Wednesday, March 31, 2010

Senator Brown Seeks Analog to Lynch Amendment on Derivatives Clearinghouses for Senate Financial Reform Bill

There has been concern that, with derivatives trading required to be conducted through clearinghouses, large financial institutions would own and control the clearinghouses and effectively set rules for their own derivatives deals. The Lynch Amendment to the House financial reform legislation prevents large financial institutions and major swap participants from taking over these new clearinghouses by imposing a 20-percent-voting-stake limitation on ownership interest in those institutions and the governance of the clearing and trading facilities.

The Lynch Amendment specifically provides that these restricted owners, which are defined as swap dealers, security-based swap dealers, major swap participants and major security-based swap participants, cannot own more than a 20 percent voting stake in a derivatives-clearing organization, a swap-execution facility, or a board of trade. Further, the rules of the clearing organization, swap-execution facility and board of trade must provide that a majority of the directors cannot be associated with a restricted owner.

Senator Sherrod Brown (D-OH) has been trying to get a similar amendment added to the Senate financial reform bill. Senator Brown, a member of the Banking Committee, failed to get the amendment added to the bill during the committee’s markup. It is now quite likely that he will try to add it as a floor amendment, which is when the Lynch Amendment was added to the House bill.

The Brown Amendment would require the CFTC and SEC to adopt rules related to conflicts of interest in ownership of the clearinghouses that set terms for derivatives trades. It would restrict shareholder ownership of a clearinghouse by the large financial institutions to 20 percent, separately or in aggregate. It would also prohibit large financial institutions from controlling a majority of the board and would require rules for self-dealing. According to Senator Brown, this would help prevent large financial institutions from setting their own rules for their derivatives trades and from tilting the playing field in their favor.


Tuesday, March 30, 2010

Bi-Partisan Senate Bill Would Provide Tax Relief to Victims of Ponzi Investment Schemes

Bi-partisan Senate legislation would provide tax relief to investors victimized by securities fraud in Ponzi-scheme types of operations. Since the legislation applies only to qualified fraudulent investment losses discovered in calendar years 2008 or 2009, it essentially assists victims of frauds such as those run by disgraced financiers Bernie Madoff and Alan Stanford. Generally, the measure would extend certain benefits that are already available to larger investors to smaller investors as well. It would allow victims to take a deduction for funds lost from their IRA accounts, allow for accelerated and increased contributions to tax-free retirement accounts to make up for losses, and allow for penalty-free early withdrawals from retirement accounts for investors in dire need of cash.

The Ponzi Victims Tax Bill of Rights,
S 3166, was introduced by Senator Charles Schumer and has picked up strong bi-partisan support, including that of Senate Banking Committee Chair Chris Dodd. Senator John Kyl, a key member of the Finance Committee, is a Republican co-sponsor. Other co-sponsors of the legislation who are also members of the Finance Committee are Senators Maria Cantwell, John Kerry, Bill Nelson, and Blanche Lincoln. Senator Schumer is a member of both the Banking and Finance Committees, as is co-sponsor Senator Robert Menendez.

The IRS originally issued rules in March 2009 allowing a direct investor to take a theft loss deduction for their Ponzi scheme losses. The rule said that theft losses could be treated as net operating losses (NOLs), as if the individual investors were small businesses. Direct investors were allowed to carry back their losses for 5 years instead of 3, and carry forward any remaining losses for up to 20 years. A longer carry back is important because it affords by providing refunds for taxes paid in past year.

However, even with the NOL relief afforded to thousands of victims, a number of tax problems remain unaddressed. In order to expand relief available to smaller investors, the Schumer-Kyl legislation would increase the amount victimized investors can carry back on their income taxes; allow victims who lost money within an IRA to recoup some of the losses for the first time by allowing a theft loss for their basis in the account, or half their total losses; raise the limit on tax-free contributions to retirement accounts so investors can replenish losses quicker; and waive penalties for withdrawing from retirement accounts to increase daily cash flow.

The measure would define a qualified fraudulent investment loss based on definitions included in the March 2009 IRS guidance. Thus, the legislation amends Section 165 of the IRC to define a ``qualified fraudulent investment loss’’ as a loss discovered in 2008 or 2009 resulting from a specified fraudulent arrangement in which, as a result of the conduct that caused the loss
a person was charged with the commission of fraud, embezzlement, or similar crime which, if proven, would constitute a theft or a person was the subject of a criminal complaint alleging the commission of fraud, embezzlement, or similar crime would constitute a theft and the complaint alleged an admission by such person admitting the crime, or a receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen.

Essentially providing a workable definition of a Ponzi scheme, amended Code Section 165 would define a ``specified fraudulent arrangement’’ to mean an arrangement in which a person
receives cash or property from investors, purports to earn income for the investors, reports income amounts to the investors that are partially or wholly fictitious, makes payments, if any, of purposed income or principal to some investors from amounts that other investors invested in the fraudulent scheme, and appropriates some or all of the investors’ cash or property.

The legislation would allow both direct and indirect investors with qualified fraudulent investment losses to carry back eligible losses to up to 6 prior taxable years, essentially doubling the period that existed prior to March 2009. Thus, under the legislation, the same rules with respect to NOL carry backs of qualified fraudulent investment losses would apply to both direct and indirect investors. For all provisions of S 3166, the amount of any qualified fraudulent investment loss is reduced by any expected recovery through the Securities Investor Protection Corporation or legal action.

Many victims, particularly a number of the smaller investors, held Ponzi-related assets in an IRA. Under current law, no tax relief is available for losses resulting from the theft of assets held in an IRA. Thus, an individual that lost a $250,000 investment in a taxable account as a result of the Ponzi-scheme theft received a deduction for the loss, but an individual that lost a $500,000 investment in an IRA received no relief.

Because taxes have not been paid on the majority of retirement savings, since they are funded with pre-tax money, the amount of the allowable tax loss must be adjusted. Under the bill, victims will be allowed to claim a loss deduction for the qualified fraudulent investment loss in an IRA in an amount equal to the greater of 100 percent of their individual and employer contributions or 50 percent of the IRA theft loss. The maximum loss that may be claimed under this provision is $1.5 million. Under the legislation, the IRA loss deduction may be carried back to up to 6 taxable years and carried forward up to 20 years. For IRAs that contain money rolled over from other retirement accounts, the amount of the rollover is not itself considered to be an employee contribution. Instead, an individual must substantiate the portion of the rollover that is attributable to employee and employer contributions.

For any eligible individual who turned 65 by December 31 of the year that the theft was discovered, the bill would increase the maximum NOL carry back period for qualified fraudulent investment losses to 7 years. Moreover, the legislation would allow a waiver of the 10 percent tax penalty for withdrawals from retirement plans for an individual who is under age 59½ and who suffered a loss related to the Ponzi scheme.

Penalty-free withdrawals would be permitted for up to 10 years from the date of the discovery of the fraud, or until a taxpayer has withdrawn the amount of the loss, whichever comes first. An individual would still be required to pay the income taxes on the withdrawn funds since the measure would simply waive the 10 percent penalty on early withdrawals in these circumstances.

To help restore an individual’s IRA savings in the event of a qualified fraudulent investment loss, the bill would include a special catch-up contribution provision allowing an individual to contribute up to an additional 100 percent of the current contribution limits to any IRA account for a period of up to 10 years. This special catch-up contribution will be available for any individual who owns an IRA that lost at least 50 percent of its value as a result of a qualified fraudulent investment loss. For an individual with multiple IRAs, the bill allows the catch-up contribution for each eligible IRA.

Many victims filed estate or gift tax returns reporting investments in Ponzi-scheme assets, which necessarily overstated the value of these assets. The measure would allow a period of time to file amended estate and gift tax returns to obtain a refund of transfer taxes paid or to adjust the lifetime gift tax or generation skipping transfer tax exemptions to reflect the lower value of the assets transferred. The effect of the bill would be to permit certain estate or gift taxes paid on Ponzi-scheme assets, or lifetime gift tax or generation skipping tax exemptions that have been utilized with respect to Ponzi-scheme assets, to be appropriately refunded or restored.

The bill would also allow an individual to amend returns, as necessary, for reportable gifts made in the year the theft is discovered, and the 6 taxable years prior to the theft discovery. An individual would have up to four taxable years after the discovery of the fraud to amend his or her gift tax returns. Thus, for example, a victim of the Madoff Ponzi scheme would have until December 31, 2012 to file amended gift tax returns for gifts made in tax years beginning January 1, 2002, and subsequent years through the date of discovery of the theft.Finally, for estate taxes, the measure would allow estate tax returns for decedents dying after December 31, 2007 to be amended to account for Ponzi scheme assets. For decedents dying before January 1, 2008, consistent with present law, beneficiaries who inherited assets that became worthless after inheritance as a result of a Ponzi scheme would be able to utilize the NOL treatment and other benefits afforded to all victims.

US Supreme Court Affirms Gartenberg Approach to Fiduciary Duty in Fund Fee Cases

The US Supreme Court has affirmed the use of the Gartenberg standards for assessing the fiduciary duty under Section 36(b) of the Investment Company Act with with regard to investment adviser compensation. The SEC had defended the venerable 1982 Gartenberg ruling in an amicus brief filed with the Court in this case, which involves the fiduciary duty imposed on mutual fund advisers under Section 36(b). The case was on appeal from a Seventh Circuit panel ruling that expressly disapproved the Gartenberg approach based on its view that a fidu­ciary duty differs from rate regulation. The SEC said that the panel’s focus on whether an adviser has made full disclosure and played no tricks on the investment company’s board is inconsis­tent with the plain text of Section 36(b), the structure of the 1940 Act, and the purposes and legislative history of the statute. The court of appeals denied rehearing en banc, with five judges dissenting.
The Supreme Court granted certiorari. (Jones v. Harris Associates L.P., Dkt. No. 08-586).

Section 36(b) gives mutual fund shareholders and the SEC an inde­pendent check on excessive fees by imposing a fiduciary duty on investment advisers with respect to the receipt of compensation for services. In Gartenberg v. Merrill Lynch Asset Management, Inc. (CA-2 1982), the appeals court ruled that, in order to violate Section 36(b), the adviser must charge a fee that is so disproportionately large that it bears no relationship to the services rendered and could not have been the product of arms-length bargaining.

Writing for the Court, Justice Alito said that, based on §36(b)’s terms and the role that a shareholder action for breach of the investment adviser’s fiduciary duty plays in the 1940 Act’s overall structure, Gartenberg applied the correct standard. The Court also noted that a consensus has developed regarding the standard the Gartenberg court set forth over 25 years ago: The standard has been adopted by other federal courts, and SEC regulations have recognized, and formalized, "Gartenberg-like" factors.

While conceding that the Gartenberg standard may lack sharp analytical clarity, the Court said that it accurately reflects the compromise that is embodied in §36(b), and has provided a workable standard for nearly three decades.

The Court reached back to its 1939 ruling in Pepper v. Litton to find the right formulation for the phrase fiduciary duty in Section 36(b), whose essence is whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain. The Investment Company Act modifies this duty in a significant way by shifting the burden of proof from the fiduciary to the party claiming breach, to show that the fee is outside the range that arm’s-length bargaining would produce.

In the Court’s view, the Gartenberg approach fully incorporates this understanding of the fiduciary duty as set out in the Pepper ruling and reflects §36(b)'s imposition of the burden on the plaintiff. The Gartenberg approach also reflects §36(b)’s place in the statutory scheme and, in particular, its relationship to the other protections that the Act affords investors.

In recognition of the role of the disinterested directors, the 1940 Act instructs courts to give board approval of an adviser’s compensation such consideration as is deemed appropriate under all the circumstances. From this formulation, the Court drew two inferences. First, a measure of deference to a board’s judgment may be appropriate in some instances, and, second, the appropriate measure of deference varies depending on the circumstances.

In the Court's view, the Gartenberg doctrine heeds these precepts by advising that the expertise of the independent trustees of a fund, whether they are fully informed about all facts bearing on the investment adviser’s service and fee, and the extent of care and conscientiousness with which they perform their duties are important factors to be considered in deciding whether they and the investment adviser are guilty of a breach of fiduciary duty in violation of §36(b).


Monday, March 29, 2010

Supreme Court Oral Argument Pits Extraterritorial Reach of Rule 10b-5 against Sovereign Right to Remedy Securities Fraud

In what is perhaps the first foreign-cubed case to reach the U.S. Supreme Court, foreign investors who purchased stock in a foreign bank on a foreign exchange, with alleged significant fraudulent conduct having occurred in the U.S., pitted their Rule 10b-5 remedy in federal court against the sovereign right of another nation to remedy securities fraud in its own way. In the oral arguments, the Justices weighed the vexing question of the right of U.S. courts to remedy securities fraud with respect for the right of other nations to enforce their own securities regulatory regimes.

The Court is reviewing a Second Circuit panel ruling that the U.S. federal securities laws did not apply to foreign investors alleging fraudulent statements by a foreign issuer when the conduct in the U.S. was merely preparatory to the fraud and the acts directly causing loss to investors occurred outside the U.S. Morrison v. National Australian Bank, Ltd., CA-2, Dkt. No. 08-1191.

Arguing for the Australian bank, George Conway said that the investors identified nothing in the text of Section 10(b) that overcomes the presumption against its extraterritoriality application. The statute should thus be construed not to apply to transactions and shares of foreign issuers on foreign exchanges. Noting that there is an implied private right of action under Rule 10b-5, counsel asserted that Congress did not intend for this right of action to exist even domestically, let alone extraterritorially.

Moreover, given the threat that the Rule 10b-5 implied right presents to the sovereign authority of other nations, as reflected in the amicus briefs of Australia, the United Kingdom, and France, counsel asked the Court not to construe the implied right to extend to claims of purchasers and sellers of securities of foreign issuers on foreign markets. In separate amicus briefs, the U.K. and France cited international comity in urging the Court not to allow the application of Rule 10b-5 to upset the delicate balance that foreign nations have struck in regulating securities fraud and thereby offend the sovereign interests of foreign nations.

Counsel also stressed the dangers of conflict with foreign law, particularly in the context of the modern Rule 10b-5, with its fraud on the market presumption, which Australia does not recognize. The investors are essentially seeking to have a U.S. federal court conduct a massive transfer of wealth and impose a direct form of market regulation that Australia has not seen fit to impose upon itself, said counsel.

Counsel also noted that Congress can speak clearly on these issues when it wants to, citing Exchange Act Section 30(a), which authorizes the SEC to promulgate regulations that apply to brokers and dealers who effect transactions of securities on foreign exchanges, if those transactions are transactions of shares of shares of U.S. issuers. Congress did not speak so clearly in Section 10(b).

Counsel noted that the amicus briefs of different nations display different rules of materiality and disclosure. Also, some countries rely on public enforcement more than others. The French rely on l'action publique, while other nations approach the U.S. in their generosity to plaintiffs. Australia allows opt-out class action. Canada dispenses with the proof of reliance and scienter in some cases.

Justice Breyer wondered how it would hurt other countries if the Court said that if some terribly bad conduct happens in the United States, and someone in the world buys some shares and as a result is hurt, U.S. courts will give them a remedy. How does that hurt Australia or France or England, queried the Justice. In response, counsel reiterated that Australia does not permit fraud-on-the-market class actions and Canada caps damages at 5 percent of an issuer's market capitalization or $1 million, whichever is greater.

So it is not just substance, argued counsel, it is also remedy. Other nations want to do things in different ways and they should be allowed to. Nations should be allowed to judge for themselves what kind of rules they want to have for people who buy shares on their own exchanges. Counsel emphasized that applying section 10(b) to cases like this would amount to legal imperialism.
Arguing for the U.S., Assistant Solicitor General Matthew Roberts asserted that the critical question is whether there is significant conduct in the U.S. that is material to the broad success of the alleged securities fraud. In counsel’s view, to say that Rule 10b-5 does not cover that kind of conduct risks allowing the United States to become a base for orchestrating securities frauds for export.

It would allow masterminds in the United States to engineer international boiler room schemes in which they direct agents in foreign countries to make fraudulent representations that victimize investors. According to the government, the critical question must be whether there was culpable conduct in the United States that is directly responsible for the plaintiff's injury. The fact that the transaction happened on the Australian exchange is not dispositive.

Arguing for the investors, Thomas Dubbs said the scope of section 10(b) extends to remedy alleged fraudulent conduct with respect to misleading financial information sent by the bank’s Florida subsidiary to Australia for incorporation into the financial statements of the Australian bank.

He disagreed with the observation that this case has "Australia" written all over it. Indeed, from the investor’s point of view it has "Florida" written all over it, he said, because Florida is where the alleged fraudulent conduct in putting the phony assumptions into the valuation portfolio was done. Senior management in Florida created those numbers with the expectation and the knowledge that they would go into the financial statement, he said, which means that there is substantial conduct in Florida in terms of the fraud.

Justice Breyer returned to the fact that France, Britain and Australia have filed briefs in this case giving what they consider very sound reasons why the Court should not assert jurisdiction because of a number of conflicts that would interfere with their efforts to regulate their own securities markets. Justice Scalia was dubious of allowing a U.S. court to determine whether there has been a misrepresentation on the Australian exchange and whether Australian purchasers relied upon that misrepresentation.

UK FSA Official Views Amendments to Proposed Hedge Fund Directive as US Officials Voice Protectionist Concerns

Amendments being readied to the proposed EU Alternative Investments Fund Management Directive go some of the way towards ameliorating the protectionist tendencies of the Directive, said Dan Waters, Director of Asset Management at the Financial Services Authority, but there is still concern that the Directive could limit fund choice and damage investor returns. The Director views a protectionist approach to hedge fund regulation as antithetical to fundamental principles of the free movement of capital and contrary to the core G-20 principles of regulatory cooperation. And, indeed, the draft has drawn the criticism of U.S. Treasury Secretary Tim Geithner and a key member of the Senate Banking Committee.

Mr. Waters praised some amendments to third country aspects of the Directive dealing with the treatment of funds and fund managers based outside of Europe. Notably, the amended proposal envisions that, after a transitional period, and subject to certain equivalence criteria being met, a marketing passport would be granted to those fund managers either established outside of Europe or managing funds which are established outside of Europe.

This approach conforms to the FSA’s traditional support of the principle of the marketing passport replacing the current patchwork of national private placement regimes. The FSA accepts that, in order for third country fund managers to obtain such a passport, equivalence criteria should be met. Crucial questions remain, however, as to the content of the standards against which equivalence would be judged and by whom the decision would be made. Given the global nature of the alternative investments market, the FSA’s view remains that the EU must create a proportionate regulatory approach recognizing the reality that alternative investment fund management, including its support services, inevitably involves markets and jurisdictions across the globe and not just in Europe.

The official emphasized the importance of striking the right balance in order to deliver sensible standards and equivalence criteria. There is also the important question about the consequences for a third country failing to make the grade. Unfortunately, proposals put forward could have an adverse effect on future alternative investment flows into and out of Europe.

For example, in instances where third country jurisdictions are not deemed equivalent, fund managers would be prohibited from marketing their funds on a private placement basis. Even more worrying, noted the Director, in instances where the hedge fund and the fund manager are based outside Europe, and the third country jurisdictions are not deemed equivalent, even investment into the fund made at the investor’s own initiative would not be permitted. Calling this a ``draconian prohibition,’’ the senior FSA official noted that it has been strongly objected to by institutional fund managers, who view it as limiting legitimate choice and damaging investor returns.

In a letter to EU Internal Market Commissioner Michel Barnier, Treasury Secretary Tim Geithner expressed concern that the proposed Alternative Investment Funds Management Directive would discriminate against US hedge funds and deny them the access to the EU market that they currently enjoy. The Secretary pointed out that pending U.S. reform legislation will maintain full access to the U.S. market for EU fund managers and custodians. In earlier remarks, Director Waters has stated that the current draft can be seen as an attempt to protect European funds from competition from legitimate U.S. and other third-country funds

Senator Charles Schumer, a key member of the Banking Committee, has expressed deep concern that the Directive would overtly discriminate against U.S. hedge funds. In a letter to Secretary Geithner, Senator Schumer said that, if the EU adopts protectionist rules that discriminate against U.S. firms and activities, he would ask Congress to pass equivalent legislation, including measures prohibiting funds that are not headquartered in the U.S. from marketing and raising money in the U.S. and requiring all funds operating in the U.S. to use only U.S.-headquartered custodian banks.


Saturday, March 27, 2010

New England Legal Foundation Asks Supreme Court to Shield Tax Accrual Work Papers Created for Audited SEC Financial Statements from IRS Discovery

The US Supreme Court has been asked to end an intolerable split among the federal circuits and hold that tax accrual work papers prepared for the dual purpose of anticipating litigation and assisting auditors in vetting SEC required financial statements were protected from IRS discovery. In doing so, said an amicus brief filed in the Textron case by the New England Legal Foundation, the Court would also be reaffirming the validity of a federal procedural rule protecting from discovery documents prepared in anticipation of litigation or for trial. While the First Circuit Court of Appeals did partially rely on the ground that disclosure was appropriate and desirable because of the difficulties the IRS faces in tax administration, the Foundation argued that any disadvantages the IRS confronts in litigation should not be remedied through the judicial rewriting of Rule 26(b)(3).

The brief was filed in a case where the Court has been asked to review an en banc First Circuit Court of Appeals ruling that the attorney work product doctrine does not shield from an IRS summons tax accrual work papers prepared by a company’s lawyers to support the calculation of tax reserves for audited financial statements filed with the SEC. Textron Inc. v. United States, Dkt. No. 09-750. In a 3-2 opinion, the full appeals court held that the purpose of the tax audit work papers was not to prepare for litigation, but rather to make book entries, prepare financial statements and obtain a clean audit.

The IRS has unfettered access to the facts necessary for it to audit the company’s return and to form its own conclusions about the propriety of the company’s reporting, noted the brief. But, emphasized the Foundation, in subpoenaing the company’s litigation tax reserve estimate work papers, including spreadsheets, supportive e-mails and notes, the IRS is seeking the mental impressions of the company’s tax attorneys, including assessments of the likelihood and possible outcomes of litigation. These documents disclose confidential attorney judgments concerning facts, law, and adversarial priority and strategy, noted the brief, and are the essence of what Rule 26(b)(3) is designed to protect. Further, disclosure of these attorney judgments would give an adversary an unfair advantage in settlement negotiations, in its pre-trial budgeting, and in its own trial risk assessment.

The company and its auditors were not adversaries, said the Foundation. In fact, the auditors had an interest in common with the potential litigant, while not in common with a potential adversary of the company. That a company has an independent legal obligation of disclosure to its auditors is of no consequence, reasoned the brief, as the district court below recognized when it correctly held that Textron had not waived work product protection.

Moreover, the fact that the auditor’s own reserve calculations may be discoverable under the Supreme Court’s ruling in United States v. Arthur Young & Co., 465 U.S. 805 (1984), which rejected an accountant-client privilege, is no reason to ignore the text of a federal rule as applied to a company lawyer’s work product disclosed in confidence to the auditor. Indeed, stressed the Foundation, the availability of auditor-created information under Arthur Young should negate any need for an exception to the protection of the corporate tax lawyer’s work product under Rule 26(b)(3).

Finally, the brief noted that Rule 26(b)(3) expressly protects from discovery documents prepared in anticipation of litigation or for trial. But the First Circuit ruled that documents drafted because of potential litigation qualify for work product protection only if they are prepared for use in possible litigation. Thus, argued the Foundation, the practical effect of the ruling is that tax reserve litigation assessment documents are not protectable because they are prepared to support tax figures for the audited SEC-filed financial statements and not for use in litigation. The Foundation contended that the First Circuit’s for use test is inconsistent with the federal rule because it ignores the protection expressly afforded documents prepared in anticipation of litigation.


Friday, March 26, 2010

Senate Financial Reform Legislation Provides for Say on Pay and Independent Compensation Committees

The Senate Banking Committee has reported out financial reform legislation that would enhance corporate governance and mandate increased transparency of executive compensation. The bill gives shareholders a say on pay with the right to a non-binding vote on executive compensation. This advisory vote on executive compensation is designed to give shareholders a powerful opportunity to hold accountable executives of the companies they own, and a chance to disapprove where they see the kind of misguided incentive schemes that threatened individual companies and, in turn, the broader economy.

The bill provides that the shareholder advisory vote on executive pay will not overrule a decision by the company or the board, or create or imply any change to, or addition to, the fiduciary duties of the directors, or restrict the ability of shareholders to make inclusion in proxy materials related to executive compensation.

The bill also authorizes, but does not require, the SEC to grant shareholders proxy access to nominate directors. It does require directors to win by a majority vote in uncontested elections, which should help shift management’s focus from short-term profits to long-term growth and stability

Most public companies currently elect directors using the plurality standard, by which shareowners may vote for, but not against, a nominee. If shareowners oppose a particular nominee, they may only withhold their votes. As a consequence, a nominee only needs one “for” vote to be elected and unseating a director is virtually impossible. Plurality voting in uncontested situations results in “rubber stamp” elections. Majority voting ensures that shareowners’ votes count and makes directors more accountable to shareowners.

Thus, the bill requires the SEC to adopt rules providing that in an uncontested election a director receiving a majority of the votes cast must be deemed to be elected. If a director fails to win a majority of the vote in an uncontested election, the director must tender his or her resignation to the board. Upon accepting the director’s resignation, the board must set a date on which the resignation will take effect in a reasonable period of time and publish such date within a reasonable period of time as established by SEC rule. If the board declines to accept the resignation, the board must disclose the specific reasons why it decided not to accept the resignation and why that decision was in the best interest of the company and its shareholders.

The Commission is authorized to exempt a company from any or all of these requirements based on the company’s size, its market capitalization, the number of shareholders of record, or any other criteria, as the Commission deems necessary and appropriate in the public interest or for the protection of investors.

It is widely acknowledged that a sound corporate governance practice is to bifurcate the roles of board chairman and CEO. Thus, the draft would direct the SEC to adopt rules requiring a company to disclose in the annual proxy sent to investors the reasons why it has chosen the same person to serve as chairman of the board of directors and chief executive officer or why it has chosen different individuals to serve as board chair and chief executive officer.

In a major corporate governance improvement, the draft mandates independent board compensation committees. The SEC must adopt rules requiring for exchange listing that compensation committees include only independent directors and have authority to hire compensation consultants. This provision is designed to strengthen their independence from the executives they are rewarding or punishing. In determining the independence of compensation committee members, SEC rules must require exchanges to consider the source of compensation and any affiliation with the company or any of its subsidiaries.

SEC rules must also allow an exchange to exempt a particular relationship from the independence requirements, taking into consideration the size of an issuer and any other relevant factors.

The compensation committee has sole discretion to hire and obtain the advice of a compensation consultant and is directly responsible for the compensation and oversight of the work of the consultant. However, the compensation committee cannot be required to implement or even act consistently with the advice or recommendations of the compensation consultant. At the end of the day, nothing can affect the ability or the obligation of a compensation committee to exercise its own judgment in the fulfillment of its duties.

Further, proxy or consent solicitation materials for an annual or special meeting of shareholders must disclose if the compensation committee retained or obtained the advice of a compensation consultant; and whether the work of the compensation committee has raised any conflict of interest and, if so, the nature of the conflict and how it is being addressed.

The legislation directs companies to provide appropriate funding, as determined by the compensation committee, for the payment of reasonable compensation to a compensation consultant; and to independent legal counsel or any other adviser to the committee

The bill would require public companies to set policies to claw back executive compensation if it was based on inaccurate financial statements that don’t comply with accounting standards. The measure also directs the SEC to clarify disclosures relating to compensation, including requiring companies to provide charts that compare their executive compensation with stock performance over a five-year period.

The SEC is also directed to adopt rules requiring a company to disclose whether any employee or director is permitted to purchase financial instruments, including derivatives such as equity swaps, that are designed to hedge or offset any decrease in the market value of equity securities granted to the employee or director by the company as part of the compensation of the employee or directors or held directly or indirectly by the employee or director.

The Managers
Amendment to the bill requires the SEC to amend Item 402 of Regulation S-K to mandate disclosure of the median of the annual total compensation of all employees, except the CEO; the annual total compensation of the CEO; and the ratio . The annual total compensation of an employee must be determined by reference to Item 402 of Regulation S-K. This disclosure is required in annual reports and proxy statements, among other filings.

The Managers Amendment also mandates that exchange rules must prohibit members that are not beneficial owners of a security from granting a proxy to vote the security in connection with a shareholder vote for the election of directors, executive compensation, or any other significant matter as the SEC may determine by rule, unless the beneficial owner of the security has instructed the member to vote the proxy in accordance with the voting instructions of the beneficial owner.

SEC Staff to Review Derivatives Use by Funds

The SEC Investment Management staff is reviewing the use of derivatives by mutual funds, exchange-traded funds and other investment companies. The review will examine if additional protections are necessary for those funds under the Investment Company Act.

The initiative will have a significant impact on new ETF applications. ETFs come to market through an exemption granted by the SEC under Investment Company Act Section 6(c). Pending the review's completion, the staff will defer consideration of new exemptive requests to permit ETFs that would make significant investments in derivatives. The staff's decision will affect new and pending exemptive requests from certain actively-managed and leveraged ETFs that particularly rely on swaps and other derivative instruments to achieve their investment objectives. The deferral does not affect any existing ETFs or other types of fund applications.

Elizabeth G. Osterman from the division staff emphasized this morning at the PLI SEC Speaks conference that the applications are being deferred and not denied. She stated that the Office of Investment Company Regulation, which is responsible for the review of exemptive applications, is not a rulemaking office. It was appropriate, however, for the staff to step back and examine the standards they apply to these requests.

"Although the use of derivatives by funds is not a new phenomenon, we want to be sure our regulatory protections keep up with the increasing complexity of these instruments and how they are used by fund managers," said Andrew Donohue, director of the SEC's Division of Investment Management. At the PLI conference this morning, Director Donohue stated that he was not being "judgmental" on derivatives use by funds, but he observed that the 1940 Act does not deal well with these instruments.

The staff generally intends to explore issues related to the use of derivatives by funds, including, among other things, whether

1) current market practices involving derivatives are consistent with the leverage, concentration and diversification provisions of the Investment Company Act,
2) funds that rely substantially upon derivatives, particularly those that seek to provide leveraged returns, maintain and implement adequate risk management and other procedures in light of the nature and volume of the fund's derivatives transactions,
3) fund boards of directors are providing appropriate oversight of the use of derivatives by funds,
4) existing rules sufficiently address matters such as the proper procedure for a fund's pricing and liquidity determinations regarding its derivatives holdings,
5) existing prospectus disclosures adequately address the particular risks created by derivatives, and
6) funds' derivative activities should be subject to special reporting requirements.

The staff also will seek to determine what, if any, changes in Commission rules or guidance may be warranted.

In Letter to Treasury, Senator Shelby Examines Resolution Regime in Senate Reform Bill

Senator Richard Shelby believes that the financial regulatory reform legislation reported out of the Banking Committee does not go far enough to end the ``too big to fail’’ problem and the moral hazard that comes with it and, indeed, institutionalizes the ``too big to fail’’ doctrine. In a letter to Treasury Secretary Tim Geithner, the Ranking Member said that the resolution regime erected by the bill does not ensure that taxpayers are protected from the costs of bailing out failed financial firms. For example, the senator pointed out that the bill provides the Federal Reserve with enhanced emergency lending authority that is open to abuse. Because the Fed is authorized to determine if collateral is satisfactory, it could provide widespread bailouts by making emergency loans against bad collateral. Senator Shelby was responding to the Secretary’s recent statement that the draft legislation meets the objectives that the senator laid out in remarks the senator made last year in a speech at the Oxford Union.

In the letter, Senator Shelby also noted that the bill authorizes the FDIC and Treasury to provide broad debt guarantees in times of economic distress when firms face a liquidity event. Because defaulting guarantee recipients are not required to be placed into FDIC receivership, bankruptcy or resolution, this broad authority would give the FDIC and Treasury a backdoor way to prop up failing institutions. In the senator’s view, a resolution regime can be credible only if the government does not have the authority to bail out failing firms.

Further, the bill sets up a $50 billion fund that, while intended for resolving failed firms, is available for any purpose Treasury sees fit. According to the senator, the mere existence of this fund will make it too easy to choose bailout over bankruptcy, which reinforces the expectation that government will intervene on behalf of large financial firms.

The legislation also charges the Fed with special oversight of firms with assets over $50 billion as well as other systemically significant financial firms. In the senator’s view, the market will view these firms as too big to fail and implicitly backed by the federal government. Senator Shelby viewed this as akin to setting up dozens of new government sponsored enterprises that will inevitably receive funding advantages.

In his
remarks to the American Enterprise Institute, Secretary Geithner quoted Senator Shelby’s earlier remarks calling for a resolution regime for large failing financial institutions that provides clarity to creditors and to the market and operates similarly to bankruptcy proceedings, with clearly delineated procedures for settling claims. The Ranking Member said that a well crafted resolution regime may require rapid access to liquidity to provide confidence to counterparties, thus reducing the need to redeem short-term claims in the face of dwindling assets. As with deposit insurance, assurances must come at a cost to those needing the resources, not at a cost to taxpayers.

The financial reform package passed by the House last year would create a resolution authority to wind down large, interconnected, financial companies in an orderly manner. The legislation thus seeks to end “too big to fail” by empowering federal regulators to rein in and dismantle financial firms that are so large, interconnected, or risky that their collapse would destabilize the entire U.S. financial system. Legislative history indicates that there is nothing in the legislation that allows a failing institution to be continued with federal money. HR 4173 creates a dissolution fund, not a bailout fund.


Thursday, March 25, 2010

UK and France Ask US Supreme Court Not to Expand Extraterritorial Reach of Federal Securities Laws

With oral argument looming in a case involving a foreign investor’s action arising out of a foreign company’s securities offering on a foreign exchange, the U.K. and the Republic of France have asked the U.S. Supreme Court not to allow the application of the federal securities laws to these "foreign-cubed" actions. In separate amicus briefs, the U.K. and France cited international comity in urging the Court not to allow the application of Rule 10b-5 to upset the delicate balance that foreign nations have struck in regulating securities fraud and thereby offend the sovereign interests of foreign nations.

The Supreme Court has scheduled oral argument for March 29, 2010 on the extraterritorial reach of the U.S. federal securities laws in what appears to be the first foreign-cubed case to ever reach the Court. The Court is reviewing a Second Circuit panel ruling that the US federal securities laws did not apply to foreign investors alleging fraudulent statements by a foreign issuer when the conduct in the U.S. was merely preparatory to the fraud and the acts directly causing loss to investors occurred outside the U.S. Morrison v. National Australian Bank, Ltd., CA-2, Dkt. No. 08-1191

The U.K. argued that the proper recognition of the sovereignty of other nations, the development of sophisticated regulation of the issuance and trading of securities within numerous nations, the globalization of capital markets, and international comity all combine to support a finding that the U.S. federal courts lack jurisdiction to consider foreign-cubed cases. The Court should rule that foreign purchasers of securities on a foreign exchange who are injured by misleading statements made outside of the United States by a foreign issuer have no private right of action under Rule 10b-5.

It was argued that the U.K. and France have sophisticated financial regulatory systems and substantive and procedural rules for remedying securities fraud and their approach to securities regulation and litigation differs in important respects from that of the U.S. Moreover, these differences represent legitimate policy choices and sovereign interests that ought to be respected by the United States.

Thus, under the major national regulatory schemes, issuers face different substantive disclosure requirements and plaintiffs confront different burdens in establishing a contravention of those requirements. Such differences arise even as between jurisdictions that have well-developed securities regulatory regimes, such as the U.K. and the U.S.

Further, jurisdiction in U.S. courts brings a host of procedural ramifications that are potentially inconsistent or in conflict with the policy choices made in other jurisdictions, including France and the U.K. Such matters include the scope of discovery, the availability of class actions or other forms of multi-party litigation, and the availability of opt-out classes.

Nations have a strong interest in regulating their own capital markets, developing disclosure rules to govern their own issuers, deciding how and when class action shareholder litigation should occur and determining the penalties for violations of such laws. Such decisions vary among countries with different regulatory, legislative and financial concerns. U.S. judicial interference in those decisions risks damaging the mutual respect that comity is meant to protect and could be perceived as an attempt to impose American economic, social and judicial values Expansive extraterritorial application of the Rule 10b-5 private right of action risks undermining the kind of global regulatory cooperation that the current economic situation demands and the G-20
calls for.

Perhaps most importantly, sovereign nations should be allowed and expected to use their own well-developed legal and regulatory regimes to address alleged securities fraud. A failure to recognize that other valid enforcement regimes exist as an alternative to the expansion of the Rule 10b-5 private right of action threatens the legitimacy of the U.S. legal system, as well as that of the legal and regulatory regimes of other sovereign nations.

The French brief also argued that allowing foreign-cubed securities actions could unfairly expose foreign companies to different regulation than their own governments have decided is fair. Especially troubling is the potential for U.S. courts to hand down large damages in a foreign-cubed case that would greatly exceed what would be available in the company’s home jurisdiction and may substantially affect the foreign company’s financial condition. Most foreign nations have erected their own regulatory methods to combat fraud, said amici, sometimes specifically rejecting the U.S. approach of private actions by plaintiffs’ attorneys working on a contingency fee basis.

France rejected the argument that ruling against U.S. jurisdiction in a foreign-cubed case would make the US a haven for fraud. In foreign-cubed securities frauds, noted the brief, the foreign country on whose exchange the fraud took place will provide a remedy for the securities fraud in accordance with its own laws. If related fraud occurs in the U.S., that separate fraud can be addressed by U.S. authorities.

10th Circuit: Protective Orders Precluded Sharing Information Obtained in SEC Action with IRS

A 10th Circuit panel found that the U.S. Attorney's Office improperly disclosed confidential information to the IRS in violation of two protective orders. These orders were entered to safeguard personal financial information provided to a receiver in an SEC enforcement action by the victim of a securities fraud scheme. The IRS then obtained the information from the U.S. Attorney in the course of an investigation into possible tax avoidance by the investors in the scheme. (SEC v. Merrill Scott & Associates)

Dr. Richard Gerber invested money with Merrill Scott & Associates under a nominee arrangement promising large tax savings. The SEC subsequently sued Merrill Scott for securities fraud. A receiver in the SEC took charge of Dr. Gerber's assets. In order to recover these assets, Dr. Gerber agreed to provide certain personal and confidential financial information to the receiver. The district court entered two protective orders to safeguard the confidentiality of this information, which found its way into the hands of the IRS.

The initial protective order provided that all confidential information supplied by Dr. Gerber, including documents and deposition testimony, would be used solely for the purpose of litigating the SEC action and related litigation commenced by the receiver or the SEC, and for no other purpose, including “any other legal proceedings.” The order did provide, however, that it could be disclosed to the U.S. Attorney. The second protective order included similar language that it would be “used solely for purposes directly related to this action.”

After obtaining the confidential information from the U.S. Attorney's office, the IRS issued a number of third-party administrative summonses to banks, law firms, and brokerages concerning Dr. Gerber’s tax liability. In response, Dr. Gerber filed a motion with the district court for return of all documents allegedly disseminated in violation of the protective orders. In ruling against Dr. Gerber, the district court relied in part on the SEC’s alleged “statutory and regulatory obligation” to share information with other governmental law enforcement agencies.

The 10th Circuit rejected this conclusion as an abuse of discretion. While the alleged obligation was reflected in the plain language of the orders permitting sharing of information with specified agencies for limited purposes, the court found that "it will not support the nearly unlimited construction placed on it by the government. The assertion of a law enforcement purpose is insufficient, without more, to justify actions in derogation of a valid protective order."

The statutory provisions allowing the SEC to share information, including Securities Act Section 20(b) and Exchange Act Sections 21(d)(1) and 24(c) are permissive rather than mandatory, noted the court. The permissive nature of the SEC’s ability to share information did not provide an extrinsic limit on the SEC’s ability to enter into binding protective orders. "The SEC can certainly make a discretionary decision to forego its opportunity to share documents with others, including law enforcement agencies," stated the 10th Circuit.

Arguments that the U.S. Attorney could not be bound by the orders because it was not a party to the proceedings also failed. While in general a non-party is not bound by a protective order, the court stated that these orders clearly contemplated that the U.S. Attorney would only receive the information in question pursuant to their terms. As stated by the court, "we therefore cannot accept the government’s argument that would permit it unlimited use of the confidential information simply by passing it through the U.S. Attorney.

The panel also observed that a showing of extraordinary or unusual circumstances is generally necessary in order to permit the government to benefit from access to confidential information provided pursuant to a protective order. The government failed to identify the presence of such unusual or extraordinary circumstances in this case, concluded the court.

IASB Chair Reaffirms US GAAP-IFRS Convergence against Backdrop of New IFRS 9 for Measuring Financial Instruments

As a second major wave of IFRS adoptions in Canada, Brazil, Japan and other countries begins this year, IASB Chair David Tweedie said that the convergence of US GAAP and IFRS is proceeding and intensifying. In remarks before the European Union’s Economic and Financial Affairs Council (ECOFIN), Chairman Tweedie also discussed the ongoing replacement of IAS 39 with IFRS 9, a new standard for measuring financial instruments.

As an example of the recently intensified activity between FASB and the IASB, the two Boards are now meeting together every month and have had more than 100 hours of joint meetings since last November. In March, the Boards are meeting jointly for three consecutive afternoons by video, and then for three consecutive days in person in London the following week. These intensive discussions are achieving positive results, said the IASB Chair, and the Boards plan to publish seven joint proposals in the next quarter. The Boards individually will also propose other changes to bring their own standards in line with each other.

Noting that the IASB does not want IFRSs to be a constantly moving target, the Chair said that completing the convergence work in 2011 will provide a period of stability of accounting standards for newly adopting countries, similar to the stable platform given to European companies and investors between 2004 and 2009. He praised the SEC’s recent reaffirmation of the US commitment to make a decision in 2011 to adopt IFRSs by 2015 or 2016.

Turning to the very important work of reforming fair value accounting, the Chair said that the new IFRS 9 on measuring financial instruments addresses the call of the G-20 Leaders to reduce the complexity of accounting standards for financial instruments. This is the first phase of reforming IAS 39.

IFRS 9 uses a single approach to determine whether a financial asset is measured at amortized cost or fair value, replacing the many different rules in IAS 39. The approach in IFRS 9 is based on how a firm manages its financial instruments, its business model, and the contractual cash flow characteristics of the financial assets. The Board also decided not to bifurcate hybrids containing embedded derivatives.

The IASB Chair assured that IFRS 9 will not result in an increase in the use of fair value. In IFRS 9, the IASB does not seek to either increase or decrease the use of fair value accounting in overhauling the accounting for financial instruments, he emphasized, rather the goal is to find the right balance and establish appropriate criteria for determining whether to use cost or fair value. The decision depends upon whether cost or fair value provides the most useful information about likely future cash flows. He noted that this is consistent with the business model approach advocated by the European Commission and the Basel Committee.

Under IFRS 9, except in the narrow circumstance where the fair value option is selected by the institution, cost based measurement is required when a financial asset has predictable cash flows and if the objective of the holder is to collect principal and interest over the life of the asset rather than to collect cash proceeds from sale. For a traditional bank that takes deposits and lends money to customers that it holds to collect principal and interest, the IASB expects IFRS 9 to result in fewer items being measured at fair value.

Those concerned about the expansion of fair value seem to be concerned primarily about the potential treatment of financial liabilities. At the suggestion of the European Commission, the IASB removed the treatment of liabilities from IFRS 9. Moreover, the Chair said that the decisions the IASB has made to date for financial liabilities post the publication of IFRS 9 would not result in an increase in the use of fair value in the measurement of financial liabilities.

EU financial institutions raised concerns regarding the decision to prohibit the bifurcation of embedded derivatives on the asset side of the balance sheet. But the IASB Chair said that this was done with the support of the great majority of stakeholders, who viewed the bifurcation as unduly costly and complex. Because the same decision on the liability side may have increased the use of fair value, the IASB retained the bifurcation of embedded derivatives for liabilities.

IFRS 9 does not allow for recycling of realized gains and losses relating to strategic investments when an entity chooses to recognize changes in fair value in Other Comprehensive Income. While both the ECB and the Basel Committee would have preferred the IASB to permit these gains and losses to be recycled to the profit and loss account, noted the Chair, the IASB decided not to allow recycling for two main reasons.

First, recycling distorts current year profits. If you have held an investment for 30 years, reasoned the Board, it is not right to recognize a one-off gain in year 30 just because the investment has been sold at that time. Economically the gain was amassed over the 30 year period. Secondly, this approach would have meant that the IASB would have to reintroduce the concept of impairment for equity investments. Problems with recycling and impairment accounting under IAS 39 were the catalyst for the IASB’s overhauling accounting for financial instruments on an expedited basis.

Noting the ECOFIN’s concern that the IASB and FASB may arrive at different conclusions when financial instruments should be measured at fair value, the Chair said that both Boards have agreed on common principles to help achieve a common standard. That is the objective. At the same time, he emphasized that the IASB is conscious of the strongly held view of investors and other international stakeholders that a combination of cost-based and fair value accounting remains appropriate for financial instruments.


Wednesday, March 24, 2010

Key Senator Scores Protectionist EU Proposed Hedge Fund Directive

Joining the growing outcry over protectionist tendencies in the proposed EU Directive regulating hedge funds, Senator Charles Schumer, a key member of the Banking Committee, expressed deep concern that the Directive would overtly discriminate against US hedge funds. In a letter to Treasury Secretary Tim Geithner, he said that the multiple proposals under consideration would all have the effect of significantly limiting or even prohibiting non-EU investment funds from marketing in the EU, despite the fact that EU-based funds have full access to US markets.

If the EU adopts protectionist rules that discriminate against U.S. firms and activities, Sen. Schumer said he will ask Congress to pass equivalent legislation, including measures prohibiting funds that are not headquartered in the U.S. from marketing and raising money in the US and requiring all funds operating in the U.S. to use only U.S.-headquartered custodian banks.

Sen. Schumer urged Treasury to work with Commissioner Barnier, the European Council and the European Parliament to ensure the adoption of provisions that will not discriminate against U.S. firms. Just as EU-based funds and custodian banks currently have full access to US markets, he emphasized, U.S.-based funds and custodian banks should similarly not arbitrarily be denied access to the European market.

The senator endorsed Secretary Geithner’s earlier letter to European Commissioner Michel Barnier, in which the Secretary expressed concern over provisions in the proposed Alternative Investment Funds Management Directive that would discriminate against US hedge funds and deny them the access to the EU market that they currently enjoy. The Secretary urged the Commission to adopt rules ensuring that non-EU fund managers and global custodian banks have the same access to their EU counterparts.

The Secretary pointed out that the US reform legislation will maintain full access to the US market for EU fund managers and custodians. More broadly, he said that it was essential to fulfill the G-20 commitment to avoid discrimination and maintain a level playing field in regulating the alternative investment fund management industry.

Manager Amendments to Senate Reform Bill Give Systemic Risk Regulator Derivatives Role and Streamline SRO Process

The Managers Amendment to the Senate Banking Committee draft reform bill gives the new Financial Stability Oversight Council veto power over SEC and CFTC exemptions from the derivatives regulation regime. For example, the amendment provides that the Commission can exempt a security-based swap only of if the Commission has provided a written notice to the Council describing the proposed exemption and the Council has not made a determination that the exemption would pose a threat to the stability of the US financial system The Council has 60 days to make such a determination.

Another Managers Amendment would help streamline the process for SRO rule approvals. The amendment provides that if, after filing a proposed rule change with the SEC, a self-regulatory organization publishes a notice of the filing of such proposedrule change, together with the substantive terms of the change, on a publicly accessible website, the Commission must send the notice to the Federal Register for publication within 15 days of the date on which the website publication is made. If the Commission fails to send the notice for publication within such 15 day period, then the date of publication must be deemed to be the date on which such website publication was made.

An amendment to the SEC whistleblower provisions would deny an award to any whistleblower who gains the information through the performance of an audit of financial statements required under the securities laws and for whom such submission would be contrary to the requirements of section 10A of the Securities Exchange Act.


Tuesday, March 23, 2010

Federal Appeals Court Construes Sarbanes-Oxley Whistleblower Protections

In deciding that an employee of the American Medical Association was not protected by the whistleblower protections of Sec.806 of Sarbanes-Oxley, a Seventh Circuit panel rejected the notion that the phrase “contractor, subcontractor, or agent” in Sec. 806 means anyone who has any contact with a company that issues securities under SEC regulations. Fleszar v. US Department of Labor, CA-7, No. 09-2423, March 23, 2010.

The statute extends its protection to SEC registered companies or those required to file reports with the SEC and their contractors, subcontractors or agents. It was conceded that the AMA was not an SEC issuer or filer. But the employee believed that an investigation by a "team of bloodhounds" at the Department of Labor might turn up facts showing that the AMA is a contractor, subcontractor, or agent covered by Sec. 806.

While noting the employee’s belief that it would improve enforcement of Sarbanes-Oxley if the Secretary were more aggressive in nosing out violations, the panel said that the federal courts are not in the business of inventing procedures that agencies must follow It is enough to enforce the statutes and regulations on the books. An agency must be allowed the authority to decide where its investigative and prosecutorial resources are best applied.

Further, in the court’s view, the phrase “contractor, subcontractor, or agent” refers to entities that participate in the company's activities. The idea behind such a provision, reasoned the panel, is that a covered firm, such as IBM, can’t retaliate against whistleblowers by contracting with an "ax-wielding specialist’’ such as the character George Clooney played in “Up in the Air”. Nothing in Section 806 implies that if the AMA buys a box of rubber bands from Wal-Mart, a company with traded securities, the AMA thereby comes with the scope of the whistleblower statute.

But whether or not this is the right way to understand "contractor, subcontractor, or agent”, the employee did not produce evidence that the AMA fits this category, and the Secretary was not legally obliged to assist her.

Dodd's Reform Bill Would Weaken Federal Preemption of Rule 506 of Reg. D

Senator Chris Dodd's Reform Bill in the Senate Banking Committee would weaken federal preemption of Rule 506 of Regulation D under Section 18(b)(4)(D) of the NSMIA Act of 1996 by:

* Requiring the SEC to designate that certain Rule 506 offerings not qualify as "covered securities" because of their size, the number of states that would contain them and the types of offerees that would receive them.

* Requiring the SEC to review Rule 506 offerings within 120 days, with an offering losing its covered security status if the SEC fails to do that review unless a state securities commissioner determines either that the issuer's made a good faith effort to comply with the offering's terms or that the terms not complied with are insignificant when compared to the entire offering.

* Permitting states to impose notice filing requirements "substantially similar to the filing requirements mandated by Section 4(4) rules or regulations in effect on September 1, 1996"; and

* Requiring the SEC to create procedures not later than 180 days after the Act is adopted, to promptly notify the States after consulting with them of the completion of the SEC's review of Rule 506 filings.

This Reg. D provision in Senator Dodd's bill will no doubt be hotly debated especially by the North American Securities Administrators Association and private industry.


Monday, March 22, 2010

Senate Banking Committee Reports Out Financial Reform Bill with Kohl Financial Planner and Senior Investor Protection Amendments

The Senate Banking Committee has reported out financial reform legislation on a partisan 13-10 vote. One of the few if only amendment to the revised draft recently set out by Committee Chair Chris Dodd was offered by Senator Herb Kohl. The Kohl Amendment would mandate a GAO study of the regulatory regime for financial planners as part of the Restoring American Financial Stability Act.

Under Kohl’s provision, the GAO will examine current oversight of the financial planning industry at the state and federal level. It will consider whether financial planning services are being provided by individuals who are licensed for other professions, including insurance and investment advice, and to what degree consumers are aware of the different services being provided. Additionally, the study will look at professional standards currently governing financial planners and financial advisors. The GAO has also been asked to identify both regulatory and legislative fixes to any gaps in regulation that would strengthen oversight of financial planners. The study will report to the Special Committee on Aging, as well as the Senate Banking Committee.

Senator Kohl was also successful in including a provision protecting seniors from fraud at the hands of unscrupulous financial advisors. The provision is based on S. 1661, the Senior Investor Protection Act, which calls for the creation of a new grant program to assist states in their efforts to protect seniors from misleading financial advisor designations. The House included similar provisions in H.R. 4173, the Wall Street Reform and Consumer Protection Act, which passed the House on December 11. 2009.

Title V, Subtitle C, Part 7 of HR 4173 would create a new grant program to provide states with the tools they need to prosecute securities fraud against seniors. The legislation recognizes the harm to seniors posed by the use of misleading professional designations by salespersons and advisers and establishes a mechanism for providing grants to states designed to give them the flexibility to use funds for a wide variety of senior investor protection efforts, such as hiring additional staff to investigate and prosecute cases; funding new technology, equipment and training for regulators, prosecutors, and law enforcement; and providing educational materials to increase awareness and understanding of designations.

New Briefing Paper Describes Jobs Bill Impact

A new
briefing paper by Principal Analyst Jim Hamilton discussing the impact of the "Hiring Incentives to Restore Employment Act," or HIRE, is now available. The jobs bill, signed into law by the president on March 18, 2010, creates a new reporting and taxing regime for foreign financial institutions with U.S. accountholders. A provision of the bill, the Foreign Account Tax Compliance casts a wide net in search of undisclosed accounts and hidden income.

The reporting and withholding obligations imposed on the foreign financial institutions will serve as a backstop to the existing obligations of the U.S. persons themselves, who have a duty to report and pay U.S. tax on the income they earn through any financial account, foreign or domestic. These new reporting obligations for financial institutions will be enforced through the imposition of a 30-percent U.S. withholding tax on a wide range of U.S. payments to foreign financial institutions that do not satisfy the reporting obligations.


Sunday, March 21, 2010

Key Senators to Offer Amendments during Markup of Revised Draft of Financial Reform Bill

With almost 400 amendments filed to the Senate Banking Committee’s revised draft of the financial reform bill, a number of key Senators plan to offer significant amendments during the bill’s mark up.

Senator Charles Schumer intends to offer amendments enhancing the corporate governance provisions of the draft. The revised draft currently gives shareholders an advisory non-binding vote on executive pay. The Schumer amendments would require a shareholder vote on a company’s golden parachute policies. The original draft provided for a separate shareholder advisory vote for golden parachute agreements in connection with a takeover. Similarly, the House reform bill passed on December 11, 2009, requires a shareholder advisory vote on golden parachutes.

The revised draft authorizes the SEC to grant shareholders proxy access to nominate directors. The Schumer amendments would require the SEC to adopt shareholder proxy access regulations within one year of enactment. The original draft required that, within, 180 days of enactment, the SEC must issue rules permitting the use by shareholders of management proxy solicitation materials for the purpose of nominating individuals to the board of directors, under such terms and conditions as the Commission determines are in the interest of shareholders and the protection of investors. The House legislation authorizes the SEC to issue proxy access regulations regarding the nomination of directors by shareholders to serve on a company’s board of directors.

The revised draft also requires directors to win by a majority vote in uncontested elections, which should help shift management’s focus from short-term profits to long-term growth and stability. If a director fails to win a majority of the vote in uncontested election, the directors must tender his or her resignation to the board. If the board declines to accept the resignation, the board must disclose the specific reasons why it decided not to accept the resignation and why that decision was in the best interest of the company and its shareholders. The Schumer amendments would eliminate the ability of a board of directors to reject a director’s resignation following the director’s failure to receive a majority of votes cast in an uncontested election.

Committee Chair Thomas Dodd will offer an amendments requiring two GAO studies. The first will require a GAO study and recommendations on the potential for conflicts of interest between securities underwriting and the securities analysis function within a financial firm. The second study will require GAO to study the accounting for off-balance sheet finance. Another Dodd amendment would require the establishment of minimum underwriting standards.

An amendment to be offered by Ranking Member Richard Shelby would exclude the auditors of introducing brokers from the requirement that the auditors of broker-dealers register with the PCAOB. Another Shelby amendment would require municipal advisors to register with the SEC rather than the MSRB. In another amendment, Sen. Shelby would require the SEC and CFTC to merger into a single regulator.

An amendment by Senator Bob Corker would add accounting standards to the items to be examined in the Financial Stability Oversight Council’s Review of financial institutions. Sen. Corker would also include GSEs in the definition of financial company and establish a Financial Company Resolution Court, outright prohibit the securitization of subprime mortgages, and order a study on securitization.


Friday, March 19, 2010

Both House and Senate Reform Bills Would Close Sarbanes-Oxley Whistleblower Loophole

The revised draft financial reform legislation being considered in the Senate Banking Committee would close a loophole in Sarbanes-Oxley Act whistleblower protection by including any subsidiary or affiliate of a company whose financial information is included in the consolidated financial statements of the company. See Section 929A. The provision in the Senate bill is identical to a provision in the reform legislation the House passed on Dec. 11, 2009. See Section 7607. Sarbanes-Oxley created federal whistleblower protections for employees when they disclose information about fraudulent activities within their companies. The Act would eliminate a defense now raised in a substantial number of actions brought by whistleblowers and apply the Sarbanes-Oxley whistleblower protections to both companies and their subsidiaries and affiliates. A letter from Senator Patrick Leahy, author of the Sarbanes-Oxley whistleblower statute, to the Department of Labor emphasized that federal whistleblower protection extends to employees of subsidiaries of companies and that the DOL should not interpret the statute to exclude employees working for company subsidiaries.


Thursday, March 18, 2010

SEC Warns Firms on Municipal Pay-to-Play Rules

The Securities and Exchange Commission issued a
report warning firms that municipal securities rules prohibiting pay-to-play apply to affiliated financial professionals, not just a firm's employees. The pay-to-play rule, MSRB Rule G-37, generally prohibits firms from underwriting municipal bonds for an issuer for two years after a municipal finance professional involved with that firm makes a campaign contribution to an elected official of that municipality.

In the report, the SEC stated that executives who supervise the activities of brokers, dealers or municipal securities dealers are not exempt from the MSRB's pay-to-play rule just because they may be outside the firm's corporate governance structure. As such, they may be deemed an MFP if they were not part of a broker-dealer, but oversee the broker-dealer from the vantage of the holding company.

“Firms and associated persons must adhere strictly to municipal securities pay-to-play rules,” said Robert Khuzami, director of the SEC’s Division of Enforcement. “Firms cannot rely solely upon titles or organizational charts in determining whether a person is subject to those rules,” he added.


Wednesday, March 17, 2010

Corporation Finance Updates C&DIs, Issues New Staff Legal Bulletin

The Corporation Finance staff added three new compliance and disclosure interpretations to its advice on Regulation S-K. New Questions 119.25 and 119.26 relate to executive compensation disclosure in the summary compensation table, while new Question 133.12 deals with compensation consultant fees. The staff also issued a new legal bulletin on the suspension of reporting duties.

C&DI Updates

In Question 119.25, a company granted annual non-equity incentive plan awards to its executive officers. The officers were informed of the performance criteria, which were based on the company's financial performance for the year. They will not, however, know the total amount earned pursuant to the award until the end of the year, when the compensation committee can determine if the performance criteria have been satisfied.

In this example, one officer declined the award after the amounts are determined and communicated. The staff advised that the award should still be included in total compensation for purposes of determining if the executive is a named executive officer for 2010. The award should also be reported in the Grants of Plan-Based Awards Table and the Summary Compensation Table for 2010. The officer's decision not to accept payment of the award did not change the fact that award was granted in and earned for services performed during 2010. The amount of the award, even though declined, should be included in total compensation for purposes of determining if the executive is a named executive officer for 2010 and reported in the Summary Compensation Table. The company should also disclose the executive's decision not to accept payment of the award, and should consider discussing the effect, if any, of the executive's decision on how the company structures and implements compensation to reflect performance.

Question 119.26 involved a company that granted discretionary bonuses to its executive officers. An officer notified the board that she will decline any bonus for 2010 before the board acted on any such awards. According to the staff, because the executive declined the bonus before it was granted, the company need not report in column (d) of the Summary Compensation Table the bonus award it would have granted her and include that amount in total compensation for purposes of determining if she is a named executive officer for 2010.

In Question 133, the staff advised that there are no limits on the types of services that are included in "additional services" to determine if compensation consultant fees must be disclosed. In addition, if the consultant also sells products to the company, then the revenues generated from such sales should be included in "aggregate fees for any additional services provided by the compensation consultant or its affiliates.

Staff Legal Bulletin Advises on Reporting Suspensions

The Corporation Finance staff issued Staff Legal Bulletin No. 18 to advise on the use of Rule 12h-3 to suspend their reporting obligations under Exchange Act Section 15(d).

When an issuer's registration statement becomes effective, Section 15(d) requires the issuer to file reports with respect to each class of securities covered by the registration statement. Issuers may utilize the suspension provided by Rule 12h-3 at any time during the issuer's fiscal year if it meets the conditions of the rule.

The legal bulletin is an attempt by the staff to streamline the Rule 12h-3 no-action process. The staff identifies specific circumstances and conditions in which no-action relief will not be necessary. The staff will, however, "continue to entertain questions regarding the availability of Rule 12h-3 for situations that fall outside the facts and conditions discussed in the legal bulletin."

Lawyer's Dismissal Was Not Unlawful Retaliation Under Sarbanes-Oxley Act

A former general counsel did not suffer unlawful retaliation under the Sarbanes-Oxley Act, concluded a federal district court (DC Md, Harkness v. C-Bass Diamond, LLC, Civil Action No. CCB-08-231.) Cynthia L. Harkness could not recover because her reports concerning alleged improper conduct by the company and its CEO were not protected activity under the statute's whistleblower provision.

Harkness was general counsel of Fieldstone Investment Corp., a company that was in the process of going public (Fieldstone subsequently merged into the named defendant). Fieldstone had not yet effectively registered with the SEC at the time of the events that formed the basis of her first allegation, however. She learned that the company's CEO, Michael J. Sonnenfeld, communicated non-public information about a possible earnings restatement to an outside investor. She interviewed the sources of this information and the CEO, and reported to the audit committee chairman what she believed might be a violation of Regulation FD.

After these events, the relationship between Sonnenfeld and Harkness deteriorated. Harkness claimed that Sonnenfeld began to criticize her legal advice and treat her in a generally hostile manner. The company also excluded her from management meetings and actions, and reduced her responsibilities prior to terminating her employment.

Judge Catherine Blake initially found that her reports concerning the alleged Regulation FD violation were not supported by an objectively reasonable belief that the conduct constituted a violation of the relevant law. The applicability of the regulation was in doubt because Fieldstone was not a public company at the time of the disclosures. The general counsel did not investigate or research the applicability of Regulation FD before contacting the audit committee chairman. While it is not necessary to have conclusive proof of the violation when reported, her belief could not be reasonable as a matter of law in light of "the undisputed fact that Ms. Harkness had the resources available to her to help clarify this threshold question, but failed to utilize them."

Her reports to the audit committee that she was unable to verify that the company was complying with its legal obligations because she was excluded from meetings and events was also not protected conduct. Judge Blake agreed with Harkness that a company "which restricts its flow of pertinent information to its general counsel is at a greater risk of flouting its legal obligations," but she concluded that "such an enhanced risk does not in and of itself constitute a violation of federal securities law." Because she could identify no specific illegal conduct, her claims failed.

Congress Passes Jobs Bill Creating New Reporting and Taxing Regime for Foreign Financial Institutions

Congress has passed and sent to the President the Hiring Incentives to Restore Employment Act (HIRE), HR 2847, creating a vast new reporting and taxing regime for foreign financial institutions with U.S. accountholders. The House passed the bill on March 4, 2010 by a vote of 217-201. Yhe Senate passed the bill on March 17, 2010 by 68-29. Under Title V, the Foreign Account Tax Compliance Act, the legislation casts a wide net in search of undisclosed accounts and hidden income. It 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. Participation in the existing Treasury Qualified Intermediary program will not exempt a firm from the new reporting obligations.

The legislation’s principal focus is tax compliance by U.S. persons that have accounts with foreign financial institutions. The Act imposes substantial new reporting and tax-withholding obligations on a broad range of foreign financial institutions that could potentially hold accounts of U.S. persons. The reporting and withholding obligations imposed on the foreign financial institutions will serve as a backstop to the existing obligations of the U.S. persons themselves, who have a duty to report and pay U.S. tax on the income they earn through any financial account, foreign or domestic.

These new reporting obligations for financial institutions will be enforced through the imposition of a 30-percent U.S. withholding tax on a wide range of U.S. payments to foreign financial institutions that do not satisfy the reporting obligations.

The legislation provides substantial flexibility to Treasury and the IRS to issue regulations detailing how the new reporting and withholding tax regime will work. It also gives Treasury broad authority to establish verification and due-diligence procedures with respect to a foreign financial institution’sidentification of any U.S. accounts.

New Chapter 4 also provides for withholding taxes as a means to enforce new reporting requirements on specified foreign accounts owned by specified U.S. persons or by U.S.-owned foreign entities. The provision establishes rules for withholdable payments to foreign financial institutions and for withholdable payments to other foreign entities. The Act will essentially present foreign financial institutions, foreign trusts and foreign corporations with the choice of entering into agreements with the IRS to provide information about their U.S. accountholders, grantors and owners or becoming subject to 30-percent withholding.

The legislation will increase the disclosure of beneficial ownership. As a tax enforcement tool, U.S. financial institutions must file annual information returns disclosing and reporting on the activities of bank accounts held by U.S. individuals. Congress believes that many Americans looking to evade their tax obligations in the United States have sought to hide income and assets from the IRS by opening secret foreign bank accounts with foreign financial institutions.

The HIRE Act defines “foreign financial institution” broadly to include many securities firms and investment vehicles. 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 on U.S.-source dividends, interest and other income, as well as U.S.-related gross proceeds. The Act also imposes related reporting and tax withholding requirements in respect of payments made to non-financial foreign entities.

The reach of the legislation goes beyond traditional financial institutions and covers virtually every type of foreign investment entity. 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. The new regime also covers fund entities and fund managers who are not currently within the scope of the Qualified Intermediary program.