)(2) and 763(e) of Dodd-Frank make it unlawful for a non-eligible contract participant to enter into a swap or security-based swap other than on a designated contract market or a regulated exchange. Also, many financial counterparties have arrangements in place with hedge funds and traditional commodity pools that are dependent upon their status as eligible contract participants.

The foreign exchange market is the world’s largest financial market, noted the Commissions, with a deep and liquid marketplace that provides an important adjunct to all of the other financial markets. Institutional investors regularly participate in the market to reduce risks by hedging currency exposures; to convert returns from international investments into domestic currencies; and to make cross-border investments. Private funds, including funds that constitute commodity pools, are significant participants in this market and provide a considerable amount of liquidity to the market.

The associations said that the adoption of the proposed definition without appropriate changes could lead to the disruption of the currency markets and increase the potential for greater systemic risk without accomplishing the regulatory goal of enhancing the protection of retail investors. Many of the funds that would become non-eligible contract participants with respect to foreign exchange trading under the proposed definition are sophisticated investors and significant liquidity providers to the U.S. foreign exchange market.

If the Commissions’ proposed definition were to be adopted, noted the trade groups, it would have the potential of categorizing a significant proportion of traditional institutional accounts managed by sophisticated money managers as retail, which would adversely impact the liquidity these market participants bring to the foreign exchange market through their active participation. In fact, investment funds and commodity pools may be precluded from trading certain currencies at all, warned the associations, since not all currencies have corresponding exchange-traded futures contracts or are represented on retail foreign exchange platforms.

According to the associations, there is no indication that requiring customers that are clearly institutional in nature to trade in the retail markets will add any protection for retail customers. Further, the proposed definition is not consistent with the underlying rationale behind the sophisticated investor framework established through law and regulation by the SEC and CFTC and limits the ability of entities managed by sophisticated money managers that are subject to registration and examination by regulators to qualify as eligible contract participants.

The proposed definition is also likely to preclude institutional accounts from effectively or efficiently diversifying or hedging their portfolio against foreign exchange risk and increase costs for individual investors who are ultimately likely to bear the burden of greater costs. Moreover, if institutional accounts and their counterparties were forced to trade in the retail foreign exchange market, the associations are concerned that many of the firms would have difficulty doing so from an operational perspective.

As a result, it will become very difficult for affected firms to operate within the U.S. In addition, requiring these entities to transact as non-eligible contract participants for foreign exchange will mean that the entities would need to trade with a separate retail-focused dealer and not with the swap dealer that will be the counterparty to the entities on all other transactions. In the view of the associations, bifurcating trading entities will create systemic risk by eliminating the benefits of close-out netting.

SEC Approves PCAOB’s 2012 Budget, Engages in Q&A with PCAOB Chair Doty

2012-01-12T15:07:00.002-06:00

The SEC unanimously approved the PCAOB’s 2012 budget of $227.7 million. Board Chair James Doty appeared at the open meeting to answer the commissioners’ questions. SEC Chief Accountant James Kroeker said that information technology and its governance continue to pose challenges to the Board. The Board was instructed to report to the SEC on its progress on those initiatives. The Board also must continue to report to the SEC on the timing of the issuance of its inspections and on developments in gaining access to certain foreign jurisdictions to conduct inspections.

Most of the Board’s budget is covered by the accounting support fee which is assessed on issuers and broker-dealers. The budget represents an increase of 11% over the 2011 budget which is primarily attributable to the Board’s inspection program. The Board will increase staff to perform inspections of the audits of SEC-registered broker-dealers and to increase the number of international inspections in 2012.

In opening remarks, SEC Chair Mary Schapiro referred to the unprecedented change that was brought about by the PCAOB’s oversight of the audit profession. The former system of peer reviews, where one auditor reviewed the work of another, has been replaced by the PCAOB’s inspection reports. Chairman Schapiro said it is striking to compare an old peer review with a PCAOB inspection report.

Chairman Doty believes the 2012 budget will place the Board in a strong position to fulfill its investor protection mandate. One of the main drivers of the budget are personnel costs, which account for 75% of the budget, 58% of which is for inspection personnel. IT costs make up 10% of the budget, rent and facility make up 8%, and travel 7%. The travel expenses are mainly inspection-related trips, including foreign travel.

Commissioner Elisse Walter asked Doty to address the Board’s enforcement efforts. He said that inspections and enforcement go hand-in-hand. Chairman Doty would like to see inspections and mediation work, with enforcement as a last resort. He added that it would also help if Congress agrees to lift the prohibition on making public the Board’s filed enforcement actions. Litigation proceedings can stretch out for years, he said, and the lack of transparency creates a tremendous roadblock to settling actions.

Commissioner Walter also asked about whether the Board plans to accelerate the issuance of its inspection reports. The PCAOB Chair said that he is optimistic about that and would like to see final reports issued within six months after the inspectors leave the field.

Commissioner Luis Aguilar addressed the serious challenges the Board faces in gaining access to foreign accounting firms to perform inspections. In his opinion, firms should not be able to participate in an issuer’s audit if they are beyond the Board’s oversight. Chairman Doty reported progress in a number of jurisdictions. The Board is working through all of the data protection issues in Europe, he said. The agreement with Japan was a big step forward, in his view. However, Doty said the 36 Chinese firms that are registered have not made information available to the Board. In Comm. Aguilar’s view, the situation cannot continue ad infinitum.

Commissioner Troy Paredes also asked about the timing of the inspection reports and how to close the gap to achieve the goal of issuance six months after inspectors leave the field. Chairman Doty said the Board had developed a backlog, which has substantially been cleared. He also pointed out that it is a retrospective process, looking back at a year of completed audits. With firms’ cooperation, he sees no reason why the Board should not be able to get the reports out within that time frame.

The Chair also noted that the inspection reports are not a report card on a firm. The purpose of the report is to direct the firm and the public to the questions they should be asking. He added that the staff’s audit practice alerts should be read by everyone, including audit committees and management, as should the Board’s 4010 reports.

Commissioner Paredes asked about the Board’s use of cooperation credit in enforcement proceedings. The PCAOB chief said that the Board applies credit, but it is not always evident. The Board has less to offer when a firm cooperates, but when it does, Doty said the Board fully acknowledges that cooperation.

When Comm. Paredes asked about the expectations for the Board’s Office of Research and Analysis, Mr. Doty said that ORA produces over 500 reports a year. It is the data management function of the Board. The Chair expects ORA to show enhancements each year in its ability to deliver refined information to help the Board make accurate decisions about rulemaking, enforcement and investigatory steps, adding that he wants to see increasing relevance in the data ORA produces.

Responding to a question about the role of economic analysis in the Board’s standard setting activities, Chairman Doty acknowledged the increased interest in economic analysis in connection with the SEC’s rulemaking and said the Board pays attention to those instructions.

Commissioner Paredes also asked how the Board determines whether it is efficiently using its resources. Mr. Doty said that firms have admitted that audit quality has improved through the inspection process. The Board can see improvements with the triennially inspected firms. Conduct is changing, in his view, and audit practices are improving, as is conduct in the boardroom.

Chairman Schapiro addressed the problem with access to foreign firms and said both the SEC and the PCAOB have a real sense of urgency on the matter. It is very easy to register and to deregister, said the PCAOB Chair, who added that the Board pushes back when a firm seeks to register in a jurisdiction where the Board has no access. The Board has denied registration, he said. Some registered firms have gone dark and the PCAOB head acknowledged that the Board has been slow to pull the plug on their deregistration.

Finally, responding to a query from Chairman Schapiro if the Board has the necessary depth of expertise in connection with international financial reporting standards, Mr. Doty said the Board has IFRS experts and expects to hire more.

This post was contributed by my colleague, Jacquelyn Lumb

Indiana Issues Private Equity/Venture Capital Fund Administrative Order In Connection with IA Registration

2012-01-12T13:51:00.004-06:00

An administrative order by the Indiana Securities Division extends a 2008 policy statement on private equity/venture capital funds and investment adviser registration by providing a post-Dodd-Frank Act IA registration exemption for the funds following that Act's elimination of the Section 203(b)(3) de minimis exemption for investment advisers.

Effective January 9, 2012 and until the Division can adopt a rule for these funds, no enforcement action will be taken against any person that fails to register in the State as either an investment adviser or investment adviser representative, provided: (1) the person maintains a place of business in Indiana; (2) has had not more than five client residents of Indiana during the preceding 12 months; (3) does not hold itself out generally to the public as an investment adviser; and (4) advises a qualified fund as defined under SEC Rule 203(m)-1, if neither the fund's adviser nor any of the adviser's affiliates are subject to federal Regulation A "bad boy" disqualification provisions.

NOTE that fund advisers described in (4) above who advise at least one qualifying private fund excluded from the "investment company" definition in Section 3(c)(1) of the Investment Company Act of 1940 that are not venture capital funds must meet additional requirements.

Hedge Fund Industry Petitions SEC to End Regulation D Ban on General Solicitation

2012-01-11T13:37:00.001-06:00

In a public rulemaking petition, the Managed Funds Association asked the SEC to amend Rule 502(c) of Regulation D to eliminate the prohibition on offers or sales securities by general solicitation or general advertising with respect to private funds. The petition is part of the broader effort by executive and regulatory policy makers and the SEC to modernize the securities laws in response to technological innovations and the evolving manner in which investors, issuers and other market participants interact. The framework for issuers to raise capital through private offerings under Regulation D dates back almost thirty years, noted the MFA, during which time the securities markets, issuers, and investors have undergone extensive change. The MFA posited that private funds and regulatory oversight of the industry, in particular, would be unrecognizable to the original drafters of Regulation D

In the petition, the MFA said that eliminating the prohibition would reduce the legal uncertainty resulting from the current regulation of private fund offerings conducted in reliance on Regulation D and increase transparency of the hedge fund industry in a manner consistent with the Dodd-Frank Act and recent regulatory initiatives. The change would also facilitate capital formation and reduce administrative costs by allowing investors to more easily obtain information about private funds, while at the same time maintaining strong investor protections and ensuring that only sophisticated investors are able to purchase interests in private funds.

Moreover, the requested amendment would reduce regulatory oversight costs and allow the SEC staff to reallocate resources to other aspects of investor protection, including products offered and sold to retail investors. The MFA emphasized that the petition is not proposing that anyone other than sophisticated investors be permitted to invest in hedge funds; and further emphasized that the activities of hedge fund managers in connection with an offering or sale of securities would continue to be subject to the broad anti-fraud provisions of the securities laws.

The MFA noted that the terms “general solicitation” and “general advertising” are not defined in Regulation D or elsewhere in the federal securities laws, and therefore have an uncertain and potentially broad application. The SEC has indicated that an issuer seeking to comply with these limitations should determine whether a particular manner of securities offering constitutes a general solicitation or general advertising based on relevant facts and circumstances.

As a result of this framework, Rule 502(c) subjects hedge funds to a sweeping prohibition on a range of activities and communications, noted the MFA, and as a practical matter fund managers only engage in activities which the SEC staff has identified as permissible. Guidance issued by the staff, however, such as no-action letters, is dependent on the specific facts and circumstances of the entity making a request, and therefore generally offers only narrow, limited relief upon which other issuers may rely.

Despite the best of intentions by the SEC staff to provide clear, workable guidance, by its nature this approach leads to uncertainty for hedge fund managers in assessing whether the facts associated with a range of communications, including discussions with potential investors, participation at industry events, and making public statements, would comply with the terms of previous guidance issued to another entity in a distinct set of circumstances. According to the MFA, this uncertainty is exacerbated by the potentially severe consequences to a hedge fund that would threaten its survival if it engages in conduct that is deemed to violate Regulation D.

For example, the SEC staff has indicated that an important factor in assessing if an offering is in compliance with Regulation D is whether an issuer, or a selling agent or other person acting on its behalf, has a pre-existing substantive relationship with an offeree so that the issuer or agent could form a reasonable belief that it meets the investor eligibility requirements. This condition is particularly difficult for hedge fund managers to interpret and apply to their businesses, said the MFA, because they generally conduct continuous offerings of securities. As a result, managers must carefully analyze whether they, or a selling agent acting on behalf of a fund, have established a substantive relationship with an offeree prior to, or in the course of, an offering.

The hedge fund industry group also noted that eliminating the ban would allow the SEC staff to reallocate resources to other important aspects of investor protection, including oversight of products that are offered and sold to retail investors. The current framework requires the SEC staff to determine whether activity constitutes a general solicitation or general advertising on a case-by-case basis. This approach requires the staff to expend scarce resources to evaluate an issuer’s conduct in connection with a broad range of activity.

In addition, eliminating the ban would reduce the cost of capital for private funds and lead to greater efficiency in private offerings, said the MFA, which in turn would facilitate the allocation of capital and investment by private funds throughout the financial markets. Private fund managers face significant costs in seeking to comply with the ban due to its broad application, the limited scope of existing guidance, and the severe consequences of an inadvertent violation. Managers expend considerable time and resources when making any sort of communications or participating in industry events, and often take a conservative approach and refrain from such activity. These effects impose administrative burdens for managers and unnecessarily limit communications with potential investors, increasing the cost of obtaining capital for private funds.

In the First Session of the 112th Congress, the House passed by an overwhelming 413-11 vote the Access to Capital for Job Creators Act, H.R. 2940, to instruct the SEC to amend Regulation D to eliminate the ban on general solicitation and advertising. There is a companion bill in the Senate.

In Letter to SEC, Securities Professionals Concerned that Volcker Rule Proposals Will Hurt Liquidity

2012-01-11T11:12:00.004-06:00

Proposed regulations implementing the Volcker Rule provisions of the Dodd-Frank Act could impose comprehensive restrictions on market making and curtail liquidity, in the view of the National Association of Securities Professionals. In a letter to the SEC, the association urged regulators to redraft the proposed regulations to clarify that basic market making functions of covered institutions are not impacted by the Volcker Rule. The congressional intent of the Volcker Rule was to restrict proprietary trading, said the association, not to impose comprehensive restrictions on market making.

The original intent of Section 619 of Dodd-Frank is to prohibit U.S. banks with insured deposits from engaging in proprietary trading and limit bank holding companies from participating in hedge fund and private equity businesses. The first objective has largely been achieved, maintained the association, since most of the covered institutions have shut down or spun off their proprietary trading operations. But the expansive and granular regulatory framework put forward by the proposals implementing Section 619 runs the risk of restricting large institutions from fulfilling their beneficial market making functions. Broker-dealers are obligated to act as an agent for buyers and sellers by executing their orders in the market, noted the securities professionals, or act as a principal by supplying liquidity directly to clients. This role is particularly vital to US interests on a routine basis and even more so in times of crisis when natural buyers may be hard to find.

The securities professionals believe that liquidity is critically important to the health and vitality of the US financial system. Liquid markets promote efficient capital allocation. Wen liquidity dries up, there is less access to credit and the cost of capital goes up, hindering business growth and job creation. If implemented in an overly intrusive manner, contended the association, Section619 has the potential to curtail liquidity. Covered institutions, fearful that their actions will be second guessed by regulators, could become hesitant to fulfill their market making role.

One particular concern is how the proposed regulations covers the natural process of maintaining inventory in anticipation of client demand. As in any business, broker dealers manage inventory in anticipation of client demand. Section 619's metrics and granularity run the risk of inserting regulators into the process of building inventory. Inventory management -including managing inventory for profitable return -is not proprietary trading as it was thought of in the debate around the Volcker rule. The association urged the SEC redraft the regulations to ensure that such normal course market making functions are not subject to regulatory second-guessing.

Texas Proposes Administrative Procedure Rule Amendments

2012-01-10T11:24:00.000-06:00

Amendments to the rules of practice in contested cases were proposed by the Texas Securities Board to more closely align the rules with the Texas Securities Act, the Administrative Procedures Act and the rules of the State Office of Administrative Hearings. Provisions would cover administrative hearing notices and costs; burden or proof; subpoenas and depositions; default; informal dispositions, decisions and orders by the Securities Commissioner; motions for rehearing; records; and ex parte communications. Other proposed changes would correct a cross-reference in a shelf registration rule and update a citation to the Texas Development Corporation Act.

Federal Magistrate Grants SEC Request for Show Cause Order in Case Involving China-Based Accounting Firm

2012-01-10T09:22:00.003-06:00

At the request of the SEC, a federal magistrate approved the issuance of a show cause order in an action brought by the Commission against a China-based accounting firm registered with the PCAOB. The court found, largely for the reasons offered by the SEC, that service of the application on the firm was not a prerequisite to the issuance of the proposed order directing the accounting firm to show cause why the court should not enter an order requiring the firm to produce documents responsive to an SEC subpoena. The SEC asserted that on May 27, 2011, it served an administrative subpoena on the accounting firm in connection with an investigation styled In the Matter of Longtop Financial Technologies Limited, SEC File HO-11698. The firm is a Chinese member firm of Deloitte Touche Tohmatsu Limited, a UK private company.

In her ruling, the magistrate cited a federal district court ruling granting the SEC’s application for an order to show cause noting that the Exchange Act permits worldwide service of process in cases involving the enforcement of subpoenas. SEC v. Lines Overseas Management, Ltd., D.D.C. No. Civ. A. 04-302, January 7, 2005. The SEC’s application for an order directing compliance with its subpoena will be a subject of a hearing, and, accordingly, remains pending. (SEC v. Deloitte Touche Tohmatsu CPA, Ltd., D.D.C, Miscellaneous Action No. 11-0512 GK/DAR, Jan. 4, 2012.)

The SEC filed the subpoena enforcement action against Deloitte Touche Tohmatsu CPA Ltd. for failing to produce documents related to the SEC’s investigation into possible fraud by the Shanghai-based public accounting firm’s longtime client Longtop Financial Technologies Limited. According to the SEC’s application and supporting papers filed in U.S. District Court for the District of Columbia, the SEC issued a subpoena on May 27, 2011, and D&T Shanghai was required to produce documents by July 8, 2011. The SEC said that, although the accounting firm is in possession of vast amounts of documents responsive to the subpoena, it has not produced any documents to the Commission to date. As a result, the Commission said that it has been unable to gain access to information that is critical to an investigation that has been authorized for the protection of public investors.

According to the court papers, D&T Shanghai was Longtop’s auditor since at least 2007, and the firm consented that its audit reports for Longtop could be filed annually with the SEC while knowing that they would be relied upon by U.S. investors. On May 22, the firm resigned as Longtop’s auditor after discovering numerous improprieties during an audit for the year ended March 31, 2011. In its resignation letter, which was included in a Form 6-K furnished by the company on May 23, D&T Shanghai identified numerous indicia of financial fraud at Longtop and indicated that the firm’s prior year audit reports for the company could no longer be relied upon by investors.

As part of the Longtop investigation, the SEC staff issued and served the subpoena on D&T Shanghai seeking production of documents related to the incomplete audit of the company for the year ended March 31 as well as prior year audits that the firm completed. According to the court papers, these documents may reveal information about the firm’s discovery of false financial records at the company, how any fraud schemes at the company were able to continue undetected, and basic information necessary to ferret out whether there was a fraud, who was behind it, how significant it was, and how it was conducted.

The SEC’s court papers note that the company is a foreign private issuer whose American depositary shares (ADSs) traded on the NYSE from the date of its initial public offering in October 2007 until May 17, 2011, when the NYSE halted trading prior to delisting Longtop’s securities in August 2011.

ESMA Guides on Inside Information, Dividends and Derivatives under Market Abuse Directive

2012-01-09T19:35:00.002-06:00

Concerned about recent incomplete disclosure of the full details of dividend payment announcements that may have caused undue effects on equity derivatives, the European Securities and Markets Authority (ESMA) reminded issuers that they should consider any relevant information related to dividend payments and policies as inside information should this information be likely to have a significant effect on the prices of either the issuer’s shares or related derivatives or both. Using a Q&A vehicle, ESMA noted that the definition of inside information in Article 1 of the Market Abuse Directive expressly includes information relating to an issuer of financial instruments that would be likely to have a significant effect on the prices of related derivative financial instruments.

ESMA is aware of the influence that information on expected dividends has on the price of futures and other derivatives. The Authority also acknowledges the effect that changes in dividend policies and payment patterns have on the price formation of equity derivatives, including futures. Like any inside information, noted ESMA, this information should be disclosed as soon as possible, according to Article 6 of the Market Abuse Directive, and in a manner which enables fast access and complete and timely assessment of the information by the public.

The provisions affect various aspects of dividend policies and payments that might have a significant effect on the prices of derivative instruments, such as ex-date, provisional and final amounts, nature of the payment, special dividend, any changes on previously announced information, and changes in dividend payment patterns. For instance, a decision to change the ex-dividend date compared to the preceding year’s date should be disclosed in a timely manner so that the information is incorporated into the pricing models used on the derivative markets.

The disclosure of this type of information should be done promptly, said ESMA, even when the proposals for any change on dividend policy, including dates and nature of the dividend, are still subject to further consideration or approval by the general shareholders meeting. Investor relations units should take special care when replying to questions posed by investors or firms so as to ensure that only the information that was previously disclosed by the issuer under the Market Abuse Directive obligations is provided in those answers and that selective or unintended disclosures regarding the issuers' dividend policy are avoided.

ESMA therefore urges issuers, especially those whose shares are included in reference indices and are the underlying in listed derivatives contracts, to pay special attention to this issue in order to ensure an effective and harmonized application of the Directive.

In Letters to PCAOB, EU, Australian and Japanese Accounting Groups Oppose Mandatory Audit Firm Rotation

2012-01-09T18:37:00.002-06:00

Comment letters to the PCAOB reveal a strong consensus among global accounting associations that mandatory audit firm rotation could reduce audit quality without increasing auditor independence or enhancing professional skepticism. The comments were in response to a PCAOB concept release on auditor independence and auditor rotation.

Mandatory audit firm rotation would not be conducive to enhancing either auditor independence or professional skepticism, said the European Federation of Accountants, and could even have a potential adverse impact on audit quality. In its letter to the PCAOB, the Federation noted that mandatory audit firm rotation would contradict the objective of reinforcing audit committees since it would take away one of the key roles of audit committees to decide when and whether a new audit firm should be appointed. Similarly, in its letter, the Japanese Institute of Certified Public Accountants said that mandatory audit firm rotation would adversely impact audit quality and financial reporting.

The Institute of Chartered Accountants in England and Wales believes that mandatory audit firm rotation would be a counter productive step that would remove authority from the audit committee and hence negatively impact sound corporate governance, while not concomitantly improving audit quality. In fact, continued the Institute, studies have concluded that discarding the audit firm’s cumulative understanding every few years will inevitably lead to a higher risk of audit failure in the early stages of a new appointment. In its letter to the Board, CPA Australia opposed mandatory audit firm rotation due to a lack of clear evidence of audit quality improvement that would result from such a measure. CPA Australia would support a pilot program to try to obtain such evidence.

The Federation observed that the European Commission is also considering mandatory audit firm rotation as well as other measures. The European debate focuses mainly on market related issues when discussing mandatory audit firm rotation, noted the Federation, while the PCAOB approaches the debate from the angle of independence, professional skepticism and audit quality. Due to the evident extraterritorial consequences of such requirements, emphasized the Federation, it is essential to carefully consider the practical feasibility of the measures if introduced in only one jurisdiction for companies with global activities and their auditors.
Thus, the Federation urged the PCAOB to coordinate any initiatives with its international counterparts in order to achieve a coherent, practical and sustainable solution.

Mandatory audit firm rotation is not the most practical or cost-effective way to respond to concerns regarding independence, said the Federation, citing the alternative of greater involvement of audit committees and making the auditor appointment process more independent of management. This could be combined with tendering procedures under the responsibility of the audit committee and through more transparency by the company regarding the selection and appointment process. Further, guidance could be given to audit committees on how they make proper use of their duty to monitor auditor independence.

The Federation also posited that there is no direct link between mandatory audit firm rotation and professional skepticism. International auditing standards professional skepticism requirements, which are similar to requirements in the current US standards, highlight that the auditor should not solely rely on the honesty and integrity of management and those charged with governance, but must obtain evidence and evaluate the persuasiveness of this evidence. Moreover, while recognizing that earlier decisions can always be challenged, engagement quality control review is an integral part of the audit of listed companies.

Thus, the Federation suggested that it may be more relevant to consider further improvements to the auditing standards on professional skepticism with the aim of enhancing the application of this principle, rather than seeking enhancements of professional skepticism through other policy measures, such as requiring audit firms to rotate on a regular basis.

The Institute of Chartered Accountants emphasized that mandatory rotation of audit firms will not address the concerns the PCAOB has about professional skepticism. In fact, the Institute cautioned that auditors are only in a position to fully apply skepticism when they have developed sufficient knowledge of the client and industry, which mandatory audit firm rotation could undermine. As an alternative, the Institute suggested enhancing auditor documentation of the approach to skepticism and increasing audit committee involvement.

The Federation also pointed out that, since Korea introduced mandatory audit firm rotation in 2006, a Korea University study concluded that audit hours and fees increased while audit quality remained unchanged or decreased slightly. In addition, a recent European Parliament report on the European Commission’s Green Paper on Audit Policy endorsed the concept of internal key audit partner rotation instead of external audit firm rotation.

The Japanese CPA Institute said that mandatory audit firm rotation would make it difficult for audit firm personnel to gain specialized knowledge and experience in specific industries or areas. Mandatory audit firm rotation may also result in low-balling of audit fees, while increasing audit cost.

In its comment letter, the German Institute of Public Auditors cautioned that mandatory audit firm rotation could increase market concentration because audit firm changes would be mainly restricted to larger firms, since audit committees perceive that medium firms lack the resources and expertise. Thus, rather than facilitating access of the medium-sized firms to more audit clients, said the Institute, it would make it easier for large audit firms to encroach on smaller firm audit clients. The German Institute also believes that mandatory audit firm rotation would intensify a price spiral that could threaten audit quality. More broadly, it would lead to permanent movement in the audit market that, in the view of the Institute, would ultimately detract from the value of auditing and lead to an audit being seen as a mere commodity to be valued by price alone, which would also undermine audit quality.

FRC Will Propose Changes to UK Corporate Governance Code on Auditor Selection and Audit Committee Reports

2012-01-09T12:42:00.002-06:00

Noting that reporting by audit committees is often unenlightening, the UK Financial Reporting Council said that it would propose changes to the UK Corporate Governance Code and the related guidance on audit committees to stimulate more informative reporting and to extend the remit of the audit committee. The FRC also intends to propose that the independent outside audit of a company’s financial statements should be put out to tender at least every ten years. It is also possible that the FRC will consult on changes to the going concern provision in the Code, depending on the outcome of the current inquiry being led by Lord Sharman.

The FRC believes that how the audit committee actually discharges its duties is rarely covered and that very few audit committees report the key decisions taken or judgments made by the committee. The FRC also believes the current state of affairs threatens to undermine confidence in audit committees at a time when there is considerable skepticism about the effectiveness of the outside audit and the audit committee.

The proposed amendments to the Corporate Governance Code would extend the reports that the audit committee gives to the board and which subsequently appear in the annual report. The FRC will also consult on proposals to require clearer reporting on how the external auditor is selected. Recommendations on what companies should disclose about the selection process were incorporated into the FRC’s Guidance on Audit Committees in 2008 but, disappointingly, these have been followed by only one-third of companies.

The FRC Guidance on Audit Committees (formerly known as the Smith Guidance) is intended to assist company boards when implementing the sections of the Corporate Governance Code dealing with audit committees and to assist directors serving on audit committees in carrying out their role. The Guidance states that the audit committee section of the annual report should explain to shareholders how it reached its recommendation to the board on the appointment, reappointment or removal of the external auditors. This explanation should normally include supporting information on tendering frequency, the tenure of the incumbent auditor, and any contractual obligations that acted to restrict the audit committee’s choice of external auditors.

The initial recommendation of the Sharman Panel was that the FRC should move away from a model where disclosures about going concern risks are only highlighted when there are significant doubts about the company’s survival to one which integrates going concern reporting within a broader disclosure model in which the directors always report how they arrived at the going concern statement, as part of their discussion of strategy and principal risks in the company’s narrative report, with the audit committee report confirming that a robust process has been undertaken. The audit committee report should also provide an explanation of the material risks to going concern considered and addressed; and identify any that they have not been able to resolve.

The Panel believes that the auditor should comment in the audit report on the going concern section of the narrative report and of the audit committee’s published report, if these fail to provide the required information, and otherwise state that it has nothing to add. The final recommendations of the Sharman inquiry are expected in February of 2012. Lord Sharman was the Liberal Democrat Spokesperson for Trade and Industry/Business and Regulatory Reform from 2001 to 2010. Before that, he held numerous senior UK and international positions with KPMG

Corporation Finance Division Guides on Financial Statement Disclosure around European Sovereign Debt Exposure

2012-01-09T09:43:00.002-06:00

Noting current uncertainties in connection with European sovereign debt exposures, and the lack of transparent, comparable information, the SEC Division of Corporation Finance issued guidance out of concern about the adequacy of financial statement disclosures for investors. Under the circumstances, the staff believes that principles-based item requirements may call for more detailed disclosure on this topic. In determining which countries are covered by the guidance, companies should focus on those experiencing significant economic, fiscal and/or political strains such that the likelihood of default would be higher than would be anticipated when such factors do not exist.

The staff expects that the countries covered by this analysis would vary and thus the disclosures should be sufficiently flexible to capture those risks as they change over time. Corp Fin encourages companies to disclose the basis used for identifying the countries included in this disclosure.

The staff said that disclosures should be provided separately by country, segregated between sovereign and non-sovereign exposures, and by financial statement category, to arrive at gross funded exposure. Companies should also consider separately providing disclosure of the gross unfunded commitments made. The staff suggests that companies provide information regarding hedges in order to present an amount of net funded exposure. In deciding what disclosure is relevant and appropriate for the particular facts of each company, the staff urges companies to consider a number of factors, including gross funded exposure, unfunded exposure, and total gross exposure, as well as the effects of credit default protection to arrive at net exposure and other risk management disclosures.

With regard to gross funded exposure, companies should consider the basis for the countries selected for disclosure and the basis for determining the domicile of the exposure, as well as the separate categories of exposure to sovereign and non-sovereign counterparties. Companies should also consider categories of financial instruments, including loans and leases, held-to-maturity securities, available-for-sale securities, trading securities, and derivatives to arrive at a gross funded exposure. For held-to-maturity securities, the amortized cost basis and the fair value should be considered. Similarly, for available-for-sale securities, the fair value, and if material, the amortized cost basis should be considered.

For trading securities, only the fair value need be considered. For derivative assets, the fair value should be considered, except that amount could be offset by the amount of cash collateral applied if separate footnote disclosure quantifying the amount of the offset is provided.

Regarding unfunded exposure, the company should consider the amount of unfunded commitments by type of counterparty and by country, and the key terms and any potential limitations of the counterparty being able to draw down on the facilities.

According to the SEC staff, the effect of gross funded exposure and total unfunded exposure should be subtotaled to arrive at total gross exposure as of the balance sheet date, separated between type of counterparty and by country. Appropriate footnote disclosure may be provided highlighting additional key details, such as maturity information for the exposures.

The effects of credit default protection purchased separately by counterparty and country should also be disclosed, along with the fair value and notional value of the purchased credit protection. In addition, the nature of payout or trigger events under the purchased credit protection contracts should be disclosed, noted the staff, and the types of counterparties that the credit protection was purchased from and an indication of the counterparty’s credit quality. The company should also reveal whether credit protection purchased has a shorter maturity date than the bonds or other exposure against which the protection was purchased. If so, there should be clarifying disclosure about this fact and the risks presented by the mismatch of maturity.

The other risk management disclosures include how management is monitoring and mitigating exposures to the selected countries, including any stress testing performed and the effects of indirect exposure in the analysis of risk. Disclosure should explain how the companies identify their indirect exposures, examples of the identified indirect exposures, along with the level of the indirect exposures.
It is also incumbent on management to disclose current developments, such as rating downgrades, financial relief plans for impacted countries and widening credit spreads of the identified countries, and how those developments, or changes to them, could impact the company’s financial condition, results of operations, liquidity or capital resources.

ESMA Planning Guidance on Hedge Fund Regulation and Proposed Regulations on ETFs in 2012

2012-01-08T14:35:00.002-06:00

Having proposed regulations under the Alternative Investment Fund Managers (AIFM) Directive last year, the European Securities and Markets Authority plans to issue guidance on the regulation of hedge fund and private equity fund managers under the Directive in 2012, according to ESMA Chair Steven Maijoor. In remarks at the EFAMA investment management forum, the Chair also said that ESMA plans to propose regulations under the UCITS Directive that are specific to exchange traded funds, such provisions ensuring an adequate level of protection of retail investors dealing on the secondary market. EFAMA is the European Fund and Asset Management Association.

The AIFM Directive introduced an entirely new regulatory landscape for managers of hedge funds and other alternative investments. By the end of 2011, ESMA delivered to the European Commission proposed implementing regulations on the AIFM Directive. The proposals were the result of two separate consultation papers and two open hearings that led to the receipt of a considerable amount of responses from a wide range of stakeholders, including valuable input from EFAMA. Despite a very tight time constraint and the significant amount of topics covered by the mandate, ESMA delivered its advice by the mid-November deadline set by the Commission.

Chairman Maijoor believes that it is generally recognized that ESMA’s proposals represent a reasonable balance between the need to introduce an adequate level of investor protection within the alternative investments framework and the constraints of the Level 1 Directive, on one hand, and the concerns expressed by the industry, on the other. He noted that ESMA introduced very important clarifications on some of the core elements of the AIFMD which are linked to investor protection, such as the transparency requirements, the duties of the depositary and its liability regime, and the rules applying to the delegation to third country managers and depositaries. The Commission will now analyze the proposals ESMA made to assist them in developing the AIFMD Level 2 measures.

But ESMA’s work on the AIFMD is not done, emphasized the Chair. Indeed, ESMA has already determined areas in which it will complement the proposals through the development of further guidelines, for example on the advanced method of calculation of leverage, and is willing to lead the negotiation of the co-operation agreements with the non-EU competent authorities which are foreseen by the AIFMD provisions on third countries. Further, ESMA is progressing with its work on the regulatory technical standards on the types of AIFM, which should be adopted in parallel with the Level 2 implementing measures, and will start working shortly on the other measures foreseen by the Directive, such as the guidelines on sound remuneration policies.

Separately, ESMA is also developing guidelines on exchange traded funds and structured UCITS designed to ensure a better regulatory framework for investors. The rationale here is the well-known issue of the retailization of complex products. Taking that into account, ESMA is determined to introduce new rules which will reduce risk and deliver more transparency for retail investors exposed to such products. The regulations will be specific to exchange traded funds, such as a requirement for such funds to use an identifier, as well as new provisions ensuring an adequate level of protection of retail investors dealing on the secondary market.

The Chair is aware of concerns that the guidelines would create an ETF-specific regime focusing on this category of product only and not imposing equivalent requirements on other UCITS that are exposed to indices or that carry out investment activity using techniques which are very similar, if not identical, to the ones used by ETFs. But he assured that ESMA intends to identify clearly those provisions which are relevant to all UCITS funds, with only some rules being specific to ETFs and reflecting their characteristics, for example, issues relating to the secondary market trading.

For issues arising from securities lending activities, for instance, ESMA will cover all kinds of UCITS, including exchange traded funds, engaging in such activity. In particular, ESMA aims to deliver more transparency for investors by requiring funds to disclose in their prospectuses the fact that they make use of securities lending, and setting out some specific rules on the disclosure of collateral and its quality.

Finally, the Chair emphasized that the packaged retail investment products (PRIPs) initiative remains a central piece of work in terms of investor protection. The range of products to be covered is quite broad and potentially includes collective investment undertakings, structured products and derivatives, and he knows there are MiFID II proposals to extend selling standards to structured deposits.

A goal of the PRIPs initiative is to apply consistent rules to similar investment product. It is essential for investor protection to ensure that similar, competing retail investment products are subject to the same requirements. The Commission clearly defined that approach in the consultation it launched last year where it proposed to apply consistent standards across the market by setting the Key Investor Information Document (KIID) as a benchmark for all PRIPs as far as the disclosure requirements are concerned, and the MiFID rules as a benchmark for all PRIPs as regards selling practices.

ESMA fully supports the creation of a level regulatory playing field for all retail investment products in terms of disclosure and selling practices. For selling practices in particular, ESMA is aware of the fact that a horizontal legislative approach may raise some issues in relation to the areas of competence of securities and insurance regulators in those EU Member States where they are not integrated and that the Commission has already presented a proposal for the review of the MiFID rules.

German and UK Governments Oppose Regulatory Monitoring of Explanations under Comply or Explain Corporate Governance Codes

2012-01-07T13:10:00.003-06:00

The UK and the Federal Republic of Germany both oppose requiring regulators to monitor company explanations as to why a provision of the corporate governance code was not complied with. In letters to the European Commission, the governments said that review of the efficacy of a company’s reason for not complying with a code provision was best left to the markets and the shareholders. The governments were responding to an EC Green Paper on reforming corporate governance. Both Germany and the UK have comply or explain corporate governance codes requiring an explanation when a company does not comply with a code provision.

While compliance with the Corporate Governance Code is monitored by investors and private sector organizations that scrutinize compliance with the Code, noted the UK, ultimately it is the shareholders’ responsibility to determine whether an explanation offers sufficient information to make an informed investment decision.

It is important that shareholders continue to make these decisions, said the UK letter, and it is not for government or regulators to interfere in these relationships. For this reason monitoring bodies should not take on the role of checking the quality of explanations, emphasized the UK, and comply or explain statements should not become regulated information under the terms of the Transparency Directive.

While sharing the Commission’s concern about the informative quality of explanations, the UK believes that the best way to allay these concerns is through guidance rather than regulatory oversight. If guidance could be given to those writing and receiving the explanations, reasoned the UK, it is possible that the quality of explanations may improve significantly and shareholders themselves may become more adept at questioning an explanation. In this spirit, the UK Financial Reporting Council will shortly develop a consensus about what constitutes a proper explanation under a comply and explain code.

In its letter to the Commission, the Federal Republic was highly skeptical of requiring regulators or other authorities to monitor the comply or explain responses of German companies under the corporate governance code, which is a job best left to the markets.

German public companies are required to declare annually whether or not they have complied with the recommendations of the German Corporate Governance Code. Since the Accounting Law Modernization Act went into effect, companies are required not only to disclose divergences from the code recommendations, but also give a reason for these divergences.

The idea of a corporate governance code with a comply or explain arrangement is based on the concept that non-mandatory statutory arrangements are developed by industry itself, reasoned the Federal Republic, and compliance or non-compliance with them is subject to the oversight of the capital markets. The German corporate governance code works with a comply or explain mechanism, said the government, because the capital markets evaluate the statements, and where appropriate, draws its conclusions from them. If the statements are not convincing or are incomplete or are not authoritative, the capital markets will draw conclusions from this.

In addition, a state monitoring authority would entail a major organizational effort. Monitoring would have to be very careful and be carried out with a uniform standard. Even more, said the Federal Republic, an undesirable standardization of comply or explain statements could result from regulatory monitoring since the monitoring agency would make it known what responses were acceptable in what form, and companies would employ these in a formulaic manner.

EU Court of Justice Rules that Unrealized Capital Gains Can Be Taxed When Company Transfers to Another Member State

2012-01-07T12:48:00.001-06:00

EU law does not in principle preclude the charging of tax on unrealized capital gains relating to the assets of a company when it transfers its place of management to another Member State, ruled the Court of Justice of the European Union. However, the immediate recovery of the tax at the time when the company transfers its place of management, without the company being given the possibility of deferred payment of the tax, is not compatible with EU law. National Grid Indus BV v. Inspecteur van de Belastingdienst Rijnmond/kantoor Rotterdam, C 371/10, 29 November 2011.

The case involved a company incorporated under Netherlands law that transferred its place of management from the Netherlands to the UK. After the transfer, it was deemed to be resident in the UK by virtue of a Convention on the avoidance of double taxation concluded between the Netherlands and the UK. Consequently, the company ceased to obtain profits taxable in the Netherlands so that, under Netherlands legislation, a final settlement of unrealized capital gains existing at the time of the transfer of the place of management was drawn up by the Netherlands tax authorities, who demanded immediate payment of the tax. The company contested that decision, claiming that it was contrary to the principle of freedom of establishment.

The Court of Justice first confirmed that the company could rely on freedom of establishment in order to challenge the decision of the Netherlands tax authorities. The Court then found that a company incorporated under Netherlands law wishing to transfer its place of effective business outside the Netherlands suffers a disadvantage in terms of cash flow compared to a similar company keeping its place of management in the Netherlands.

Under the national legislation, the transfer of a Netherlands company's place of management to another Member State entails the immediate taxation of the unrealized capital gains relating to the assets transferred, whereas such capital gains are not taxed when a Netherlands company transfers its place of management within the Netherlands. That difference of treatment is liable to deter a company incorporated under Netherlands law from transferring its place of management to another Member State, reasoned the Court, and constitutes a restriction that is in principle prohibited by the Treaty provisions on freedom of establishment.

However, the Court also noted that preserving the allocation of powers of taxation between EU Member States is a legitimate objective. Also, in the absence of any harmonizing measures of the European Union, Member States retain the power to define, by treaty or unilaterally, the criteria for allocating their taxing powers. In that context, the transfer of the place of effective management of a company of one Member State to another does not mean that the Member State of origin has to abandon its right to tax a capital gain that arose within the ambit of its powers of taxation before the transfer. The legislation at issue is therefore appropriate for ensuring the preservation of the allocation of powers of taxation between the Member States concerned. The Court pointed out that the Treaty offers no guarantee to a company that transferring its place of effective management to another Member State will be neutral as regards taxation.

However, in order to assess the proportionality of such legislation, the Court drew a distinction between the establishment of the amount of tax and the recovery of the tax. The Court found that the Member State of origin complies with the principle of proportionality if, for the purpose of safeguarding the exercise of its powers of taxation, it determines definitively, without taking account of decreases or increases in value which may occur subsequently, the tax due on the unrealized capital gains that have arisen in its territory at the time when its power of taxation in respect of the company in question ceases to exist. But the Court did rule that legislation prescribing the immediate recovery of tax on unrealized capital gains relating to assets of a company transferring its place of effective management to another Member State at the very time of that transfer is disproportionate.

House Oversight Chair Asks DOJ for Information About Cordray Recess Appointment

2012-01-06T20:24:00.000-06:00

In a letter to Attorney General Eric Holder, House Financial Services Chair Spencer Bachus (R-ALA) asked for information about the recess appointment of Richard Cordray to be Director of the Consumer Financial Protection Bureau, which the Chair described as a matter of significant public interest and importance. Chairman Bachus noted that, by launching its non-bank regulatory program, the CFPB apparently views the appointment as sufficient to activate rulemaking and other authorities pursuant to Section 1066 of Dodd-Frank, even though that provision on its face conditions the exercise of these authorities on Senate confirmation of a Director.

In order to assist the Committee in reviewing this matter, Chairman Bachus asked for a response to three questions by January 20, 2012. First, he asks if the White House sought DOJ’s advice on any aspect of the appointment and, if so, copies of any documents reflecting such advice. Second, given that the Senate has been meeting in pro forma session once every third day, and no adjournment resolution has been passed by either house of Congress, the Chairman would like DOJ’s view on whether the Senate was in recess at the time of Mr. Cordray’s appointment such that the President could lawfully exercise his recess appointment authority.

Third, Chairman Bachus asks if it is DOJ’s view that the Bureau Director position was a vacancy that happened such that the President was authorized to constitutionally fill it. If so, the Oversight chair asks how DOJ would reconcile that view with the Vacancies Reform Act (P.L. No. 105-277), which purports to codify aspects of the exercise of the recess appointment power and does not appear to provide that a newly-created office like CFBP Director is vacant.

Texas Adopts IA Custody Rule and Amendments to Written Exam Rules

2012-01-06T15:42:00.003-06:00

A safekeeping rule for investment advisers with custody of their clients’ funds or securities was adopted by the Texas Securities Board, together with amendments to the written examination rules for dealer principals, agents, investment advisers and investment adviser representatives. The "solicitor" definition was clarified. NOTE: A rule on advisory performance based fees remains proposed.

Corporate Secretaries Society Concerned About DOL Interim Rules for Handling Whistleblower Retaliation Claims

2012-01-05T19:15:00.002-06:00

Some aspects of the Department of Labor’s interim final rules for handling whistleblower retaliation claims under Section 806 of the Sarbanes-Oxley Act are unauthorized by statute, imbalanced, and unduly prejudicial to employers’ reasonable interests, in the view of the Society of Corporate Secretaries and Governance Professionals. In a letter to the DOL, the Society maintained that the interim final rules lack any standards governing the issuance of preliminary reinstatement orders, that OSHA lacks the authority to enforce preliminary reinstatement orders in federal court, and that the oral complaint provision will have unintended negative consequences. And all this comes against the backdrop of recent decisions where the Administrative Review Board (ARB) has taken an exceedingly broad approach to interpreting Section 806. While the Society embraces the need to ensure that good faith whistleblowers are protected against retaliation, the final rules must protect employers' interests on par with those of employee whistleblowers.

The interim final rules lack standards governing the issuance of preliminary reinstatement orders, noted the Society, which is particularly troublesome in light of OSHA’s presumption in favor of reinstatement and that staying a preliminary reinstatement order would be available only based on exceptional circumstances. Since reinstatement orders may carry potentially significant, harmful consequences for the employer, reasoned the Society, the rules should contain safeguards ensuring that such a remedy is warranted and appropriate under the circumstances rather than presuming that reinstatement is proper.

The lack of clear and reasonable standards gives OSHA unfettered discretion to issue reinstatement orders without regard to business, human resources or legal concerns, said the Society, which is inconsistent with constitutional requirements. The Society suggests that OSHA include in the final rules factors that which have been considered by courts to determine when reinstatement is appropriate, such as whether hostility exists between the employee and the company such that reinstatement would adversely impact productivity or information flow, whether the employee poses risks in terms of violence, misappropriation, or otherwise compromising the value of the company’s reputation or property, and whether the employee’s position no longer exists.

The Society also urged that the rules be modified to provide meaningful standards governing when an ALJ should stay a preliminary order of reinstatement. The current language stating that such a stay must be granted only based on exceptional circumstances is substantive, said the Society, not procedural, and would unduly constrain the ALJ’s otherwise vested discretion and authority and leave them in the dark as to when a stay is warranted.

In the interim final rules, continued the Society, OSHA’s position that any preliminary reinstatement orders that it issues are enforceable by federal courts is directly at odds with express statutory language and federal court decisions. OSHA rebuffs this solid line of decisions, noted the Society, and takes a position that would allow an employee to be taken in and out of the work force at each stage of appeal. For example, an ALJ could decide against reinstatement, the ARB could then order reinstatement and the federal Circuit Court of Appeals could then reverse the reinstatement order; and the employee would move in and out of the company with each decision. The rules do not provide any standards that would resolve this real and unacceptable risk.

The Society is also concerned that provisions in the interim final rules would enable OSHA investigators to take in oral complaints and then create a written complaint based on the complainant’s statements. This could have unintended negative consequences, warned the Society, and urged OSHA not to enact it. The prior rule requires complaints to be in writing. OSHA does not provide examples of how the prior requirement prejudiced whistleblowers or otherwise was unworkable, noted the Society. Further, the new rule is unnecessary because most Sarbanes-Oxley complaints are filed by sophisticated professionals.

Moreover, the new rules shift the OSHA investigator’s role from neutral fact-finder to advocate. The investigator in this circumstance now creates the complaint, said the Society, rather than just reviewing and investigating it and can be expected to make efforts to ensure that it sets forth a defensible prima facie case. This is problematic because the rules lack any standards governing the investigator’s creation of a written complaint to ensure that the investigator will act in an entirely neutral capacity, avoid asking leading questions in the course of preparing the complaint, and avoid expanding the scope of the complaint to fill in gaps to avoid dismissal.

Section 806 of Sarbanes-Oxley provides whistleblowers with broad protection against retaliation, and its safeguards recently became even more robust as a result of the enactment of the Dodd-Frank Act and a range of decisions recently issued by the Administrative Review Board. Dodd-Frank amended Section 806 to cover private subsidiaries of publicly traded companies and to guarantee a jury trial in SOX whistleblower cases pursued in federal district court.

In addition, the ARB issued a ruling that significantly expanded the scope of protected activity under Section 806. In Sylvester v. Parexel International LLC, ARB No. 07-123 (May 25, 2011), the ARB ruled that a complainant need not demonstrate a fraud on shareholders to sustain a whistleblower claim under Section 806 and repudiated what the Society called the widely accepted standard requiring complaints to definitively and specifically relate to one of the categories of fraud in Section 806. In the Society’s view, the existence of these expanded whistleblower protections underscores the need to ensure that employers are provided adequate due process in the context of the DOL’s administration of Section 806 complaints.

Japanese Securities and Banking Regulators Fear that Volcker Rule Proposed Regulations Would Hurt Government Bond Trading

2012-01-05T16:17:00.001-06:00

The proposed regulations implementing Dodd-Frank’s Volcker Rule provisions would have an adverse impact on the trading of Japanese government bonds, in the view of the Financial Services Agency and the Bank of Japan. In a letter to the SEC, the Japan’s financial regulators said that the Volcker proposals would raise the operational and transactional costs of trading in Japanese government bonds and could lead to the exit from Tokyo of Japanese subsidiaries of US banks.

In addition, some Japanese banks might be forced to cease or dramatically reduce their US operations. In turn, these reactions could further adversely affect liquidity and pricing of the government bonds. Even more, sovereign bond markets worldwide might be affected at this critical juncture. Thus, the FSA and Bank of Japan urged the SEC and the banking agencies to expand the range of exempted securities to include Japanese government bonds.

The Japanese regulators posit that the extraterritorial application of the Volcker Rule restrictions on proprietary trading and relationships with hedge funds and private equity funds to foreign entities owned by foreign financial groups could adversely affect the liquidity of the financial markets globally. It could also have a negative impact on US financial stability, which the Dodd-Frank Act aims to achieve as a primary objective. As long as the groups are subject to appropriate group-wide supervision by foreign supervisors, noted the letter, such foreign entities should be exempted from the requirements.

According to the proposed restrictions, US banking groups and foreign banking groups with a branch or a subsidiary in the US would be subject to restrictions on their current positions of government bonds, except US treasuries. While market making and other less-risky trading are exempted, noted Japan’s financial regulators, the restrictions would impose a significant burden and higher costs on foreign banks, including major Japanese firms, and make sovereign bond trading less attractive and profitable.

It is also possible that the smooth functioning of the Bank of Japan's money market operations would be adversely affected by the proposed restrictions. This might, in turn, exert extremely negative pressures on sovereign bond markets worldwide through reduced liquidity and a rise in volatility, which would be particularly worrisome under current financial market condition.

Short-term foreign exchange swaps would also be subject to the proposed restrictions. In many jurisdictions, short-term foreign exchange swaps are used uniquely for the purpose of US-dollar funding by major foreign banking entities, observed the regulators, including the Japanese Banking Groups, rather than as tools for proprietary trading. If foreign exchange swaps are restricted by the new Volcker regulations, cautioned Japan’s financial regulators, branches and subsidiaries of US banks would not be able to provide USD liquidity to foreign counterparts through short-term swaps.

This could squeeze USD funding significantly outside the US and accelerate the deleveraging of European banks by liquidating foreign assets. In addition, it does not seem consistent to restrict short-term swaps while FX spot trading and long-term swaps, through which more risks could be assumed, are exempted. Therefore, the FSA and central bank strongly request that short-term foreign exchange swaps be exempted from the Volcker restrictions.

Non-US asset management funds would also be subject to the restrictions, said the regulators, except those which do not have US investors or those which would need to register under the Investment Company Act. In practice, it would be almost impossible for an investor to judge whether a fund is exempted or not, and the proposed restrictions could create an uncertain investment climate for non-US funds, resulting in significantly reduced investments in those funds and reduced investment opportunities for US investors. The FSA and central bank said it would be more appropriate to dialogue with foreign regulators to find a clear objective definition of the funds in question.

Finally, and more broadly, Japan’s regulators urged the SEC and the banking agencies to take due account of the cross-border impact of financial regulations and the need to collaborate with affected countries. When it comes to the extraterritorial application of financial regulations, emphasized the FSA and Bank of Japan, the home authorities bear the primary regulatory responsibilities.

Considering the potentially serious negative impact on the Japanese markets and associated significant rise in the cost of related transactions for Japanese banks, the regulators urged the SEC and banking agencies to refrain from extraterritorial application of the Volcker restrictions, or to amend the definition of “control” and “affiliate” in the final regulations so as not to include foreign joint ventures and foreign subsidiaries which are controlled by foreign banking groups.

Director Cordray Outlines Vision for CFPB and Begins Regulation of Non-Bank Financial Entities

2012-01-05T11:32:00.001-06:00

In his first remarks as Director of the Consumer Financial Protection Bureau, Richard Cordray outlined a vision for the Bureau of transparency, effective enforcement and exercising the full powers of the Bureau over banks and non-bank financial entities. In remarks at The Brookings Institution, the Director announced that the Bureau will immediately launch a program for supervising non-bank financial entities, such as payday lenders, mortgage servicers, mortgage originators, private student lenders, and other firms that often compete with banks but have until now escaped meaningful federal oversight. This launch fulfills the twin promises of the Dodd-Frank Act that the Bureau will have a singular focus on protecting consumers in the financial marketplace, and ensuring that large banks and non-bank financial firms are held to the same standards.

The non-bank markets are large and significant, the Director emphasized, and provide valuable services to customers who lack access to other forms of credit. For example, he noted that nearly 20 million US households use payday lenders and pay roughly $7.4 billion in fees every year. Also, many subprime loans during the housing bubble were made by nonbank mortgage brokers. The Bureau is pledged to establish clear standards of conduct so that all financial providers play by the rules.

He also noted that a primary objective of the Bureau is to bring clarity to the financial markets. Since people have a hard time understanding the terms of a financial deal when they have to pore over reams of fine print, he said, so the Bureau launched its Know Before You Owe campaign to provide consumers with easy-to-understand disclosures clarifying the prices and risks of financial products right up front. The Director posited that two basic premises of a well-functioning market are that buyers and sellers understand the terms of the deal, and that buyers are able to compare possible alternatives. Honest businesses want to compete in such a market, he reasoned, and they are satisfied to win market share based on fair competition and excellent customer service, not through deception or fraud.

Another key objective of the CFPB is ensuring that financial institutions are playing by the rules. The Bureau inherited the responsibility of supervising the largest banks in the country to make sure they are following the law. In practical terms, that means that the Bureau has examiners on the ground with broad authority to review loan documents, ask tough questions, and make a financial institution fix problems that come to light. The Director believes that financial institutions can speak to their customers more simply and more clearly, adding that straightforward transparency promotes responsible decision-making by consumers.

The Bureau will also clarify that there are real consequences to breaking the law. Informants and whistleblowers have been given direct access to the CFPB. The Bureau took over a number of investigations from other agencies in July, he noted, and are pursuing some investigations jointly with them. The CFPB has also started its own investigations. While some investigations may be resolved through cooperative efforts to correct problems, he said, others may require enforcement actions to stop illegal behavior.

House Oversight Panel Invites CFPB Director Cordray to Testify as Legislation Blocking His Appointment is Readied

2012-01-05T09:44:00.004-06:00

A House panel has invited the recess-appointed CFPB Director Richard Cordray to testify January 24 on policy concerns about the structure of the Bureau and how the concerns of the oversight panel can be reconciled. In a letter to Mr. Cordray, Rep. Patrick McHenry (R-NC), Chair of the Oversight Subcommittee on TARP and Financial Services, noted that the CFPB Director has enormous authority to invalidate any consumer financial product in the United States and broadly regulate financial products and services with minimal oversight. The letter emphasizes that the Subcommittee is deeply interested on how the Director will implement and enforce the unparalleled powers of his new office.

In a separate statement, Chairman McHenry said that this unprecedented appointment runs counter to the constitutional requirements for a recess appointment and President Obama’s own campaign pledge to run the most transparent administration in history. He posited that the enormous authority put in the hands of a single director for the CFPB must be accompanied by appropriate congressional oversight and transparency.

Meanwhile, Rep. Jeff Landry (R- LA) said that he would introduce legislation to prevent Mr. Cordray's appointment from going forward until a court rejects his appointment on its unconstitutionality. The Constitution is clear, said Rep. Landry, the President can appoint officials with the Advice and Consent of the Senate. Since the Senate has advised the President against making Cordray’s nomination and has not given its consent on his appointment and with the House meeting to keep Congress in session, reasoned Rep. Landry, the appointment of Mr. Cordray can only be considered an abuse of the recess appointment process.

Separately, Financial Services Committee Chairman Spencer Bachus (R-ALA), said that the President’s unprecedented attempt to circumvent the Constitution and ignore the law indicates that he has abandoned any effort to work in a bipartisan manner to strengthen accountability and oversight of the CFPB. In the Chairman’s view, the recess appointment of Director Cordray has delegitimized the CFPB and has opened the agency up to legitimate legal challenges that will cripple it for years.

Applying Spanish Law and Citing Internal Affairs Doctrine, Delaware Supreme Court Affirms Dismissal of Derivative Action

2012-01-05T06:18:00.003-06:00

The Delaware Supreme Court has upheld the Chancery Court’s application of Spanish law to dismiss a derivative action by a Spanish minority shareholder on behalf of a Spanish parent company with a Delaware subsidiary that aided in effectuating the challenged acquisition of another company. The parent’s majority shareholder, a Spanish entity, also held a majority interest in the acquired company. Invoking the internal affairs doctrine, the Supreme Court said it would violate the principle of comity for a Delaware court to disrupt the internal affairs of a Spanish corporation by displacing Spanish derivative standing rules with those of Delaware. Sagarra Inversiones, S.L. v. Cementos :Portland Valderrivas, et al.,Uniland Acquisition Corp., Nominal Defendant, C.A. No. 6179-VCN, Aug. 5, 2011.

The internal affairs doctrine recognizes that only one state should have the authority to regulate a company’s internal affairs and that is the state of incorporation. In a double derivative action of this type involving a wholly-owned subsidiary, a shareholder must plead demand futility at the parent level. Thus, where the parent is not a Delaware corporation, under the internal affairs doctrine, the law of the state of incorporation determines the showing that a plaintiff must make to show it has standing to bring a multiple derivative action. Because the minority shareholder only owns shares in the parent corporation organized under the laws of Spain, the Chancery Court properly considered whether it had standing to bring a derivative claim under Spanish law.

In an en banc opinion, the Delaware Supreme Court rejected the notion that the presuit demand requirement in derivative actions is not within the embrace of the internal affairs doctrine. The Court held that the presuit demand requirement is quintessentially an internal affair that falls within the scope of the internal affairs doctrine. Noting that the internal affairs doctrine is a dominant and overarching choice of law principle, the Supreme Court said that an important rationale for the doctrine is to prevent companies from being subjected to inconsistent legal standards, and thus the authority to regulate a corporation’s internal affairs should not rest with multiple jurisdictions. The term internal affairs encompasses matters pertaining to relationships among or between the corporation and its officers, directors, and shareholders The doctrine requires that the law of the sovereign nation of incorporation must govern those relationships.

The presuit demand requirement serves a core function of substantive corporation law, said the Court, in that it allocates as between directors and shareholders the authority to sue on behalf of the corporation. The entire question of demand futility is inextricably bound to issues of business judgment and the standards of that doctrine's applicability. The decision to bring a lawsuit or to refrain from litigating a claim on behalf of a corporation is a decision concerning company management.

In the Court’s view, those contours of the demand requirement fall firmly within the gravitational pull of the internal affairs doctrine, and thus are determined by the law of the jurisdiction of incorporation of the entity on whose board a presuit
demand is required. In this case, the law of Spain governs the presuit demand requirements that the shareholder must satisfy to sue derivatively.

The Court also rejected the claim that public policy should displace the internal affairs doctrine. It would violate the principle of comity, said the Supreme Court, and serve no legitimate Delaware interest, for a Delaware court to disrupt the internal affairs of a Spanish corporation by displacing Spanish derivative standing rules with those of Delaware.

Public policy cannot operate as a protean ethic that trumps, on an ad hoc basis, settled choice of law rules that govern the right of a stockholder to enforce, derivatively, claims that belong to the corporation in which it owns shares. When the shareholder took ownership of its shares, reasoned the Court, it did so with presumed knowledge that its ownership interest was subject to the legal rights conferred, and the restrictions imposed, by the Spanish legal regime.

Hawaii Investment Company and Advisory Fees Remain Reduced in 2012

2012-01-04T16:46:00.003-06:00

The 2012 reduced fees for investment adviser, investment adviser representative and investment company security filings will remain at the 2011 reduced fee amounts throughout 2012. Broker-dealer and agent fees were removed from the reduced fee schedule for 2012, having returned to their pre-reduced amounts of $200 and $50, respectively, for initial and renewal registration. Please email Henry Tanji, Securities Compliance Specialist, at htanji@dcca.hawaii.gov with any questions.

President Intends to Use Recess Appointment to Name Cordray CFPB Director

2012-01-04T13:14:00.002-06:00

The President is set to use a recess appointment to name Richard Cordray as the first Director of the Consumer Financial Protection Bureau. A Statement on the White House blog sets out the legal and factual background of the appointment.

The Statement notes that the Constitution gives the President the authority to make temporary recess appointments to fill vacant positions when the Senate is in recess, a power all recent Presidents have exercised. The Senate has effectively been in recess for weeks, it says, and is expected to remain in recess for weeks. The Statement posits that in an ``overt attempt to prevent the President from exercising his authority during this period, Republican Senators insisted on using a gimmick’’ called pro forma sessions, which are sessions during which no Senate business is conducted and instead one or two Senators simply gavel in and out of session in a matter of seconds. The Statement asserts that ``gimmicks do not override the President’s constitutional authority to make appointments to keep the government running.’’ In fact, continues the Statement, the lawyers who advised President Bush on recess appointments wrote that the Senate cannot use sham “pro forma” sessions to prevent the President from exercising a constitutional power.

Reacting to the recess appointment, Senator Richard Shelby (R-ALA), Ranking Member on the Banking Committee, said that the President did an end run around Congress, the elected representatives of the American people, in order to avoid accountability to them. Senator Shelby said that he has led the fight for accountability at the consumer bureau. Joined by 44 Republican Senators, Senator Shelby sent a letter last year to the President urging amendments to the Dodd-Frank Act to change the Bureau’s governance, replacing the single Director with a Board to oversee the Bureau. On December 8, 2011, Senator Shelby said on the Senate floor that in order to make the Bureau more accountable, the Bureau should be led by a Board of Directors rather than a single Director.

On the one-year anniversary of the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the House of Representatives passed legislation restructuring the Consumer Financial Protection Bureau created by the Act. The Consumer Financial Protection Safety and Soundness Improvement Act, HR 1315, would establish a bi-partisan, five-member Commission consisting of a Chair and four additional members to carry out all of the duties that would otherwise fall to the Director of the CFPB. Commission members would be appointed by the President, confirmed by the Senate, and would serve five-year terms.

Massachusetts Private Fund Adviser Exemption Up for Public Hearing January 5, 2012

2012-01-04T11:41:00.006-06:00

A public hearing on a new private fund adviser exemption, as well as an amended institutional investor definition and revised custody requirements for investment advisers will be held at the Massachusetts Securities Division on Thursday, January 5 at One Ashburton Place, Room 1701 in Boston Massachusetts 02108. Public comments will be received through Friday, January 6. Please email your comments to securitiesregs-comments@sec.state.ma.us.

The proposed amendments for the public hearing are as follows:

Registration exemption for private fund advisers. As proposed, private fund advisers would be exempt from investment adviser registration in Massachusetts, provided the advisers are not subject to "bad boy" disqualifications under Rule 262 of federal Regulation A, and electronically file through the IARD the SEC-filed reports and amendments required by SEC Rule §204-4, together with a $300 fee, at which time the electronic submission would be considered "filed."

Private fund advisers to certain 3(c)(1) funds. Private fund advisers advising at least one 3(c)(1) fund that is not a venture capital fund would, in addition to meeting the above requirements: (1) advise only those 3(c)(1) funds (other than venture capital funds) whose outstanding securities (other than short-term paper) are beneficially owned solely by persons who, after deducting the value of the primary residence from the person’s net worth, would each meet the “qualified client” definition in SEC rule 205-3 at the time the securities are purchased from the issuer; (2) disclose in writing to each “non-venture capital 3(c)(1) fund beneficial owner,” at the time of purchase, either the services the advisers will provide, and duties the advisers will owe, the beneficial owners, or disclose to the beneficial owners that services will not be provided, or duties owed, to them, and disclose all other material information affecting the beneficial owners’ rights or responsibilities; and (3) obtain audited financial statements annually of each non-venture capital 3(c)(1) fund and deliver a copy of the financial statements to each beneficial owner.

Grandfathering for private fund advisers with non-qualified client. Private fund advisers to one or more non-venture capital 3(c)(1) funds beneficially owned by persons who are not “qualified clients” as defined above could still qualify for the private fund adviser exemption if: (1) the subject fund(s) existed before March 30, 2012 and cease(s) to accept beneficial owners who are not qualified clients as of that date; and (2) the private fund advisers to the subject fund(s) were in compliance, as of March 30, 2012, with the “no transacting business in Massachusetts unless registered” requirement of §201(c) under the Massachusetts Securities Act, disclose in writing to the fund(s)’ beneficial owners the “services/duties provided (or not provided) to them as mentioned above, and deliver the audited financial statements mentioned above.

Notes pertinent to all private fund advisers. (1) Investment adviser representatives would be exempt from registration if registration would be required solely because of their being employed by or associated with an "exempt private fund adviser." (2) The exemption would not apply to federal covered investment advisers, i.e., private fund advisers registered with the SEC; they would need to comply with state notice filing requirements. (3) A "private fund,""private fund adviser, " "3(c)(1) fund," "value of primary residence," and "venture capital fund" would be defined.

Institutional buyer definition. Currently, institutional buyers may be: (1) an organization described in Section 501(c)(3) of the Internal Revenue Code having a securities portfolio of more than $25 million; (2) an investing entity whose only investors are financial institutions and institutional buyers as described in Massachusetts Securities Act §401(m) and Massachusetts Securities Rule 12.205(1)(a)6.a.; or (3) an investing entity made up exclusively of accredited investors as defined in Rule 501(a) of federal Regulation D under the Securities Act of 1933 who each invested a minimum of $50,000. As proposed, the definition in (3) above would additionally require the subject fund to have existed before March 30, 2012 and to have ceased to accept new beneficial owners as of that date.

Custody of, and discretionary authority over, client funds or securities. As proposed, investment advisers registered or required to register in Massachusetts that have custody of their clients’ funds or securities would need to comply with the safekeeping requirements of SEC Rule 206(4)-2 under the Investment Advisers Act of 1940. Massachusetts would adopt the "custody" definition in SEC Rule 206(4)-2 of the 1940 Act. An investment advisers would not be exempt from the independent verification requirement in subsection (b)(3) of SEC Rule 206(4)-2 unless the adviser: (1) has written consent from the client to deduct advisory fees from the qualified custodian-held account; and (2) sends the qualified custodian and client an invoice or statement of the fee amount to be deducted from the client’s account each time a fee is directly deducted.

Investment advisers registered or required to register in Massachusetts that have discretionary authority over their clients’ funds or securities would maintain a minimum $10,000 bond from a Massachusetts-qualified bonding company.

Pamela Gibbs Named Director of SEC Office of Minority and Women Inclusion

2012-01-03T18:26:00.001-06:00

Pamela A. Gibbs has been named the first Director of the SEC’s Office of Minority and Women Inclusion, which was mandated by the Dodd-Frank Act so that the federal financial regulators would each establish an office devoted to workforce diversity, the use of minority and women-owned service providers, and the assessment of the diversity policies and practices of the businesses each regulates.

Director Gibbs comes to the SEC from the CFTC, where she has served since October 2009 as the Director of its Office of Diversity and Inclusion. In that role, Ms. Gibbs was the principal advisor to the CFTC Chair on equal employment and diversity matters, and oversaw outreach and recruitment of minority and women’s groups. She also worked with the agency’s Office of General Counsel and Office of Human Resources to ensure fairness and consistency in the agency’s personnel policies and practices.

Prior to her service with the CFTC, Ms. Gibbs spent 18 years at the U.S. Department of Labor, where she started in 1991 as a trial attorney in the Civil Rights Division. She later was Acting Deputy Director for Program Operation in the Office of Federal Contract Compliance Programs, and was Director of the Equal Employment Opportunity Unit in the Employment Standards Administration from April 2006 to October 2009.

German and UK Governments Oppose Regulatory Monitoring of Explanations under Comply or Explain Corporate Governance Codes

2012-01-03T17:46:00.002-06:00

The UK and the Federal Republic of Germany both oppose requiring regulators to monitor company explanations as to why a provision of the corporate governance code was not complied with. In letters to the European Commission, the governments said that review of the efficacy of a company’s reason for not complying with a code provision was best left to the markets and the shareholders. The governments were responding to an EC Green Paper on reforming corporate governance. Both Germany and the UK have comply or explain corporate governance codes that require an explanation when a company does not comply with a code provision.

While compliance with the Corporate Governance Code is monitored by investors and private sector organizations that scrutinize compliance with the Code, noted the UK, ultimately it is the shareholders’ responsibility to determine whether an explanation offers sufficient information to make an informed investment decision.

It is important that shareholders continue to make these decisions, said the UK letter, and it is not for government or regulators to interfere in these relationships. For this reason monitoring bodies should not take on the role of checking the quality of explanations, emphasized the UK, and comply or explain statements should not become regulated information under the terms of the Transparency Directive.

While sharing the Commission’s concern about the informative quality of explanations, the UK believes that the best way to allay these concerns is through guidance rather than regulatory oversight. If guidance could be given to those writing and receiving the explanations, reasoned the UK, it is possible that the quality of explanations may improve significantly and shareholders themselves may become more adept at questioning an explanation. In this spirit, the UK Financial Reporting Council will shortly develop a consensus about what constitutes a proper explanation.

In its letter to the Commission, the Federal Republic was highly skeptical of requiring regulators or other authorities to monitor the comply or explain responses of German companies under the corporate governance code, which is a job best left to the markets.

German public companies are required to declare annually whether or not they have complied with the recommendations of the German Corporate Governance Code. Since the Accounting Law Modernization Act went into effect, companies are required not only to disclose divergences from the code recommendations, but also give a reason for these divergences.

The idea of a corporate governance code with a comply or explain arrangement is based on the concept that non-mandatory statutory arrangements are developed by industry itself, reasoned the Federal Republic, and compliance or non-compliance with them is subject to the oversight of the capital market. The German corporate governance code works with a comply or explain mechanism, said the government, because the capital market evaluates the statements, and where appropriate draws its conclusions from them. If the statements are not convincing or are incomplete or are not authoritative, the capital market will draw its conclusions from this.

In addition, a state monitoring authority would entail a major organizational effort. Monitoring would have to be very careful and be carried out with a uniform standard. Even worse, said the Federal Republic, an undesirable standardization of comply or explain statements could result from regulatory monitoring since the monitoring agency would make it known what responses were acceptable in what form, and companies would employ these in a formulaic manner.

California Proposes Private Fund Adviser Exemption

2012-01-03T15:40:00.004-06:00

An exemption from investment adviser registration was proposed for private fund advisers by the California Department of Corporations. The exemption, if adopted, would replace the currently effective de minimis exemption that has been extended by emergency for 90 days from January 18, 2012 and anticipated to become inoperative on June 28, 2012. The proposed exemption would require private fund advisers to meet certain conditions, including the advisers not being subject to specified "bad boy" disqualification provisions, submitting SEC-filed reports required by Rule 204-4 of the Investment Advisers Act of 1940, and paying the $125 adviser registration fee to make the exemption effective for one year. Additional requirements would apply to private fund advisers to 3(c)(1) funds.

While no public hearing is currently scheduled, interested persons may submit written comments about the proposed rule until 5:00 p.m. on February 20, 2012. Comments may be mailed to the Department of Corporations, Attn: Karen Fong, Office of Legislation and Policy, 1515 K Street, Suite 200, Sacramento, CA 95814, or emailed to regulations@corp.ca.gov, or faxed to (916)-322-5875.

In Letter to CFPB, Key Senator Says Proposed Regulations on Foreign Remittance Transfers Challenge Community Banks

2012-01-03T13:11:00.000-06:00

Senator Jeff Merkley (D-Ore) is concerned that the Consumer Financial Protection Bureau’s proposed regulations implementing the foreign remittance transfer provisions of the Dodd-Frank Act present challenges for community banks and credit unions. In a letter to Raj Date, CFPB Acting Director, Senator Merkley, a key member of the Banking Committee, said that compliance with in-advance disclosure requirements may be challenging for foreign remittance transfers involving open networks where transactions are conducted through a series of independent correspondent entities. Community banks and credit unions will need time to develop the systems needed to provide the full disclosure that Section 1703 promises.

Authored by Senator Daniel Akaka (D-Haw), Section 1703 provides certainty to consumers making foreign remittance transfers by requiring full disclosure of exchange rates and transaction fees prior to the transaction.

Senator Merkley is also concerned that the draft regulations contain a permanent exemption for countries where exchange rates are not legally knowable. In his view, this could be a troubling loophole that, if needed at all, should only be used in the narrowest of circumstances with additional safeguards.

The Senator also urged the CFPB to clarify the distinctions between consumer transactions covered by the implementing regulations and business transactions. The intent of Section 1073 is to protect retail consumers from undisclosed fees and problems concerning error resolution, said the Senator, adding that the statute was not intended to cover commercial or business transactions. Thus, final regulations should exclude commercial transactions, he said, in order to avoid any confusion under the definition of consumer in the statute, including both incorporated and unincorporated businesses

Finally, the Senator urged the CFPB to consider if requiring the open network institution to provide consumers with a clear and understandable summary or average of recent comparable transactions to the same destination country would be helpful. In his view, this would assist the consumer in making an informed decision, and also assist the marketplace in transitioning to the new system.

Federal Judge Asks SEC to Provide Factual Predicate in Settling Enforcement Action Involving Disgorgement of Bonuses

2012-01-03T10:58:00.002-06:00

A federal judge has asked the SEC to provide a written factual predicate for why the agency believes the court should find that proposed final judgments in an enforcement action alleging that a company prepared materially inaccurate financial statements and lacked adequate financial controls are fair, reasonable, adequate, and in the public interest. (SEC v. Koss Corporation, No. 2:11-cv-00991, ED Wis). Citing Judge Rakoff’s opinion in SEC v. Citigroup Global Mkt. (SD N.Y. Nov. 28, 2011), Judge Randa specifically requested that the SEC provide, by January 24, 2012, a written factual predicate addressing the adequacy of the proposed final judgment provision regarding disgorgement by the company’s CEO.

The company and its CEO consented to the entry of an injunctive order without admitting or denying the SEC’s allegations. As part of the settlement, the CEO agreed to reimburse the company incentive-based compensation pursuant to Section 304 of the Sarbanes-Oxley Act, which requires CEOs and CFOs to disgorge bonuses and other incentive-based compensation in cases of accounting restatements resulting from material non-compliance with SEC financial reporting requirements.

In a letter to the SEC, Judge Randa noted that the Commission has alleged that the CEO, who was also the company’s CFO, failed to oversee the accounting and financial functions of the company. The SEC relies upon the separate consent documents of the company and the CEO, and has filed proposed final judgments as to each defendant. The letter requests that the SEC address concerns raised by the proposed final judgments and provide a written factual predicate for why it believes the court should find that the proposed final judgments are fair, reasonable, adequate, and in the public interest.

The consent document states that the CEO will be required to reimburse the Company for $242,419 in cash and 160,000 of options, and that bonus reimbursement, together with his previous voluntary reimbursement of bonus amounting to $208,895 represents the CEO’s entire fiscal year 2008, 2009, and 2010, incentive bonuses. Without any factual predicate for how those disgorgement terms were determined and what more, if anything, could have been subject to disgorgement, said Judge Randa, the court cannot assess their fairness and the extent to which they serve the purpose of disgorgement, which is to deprive the violator of unjust enrichment and thereby further the deterrence objectives of the securities laws.

Moreover, the court is concerned that the proposed judgments are not final judgments because they do not expressly state the disposition of the claims against the parties; e.g., dismissal without prejudice, while including a provision for the retention of jurisdiction over the enforcement of the terms of the settlement agreement. With respect to the retention of the Court’s jurisdiction,

UK Finance Minister Skeptical of Blanket Position Limits in EU Derivatives Legislation

2012-01-02T19:51:00.001-06:00

As the EU moves towards implementation of a derivatives regulatory regime, it is imperative to adopt consistent, harmonized and high regulatory standards for all Member States, said UK Finance Minister Mark Hoban, adding that the effective regulation of financial services has to be done at an international level. In recent remarks in Helsinki, the Minister was encouraged by the European Commission’s proposal to close loopholes in the Markets in Financial Instruments Directive (MiFID) with respect to the clearing obligation and ensure fair and open access with respect to licenses in future legislation. Indeed, he believes that MiFID offers an opportunity to promote competition and the Single Market in financial services. MiFID has already lowered costs and spurred growth in the equities market, he emphasized, and it is proper to update the Directive to account for the significant changes in the financial markets in recent years.

Specifically, that means updating the Directive to reflect changes in the commodities market, he said, but not succumbing to a form of populism that will simply increase costs for EU citizens. That is why the UK is skeptical about blanket position limits across all markets, noted Mr. Hoban, while at the same time acknowledging that they have a role to play in defined circumstances.
He posited that active position management by exchanges and authorities will be much more effective in tackling market abuse and provide a more rigorous approach. It is incorrect to think that blanket position limits will enable governments to control prices as some would wish, he stressed. More broadly, he noted that the debate on position limits underlines just how important it is to get the evidence base right before embarking on fundamental reform.

He noted that the UK has been vocal in the past about the lack of consultation by the Commission on the Alternative Investment Fund Managers Directive and on short selling. In both instances, he continued, the Commission risked succumbing to political need, with unintended consequences for competitiveness and to the benefit of international competitors

With regard to EMIR (the European Market Infrastructure Regulation), the UK has been pressing for consistent implementation that protects open competition. While EMIR imposes an obligation to use clearing houses, noted the Minister, it is essential that there is genuine competition, which is why the UK has pushed for open access requirements in relation to all derivatives in EMIR. Free and open competition between clearing houses, he emphasized, goes in tandem with non-discrimination between Member States.

He urged policymakers and regulators not to surrender to proposals that would merely fragment European financial services market by currency. This is why the UK has pressed for clear recognition of the principle of non-discrimination in the Council position on EMIR.

On a separate point, Mr. Hoban noted that the UK is in the process of fundamentally reforming its domestic financial regulatory regime. The Financial Services Authority is being abolished in its current form. The FSA’s significant prudential functions are being transferred to a new Prudential Regulatory Authority that will sit in the Bank of England, with a focus on micro-prudential regulation. A new Financial Conduct Authority will oversee the conduct of financial services firms, the operation of markets and the protection of consumers, with new powers to ban the sale of toxic products. A permanent Financial Policy Committee, housed in the Bank of England, will monitor overall risks in the financial system, identify bubbles as they develop, and possess enhanced tools to take corrective action.

SEC and Global Regulators Engage in Dialogues on OTC Derivatives Regulation

2012-01-02T17:15:00.001-06:00

Leaders and senior representatives of the authorities responsible for the regulation of the over-the-counter derivatives markets in Canada, the European Union, Hong Kong, Japan, Singapore and the United States are continuing a cross-border dialogue on OTC derivatives regulations. The meeting included CFTC Chair Gary Gensler, SEC Chair Mary Schapiro, Steven Maijoor, Chair of the European Securities and Markets Authority (ESMA), Jonathan Faull, Director General for Internal Market at the European Commission, Ashley Alder, CEO of the Hong Kong Securities and Futures Commission, Masamichi Kono, Vice-Commissioner of the Japanese Financial Services Agency, Teo Swee Lian, Deputy Managing Director of the Monetary Authority of Singapore, Mary Condon, Vice-Chair of the Ontario Securities Commission, and Louis Morisset, Superintendent of Securities Markets at l’Autorité des marches financiers du Québec.

Since mid-2011, the authorities have engaged in a series of bilateral dialogues on OTC derivatives regulation on the cross-border issues related to the implementation of a regulatory regime to govern the OTC derivatives markets in their respective jurisdictions. The authorities have agreed to continue bilateral regulatory dialogues and meet as a group again in early 2012.

During a recent dialogue sponsored by the Managed Funds Association, Chairman Schapiro spoke of the efficacy of the fact that the Financial Stability Board and most of the international jurisdictions have a common framework with the SEC. Since the devil is in the details when it comes to issues around derivatives regulation, noted the SEC Chair, the SEC has been having weekly calls to go line by line through the rules, and what the EU expects out of the Markets in Financial Instruments Directive and EMIR (the European Market Infrastructure Regulation) and how they think that will translate into real regulatory frameworks in Europe and how those might match up and where there might be gaps and the opportunity for duplication.

The sessions of going through this in detail have been enormously helpful for all the jurisdictions involved, said the SEC Chair, who added that regulators genuinely want to try to land in the same place. They want to have high global standards in order to avoid any distortions or dislocations. Specifically, the SEC has been engaged in weekly phone calls with the European Commission and ESMA, and slightly less often than weekly with Japanese and Singaporean regulators to try to understand exactly where each other is going with respective regulatory frameworks in order to minimize the potential for regulatory arbitrage.

Canadian Bank Regulator Urges Volcker Rule Proprietary Trading Exemption for Foreign Government Securities

2012-01-01T12:56:00.001-06:00

The proposed regulations implementing the Volcker Rule provisions of the Dodd-Frank Act could inadvertently hinder the ability of foreign financial institutions to efficiently manage their risks, thereby potentially undermining the financial condition of those entities and the systemic stability of foreign financial systems, in the view of the prudential regulator of Canadian banks. In a letter to the SEC and the federal banking agencies, Julie Dickson, Superintendent, Financial Institutions of Canada, said that these concern are especially acute given the deep inter-linkages between the Canadian and US financial systems.

Canadian financial institutions use US-owned infrastructure to conduct financial transactions in support of their market making activities in Canada, said the Superintendent, and in their risk management activities more broadly in support of their Canadian and US banking operations. For example, Canadian financial institutions actively rely on the systems operated by The Depository Trust & Clearing Corporation (DTCC) for clearing and settlement of transactions involving US securities. Moreover, they regularly employ US financial exchanges for transacting futures and options derivatives involving both Canadian dollar and other currencies to manage financial risk exposures.

The draft regulations would only allow proprietary trading by banking entities in US Treasury, state, and municipal general, limited, and pass-through obligations. Question 122 of the consultative document asks whether US federal regulators should adopt an additional exemption for proprietary trading in the obligations of foreign governments and international and multinational development banks.

The Superintendent believes that additional exemptions from the restrictions on proprietary trading should be given to foreign government securities, at least for banking groups whose parent bank is located outside of the US. Many foreign banks play important market making roles in the trading of government securities in their home jurisdictions, she noted, and they also actively rely on government securities of their home jurisdiction to efficiently manage their liquidity and funding requirements at a global enterprise level.

This is a practice that will be further reinforced in the future by new bank liquidity requirements that have been proposed by the Basel Committee on Banking Supervision. Thus, the Superintendent believes that a failure to include these additional exemptions, at least for banking entities with parents outside of the US, would undermine the liquidity of government debt markets outside of the US and could significantly impede the ability of foreign banks to efficiently manage their liquidity and funding requirements at an enterprise-wide level.

More broadly, the Superintendent urged the SEC and other federal regulators implementing the Volcker Rule to keep in mind that US financial institutions and markets, and their supporting infrastructure, are deeply connected to the broader global financial system. Indeed, in many cases they represent core segments for global financial inter-mediation. Thus, when implementing reforms like the Volker Rule, emphasized Ms. Dickson, it is important to not only focus on the implications for the US financial system, but also to take care that these restrictions do not give rise to prudential issues for other jurisdictions.

SEC Issues Revised Dodd-Frank Implementation Schedule at Year End

2011-12-31T10:39:00.001-06:00

On December 30, 2011, the SEC revised its Dodd-Frank implementation timetable, moving a number of items planned for December 2011 into 2012 time frames. All of the regulatory activity around the Title VII derivatives regulatory regime is now planned for the July-December 2012 time frame. Similarly, the adoption of regulations setting up a registration regime for municipal securities advisors has been moved to July-December 2012.

Regulations regarding disclosure related to conflict minerals under Section 1502 of Dodd-Frank and disclosure by resource extraction issuers under Section 1504 are slated to be adopted in the January-June 2012 time period. The SEC also plans to virtually complete Title IV implementation in the first half of 2012, adopting regulations adjusting the threshold for qualified client as directed by Section 418 and reporting to Congress on the study of the costs and benefits of real time reporting on short sale positions as directed by Section 417. However, a report to Congress on a study on the state of short selling on exchanges and in the over-the-counter markets under Section 417 will wait until the second half of 2012.

The adoption of regulations implementing the Volcker Rule prohibitions on proprietary trading and certain relationships with hedge funds and private equity funds is scheduled for the July-December 2012 time frame.

The adoption of risk retention rules for securitizers of asset-backed securities is set for the first half of 2012. The SEC is also slated to complete the implementation of Title VIII in the first half of 2012 by adopting rules regarding standards for clearing agencies designated as systemically important under Section 805 and adopting rules regarding the process to be used by designated clearing agencies to provide notice of proposed changes under Section 806.

Federal District Court that Rejected SEC-Citigroup Settlement Now Orders SEC to Promptly Notify It of Any Filings in Second Circuit Court of Appeals

2011-12-30T17:17:00.001-06:00

A federal court that had refused to approve a settlement in an SEC enforcement action against Citigroup declined to grant a request by the parties to stay all proceedings in the case pending determination of an appeal to the Second Circuit Court of Appeals. SEC v. Citigroup Global Markets, Inc., 11 Civ. 7387, Dec. 27, 2012, (memorandum order). Further, in a December 29th order supplementing the memorandum order, the district court ordered the parties to promptly notify it of any filings in the court of appeals by faxing copies of the filings to the district court immediately after they are filed in the court of appeals.

Virtually simultaneously with the district court’s opinion denying the stay, the appeals court granted the SEC’s request for a temporary stay until Jan. 17, 2012 when a Second Circuit motions panel will consider the motion for a stay. According to the district court, the appeals court issued its decision without the benefit of the memorandum order denying the stay in which the district judge concluded that the purported statutory basis for the instant appeal is patently defective, and, given the absence of any obligation to consider a stay on the basis of the SEC's putative intention to seek mandamus, there is no occasion for the court to address the merits of the parties' request for a stay.

According to the district court, the alleged error that the SEC, joined by Citigroup, seeks to correct by their appeal is the court's insistence that it be provided with proven or acknowledged facts in order to evaluate whether the proposed consent judgment, in any of its aspects, is fair, reasonable, adequate, and in the public interest. Thus, said the district judge, the gravamen of the parties’appeal has nothing to do with the denial of injunctive relief per se.

Moreover, the court said that failure to grant the injunctive relief sought in the proposed consent decree does not relate in any material way to the primary irreparable harm that the parties assert they will suffer if the decree is not immediately approved, namely that they will be required to allocate substantial resources to the litigation of this matter. This alleged harm is a product of the rejection of the settlement overall, reasoned the district court, and would not be cured by the granting of the proposed injunctive relief.

Furthermore, the alleged harm is largely illusory because the SEC has filed a parallel action against a Citigroup employee that repeats every allegation that is made in the Citigroup complaint, and more. Given that the employee intends to litigate these charges to the fullest, noted the court, the SEC will have to undertake virtually the same discovery, motion practice, and trial preparation with respect to him as it will have to
undertake with respect to Citigroup.

In the view of the district judge, a more fundamental problem with all these arguments is that if these kinds of harms were sufficient to justify interlocutory appeals the final judgment rule would be rendered a nullity. The court cited a 1994 US Supreme Court ruling involving a refusal by a district court to enforce a settlement agreement. In Digital Equip. Corp. V. Desktop Direct, Inc., 511 U.S. 863 (1994), the Court held that such harms cannot support an interlocutory appeal. The Supreme Court noted that there are innumerable situations, including rejections of settlement agreements, where the effect is to force the parties to go to trial even though they had expressly bargained not to. But if immediate appellate review were available every such time, reasoned the Court, Congress’ final decision rule would end up a pretty puny one.

In its supplemental order, the district court noted that as a reason for proceeding on an emergency basis, the SEC stated that Citigroup had only until January 3, 2012 to answer or move to dismiss the underlying complaint, and that if Citigroup files its answer denying some or all of the allegations, or if Citigroup moves to dismiss, challenging the complaint’s legal sufficiency, it will disrupt a central negotiated provision of the consent judgment pursuant to which the financial institution agreed not to deny the allegations. According to the district judge, this statement would seem to have been materially misleading in at least four respects.

First, a motion to dismiss does not constitute either an admission or denial but is rather a challenge to the face of the complaint. Second, the SEC was either already aware that Citigroup was planning to move to dismiss rather than to answer or could have readily found this out by calling counsel for the bank. Third, nowhere in the underlying papers of the parties to the district court seeking a stay had they argued that January 3 was a critical or even material date. Fourth, in light of the fact that the court’s position was not before the appeals court, the SEC was under a professional obligation to bring to the attention of the appeals court the fact that the US Supreme Court had previously ruled that the denial of the fruits of a settlement does not, without more, provide a basis for interlocutory appeal, let alone a stay, citing the Court’s ruling in Digital Equip. Corp. V. Desktop Direct, Inc.

PCAOB Member Goelzer Outlines Auditor Reporting Model Projects at IFIAR Roundtable

2011-12-30T15:55:00.002-06:00

Auditor responsibilities for the completeness and accuracy of financial institution risk disclosures affect the inspection programs of the members of the International Forum of Independent Audit Regulators (IFIAR), noted PCAOB Member Dan Goelzer in a paper submitted at the IFIAR Roundtable on Financial Institution Risk Disclosure. He also said that through inspection workshop and plenary meeting discussions IFIAR members share inspections insights and identify challenges. In his view, this process could be a vehicle for gathering information about how auditors are performing in this area. Mr. Goelzer is Vice-Chair of the IFIAR.

IFIAR engages in dialogue with the major multi-national firms, both at the plenary meeting and working group level. In particular, IFIAR's Global Public Policy Committee Working Group provides a central forum for regular dialogue between audit regulators and the six largest audit firms regarding audit challenges and quality control system improvements. To the extent specific issues emerge regarding risk disclosure auditing, Member Goelzer suggested that these mechanisms could be used to discuss those issues with the large firms.

IFIAR members have a strong interest in the responsibilities of auditors with respect to financial institution risk disclosures and in any changes in those responsibilities. Member Goelzer reviewed the three major reporting model projects affecting risk disclosures put forth by key regulatory and standard-setting bodies that are considering ways of expanding the scope of the auditor's reporting responsibilities. These initiatives arise from dissatisfaction expressed by users of financial statements concerning the lack of information that auditors were required to provide about the risks and uncertainties faced by major financial institutions in the run-up to the 2008 economic crisis. The various auditor reporting proposals and alternatives under discussion extend beyond financial institution risk
disclosure.

The IAASB issued a consultation paper setting out options to close a perceived information gap and states that some investors and analysts believe that the auditor could report on key business, operational and audit risks the auditor believes exist as well as on the quality and effectiveness of the governance structure and risk management. The paper seeks views about types of additional information that could be included in the auditor's report and on the prospect of the auditor providing insight about the quality of entity financial reporting. Through IFIAR's Standards Working Group, members discuss and may comment on the implications of IAASB proposals, including any that address risk disclosure.

Issued on June 21, 2011, the PCAOB concept release discusses alternative ways of expanding the auditor's reporting model. Three of those alternatives could result in expanded information or assurance regarding risk, said Member Goelzer. The first alternative would require the auditor to provide an auditor's discussion and analysis (AD&A), similar to MD&A, which would be a supplemental narrative report discussing the auditor’s views regarding significant matters, such as audit risks.

The AD&A might also include a discussion of the auditor's views regarding the company's financial statements, such as management's judgments and estimates, accounting policies and practices, and difficult reporting issues.
The second alternative would require one or more emphasis paragraphs in all audit reports. The Board member noted that emphasis paragraphs could be used to highlight the most significant matters in the financial statements and identify where these matters are disclosed. The auditor might also be required to comment on key audit procedures performed pertaining to such matters. The third alternative would require auditors to provide assurance on information outside the financial statements, such as MD&A or earnings releases. Such a requirement could have the effect of requiring that risk discussion in MD&A be audited.

Finally, On November 30, 2011, the European Commission proposed a series of new requirements regarding statutory audits of public interest entities. Under the proposal, the content of the audit report disclosed to the public would be expanded to include an explanation of key areas of risk of material misstatements in the financial statements, a going concern assessment, and whether the audit was designed to detect fraud. In addition, the auditor would be required to prepare a more detailed report for the audit committee. This report would explain judgments about material uncertainty that may cast doubt about the entity's ability to continue as a going concern and on the findings of the audit with the necessary explanations.

California to Extend Emergency Effectiveness of Private Fund Adviser Exemption

2011-12-28T16:20:00.004-06:00

On January 5, 2012, the Commissioner of Corporations will file with the Office of Administrative Law (OAL) the readoption of emergency Rule 260.204.9 of Title 10 of the California Code of Regulation (10 C.C.R. §260.204.9) for a period of no longer than 90 days. The changes to the rule will extend the current exemption from registration for investment advisers who are “private advisers” for an additional 90 days. The changes to the rule will extend the current exemption from registration for investment advisers who are “private advisers” for an additional six months. The anticipated operative date of the emergency regulation is January 18, 2012.

EU Tax Commissioner Says Financial Transactions Tax Will Advance in 2012

2011-12-28T14:00:00.003-06:00

A consensus is growing in the European Union on the efficacy of a financial transactions tax that should presage quick progress towards enactment of legislation in 2012, said EU Tax Commissioner Algirdas Semeta. In remarks before a European Parliament group, the Commissioner noted that a financial transactions tax is the only policy instrument that can ensure that financial institutions make a fair and substantial contribution to public finances, can discourage high frequency trading, and can reduce competitive distortions. Neither a financial activity tax, nor a bank levy, nor a levy on bonuses, nor exposing financial services to VAT would deliver on all these goals, he remarked.

The European Commission has recommended that a financial transaction tax be applied to all financial transactions, in particular those carried out on organized markets such as the trade of equity, bonds, derivatives, and currencies. The tax would be levied at a relatively low statutory rate and would apply each time the underlying asset was traded.

After a first debate on the Commission’s proposal for a financial transactions tax in the ECOFIN in November, the Tax Commissioner has detected the start of a convergence of views among the Euro zone members. The proposal must now be analyzed in detail by the Member States.

It is important to be clear on the scope of this tax, emphasized the Commissioner. The financial transactions tax will tax the trading typically carried out by financial institutions. The day-to-day financial activities of ordinary citizens or companies will not to be taxed, he pointed out, and neither would be the primary markets where companies and governments issue securities necessary to finance their activities. Therefore, financing of the real economy such as industrial projects will not be directly affected, he added, thereby mitigating the risk of adverse economic effects.

Moreover, the tax rate proposed is very low in order not to penalize medium and long term investing strategies. Only aggressive and very active investment strategies, such as high frequency trading or very actively-managed pension and hedge funds, will be affected.

In addition, the proposal contains measures to fight tax avoidance effects. In this respect,together with low tax rates differentiated per product group, the Commission proposes taxation at the place of establishment of the financial institution. In combination with other administrative tax cooperation instruments and regulatory reforms aiming at more financial market transparency, it will adequately target tax avoidance. As a result, reasoned the Commissioner, delocalization would not be an option for avoiding the tax, unless the operator wants to completely abandon European markets and clients in the European markets.

PCAOB Answers Questions About Broker-Dealer Accounting Support Fee

2011-12-28T08:56:00.002-06:00

In the wake of the Dodd-Frank Act authorizing PCAOB oversight of the audits of broker-dealers, all brokers and dealers registered with the SEC as of the date on which the allocation of the annual accounting support fee is set are subject to the accounting support fee. The Board's funding rules require that the allocation of the broker-dealer accounting support fee be based on tentative net capital, as that term is defined in SEC regulations.

The funding rules are based on Section 109(h)(3) of the Sarbanes-Oxley Act of 2002, which states that the amount due from a broker or dealer shall be in proportion to the net capital of the broker or dealer. The Board uses tentative net capital reported by brokers and dealers on their quarterly FOCUS reports to determine the allocation of the broker-dealer accounting support fee. In the Board’s view, this data provides a common basis among the broker and dealer population for determining the combined average, quarterly tentative net capital amount. In a FAQ, the Board noted that it would not recalculate a firm’s share of the broker-dealer accounting support fee using tentative net capital amounts reflected on the monthly FOCUS reports, instead of the quarterly FOCUS reports, even if a firm provided such data to the Board.

A firm ceasing to be a broker or dealer after the 2011 Calculation Date, which was October 31, 2011, will still have to pay the accounting support fee. The Board noted that the fact that a firm ceases to be a broker or dealer after that date does not relieve the firm of its responsibility for a share of the broker-dealer accounting support fee. However, a firm ceasing to be a broker or dealer before the 2011 Calculation Date would not have to pay the accounting support fee.

PCAOB Rule 7104(b)(1) provides that an auditor may not sign an unqualified audit opinion with respect to a broker-dealer’s financial statements unless the auditor has ascertained that the firm has no outstanding past-due share of the accounting support fee. There are three exceptions to this rule. First, PCAOB Rule 7103(c) allows a broker or dealer, under certain circumstances, to petition for correction of its share of the accounting support fee. Second, PCAOB Rule 7104(b)(2) creates a one-time exception to take account of a situation in which a broker or dealer may have a past-due share of the accounting support fee at a time when the broker or dealer needs the audit report to submit a report to, or make a filing with, the SEC.

Third, the Board will not enforce PCAOB Rule 7104(b) against an auditor that signs an unqualified audit opinion with respect to the financial statements of a broker or dealer with an outstanding past-due share of the accounting support fee of less than $50.

If a broker or dealer has paid its original share of the broker-dealer accounting support fee but not interest due under the PCAOB's rules, the auditor cannot sign an unqualified opinion unless one of the three exceptions is applicable.

PCAOB rules allow an auditor to ascertain that a broker or dealer has no outstanding past-due share of the accounting support fee by obtaining a representation from the broker or dealer. In addition, the PCAOB posts a list of brokers and dealers that have no outstanding past-due share of the accounting support fee.

Further, the Board said that a management representation that the brokerage firm has no outstanding past due share is sufficient to not preclude the auditor from signing an unqualified report. In such situations, the auditor does not have to also obtain a confirmation from the Board that no past-due share of the broker-dealer accounting support fee is outstanding. Further, the PCAOB noted that the fact that a broker or dealer is not on the Board's Web site confirmation list is not, in and of itself, a reason for an auditor to believe that a broker's or dealer's representation is inaccurate.

SEC Extends to Feb. 13, 2012 the Comment Period on Proposed Regulations Implementing Dodd-Frank Securitization Conflict of Interest Provisions

2011-12-27T17:09:00.002-06:00

The SEC has extended until February 13, 2012 the comment period on proposed regulations implementing Section 621 of the Dodd-Frank Act, which deals with material conflicts of interest in connection with the securitization of asset-backed securities. Release No. 34-66058. The original comment period for the ABS Conflicts Proposal was scheduled to end on December 19, 2011. On December 13, 2011, the comment period was extended until January 13, 2012. The Commission is again extending the time period in which to provide comments on the ABS Conflicts Proposal until February 13, 2012 to allow interested persons additional time to analyze the issues and prepare their comments. A main reason for the extension is to provide the public with a better opportunity to consider the potential interplay between the ABS Conflicts Proposal and the and proposed regulations implementing the Volcker Rule provisions of Dodd-Frank, whose comment period lasts until February 13, 2012.

Proposed Securities Act Rule 127B would prohibit persons who create and distribute an asset-backed security, including a synthetic asset-backed security, from engaging in transactions, within one year after the date of the first closing of the sale of the asset-backed security, that would involve or result in a material conflict of interest with respect to any investor in the asset-backed security. The proposed rule also would provide exceptions from this prohibition for certain risk-mitigating hedging activities, liquidity commitments, and bona fide market-making.

In an earlier letter to the SEC and other federal financial regulators, Senators Jeff Merkley (D-ORE) and Carl Levin (D-MICH), the co-authors of Section 621, noted that, like the Volcker Rule, the statute also addresses conflicts of interest, but only in the context of asset-backed securities. Section 621 prohibits firms from packaging and selling asset-backed securities to their clients and then engaging in transactions that create conflicts of interest between them and their clients.

PCAOB Settles Two Disciplinary Proceedings involving Audit Firms

2011-12-26T13:52:00.002-06:00

An audit firm and engagement partner that failed to plan, perform or supervise the audit of a company’s financial statement in accordance with PCAOB auditing standards had its registration revoked for at least two years and the engagement partner was barred from the industry for at least two years. The audit firm and engagement partner settled the disciplinary proceeding without either admitting or denying the Board’s findings. In the Matter of Bentleys Brisbane Partnership, PCAOB Release No. 105-2011-007 (Dec. 20, 2011)

The PCAOB said that a network member firm that was not registered with the Board purportedly performed the audit and the audit firm performed a limited review of the work papers. Yet, the audit firm still expessed an unqualified opinion in its audit report on the company’s financial statements filed with the SEC.

The firm also violated PCAOB rules and quality control standards by failing to develop policies and procedures to provide it with reasonable assurance that the work performed by its engagement personnel met applicable PCAOB auditing standards and to provide reasonable assurance that the firm undertook only those engagements that the firm could reasonably expect to complete with professional competence. The PCAOB found that the engagement partner substantially contributed to those quality control violations.

Thus, the Board found that the audit firm neither performed the audit nor ensured that the audit by the network firm was performed in accordance with PCAOB standards. The firm performed no audit procedures, and collected no evidential matter. They never visited the company, nor did they perform any fieldwork in the audit; noted the Board, and they prepared no work papers relating to the audit. Their audit procedures were limited to the engagement partner’s review of work papers provided by the network firm.

PCAOB Censures Audit Firm for Failing to Timely File Annual Report and Pay Fee

In another proceeding, the PCAOB censured and imposed a fine on a public accounting firm that failed to timely file an annual report and timely pay an annual fee in both 2010 and 2011. Without either admitting or denying the Board’s findings, the firm settled the disciplinary proceeding. The PCAOB noted that Section 102(d) of the Sarbanes-Oxley Act and PCAOB Rule 2200 require that each registered public accounting firm must file with the Board an annual report on Form 2 by June 30 of each year. In addition, pursuant to Section 102(f) of the Act and PCAOB Rule 2202, each registered public accounting firm must pay an annual fee to the Board on or before July 31. On November 18, 2011, the audit firm filed its annual reports for 2010 and 2011, noted the Board, and on December 2, 2011, the audit firm paid its annual fees for 2010 and 2011. In the Matter of Reuben E. Price & CO., PCAOB Release No. 105-2011-008, December 20, 2011.

Pontifical Council Calls for Global Financial Authority on Bretton Woods Level

2011-12-25T12:22:00.003-06:00

As the G-20 and national policymakers and regulators wrestle with the specter of financial regulatory arbitrage, the Pontifical Council for Justice and Peace has set forth a vision for reforming the international financial and monetary systems in the context of a global public authority. Essentially, the Council is calling for a Bretton Woods type agreement on sustained and coordinated and consistent global financial regulation in order to avoid a race to the bottom. Regulations, imperfect though they may be, already often exist at the national and regional levels, noted the Council, but on the international level it is hard to apply and consolidate such regulations.

The purpose of the public authority, as John XXIII recalled in Pacem in Terris, is first and foremost to serve the common good. Therefore, it should be endowed with effective mechanisms equal to its mission and the expectations placed on it. This is especially true in a global financial system that makes individuals and peoples increasingly interconnected and interdependent, reasoned the Council, but which also reveals the existence of speculative monetary and financial markets that are harmful to the real economy

A supranational Authority should be set up gradually. It should be favorable to the existence of efficient and effective financial systems and promote free and stable markets overseen by a suitable legal framework, well-functioning in support of sustainable development and social progress of all, and inspired by the values of charity and truth. A person is not made to serve authority unconditionally, instructed the Council, rather it is the task of authority to be at the service of the person, consistent with the pre-eminent value of human dignity.

According to the Council, the underlying logic of coordination and common vision which led to the Bretton Woods Agreements needs to be dusted off in order to provide adequate answers to the current questions. The process could begin by strengthening existing institutions, such as the European Central Bank. However, this would require not only a reflection on the economic and financial level, but also and first of all on the political level, so as to create the set of public institutions that will guarantee the unity and consistency of the common decisions. These measures ought to be conceived of as some of the first steps in view of a public Authority with universal jurisdiction.

More specifically, the Council urged consideration of a coordinated financial transactions tax through fair but modulated rates with charges proportionate to the complexity of the operations, especially those made on the secondary market. Such taxation would be very useful in promoting global development and sustainability according to the principles of social justice and solidarity. It could also contribute to the creation of a world reserve fund to support the economies of the countries hit by crisis as well as the recovery of their monetary and financial system. The Council also called for the recapitalization of banks with public funds, making the support conditional on virtuous behavior aimed at developing the real economy. Moreover, the Council recommended defining distinct domains of ordinary credit and investment banking in a way allowing for a more effective management of the shadow markets which have no controls and limits.

Finally, and more broadly, the Council states that the economic and financial crisis which the world is going through calls everyone, individuals and peoples, to examine in depth the principles and the cultural and moral values at the basis of social coexistence. In his social encyclical, Benedict XVI precisely identified the roots of a crisis that is not only economic and financial but above all moral in nature. In fact, as the Pontiff notes, to function correctly the economy needs ethics; and not just of any kind but one that is people-centered.

SEC and Banking Regulators Extend Comment Period on Proposed Regulations Implementing Volcker Rule

2011-12-23T15:10:00.002-06:00

The SEC and federal banking regulators have extended the comment period on the proposed regulations implementing the Volcker Rule provisions of the Dodd-Frank Act from January 13, 2012 to February 13, 2012. The comment period was extended as part of a coordinated interagency effort to allow interested persons more time to analyze the issues and prepare their comments. The Dodd-Frank Act requires the regulators to implement prohibitions and restrictions on the ability of bank and non-bank financial companies to engage in proprietary trading and have certain interests in, or relationships with, a hedge fund or private equity fund.

In Release No. 34-66057, the SEC noted that the extension of the comment period is appropriate due to the complexity of the issues involved and the variety of considerations involved in its impact and implementation. The Agencies believe that the additional period for comment will facilitate public comment on the provisions of the proposed rule and the questions posed by the proposal.

The Agencies have received a number of requests for an extension of the comment period to allow for additional time for comments related to the provisions of the proposed rule. The SEC Release cites comment letters from the Center for Capital Markets Competitiveness of the U.S. Chamber of Commerce (November 17, 2011); American Bankers Association et al. (November 30, 2011); and House Members led by Oversight Subcommittee Chair Randy Neugebauer (R-TX) (December 20, 2011).

President Signs Legislation Funding SEC for FY 2012 and Authorizing CFTC Fund Transfer

2011-12-23T14:38:00.000-06:00

President Obama signed the Consolidated Appropriations Act, which provides $1,321,000,000 for the SEC for FY 2012 instead of $1,185,000,000 as proposed by the House and $1,407,483,130 as proposed by the Senate. The conference agreement provided that $1,321,000,000 be derived from offsetting collections resulting in no net appropriation. The conference agreement also provided that the SEC Office of Inspector General must receive no less than $6,795,000 as proposed by the Senate, instead of$6,790,000 as proposed by the House. The legislation contains a provision allowing the CFTC to transfer $10 million in funding between the agency’s Information Technology account and its Salaries and Expenses account.

The Act also makes available $100,000 for expenses for consultations and meetings hosted by the SEC with foreign regulatory officials to exchange views concerning securities matters. It also rescinds $25 million from the unobligated balances available in the SEC Reserve Fund established by Section 991 of the Dodd-Frank Act, which created a Reserve Fund that the SEC could use as it deems necessary to carry out its functions.

While the Consolidated Appropriations Act generally withholds funding for interagency commissions, councils, or committees, the legislation specifically states that funds made available to the CFTC and SEC may be used for the interagency funding and sponsorship of a joint advisory committee to advise on emerging regulatory issues.

The conferees did not adopt the Senate designation of $483, 130 specifically for the strengthening of the acquisition workforce. However, while not designating funding, the Conference Committee remains concerned about the SEC's acquisition processes and expects the SEC to dedicate sufficient resources to strengthening the agency's capacity and capabilities of the acquisition workforce.

The conferees remain concerned with the SEC's lack of judgment in its past
leasing practices. (H 112-131) The conferees are aware of the SEC's arrangement with the General Services Administration, which the conferees believe is a good first step. The conferees intend to closely monitor how the SEC exercises its leasing authority to ensure that the Commission has adequately reformed its leasing practices. The conferees are also concerned about the unauthorized destruction of documents by the SEC.

Due to the above concerns, the conferees direct the SEC to provide the House and Senate Appropriations Committees with corrective action reports, submitted to the SEC Inspector General, related to lease agreements and document destruction no later than 30 days after enactment.

NASAA Supports Transparency in PCAOB Disciplinary Proceedings

2011-12-23T14:36:00.006-06:00

The North American Securities Administrators Association (NASAA) has supported provisions in the proposed PCAOB Enforcement Transparency Act of 2011 (S. 1907) that would amend the Sarbanes-Oxley Act of 2002 to make disciplinary proceedings of the Public Company Accounting Oversight Board (PCAOB) open to the public. In a comment letter to leaders of the Senate Banking Committee, NASAA wrote that the non-public nature of PCAOB disciplinary proceedings has serious adverse consequences for the investing public, audit committees, the auditing profession, the PCAOB and other interested parties.

NASAA observed that Congress established the PCAOB in order to protect investors and further the public interest in the preparation of informative, fair and independent audit reports on the financial statements of public companies. NASAA believes that adjudicatory proceedings to determine whether an auditor or audit firm should be sanctioned for violating applicable rules form an important part of the PCAOB's oversight authority. Unlike disciplinary proceedings of other, comparable regulators, however, current law provides that PCAOB cases may not be made public until they are appealed to the SEC.

NASAA reminded the lawmakers that making the PCAOB's disciplinary proceedings "open to the public" was among the goals that NASAA had articulated in its Pro-Investor Legislative Agenda for the 112th Congress. Accordingly, NASAA believes that the enactment of S. 1907 will achieve this objective.

Rep. Schweikert Urges SEC and Bank Regulators to Exclude Venture Capital Funds from Volcker Rule or Classify Them as Dodd-Frank Permitted Activity

2011-12-23T12:35:00.001-06:00

A leading member of the House Financial Services Committee urges that the final regulations implementing the Volcker Rule provisions of Dodd-Frank exclude venture capital funds or classify them as a permitted activity under Section 619 (d)(l )(J), which is a catch all allowing the regulators to permit an activity promoting safety and soundness and financial stability. In a letter to the SEC and banking regulators, Rep. David Schweikert said that Congress did not intend for the Volcker Rule, as codified by Dodd-Frank, to cover venture capital investing because it does not promote excessive risk and is critical to job creation and continued economic growth. Properly conducted venture capital investing does not carry the types of risk that threaten the safety and soundness of the U.S. financial system, said the Congressman, and is limited in scale, does not use leverage and is long term in nature.

He noted that the Financial Stability Oversight Council underscored these points in a report released in January. The Council identified concerns that noted venture capital funds are fundamentally different from other funds as significant, and recommended that the implementing agencies carefully consider whether it is appropriate to narrow the statutory definition by rule in some cases, including to exclude venture capital funds.

Rep. Schweikert is disappointed that the proposed regulations do not take a position on the question of how to treat venture capital funds. The draft acknowledges that the agencies have the discretion to refine the definition of covered funds, as proposed in some limited cases for bank owned life Insurance vehicles, asset-backed securitization vehicles, and corporate organizational vehicles, and that an exemption for venture capital funds under Section 619 (d)(l )(J) might be warranted. But the draft did not contain any definitive clarification on the treatment of venture capital funds.

Over 100 House Members Urge SEC and Bank Regulators to Extend Comment Period on Volcker Rule Proposal

2011-12-23T11:51:00.002-06:00

In a letter to the SEC and banking regulators, a bipartisan group of over 100 House Members, including oversight Chairs, urged that the comment period on the proposed regulations implementing the Dodd-Frank Volcker Rule be extended for at least 30 days past the current January 13,2012 deadline. The Members also asked the financial regulators to consider producing an interim proposed rule reflecting the comments from affected stakeholders and the CFTC, and to extend the implementation deadline.

Given the short timeline for comment and the rapidly approaching July 2012 implementation deadline, noted the House Members, concerns have been raised that affected stakeholders will not have a sufficient opportunity to examine the proposal, which is approximately 300 pages and includes a request for comment on more than 1,300 questions, and provide meaningful comment, and that regulators will not have adequate time to digest these comments.

According to the Members, the complexity of these issues necessitates a deliberative and thoughtful process that considers an appropriately tailored proposal to improve safety and soundness without disrupting market liquidity for investors and the flow of capital to businesses.

Ultimately, the significance of any final Volcker Rule for US businesses cannot be overstated given the direct impact on the U.S. capital markets, which today are the deepest and most liquid in the world. Initial reports from asset managers, mutual funds, pension plans and other stakeholders suggest that the draft would result in higher borrowing costs for US businesses, thereby impacting economic growth and job creation.

For example, noted the Members, given the nearly $8 trillion corporate bond market, if the cost of borrowing increases by just one-quarter of a percent for investment-grade bonds, and one-and-a-quarter percent for high-yield bonds, the impact on the economy will be greater than $45 billion for corporate bonds alone. This estimate does not consider the costs associated with consumer lending (e.g. student loans, auto loans), commodities, or other impacted markets. The effects are expected to be most pronounced for small and medium-sized companies.

President Signs Legislation Extending Payroll Tax Holiday and Increasing Fee Charged by GSEs on Mortgage-Backed Securities

2011-12-23T11:23:00.003-06:00

President Obama has signed the Temporary Payroll Tax Cut Continuation Act, HR 3675, extending the payroll tax holiday for two months and increasing the guarantee fees charged by Fannie Mae and Freddie Mac for assuming the risk of mortgage-backed securities.

The legislation increases the guarantee fees that are charged to mortgage lenders with respect mortgage-backed securities by Fannie Mae and Freddie Mac by 10 basis points. An enterprise cannot offset the cost of the fee to mortgage originators, borrowers, and investors by decreasing other charges, fees, or premiums, or in any other manner. Revenue generated by the increase is deposited directly into the United States Treasury.

Implementing Vickers Commission Recommendations, UK Will Ring Fence Retail Banking from Proprietary Trading and Sponsoring Hedge Funds

2011-12-22T19:19:00.004-06:00

The UK government will draft legislation implementing the Vickers Commission recommendation to ring-fence retail traditional banking activities from investment banking activities. Ring-fencing vital banking services on which households and small and medium-sized businesses depend from investment banking activities will effectively insulate them from problems elsewhere in the financial system, reduce risk taking, and curtail implicit government guarantees. While proprietary trading and investments in hedge funds would not be prohibited, these activities would be outside the ring-fence and thus isolated from retail banking where implicit government guarantees appear strongest.

In addition, the ring-fenced bank should be legally and operationally independent from the rest of its corporate group. Ring-fenced banks should be regulated for capital and liquidity purposes on a solo basis; should not be over-reliant on the rest of the corporate group for funding, and should undertake transactions with the rest of the group on a third-party basis.

According to the Vickers Commission, effective ring-fencing also requires measures for independent governance to enforce the arm’s length relationship. The Commission’s view is that the board of the ring-fenced retail subsidiary should normally have a majority of independent directors, one of whom is the chair. For the sake of transparency, the ring-fenced subsidiary should make disclosures and reports as if it were an independently listed company. While corporate culture cannot directly be regulated, noted the Commission, proper structural and governance arrangements should consolidate the foundations for long-term customer-oriented UK retail banking.

The Commission set forth five ring-fence principles identifying the features of financial services that should determine their treatment and thus provide a guide for the operation of the ring-fence when new products arise. Notably, the Commission pointed out that the Glass-Steagall Act, which prevented deposit-taking banks from underwriting or dealing in securities, was undermined in part by the development of derivatives.

Principle 1 is that only ring-fenced banks should be granted permission by the UK regulator to provide mandated services. Conversely, Principle 2 states that ring-fenced banks should be prohibited from providing services that make resolution significantly more costly, increase exposure to global financial markets, and involve risks not integral to the provision of traditional banking services to customers. Under, Principle 3, the ring-fenced bank should be allowed to conduct ancillary activities to support the provision of its core functions.

The height of the fence is specified in Principles 4 and 5, which describe the legal, operational and economic links which should be permitted between a ring-fenced bank and any wider corporate group of which it is part. Ring-fenced banks should be separate legal entities. Where a ring-fenced bank is part of a wider corporate group, its relationships with entities in that group should be conducted on a third-party basis and it should not be dependent for its solvency or liquidity on the continued financial health of the rest of the corporate group.

The Commission said that, under the Volcker Rule, banks are not allowed to engage in proprietary trading, and investments in hedge funds and private equity firms are restricted. In part the Volcker Rule aims to remove from certain activities the benefit of implicit and explicit government support for the banking system.

According to the Vickers Commission, those activities prohibited by the Volcker Rule should be prohibited from ring-fenced banks. Proprietary trading is not a necessary part of intermediation in the real economy and so should not be conducted in the same entity as the mandated services.

However, the Commission emphasized that prohibiting only those activities caught by the Volcker Rule would not achieve all of the objectives of ring-fencing. As a result, most of the efforts to improve the resolvability of universal banks involve requiring that all investment banking activities must be separable from the rest of the bank.

Also, in order to reduce the ring-fenced bank’s interconnectedness with the financial system and the correlation of its performance with that of financial markets, it should not conduct trading or other activities which give rise primarily to market risk or counterparty credit risk. The Commission reasoned that removing the complexity of some investment banking would make it easier for ring-fenced banks to be managed, monitored and supervised.

House Oversight Chairs Urge the SEC to Scale Back Scope of Municipal Securities Advisor Regulations

2011-12-22T12:44:00.000-06:00

In a bi-partisan letter to the SEC, two House oversight chairs urged the Commission to scale back the scope of the proposed regulations defining municipal securities advisors as part of implementing Section 975 of the Dodd-Frank Act, which directs the SEC to set up an effective registration and examination program for municipal financial advisors. Capital Markets Subcommittee Chair Scott Garrett (R-NJ) and Oversight Subcommittee Chair Randy Neugebauer (R-TX) said that the SEC regulations should exempt from the definition of municipal advisor broker-dealers, investment advisers and banks that are already regulated by the Commission and the federal banking agencies. The letter was signed by 30 other House Members.

In the view of the Members, the SEC’s proposal goes far beyond the legislative intent of Section 975 and embraces parties and activities neither anticipated by Congress nor authorized by the statute and imposes duplicative regulation on parties that are already heavily regulated. The proposal may even harm state and local government, said the Members, by driving some parties out of the municipal market or limiting the services they provide.

The intentionally narrow focus of Section 975 is to bring under the regulatory umbrella of the SEC and the MSRB parties who provide advice to municipal entities on securities issuances and the investment of the proceeds of municipal securities and who are not already regulated. Specifically, Congress intends Section 975 to apply to parties known in the municipal securities markets as independent financial advisors, swap advisors, and other parties who are not already regulated by the SEC, the MSRB or the federal and state bank regulators. Congress did not intend to impose additional layers of regulation on parties and entities that are already well regulated.

In an earlier letter to the SEC, Financial Services Committee Chair Spencer Bachus (R-AL) said that the proposed regulations are overly broad and would reach significantly more people than Congress intended. For example, he said that the broad definition of municipal financial products combined with the failure to define ``advice’’ would result in thousands of bank employees conducting routine business with municipal entities having to register with the SEC Chairman Bachus urged the Commission in developing rules under Sec. 975 to strike a balance ensuring that non-broker-dealer financial advisors register with the SEC, while not forcing thousands of unsuspecting individuals to comply with yet another regulatory burden that he feels would be detrimental to the very municipal entities Congress is trying to protect.

Supreme Court of Canada Says Federal Securities Regulatory Regime Not Valid under Constitutional Trade and Commerce Clause

2011-12-22T09:46:00.001-06:00

The proposed Canadian Securities Act creating a single national federal securities regulator and regime is not valid under the general branch of the federal power to regulate trade and commerce under s. 91(2) of the Constitution Act, 1867, ruled the Supreme Court of Canada. In an advisory opinion, the Court said that, while the trade and commerce power is broad its face broad, it cannot be used in a way that denies the provincial legislatures the power to regulate local matters and industries within their boundaries. Allowing an interpretation of the general trade and commerce power supporting an exclusively federal securities regulatory regime, said the Court, would disrupt the careful balance of federal and provincial powers.

Parliament cannot regulate the whole of the securities system simply because aspects of it have a national dimension, held the Court. The Court did say, however, that a cooperative approach involving a regime recognizing the essentially provincial nature of securities regulation while allowing Parliament to deal with genuinely national concerns, such as systemic risk, remains available and is supported by Canadian constitutional principles. But the Court cautioned that the need to prevent and respond to systemic risk may support federal legislation pertaining to the national problem raised by this phenomenon, but it does not alter the basic nature of securities regulation which remains primarily focused on local concerns of protecting investors and ensuring the fairness of the markets through regulation of participants.

Taken as a whole, the proposed Act overreaches genuine national concerns. While acknowledging that the economic importance and pervasive character of the securities market may, in principle, support federal intervention, the Court said that this does not justify a wholesale takeover of the regulation of the securities industry, which is the ultimate consequence of the proposed federal legislation. Indeed, in order to be included in the comprehensive regulatory scheme created by the Act, provinces and territories must suspend their own securities laws. The follow-through effects of the proposed Act will therefore be to subsume the existing provincial and territorial legislative schemes governing securities under the federal regulatory scheme.

The main thrust of the Canadian Securities Act is to exclusively regulate all aspects of securities trading in Canada, including the trades and occupations related to securities in each of the provinces. The purpose of the Act is to implement a comprehensive Canadian regime to regulate securities with a view to protect investors, to promote fair, efficient and competitive capital markets and to ensure the integrity and stability of the financial system. It would effectively duplicate and displace the existing provincial and territorial securities regimes.

Viewed in its entirety, noted the Court, the Act cannot be classified as falling within the general trade and commerce power. The main thrust of the legislation does not address a matter of genuine national importance and scope going to trade as a whole in a way that is distinct and different from provincial concerns.
Canada has not established that the area of securities has been so transformed that it now falls to be regulated under the federal head of power. The preservation of capital markets to fuel Canada’s economy and maintain Canada’s financial stability is a matter that goes beyond a specific industry and engages trade as a whole.

However, the Act is chiefly concerned with the day to day regulation of all aspects of contracts for securities within the provinces, including all aspects of public protection and professional competences. In the Court’s view, these matters remain essentially provincial concerns falling within property and civil rights in the provinces and are not related to trade as a whole.

Specific aspects of the Act aimed at addressing matters of genuine national importance and scope going to trade as a whole in a way that is distinct from provincial concerns, including management of systemic risk and national data collection, appear to be related to the general trade and commerce power. With respect to these aspects of the Act, the provinces, acting alone or in concert, lack the constitutional capacity to sustain a viable national scheme. Viewed as a whole, however, the Act is not chiefly aimed at genuine federal concerns. It is principally directed at the day to day regulation of all aspects of securities and, in this respect, it would not founder if a particular province failed to participate in the federal scheme.

SEC Implements Dodd-Frank Changes to Accredited Investor Definition

2011-12-21T17:20:00.002-06:00

The SEC adopted amendments to the accredited investor standards in the Securities Act regulations to implement the requirements of Section 413(a) of the Dodd-Frank Act, which requires the definition of accredited investor to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an accredited investor on the basis of having a net worth in excess of $1 million. Under the previous standard, individuals qualified as accredited investors if they had a net worth of more than $1 million, including the value of their primary residence. The definition of accredited investor was adjusted in Rule 501(a)(5) of Regulation D and Securities Act Rule 215(e).

Under the new regulations, the value of an individual’s primary residence will not count as an asset when calculating net worth to determine accredited investor status. Thus, an individuals’ net worth will be calculated excluding any positive equity that they may have in their primary residence.

Thus, for example, if an investor with a net worth of $2 million (calculated in the conventional manner before the enactment of Section 413(a), that is, by subtracting from the investor’s total assets, including primary residence, the investor’s total liabilities, including indebtedness secured by the residence, has a primary residence with an estimated fair market value of $1.2 million and a mortgage loan of $800,000, the investor’s net worth for purposes of the new accredited investor standard is $1.6 million. Before enactment of Section 413(a), the primary residence would have contributed a net amount of $400,000 to the investor’s net worth for purposes of the accredited investor net worth standard, the value of the primary residence ($1.2 million) less the mortgage loan ($800,000). Under the changes, exclusion of the value of the primary residence would reduce the investor’s net worth by the same $400,000 amount.

Also, under the amended net worth calculation, indebtedness secured by the person’s primary residence, up to the estimated fair market value of the primary residence, is not treated as a liability, unless the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence. In such cases, the debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering.

In addition, any indebtedness secured by a person’s primary residence in excess of the property’s estimated fair market value is treated as a liability under the new definition. Thus, the fair market value of the residence and the amount of the mortgage up to that fair market value are excluded from the calculation, and the excess of the amount of the mortgage over the fair market value of the primary residence is included as a liability. In both cases, the overall impact on net worth is a reduction equal to the underwater amount (i.e., the excess of the amount of the mortgage over the fair market value of the esidence). For example, if you have an investor whose primary residence has an estimated fair market value of $1.2 million, with a mortgage of $1.4 million, the excess of mortgage loan over the fair market value of the primary residence (in this case, $200,000) would be taken into account as a liability and serve to reduce net worth both under a conventional net worth calculation and under the accredited investor definition adopted by the SEC. If, on the other hand, all debt secured by the primary residence were excluded, including debt in excess of the estimated fair market value of the residence, the investor’s net worth would be $200,000 higher than under a conventional calculation because the mortgage debt in excess of the value of the primary residence would not be treated as a liability.

German Finance Minister Calls for Financial Transactions Tax and Market Transparency

2011-12-21T11:59:00.001-06:00

The German Federal Finance Minister, Dr. Wolfgang Schäuble, called for EU-wide implementation of a financial transactions tax. In recent remarks, he also endorsed more transparency for the financial markets. More broadly, he said that one lesson of the financial crises is that a self-regulating financial market is an elusive dream. The financial markets need regulations and boundaries in order to act responsibly. The goal of federal regulators is to find a new balance between financial markets and the state. Financial markets need a regulatory framework that above all increases transparency, reduces extreme leverage, and limits excessive volatility. Only the state can provide such a framework, said the Minister, and with global markets, only the community of states.

At the same time, he fears the increasing danger of what the Minister called “regulatory parochialism”. One example of this is the proposed Financial Transaction Tax. It is short-sighted parochialism which is currently keeping the EU from implementing a European Financial Transaction Tax. If a Financial Transactions Tax were introduced in all of Europe it could help reduce volatility further, he reasoned, not least because it could make leveraged trading less profitable. He is also in favor of an FTT because financial market participants need to convincingly demonstrate to taxpayers and their fellow citizens that they are willing to contribute to clean up the mess they helped to create. One way of doing that is through the FTT. More broadly, the Minister believes that the current demonstrations against financial market participants show that the FTT can play an essential in peace-making between different parts of the society.

The European Commission has recommended that a Financial Transaction Tax be applied to all financial transactions, in particular those carried out on organized markets such as the trade of equity, bonds, derivatives, and currencies. The tax would be levied at a relatively low statutory rate and would apply each time the underlying asset was traded. A Financial Transaction Tax could narrowly apply only to stocks and bonds or could be broadly extended to all financial instruments, including derivatives and structured instruments.

To stabilize the international financial system, continued the Minister, regulators need to overcome such parochial behavior, increase transparency and reduce volatility. Dark pools and over-the-counter-trades must be made more transparent, the shadow banking system, including hedge funds, must be regulated, and the risks posed by the extensive leverage of some modern financial instruments, including credit default swaps, must be contained. Similarly, the assumptions of credit rating agencies must be more transparent and the financial markets must be weaned away from their influence. States empowered rating agencies so that they could point to policy errors earlier than financial markets and thereby blunt market reactions, he noted, but the opposite has happened.

Former IASB Member and Auditor Becomes Head of German Financial Authority

2011-12-21T10:33:00.001-06:00

Dr. Elke König has been named the new President of the German Federal Financial Supervisory Authority (BaFin). Dr. Wolfgang Schäuble, Federal Minister of Finance, presented her with her certificate of official appointment. Dr. König's term will commence in early January 2012. Previously, Dr. König was a member of the International Accounting Standards Board (IASB). From 2002 to March 2009, she served as CFO of Hannover Rückversicherung AG and E+S Rückversicherung AG, Hanover. From 1990 to 2002, Dr. König was a member of the senior management and head of accounting and financial control of the Munich Re Group. Before entering the reinsurance industry, she was a partner in KPMG’s German audit practice.

California Proposes Private Fund Adviser Exemption

2011-12-21T10:08:00.005-06:00

Interested persons may, in writing, comment on the California Department of Corporations' proposed private fund adviser exemption until 5 pm on February 20, 2012. Send comments by regular mail to Department of Corporations, Attn: Karen Fong, Office of Legislation and Policy, 1515 K. Street, Suite 200, Sacramento, CA 95814, and by electronic mail to regulations@corp.ca.gov. Private fund advisers are exempt from investment adviser registration if they satisfy specified requirements.

Martin Act Does Not Preempt Common Law Claims, New York High Court Rules

2011-12-21T07:55:00.005-06:00

The New York Court of Appeals held yesterday that the New York Blue Sky Law (Martin Act) does not preempt common law claims involving securities. In Assured Guaranty (UK) Ltd. v. J. P. Morgan Investment Management Inc., the state high court ruled that the statute did not preempt the plaintiff's causes of action for breach of fiduciary duty and gross negligence arising from the defendant's management of an investment portfolio. The decision appears to have settled a long-standing question concerning the viability of common law securities claims by private litigants under New York law.

Although the defendant contended that the Martin Act vests the Attorney General with exclusive authority over fraudulent securities and investment practices, the state high court reasoned that the plain text of the statute, while granting the Attorney General investigatory and enforcement powers and prescribing various penalties, does not expressly mention or otherwise contemplate the elimination of common law claims. Moreover, nothing in either the original conception of the Martin Act in 1921 or any of the subsequent amendments demonstrates a "clear and specific" legislative mandate to abolish preexisting common law claims that private parties would otherwise possess in the securities field.

The state high court rejected the defendant's argument that the court's previous decisions in CPC International, Inc. v. McKesson Corp. (N.Y. 1987) and Kerusa Co. v. W10Z/515 Real Estate L.P. (N.Y. 2009) settled the issue in favor of preemption. Rather, these decisions stand for the proposition that a private litigant may not pursue a common law cause of action where the claim is predicated solely on a violation of the Martin Act or its implementing regulations and would not exist but for the statute. But, the state high court noted, an injured investor may bring a common law claim, either for fraud or otherwise, that is not entirely dependent on the Martin Act for its viability. Mere overlap between the common law and the Martin Act is not enough to extinguish common law remedies.

Fed Proposes Enhanced Standards for Systemically Important Financial Companies, Including Counterparty Credit Limits

2011-12-20T19:07:00.003-06:00

As directed by the Dodd-Frank Act, the Federal Reserve Board has proposed enhanced prudential standards for systemically important backs and non-bank financial companies that pose a grave threat to financial stability. The Dodd-Frank Act tags banks and bank holding companies with $50 billion in assets as subject to enhanced oversight. For hedge funds, private equity funds and other non-bank financial firms, the Act entrusts the Financial Stability Oversight Council with the task of designating the firms for enhanced regulation based on a set of factors.

The prudential standards for covered companies must include enhanced risk-based capital and leverage requirements, enhanced liquidity requirements, enhanced risk management and risk committee requirements, a requirement to submit a resolution plan, single-counterparty credit limits, stress tests, and a debt-to-equity limit for covered financial companies that the Council has determined pose a grave threat to financial stability. Dodd-Frank also requires the Fed to establish a regulatory framework for the early remediation of financial weaknesses of covered financial companies in order to minimize the probability that they will become insolvent and the potential harm of such insolvencies to US financial stability.

In addition to the required standards, the Act authorizes but does not require the Board to establish additional enhanced standards for covered financial firms relating to contingent capital; disclosure; short-term debt limits; and such other prudential standards as the Board determines appropriate. But the Fed decided not to propose any of these supplemental standards at this time.

The single-counterparty credit requirements would limit credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital. Credit exposure between the largest financial companies would be subject to a tighter limit. Credit exposures to sovereign entities would be subject to the credit exposure limits in the same manner as credit exposures to financial companies.

Interconnectivity among major financial companies poses risks to financial stability. The effects of one large financial company’s failure or near collapse may be transmitted and amplified by the bilateral credit exposures between large, systemically important financial companies. Thus, Dodd-Frank directs the Board to establish single-counterparty credit limits for covered financial companies in order to limit the risks that the failure of any individual company could pose to a financial company.

The Fed proposes a two-tier single counterparty credit limit, with a more stringent limit applied to the largest financial companies. The general limit would be 25 percent of capital stock and surplus and the more stringent limit between major covered financial companies and major counterparties would be 10 percent of capital stock and surplus. They both apply to the aggregate net credit exposure between the covered company and the counterparty.

Credit exposure to a company is defined broadly in Section 165(e) of Dodd-Frank to cover all extensions of credit to the company; all repurchase and reverse repurchase agreements, and securities borrowing and lending transactions, with the company as well as all investments in securities issued by the company and counterparty credit exposure to the company in connection with derivative transactions.

The Fed would allow covered financial companies to reduce their credit exposure to a counterparty for purposes of the limit by obtaining credit risk mitigants such as collateral and credit derivative hedges. The proposal describes the types of eligible collateral and derivative hedges and provides valuation rules for reflecting such credit risk mitigants.

The Fed proposed risk-based capital and leverage requirements that would be implemented in two phases. In the first phase, the financial firms and institutions would be subject to the Board's capital plan rule, which was issued in November 2011, requiring them to develop annual capital plans, conduct stress tests, and maintain adequate capital, including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions. In the second phase, the Board would issue a proposal to implement a risk-based capital surcharge based on the framework and methodology developed by the Basel Committee on Banking Supervision.

The Fed also proposed liquidity requirements that would be implemented in multiple phases. First, financial firms and institutions would be subject to qualitative liquidity risk-management standards generally based on the interagency liquidity risk-management guidance issued in March 2010. These standards would require companies to conduct internal liquidity stress tests and set internal quantitative limits to manage liquidity risk. In the second phase, the Board would issue one or more proposals to implement quantitative liquidity requirements based on the Basel III liquidity rules.

Sound, enterprise-wide risk management by financial companies reduces the likelihood of their material distress or failure and thus promotes financial stability. Thus, the Fed would require all covered financial companies to implement robust enterprise-wide risk management practices that are overseen by a risk committee of the board of directors and chief risk officer with appropriate levels of independence, expertise and stature.

Stress tests of the financial companies would be conducted annually by the Board using three economic and financial market scenarios. The stress tests would be under baseline, adverse, and severely adverse scenarios and financial firms subject to company-run stress test requirements would conduct their own capital adequacy stress tests on an annual or semiannual basis. A summary of the results, including company-specific information, would be made public. In addition, the proposal requires financial companies to conduct one or more company-run stress tests each year and make a summary of their results public.

Dodd-Frank says the Board must require a covered financial firm to maintain a debt-to-equity ratio of no more than 15-to-1, upon a determination by the Council that the firm poses a grave threat to US financial stability and the imposition of such a requirement is necessary to mitigate the risk that the firm poses to financial stability. The Fed proposes to notify a financial company that the Council has made a determination that the company must comply with the 15-to-1 debt-to-equity ratio requirement. The proposal defines the terms “debt” and “equity” for purposes of calculating compliance with the ratio, and provides an affected financial firm with a transition period to come into compliance with the ratio.

The early remediation requirements would be put in place for all financial firms subject to the proposal so that financial weaknesses are addressed at an early stage. The Board is proposing a number of triggers for remediation, such as capital levels, stress test results, and risk-management weaknesses. In some cases, the triggers would be calibrated to be forward-looking. Required actions would vary based on the severity of the situation, noted the Fed, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales.

Chamber of Commerce Urges SEC Not to Recommend Legislation Altering Supreme Court Ruling on Transnational Securities Fraud

2011-12-20T13:49:00.001-06:00

In a letter to the SEC, the US Chamber of Commerce said there is no basis for the Commission to recommend congressional action to alter the US Supreme Court’s ruling in Morrison setting a transactional test for the extraterritorial application of the federal securities laws. In its 2010 ruling in Morrison v. National Australia Bank, the Court found that securities antifraud provisions applied to transactions in securities listed on domestic exchanges, and domestic transactions in other securities. The Chamber noted that the United States should not create a new, extraterritorial private cause of action for securities fraud to overturn the Supreme Court’s decision. The letter references Section 929Y of the Dodd-Frank Act, which directs the SEC to conduct a study to determine the extent to which private rights of action under the antifraud provisions of the Exchange Act should be extended to cover transnational securities fraud.

The Chamber’s review of post-Morrison decisions revealed that the federal courts have been consistently and appropriately applying Morrison. When a transaction occurs in the United States, courts have been permitting claims under the antifraud rule. Conversely, when a transaction occurs abroad, courts have been deferring to the judgment of foreign nations on the appropriate security enforcement mechanisms. Moreover, there is no indication that the application of the principles set forth in Morrison is leaving unsophisticated U.S. investors without a remedy that they believed to have been available or leaving any U.S. investors without protection. To the contrary, said the Chamber, the off-exchange transactions to which Morrison is being applied are highly complex transactions entered into by extremely sophisticated investors able to ascertain the governing remedial laws, which in virtually all cases have been the well-developed laws of key U.S. allies and trading partners.

Following Morrison, courts have concluded that the purchase of securities by foreigners on a foreign market cannot be the basis for a Section 10(b) claim. Similarly, courts have universally extended Morrison’s transactional test to reject also claims where U.S. individuals purchase securities of a foreign issuer on a foreign exchange. In both of these situations, reasoned the Chamber, the investor is purchasing shares on a non-U.S. exchange, and, there is little chance that the investor could mistakenly believe that U.S. laws apply. Moreover, because the foreign exchanges are supervised by sophisticated regulators there is little chance that the investor will be left unprotected.

Although the Supreme Court in Morrison did not explicitly define the phrase domestic transactions, courts have found that the phrase was intended to be a reference to the location of the transaction, not to the location of the purchaser and that the Supreme Court clearly sought to bar claims based on purchases and sales of foreign securities on foreign exchanges, even though the purchasers were American. See In re Vivendi Universal Securities Litigation, (SDNY 2011).

The Chamber also observed that courts have correctly concluded that when a plaintiff purchases the securities issued by a defendant on a U.S. exchange, a Section 10(b) remedy is available against the issuer for fraudulent conduct. This principle applies even when the fraudulent conduct occurs abroad. But when a foreign issuer lists securities on both foreign and domestic exchanges, Section 10(b) extends only to parties to transactions that occur on a U.S. exchange

Swap agreements can replicate other securities transactions, such as purchasing or shorting company stock. These transactions are synthetic in the sense that gains and losses are the product of contracts and the parties need not actually own the underlying security instrument at issue. The economic reality of such swap agreements determines whether it is foreign or domestic for Morrison purposes. Thus, when a swap agreement is functionally indistinguishable from purchasing or shorting stock on a foreign market, it must he treated as a foreign transaction and thus outside the scope of the federal antifraud rule.

Similarly, contracts for difference are another type of synthetic security pegged to an underlying since they are derivative instruments allowing a trader to take a long or short position on an underlying financial instrument without actually owning it.

A federal district court recently concluded that foreign purchases of contracts for difference nonetheless fell within Section 10(b) when the underlying referent is a stock traded on a U.S. exchange. See SEC v. Compania Internacional Financeria SA (SDNY 2011). As with swap-based agreements, the Court looked to the economic reality of the transaction. As the transaction was indistinguishable from the purchase of a U.S. security, and indeed likely caused the provider to purchase U.S. securities, it properly fell within the scope of U.S. regulation.

PCAOB Re-Proposes Expanded Standard on Auditor Communications with the Audit Committee

2011-12-20T11:22:00.001-06:00

The PCAOB has unanimously re-proposed a standard on the outside auditor’s communications with the audit committee. The re-proposed standard will supersede AU sec. 380, the existing PCAOB auditing standard governing communications with audit committees and will apply to auditor communications with issuer and broker and dealer audit committees. The new proposed standard does not impose new performance requirements on auditors but does expand and clarify the nature of communications that the auditor needs to have with the audit committee. It also aligns the auditor's communications more closely with other PCAOB standards governing the auditor's performance requirements. The comment period on the re-proposed standard will end on Feb 29, 2012. According to PCAOB Chief Auditor Marty Baumann, the goal is for the standard to take effect for audits beginning after Dec 15, 2012.

While the re-proposed standard is not fundamentally different from than the original proposal, there have been some significant changes. For example, the requirement in the original proposal that auditors evaluate the two-way communications process between the auditor and the audit committee has been deleted. Further, the requirements concerning auditor communications regarding management's critical accounting estimates have been streamlined. Also, there is a new requirement that the auditor communicate with the audit committee regarding significant transactions not in the ordinary course of business, including any transactions that appear to be unusual due to their timing, size, or nature. The auditor also would be required to explain his or her understanding of the business rationale for such transactions.

PCAOB Chair James Doty said that the new proposed standard is designed to benefit investors by enhancing the relevance and quality of the communications between the auditor and the audit committee. It should also help auditors perform their job by fostering thoughtful and engaged discussions between the auditor and the audit committee that, over time, arm the audit committee with the information it will need when a tough issue arises and the time comes to champion investor interests. The standard should also avoid burdening the audit committee with minutia. He cautioned auditors and audit committees to avoid turning the standard into a mere compliance exercise. The Chair believes that the re-proposed standard moves the auditor's communication with the audit committee away from compliance checklists, and decisively in the direction of meaningful, effective interchange.

Board Member Lewis Ferguson noted that the re-proposed standard now includes a number of specific matters that must be discussed with the audit committee, including the structure and timing of the audit, the auditor's assessment of risk areas including fraud risks, the auditor's use of outside experts and other auditors, difficult or contentious issues that arise in the course of the audit, significant accounting policies, judgments and estimates, going concern issues and other matters. Importantly, the enumerated items in the standard are not exclusive and any other matter that the auditor deems important should also be brought to the audit committee's attention.

For highly experienced and knowledgeable audit committees some of these required communications may seem unnecessary, noted Member Ferguson, but experience levels among audit committees of public companies vary widely and robust communications between an auditor and an audit committee can both educate the audit committee members and assist them in performing their oversight functions.

Board Member Jay Hanson noted that some commenters responding to the original proposed standard were hoping that the Board would require auditors to discuss their assessment of the company's tone at the top. The Board was careful to tie its communications requirements in the proposed standard to existing requirements for audit procedures in order to avoid increasing the substantive audit work that must be performed through the communication standard. As a result, the standard addresses tone at the top only insofar as AS 5 includes audit performance requirements to evaluate management in connection with the control environment.

According to Member Hanson, audit committees are free, however, to expand on these discussions with their auditors by asking for additional information about management's philosophies and priorities, in order to develop a more comprehensive picture of the company's tone at the top.

During Q&A with the staff, Member Hanson, noting that the communications should involve consultations with other accountants not involved with the audit, asked who are these other accountants. Chief Auditor Marty Baumann said that they could be accountants consulted by management with regard to complex accounting issues, or they could also be accountants consulted for opinion shopping purposes. The re-proposed standard clarifies that the auditor should communicate to the audit committee consultations by management with other accountants when the auditor has concerns about the subject matter of those consultations.

Member Ferguson, noting that the re-proposed standard requires documentation of the auditor communications with the audit committee, asked about the level of detail of the documentation. The Chief Auditor said that the general rule is that the documentation must be such that an experienced auditor not having been involved with the audit can look at the documentation and understand the nature of the communications.

Member Steven Harris noted that some have called the standard overly prescriptive: The Chief Auditor observed that the re-proposed standard embodies important requirements for communication between the auditor and the audit committee. He added that the standard does not prescribe the nature of how these communications are to take place. Communications can be in the form of bringing attention to critical matters to the audit, for example. Similarly, Member Dan Goelzer noted that the original proposal had been criticized for being one-size-fits-all. The Chief Auditor responded that the re-proposal provides great flexibility on how the audit committee and the auditor carry out their dialogue.

Member Harris posed a question concerning the difference between the terms must or should as used in the standard and the legal implications of such. The staff replied that the term ``must’’ connotes an unconditional responsibility, such as the auditor must be independent. The term ``should’’ carries the presumption of unconditional responsibility, that the auditor can rebut by showing that an alternative approach would otherwise satisfy the objective of the standard. This would be a rare occurrence, said the staff, since the term ``should’’ leaves little flexibility, is tantamount to a requirement, and is enforceable.

Member Goelzer is concerned about how the re-proposed standard will apply, and indeed be efficacious, to smaller broker-dealers where the same people both manage and oversee the financial reporting process. The staff shares these concerns. The Chief Auditor noted that the re-proposal questions if the standard should apply to all broker-dealers in an effort to elicit feedback from which the staff can learn more about whether the standard should be applicable in all cases.

SEC May Provide Guidance on Proxy Advisory Firms, Says Chairman Schapiro, and Will Review Beneficial Ownership Rules

2011-12-19T16:56:00.003-06:00

The SEC is considering providing guidance on how the federal securities laws should regulate the activities of proxy advisory firms as a result of comments received on a Concept Release on the US proxy system, said SEC Chair Mary Schapiro. In remarks at the Transatlantic Corporate Governance Dialogue, she also noted that the beneficial ownership reporting rules will be reviewed next year with an eye to modernizing them in light of modern investment strategies and innovative financial products. Chairman Schapiro also examined say-on-pay, proxy access, and beneficial ownership issues.

More broadly, the SEC Chair set a goal of breaking down barriers that may prevent effective engagement, impact investor confidence and, ultimately, diminish financial performance to the detriment of shareholders. Effective corporate governance is an imperfect art, she said, with case-specific rules of engagement that can vary dramatically from company to company, while yielding satisfactory results. Given the diversity of approaches, the focus of the SEC is on variables through which the Commission can have a beneficial impact on engagement, and where it can increase the quality of communication in the board-shareholder dialogue.

Many commenters suggested that proxy advisory firms may interfere with, rather than enhance, the communication at the heart of effective engagement. Companies are frustrated by the influence these firms have, noted Chairman Schapiro, and worry that they may not be accountable for, or even concerned with, the quality of the information on which they make voting recommendations.

And, when boards believe that a recommendation has been based on incorrect information, she reasoned, those recommendations can act as a barrier to boards’ efforts to persuade investors to change their minds. A related fear is that proxy firms’ conflicts of interest may be insufficiently disclosed, preventing shareholders from considering possible conflicts when analyzing those recommendations.

The SEC is also examining uncertainty surrounding vote confirmation. Currently, investors are often not able to receive confirmation that their votes have been cast and accurately counted. This inability to confirm voting information is caused in part because no one individual participant in the voting process, neither issuers, transfer agents, vote tabulators, securities intermediaries, nor third party proxy service providers, possesses all of the information necessary to confirm whether a particular shareholder’s vote has been timely received and accurately recorded.

Thus, the SEC is considering how to require participants in the voting process to share information with each other in order to allow for vote confirmations.
The review of beneficial ownership reporting will consider whether the 10-day initial filing requirement for Schedule 13D filings should be shortened and whether beneficial ownership reporting should be changed with respect to the use of cash-settled equity swaps and other types of derivative instruments. According to Chairman Schapiro, the first step will likely be a concept release given the controversy surrounding some of the issues

The Dodd-Frank Act has provided the Commission with new statutory authority to shorten the 10-day filing deadline for 13D, as well as to regulate beneficial ownership reporting based on the use of security-based swaps. And, earlier this year, the SEC received a petition for rulemaking recommending amendments to Regulation 13D-G.

The petition asks the SEC to broaden the definition of beneficial ownership to include interests held by persons who use derivative instruments. The petition also specifically requests that the time period within which initial beneficial ownership reports must be filed be shortened to one calendar day because technological advances have rendered the 10-day window obsolete.

The SEC Chair noted that many feel that the 10-day window results in secret accumulation of securities and material information being reported to the marketplace in an untimely fashion. They also say that it allows 13D filers to trade ahead of market-moving information and maximize profit, perhaps at the expense of uninformed security holders and derivative counterparties. In response, some argue that tightening the timeframe may reduce the rate of returns to large shareholders, thereby resulting in decreased investments and monitoring of and engagement with management. They also maintain that state law developments, such as the validity of poison pills and staggered boards, have tilted the regulatory balance towards issuers.

While disappointed by the DC Circuit decision striking down the proxy access regulation, Chairman Schapiro believes that, as a matter of fairness and accountability, long-term significant shareholders should have a means of nominating candidates to the boards of the companies that they own. She has great faith in the collective wisdom of shareholders to determine which competing candidates will best fulfill the responsibilities of serving as a director. The critical point is that shareholders have the ability to identify alternatives and for all shareholders to make an informed choice.

She noted that, while the appeals court vacated the proxy access rule, it did not impact Rule 14a-8, which will increase shareholder access to the proxy ballot in key circumstances. Shareholders will be able to submit proposals for proxy access at their individual companies, she emphasized, a process known as private ordering.
Rule 14a-8 provides an opportunity for shareholders owning a relatively small amount of a company’s securities to have their proposal placed alongside management’s proposals in the proxy materials.

There are several procedural requirements that a shareholder must satisfy to have a proposal included in the company’s proxy materials, including ownership of at least $2,000 or 1 percent of the company’s securities entitled to be voted for at least one year. Within the parameters of Rule 14a-8, said the Chair, shareholders will now have the chance to ask their fellow shareholders to support a proxy access system at their companies.

Finally, Chairman Schapiro reported that it appears that say-on-pay regulations put in place through Dodd-Frank are leading to improvements in communication in both directions. It has given shareholders a clear channel to communicate to the boards their satisfaction or lack of satisfaction with executive compensation practices. And it is giving boards a powerful incentive to clarify disclosure to shareholders, and to make a coherent case for the compensation plans they have approved.

The regulations require companies to provide shareholders with an advisory vote on executive compensation at least once every three years and an advisory vote on the frequency of say-on-pay votes at least once every six years. In addition, companies must provide a separate advisory vote regarding certain golden parachute arrangements in connection with a merger, acquisition, or other disposition of all or substantially all, assets.

While the outcomes of these votes are not binding on the company, noted the SEC Chair, the advisory vote does let boards know what shareholders think of compensation arrangements. Also, companies are required to quickly report on Form 8-K the results of these votes, she emphasized, and there is tremendous interest in the outcome of these votes.

In addition, companies have to report the decision on the frequency of say-on-pay votes. And, going forward, companies will have to disclose in proxy statements, in the year following the vote, how they have responded to the most recent say-on-pay vote. Chairman Schapiro is heartened that the SEC is beginning to see companies filing proxy statements following say-on-pay votes that are, in fact, responding to these issues.

Corporate Secretaries Society Says Costs of Mandatory Auditor Rotation Outweigh Benefits, Urges PCAOB to Use ``Bully Pulpit''

2011-12-19T12:11:00.004-06:00

In a letter to the PCAOB, the Society of Corporate Secretaries and Governance Professionals said that the cost of mandatory audit firm rotation outweighs the benefits. Moreover, the Society believes that mandatory auditor rotation will introduce significant issues that would likely contribute to an actual decrease in audit quality. In the Society’s view, existing Sarbanes-Oxley regulations, including the rotation of the lead audit partner every five years and other audit firm employees with significant involvement in the audit every seven years, adequately addresses the concerns of professional skepticism and ongoing objectivity. Essentially, reasoned the Society, the rotation of audit firm personnel gives the audit a fresh look without disrupting the continuity of audit firm service. The Society was responding to a PCAOB Concept Release on enhancing auditor independence and audit quality.

The Society noted that there would be considerable costs underlying an auditor rotation requirement for both audit firms and public companies at the various stages of the process, including the selection of the new audit firm, the costs of changing firms and finally the costs of rotating the audit firms after a certain amount of time. Each time an audit firm rotation occurs, noted the Society, the company’s audit committee, management and employees in its finance, legal, tax, accounting, and internal audit organizations, across all the jurisdictions in which the company operates, will have to invest significant amounts of time and money to ensure selection of an appropriate new audit firm.

The complex process of evaluating a potential new audit firm includes consideration of numerous factors, including the firm’s reputation; the firm’s knowledge and experience in the company’s lines of business; potential conflicts of interest or independence issues; and the scope of the audit firm’s international network in the countries and regions in which the company operates. According to the Society, the thoughtful consideration of each of these factors in support of the important decision on the best audit firm for a company at a given time would likely necessitate thousands of hours of work and analysis and concomitant expenditures. More broadly, the Society said it would be inefficient to require thousands of company hours every five or ten years to assess an audit firm change, especially when such a change may not be needed or be in the best interests of the company or its shareholders.

Further, once a new audit firm has been retained, observed the Society, a significant amount of company management time is required to provide the successor firm with the information needed to plan its audits and gain familiarity with the company and its accounting policies and methodologies, and its internal controls. The company’s audit committee must maintain an appropriate level of oversight throughout the entire process.

Contrary to the Concept Release’s position that mandatory auditor firm rotation would enhance auditor quality, the Society believes that it will actually harm audit quality. Evidence in the Concept Release indicates that audit quality in the first years of an engagement tends to be lower, and therefore could lead to a greater risk of audit failure. Because the start-up requirements for a new audit, such as gaining familiarity with the client’s particular practices, are significant for an incoming auditor, the ability to conduct the audit with the degree of diligence and thoroughness possible in later years is lessened.

With a mandatory rotation rule in place, reasoned the Society, companies will spend more time in a short-tenure audit situation, and overall audit quality will be negatively impacted. Also, incoming auditors, unfamiliar with the details of a new client’s business, will be less likely to identify fraud or deception. The accumulated experience of a longer audit tenure helps a firm better spot and account for these issues.

The Society also posited that mandatory rotation of external auditors would be an ineffective means of addressing the risk of inadequate professional skepticism, primarily because it fails to consider that professional skepticism is a skill the auditor employs, and instead confuses it with the normal questioning that takes place as a new auditor tries to understand a new client. Professional skepticism is most effectively used by an auditor with a full understanding of the facts and circumstances related to the clients’ businesses, emphasized the governance group, and mandatory rotation of external auditors will not cure this purported problem.

Indeed, continued the Society, there is no foolproof method for ensuring that professional skepticism is maintained throughout the life of an audit firm’s tenure. However, the Society believes that the inspection and enforcement tools that the PCAOB already possesses are sufficient to ensure professional skepticism. These tools provide an effective arsenal to address issues with the firms through monetary penalties, professional penalties and by publicity of failures that would adversely impact their customer base and, ultimately, an audit firm’s ability to retain clients. In this regard, the Society urged the PCAOB to use its “bully pulpit” to speak out on the need for auditor skepticism and thereby heighten sensitivity to the topic.

House Panel Will Conduct Hearings on Use of SEC Consent Judgments in Wake of Citigroup Ruling

2011-12-19T10:33:00.001-06:00

House Financial Services Committee Chair Spencer Bachus (R-ALA) and Ranking Member Barney Frank (D-MASS) jointly announced that the Committee will hold a hearing next year to examine the practice by the SEC of settling enforcement actions with defendants that neither admit nor deny complaints made by the SEC. The SEC has proposed to settle a string of recent cases by levying fines without requiring the defendants to admit wrongdoing.

In the most recent case, a federal judge (SD NY) rejected a $285 million settlement between Citigroup and the SEC in November because, the judge said, he could not determine whether the settlement was fair, adequate or in the public interest since the SEC had alleged, but had not proven, that Citigroup committed fraud. Such settlements require approval by a federal judge.

The SEC’s practice of using no-contest settlements has raised concerns about accountability and transparency, noted Chairman Bachus, adding that he is pleased the Committee will examine these concerns in a bipartisan manner. The policy of signing agreements without forcing firms to admit or deny wrongdoing raises serious issues, said Rep. Frank, who expressed his appreciation that Chairman Bachus is moving to address this issue in a bipartisan, cooperative manner.

The timing of the hearing will be announced at a later date, as will the list of witnesses the Committee will call to testify

The court said that the consent judgment was neither fair, nor reasonable, nor adequate, nor in the public interest. It is not reasonable, said Judge Rakoff, because how can it ever be reasonable to impose substantial relief on the basis of mere allegations. It is not fair, because, despite Citigroup's nominal consent, there is a potential for abuse in imposing penalties on the basis of facts that are neither proven nor acknowledged patent. It is not adequate, because, in the absence of any facts, the court lacked a framework for determining adequacy. And, the proposed consent judgment does not serve the public interest because it asks the court to employ judicial power and assert judicial authority when it does not know the facts. SEC v. Citigroup Global Markets, Inc., SD NY, 11 Civ. 7387, Nov. 28, 2011.

The SEC's long-standing policy of allowing defendants to enter into consent judgments without admitting or denying the underlying allegations deprived the court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.

The SEC took the position that, because the financial institution did not expressly deny the allegations, the court, and the public, somehow knew the truth of the allegations. This is wrong as a matter of law and unpersuasive as a matter of fact, said the court. As a matter of law, an allegation that is neither admitted nor denied is simply that, an allegation. It has no evidentiary value and no collateral estoppel effect.

The court observed that a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, particularly in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies.

Moreover, the court found that the combination of charging the financial institution only with negligence and then permitting it to settle without either admitting or denying the allegations deals a double blow to any assistance defrauded investors might seek to derive from the SEC enforcement action in attempting to recoup their losses through private litigation, since private investors not only cannot bring securities claims based on negligence, but also cannot derive any collateral estoppel assistance from Citigroup's non-admission/non-denial of the allegations.

The SEC will appeal the federal district court’s rejection of the proposed settlement to the US Court of Appeals for the Second Circuit.

In an earlier memorandum to the federal district court, the SEC noted that use and entry of consent judgments has long been endorsed by the US Supreme Court. Lower federal courts have recognized the importance of consent judgments to the SEC’s effective and efficient enforcement of the federal securities laws. In its 1983 ruling in SEC v. Clifton, the DC Circuit noted that, because of its limited resources, the SEC has traditionally entered into consent decrees to settle most of its injunctive actions.

The SEC said that there is nothing unusual or untoward about a consent decree entered into without an admission of wrongdoing by the defendant, and that criticism of consent decrees for not including such an admission is unjustified. Consistent with this standard practice, the SEC has long used consent decrees in which defendants admit no wrongdoing.

Courts have repeatedly recognized the balance of advantages and disadvantages in settlements entered in no admit/deny enforcement actions and have been reluctant to upset that balance, said the SEC. While the defendant is not subject to collateral estoppel with regard to the claims asserted, acknowledged the SEC, investors are able to pursue any available private remedies, in addition to the relief obtained by the SEC. Moreover, the SEC was able to bring the matter to a speedy conclusion, obtain compensation for victims in a timely manner, and allocate limited resources to bring additional enforcement actions for the protection of more investors.

Corporate Secretaries Society Supports House Whistleblower Legislation Requiring Initial Reporting to Company

2011-12-19T06:19:00.000-06:00

In a letter to House Capital Markets subcommittee leaders, the Society of Corporate Secretaries and Governance Professionals expressed support for the Whistleblower Improvement Act as it move towards the House floor. In the Society’s view, companies need the information they receive through their internal compliance programs and hotlines to stop wrongdoing as well as for other purposes. Companies use all the information received, assured the Society, no matter how minor, to improve the workplace and their compliance programs.

The Society believes that the incentive in current SEC regulations for employees to first report to the SEC rather than to raise a concern with a manager or report it via an internal hotline tips the balance too far. H.R. 2483 conditions receipt of an award on first reporting to the company except where the company lacks an anti-retaliation policy or an internal reporting system with anonymous reporting or the SEC determines in a preliminary investigation not exceeding 30 days that internal reporting was not a viable option because the alleged misconduct was committed by or involved the complicity of the highest level of management, or because there is other evidence of bad faith on the part of the company.

The legislation would also clarify that Section 21F of the Exchange Act does not prohibit or restrict any employer from enforcing any established employment agreements, workplace policies, or codes of conduct against a whistleblower, and further clarifies that if an employer takes adverse action against a whistleblower for any violation of such agreements, policies, or codes, it will not constitute retaliation. The Society believes that companies should be allowed to enforce existing codes of conduct, and notes that such codes and compliance programs have been enhanced since passage of the Sarbanes-Oxley Act.

According to the Society, a regime that undercuts compliance code requirements that employees report to their managers or elsewhere in the company any suspected wrongdoing would hurt a company’s ability to police their own employees for the ultimate benefit of the investors and the public. Company compliance systems should be the first line of defense in upholding federal securities regulations.

More broadly, Society members, many of whom are compliance personnel or oversee the compliance function, feel strongly that legal and compliance personnel with similar responsibilities who have a duty to report wrongdoing should never receive a bounty for doing what they are required to do by virtue of their role. In addition, someone who committed or facilitated, wrongdoing should not benefit financially from his or her own misconduct by receiving an award.

Congress Clears Legislation Funding SEC for FY 2012 and Authorizing CFTC Fund Transfer

2011-12-17T15:51:00.003-06:00

Congress has passed the House-Senate conference report (H 112-331) on the Consolidated Appropriations Act, HR 3671, and cleared the legislation for signing by the President, which is expected. The conference agreement provides $1,321,000,000 for the SEC for FY 2012 instead of $1,185,000,000 as proposed by the House and $1,407,483,130 as proposed by the Senate. The conference agreement provides that $1,321,000,000 be derived from offsetting collections resulting in no net appropriation. The conference agreement also provides that the SEC Office of Inspector General must receive no less than $6,795,000 as proposed by the Senate, instead of$6,790,000 as proposed by the House. The conference report contains a provision allowing the CFTC to transfer $10 million in funding between the agency’s Information Technology account and its Salaries and Expenses account.

The Act also makes available $100,000 for expenses for consultations and meetings hosted by the SEC with foreign regulatory officials to exchange views concerning securities matters. It also rescinds $25 million from the unobligated balances available in the SEC Reserve Fund established by Section 991 of the Dodd-Frank Act, which created a Reserve Fund that the SEC could use as it deems necessary to carry out its functions.

While the Consolidated Appropriations Act generally withholds funding for interagency commissions, councils, or committees, the legislation specifically states that funds made available to the CFTC and SEC may be used for the interagency funding and sponsorship of a joint advisory committee to advise on emerging regulatory issues.

The conferees did not adopt the Senate designation of $483, 130 specifically for the strengthening of the acquisition workforce. However, while not designating funding, the Conference Committee remains concerned about the SEC's acquisition processes and expects the SEC to dedicate sufficient resources to strengthening the agency's capacity and capabilities of the acquisition workforce.

The conferees remain concerned with the SEC's lack of judgment in its past
leasing practices. The conferees are aware of the SEC's arrangement with the General Services Administration, which the conferees believe is a good first step. The conferees intend to closely monitor how the SEC exercises its leasing authority to ensure that the Commission has adequately reformed its leasing practices. The conferees are also concerned about the unauthorized destruction of documents by the SEC.

Due to the above concerns, the conferees direct the SEC to provide the House and Senate Appropriations Committees with corrective action reports, submitted to the SEC Inspector General, related to lease agreements and document destruction no later than 30 days after enactment.

Senate Passes Payroll Tax Credit Extension with Increase in Fee Charged by GSEs on Mortgage-Backed Securities

2011-12-17T14:57:00.000-06:00

The Senate has passed, as amended, the Middle Class Tax Relief and Job Creation Act, HR 3630, extending the payroll tax holiday for two months and increasing the guarantee fees charged by Fannie Mae and Freddie Mac for assuming the risk of mortgage-backed securities. The legislation will be taken up by the House early next week. The House version of the legislation also contained language raising the GSE guarantee fee to help pay for the tax relief extension.

The legislation increases the guarantee fees that are charged to mortgage lenders with respect mortgage-backed securities by Fannie Mae and Freddie Mac by 10 basis points. The increase in the fees will be adjusted so that they only cover the cost of the bill. Revenue generated by the increase is deposited directly into the United States Treasury. The increase in the annual premium expires in ten years. This change does not affect the upfront premium charged by FHA for insuring loans.

IRS Proposes Regulations under Dodd-Frank Swap Exclusion for Section 1256 Contracts

2011-12-16T18:45:00.001-06:00

The IRS has proposed regulations describing swaps and similar agreements that fall within the meaning of Section 1256(b)(2)(B) of the Internal Revenue Code, which was added to the Code by Section 1601 of the Dodd-Frank Act to exclude certain swaps and similar agreements from the reach of Section 1256 of the Code.

Section 1256 provides that contracts classified as Section 1256 contracts are marked to market and any gain or loss is generally treated as 60 percent long-term capital gain or loss and 40 percent short-term capital gain or loss. Section 1256(b)(1) defines the term “section 1256 contract” as a regulated futures contract, foreign currency contract, non-equity option, dealer equity option, and dealer securities futures contract. With the exception of a foreign currency contract, a Section 1256 contract must be traded on or subject to the rules of a qualified board or exchange. Section 1601 of Dodd-Frank excluded securities futures contracts and swaps and similar agreements from the definition of a Section 1256 contract.

In Dodd-Frank Section 1601, Congress was resolving uncertainty under Section 1256 for swap contracts that are traded on regulated exchanges. Section 1601 contemplates that a swap contract, even if traded on or subject to the rules of a qualified board or exchange, will not be a Section 1256.

The IRS noted that Congress incorporated into Section 1601 a list of swaps, including interest rate swaps and credit default swaps, that parallels the list of swaps included under the definition of a notional principal contract in IRS Regulation § 1.446-3(c) with the addition of credit default swaps. According to the IRS, the parallel language suggests that Congress was attempting to harmonize the category of swaps excluded under Section 1601 with swaps that qualify as notional principal contracts under § 1.446-3(c), rather than with the contracts defined as swaps under Section 721 of Dodd-Frank. Thus, the proposed regulations provide that a Section 1256 contract does not include a contract that qualifies as a notional principal contract. The proposed regulations expressly provide that a credit default swap is a notional principal contract.

Section 1601 raises questions as to whether an option on a notional principal contract that is traded on a qualified board or exchange would constitute a “similar agreement” under the section or would instead be treated as a non-equity option under Section 1256(g)(3)of the Code. Since an option on a notional principal contract is closely connected with the underlying contract, the IRS reasoned that such an option should be treated as a similar agreement within the meaning of Section 1601. Thus, the proposed regulations also provide that a Section 1256 contract does not include an option on any contract that is a notional principal contract.

The proposed regulations also provide an ordering rule for a contract that trades as a futures contract regulated by the CFTC, but that also meets the definition of a notional principal contract. The IRS believes that such a contract is not a commodity futures contract of the kind envisioned by Congress when it enacted Section 1256. Thus, the proposed regulations provide that Section 1256 does not include any contract, or option on such contract, that is both a Section 1256 contract and a notional principal contract.

SEC Will Appeal Rejection of Citigroup Consent Judgment to Second Circuit Court of Appeals

2011-12-16T17:19:00.002-06:00

The SEC will appeal a federal court’s (SDNY) rejection of a proposed settlement of an enforcement action against a global financial institution to the US Court of Appeals for the Second Circuit. The court ruled that the consent judgment was neither fair, nor reasonable, nor adequate, nor in the public interest. It is not reasonable, said Judge Rakoff, because how can it ever be reasonable to impose substantial relief on the basis of mere allegations. It is not fair, because, despite Citigroup's nominal consent, there is a potential for abuse in imposing penalties on the basis of facts that are neither proven nor acknowledged patent. It is not adequate, because, in the absence of any facts, the court lacked a framework for determining adequacy. And, the proposed consent judgment does not serve the public interest because it asks the court to employ judicial power and assert judicial authority when it does not know the facts. SEC v. Citigroup Global Markets, Inc., SD NY, 11 Civ. 7387, Nov. 28, 2011.

In the enforcement action, the SEC alleged that the principal U.S. broker-dealer subsidiary of the financial institution mislead investors about a $1 billion collateralized debt obligation (CDO) tied to the U.S. housing market in which the entity bet against investors as the housing market showed signs of distress. The CDO defaulted within months, leaving investors with losses while Citigroup made $160 million in fees and trading profits. Without admitting or denying the allegations, the financial institution agreed to settle the SEC’s charges by paying a total of $285 million, which will be returned to investors.

SEC Enforcement Director Robert Kuazami said that the district court committed legal error by announcing a new and unprecedented standard that inadvertently harms investors by depriving them of substantial, certain and immediate benefits. The court announced a new standard that is at odds with decades of court decisions that have upheld similar settlements by federal and state agencies across the country. In fact, noted the Director, courts have routinely approved settlements in which a defendant does not admit or even expressly denies liability, exactly because of the benefits that settlements provide.

A settlement puts money back in the pockets of harmed investors without years of courtroom delay and without the twin risks of losing at trial or winning but recovering less than the settlement amount, he continued, risks that always exist no matter how strong the evidence is in a particular case. Based on a careful balancing of these risks and benefits, settling on favorable terms even without an admission serves investors, including investors victimized by other frauds. This is due to the fact that other frauds might never be investigated or be investigated more slowly because limited agency resources are tied up in litigating a case that could have been resolved.

He emphasized that the $285 million obtained from Citigroup under the proposed settlement, while less than investor losses, represents most of the total monetary recovery that the SEC could have sought at trial. An SEC settlement does not limit the ability of injured investors to pursue claims for additional relief, he said. Moreover, while the court alluded to Citigroup’s size, the law does not permit the Commission to seek penalties based upon a defendant’s wealth.

The court was incorrect in requiring an admission of facts as a condition of approving a proposed consent judgment, observed the Director, particularly when the SEC provided the court with information laying out the reasoned basis for its conclusions.

In its reasoned memorandum to the court, the SEC answered questions posed by the judge before issuing an opinion on the proposed consent judgment. The SEC noted that use and entry of consent judgments has long been endorsed by the US Supreme Court. Lower federal courts have recognized the importance of consent judgments to the SEC’s effective and efficient enforcement of the federal securities laws. In its 1983ruling in SEC v. Clifton, the DC Circuit noted that, because of its limited resources, the SEC has traditionally entered into consent decrees to settle most of its injunctive actions.

The SEC said that there is nothing unusual or untoward about a consent decree entered into without an admission of wrongdoing by the defendant, and that criticism of consent decrees for not including such an admission is unjustified. Consistent with this standard practice, the SEC has long used consent decrees in which defendants admit no wrongdoing.

Courts have repeatedly recognized the balance of advantages and disadvantages in settlements entered in no admit/deny enforcement actions and have been reluctant to upset that balance, said the SEC. While the defendant is not subject to collateral estoppel with regard to the claims asserted, acknowledged the SEC, investors are able to pursue any available private remedies, in addition to the relief obtained by the SEC. Moreover, the SEC was able to bring the matter to a speedy conclusion, obtain compensation for victims in a timely manner, and allocate limited resources to bring additional enforcement actions for the protection of more investors.