Commentary and musings on the complex, fascinating and peculiar world that is securities regulation
Saturday, June 30, 2012
President’s FY 2013 Budget Would Repeal LIFO Accounting, Conforming to IFRS
President
Obama’s proposed FY 2013 Budget would repeal the last-in, first-out (LIFO) inventory
accounting method under which it is assumed that the last items entered into the
inventory are the first items sold. Unlike U.S. GAAP, IFRS reporting standards
do not treat LIFO as a permitted method of accounting. The SEC has
indicated its support for global accounting standards and it continues to work
toward making a determination as to whether, when, and how to further
incorporate IFRS into the U.S.
financial reporting system. The Joint Senate-House Committee on Taxation has
noted that the potential shift from GAAP to IFRS raises the issue of whether
companies will be able to continue using LIFO for tax purposes in light of the
conformity requirement.
Friday, June 29, 2012
Chairman Schapiro Testifies JOBS Act Title II Rules Near But May be Late
The Jumpstart Our Business Startups (JOBS) Act, which became
law April 5, 2012, requires the Commission to engage in several rulemakings. In
the near term, the SEC must adopt rules to implement Title II within 90 days
after enactment. The Commission has not yet proposed any JOBS Act rules, but the
Title II rules are due on or about July 4, 2012.
In testimony on June 28, 2012 before the U.S. House
Subcommittee on TARP, Financial Services and Bailouts of Public and Private
Programs, SEC Chairman Mary L. Schapiro stated:
"The rulemakings to revise Rule 506
and Rule 144A are both required to be completed within 90 days of enactment of
the JOBS Act. As I stated to Congress prior to the passage of the Act, time
limits imposed by the JOBS Act are not achievable. Here, the 90 day deadline
does not provide a realistic timeframe for the drafting of the new rule, the
preparation of an accompanying economic analysis, the proper review by the
Commission, and an opportunity for public input. Although we will not meet this
deadline, the staff has made significant progress on a recommendation and
economic analysis, and it is my belief that the Commission will be in a
position to act on a staff proposal in the very near future."
Title II directs the Commission to remove the ban on general
solicitation or general advertising stated in Securities Act Rule 502(c) of
Regulation D for offers and sales of securities made under Rule 506 of Regulation
D. Amended Rule 506 must require all purchasers of these securities to be
accredited investors. The rules also must require an issuer to take reasonable
steps to verify the accredited investor status of any purchasers, using methods
to be determined by the Commission. Rule 506 must continue to be treated as
issued under Securities Act Section 4(2).
Title II also requires the Commission to amend Securities Act Rule 144A(d)(1) to provide that securities sold under the revised exemption may be offered (including by general solicitation or advertising) to persons who are not qualified institutional buyers (QIBs), but these securities may be sold only to persons the seller (or any person acting on the seller’s behalf) reasonably believes are QIBs.
President Issues Veto Message on House SEC Funding Legislation
President Obama said
that he would veto House legislation funding the SEC $245 million below his FY 2013 Budget request,
including a provision preventing obligation of funds from the Commission's
non-appropriated Reserve Fund.
More generally, said
the President, HR 6020 would severely undermine key investments in financial
oversight and implementation of Wall Street reform to protect American
consumers, as well as needed tax enforcement and taxpayer services. Taken together with onerous mandated increases in information technology in excess of requested amounts, said the Statement of Administration Policy, The Financial Services and General Government Appropriations Act, HR 3060, would require the SEC to reduce staff that polices the US securities markets and enforces the federal securities laws, thereby threatening the stability of the financial markets. Similar
to its position on SEC funding, the
Administration strongly opposes the bill's reduction in funding from the FY
2013 Budget request for the IRS. HR 2060 has been approved by the House
Appropriations Committee.
The Statement of
Policy noted that Sections 501 and 502 of the Act would terminate Federal
Reserve transfers to fund CFPB and subject the agency to the annual appropriations
process beginning in FY 2014. The
provision would shred the necessary independence of CFPB set in statute, in the
President’s view, and would increase the likelihood of underfunding the Bureau,
reducing consumer protection in the financial services marketplace.
In addition, Sections
120, 203, and 503 place additional reporting requirements on the Office of
Financial Research, OMB, and CFPB, respectively, that are duplicative of
existing reporting requirements and costly to produce.
Under Section 503, the
CFPB must submit a report to Congress detailing the obligations made during the
previous quarter by object class, office and activity and the estimated
obligations made during the previous quarter by object, class and activity. Similarly,
Section 120 requires the Office of Financial Stability and the Office of Financial
Research to submit quarterly reports to Congress on the obligations made during
the previous quarter by object class, office and activity and the estimated
obligations made during the previous quarter by object, class and activity. Section
203 requires the OMB to report to Congress on the cost of implementing the Dodd-Frank
Act.
Thursday, June 28, 2012
Chamber of Commerce Urges CFTC to Conduct Formal Rulemaking on Cross-Border Application of Dodd-Frank Swaps Dealer Provisions
In
a letter to CFTC Chair Gary Gensler, the US Chamber of Commerce expressed
concern about reports that the Commission intends to address the extraterritorial
application of the swaps dealer provisions of the Dodd-Frank Act through interpretative
guidance rather than in a release that the Commission denominates a substantive
rule and promulgates according to the procedures required for such rules. The
Chamber noted suggestions that the Commission is considering proceeding in this
manner to avoid the requirements of Section 15(a) of the Commodity Exchange
Act, which directs the Commission to evaluate the costs and benefits of its
actions in light of their effects on efficiency, competitiveness, and price
discovery.
The
Chamber urged the CFTC to conduct a full rulemaking, taking and
considering public comments on the proposal in accordance with the
Administrative Procedure Act and giving full consideration to the economic
consequences of its action. In the Chamber’s view, setting an appropriate scope
for Dodd-Frank’s extraterritorial application is crucial for achieving
effective cross-border swaps regulation.
The
letter went on to express the Chamber’s agreement with the position of European
Commissioner for the Internal Market Michel Barnier that
where the rules of a foreign country are comparable and consistent with the
objectives of U.S. law, it is reasonable to expect U.S. authorities to rely on
those rules and recognize activities regulated under them as compliant with U.S. regulations. The Chamber cautioned that an overly-broad
extraterritorial application of new derivatives regulations could create
competitive disadvantages for U.S.
firms. Foreign branches of U.S.
firms could have to comply with U.S.
regulations in foreign markets, the letter said, whereas foreign firms in
foreign markets would have to comply with host country regulations. More costly
regulations would drive up expenses for U.S.
firms and could reduce the number of counterparties available to U.S.
end-users.
Corp Fin to Implement EDGAR Procedure for JOBS Act Submissions
The SEC’s Division of Corporation Finance has
announced that it will implement an EDGAR-based system for receiving
confidential draft registrations from emerging growth companies (EGCs) under
JOBS Act Section 106. The EDGAR system also will receive submissions from certain
foreign private issuers. Currently, both EGCs and foreign private issuers can
make submissions via a secure email system. Some aspects of the new EDGAR
procedure will be detailed in the next EDGAR update (Release 12.1) as early as July
2, 2012. However, Corp Fin has instructed companies to continue using the
secure email system until further notice. Once the EDGAR procedure is operational,
Corp Fin will issue instructions explaining how eligible companies may make
submissions via EDGAR.
Wednesday, June 27, 2012
Senators Request Data from Securities Industry on Political Intelligence as Sen. Grassley Vows to Seek another Legislative Vehicle
Senator Charles Grassley (R-Iowa) and Senator Mark Udall (D-Colo) sought
information from the financial services industry to attempt to understand the
industry’s contention that the registration and disclosure requirement for
political intelligence agents that Senator Grassley advanced earlier this year in
the STOCK Act was overly broad. In a letter to SIFMA, the Senators noted that,
because political intelligence activities are not disclosed, there is little
information available on the scope of political intelligence and how it is
actively prepared, marketed and sold to Wall Street.
The Senators asked SIFMA to respond by July 25, 2012 to a series of
questions designed to give Congress information about the unique public policy
implications of the growing political intelligence industry. They ask if SIFMA
supports some kind of registration requirement for political intelligence
agents and, if so, how should it be structured and, if not, why not. They asked
for a list of all SIFMA members who have retained political intelligence firms
from 2007 to the present, along with the names of the firms, and the amount of
money spent on contracts with the firms.
Congress is inviting the financial services industry to explain its position on registration, Sen. Grassley said, and trying to understand the size and scope of political intelligence gathering. If the previous disclosure provision was too broad, he indicated, the industry is welcome to propose a solution that would accomplish the same goals of transparency and accountability.
It is essential to increase disclosure and transparency requirements for political intelligence’ activities, Sen. Udall said, adding that political intelligence firms use information normal taxpayers and investors do not have to benefit their clients on Wall Street. When it comes to betting on government policy, Wall Street should not be able to secretly buy insider information.
Congress is inviting the financial services industry to explain its position on registration, Sen. Grassley said, and trying to understand the size and scope of political intelligence gathering. If the previous disclosure provision was too broad, he indicated, the industry is welcome to propose a solution that would accomplish the same goals of transparency and accountability.
It is essential to increase disclosure and transparency requirements for political intelligence’ activities, Sen. Udall said, adding that political intelligence firms use information normal taxpayers and investors do not have to benefit their clients on Wall Street. When it comes to betting on government policy, Wall Street should not be able to secretly buy insider information.
In February, the Senate gave 60 votes to a Grassley Amendment to the Stock
Act requiring the registration and disclosure of political intelligence
agents. The Amendment would have imposed the same registration
requirements on political intelligence agents that have applied to lobbyists
for decades. However, the Grassley Amendment was dropped from the final
legislation. Senator Grassley plans to revisit the provision in future legislative
vehicles.
House Oversight Hearings Reveal that SEC Implementing Regulations Will Be Crucial to the Efficacy of JOBS Act Crowdfunding Title
House hearings focused on the implementation
of the recently-enacted JOBS Act demonstrated a consensus that the SEC regulations
implementing the Title III crowdfunding provisions will be critical in determining
the efficacy of crowdfunding as a capital-raising mechanism. The hearings were held before the Financial
Services Subcommittee of the House Oversight Committee, chaired by Rep. Patrick
McHenry (R-NC), who authored the House version of Title III, which was replaced
by a Senate version in the enacted JOBS Act. Chairman McHenry said that the
Senate version of Title III contains imperfect language. He said that the
Senate inserted provisions complicated crowdfunding and made sections of the
Act ambiguous and inconsistent.
On the day the House concurred with the
Senate Amendment to the JOBS Act, Chairman McHenry said that the Senate changes
to Title III were ill-conceived and burdensome and misguided in seeing
crowdfunding as simply unregulated activity. He pledged to work in a
bi-partisan way to fix the legislation. (Cong. Rec., Mar 27, 2012, p. H1590).
At the hearing, Chairman McHenry noted
that the SEC holds a great deal of discretion over the Title III implementing
regulations and questioned whether this discretion could place at risk the
viability of using crowdfunding. He spoke about using light-touch regulation in
the area of crowdfunding.
Professor C. Steven Bradford, University
of Nebraska Law School, said that there is a potential that regulatory cost
could make crowdfunding not feasible to use. The professor urged that the SEC
regulations implementing Title III be as light-handed and unobtrusive as
possible. Chairman McHenry said that, while the disclosure piece is important,
there is concern over the cost of compliance.
Ranking Member Mike Quigley (D-IL) said
that Title III is a welcome step forward. He also noted that the regulatory
restrictions rolled back by the JOBS Act were put in place for a reason. He
acknowledged a fear of fraud. While Congress correctly judged that there were
too many hurdles to raising capital, he observed, the SEC has to protect
investors. The Ranking Member also emphasized that the regulations implementing
the JOBS Act should not be placed before regulations implementing the
Dodd-Frank Act.
Professor Bradford said that crowdfunding
has the potential to spark a revolution in small business financing. Whether
that happens will depend a great deal on the regulatory burden in that the SEC
implementing regulations will determine the future usefulness of crowdfunding
under Title III. Professor Bradford believes that regulations should be imposed
on the crowdfunding intermediaries and not the entrepreneurs raising the funds.
Brokers and funding portals can spread regulatory costs over a large number of offerings,
he reasoned, and they will be more heavily capitalized than almost all of the
entrepreneurs using the crowdfunding sites. By contrast, the small companies
and entrepreneurs most likely to engage in crowdfunding are poorly capitalized
and legally unsophisticated.
Professor Bradford also urged the SEC to adopt
a substantial compliance rule to protect those who inadvertently violate a regulation
so that a minor technical violation will not cause the loss of the exemption. Given
the complexity of the exemption’s requirements, he noted, inadvertent
violations are likely and the consequence of even a minor violation is drastic.
He added that other Securities Act exemptions include substantial compliance
rules that protect issuers if they fail to comply with the exemption in certain
insignificant ways.
While acknowledging that nothing in the
JOBS Act itself specifically authorizes the SEC to enact a substantial
compliance rule, Professor Bradford noted that Section 302(c) of the JOBS Act
gives the SEC blanket authority to issue such rules as the Commission
determines may be necessary or appropriate for the protection of investors to
carry out Sections 4(6) and 4A of the Securities Act.
He observed that the SEC has even broader
authority in both the Securities Act and the Securities Exchange Act to exempt
any person, security, or transaction from any provision of the statutes if the
Commission determines that such exemption is necessary or appropriate in the
public interest and is consistent with the protection of investors. Professor
Bradford said that the Commission could use this authority to specify that an
issuer that reasonably believed it met the requirements of Section 4(6) or that
substantially complied with Section 4(6) would still be entitled to the
exemption, in spite of the noncompliance.
Former SEC General Counsel Brian Cartright
noted that the JOBS Act calls for SEC rulemaking to address 15 separate
matters, in addition to necessary FINRA rulemaking. How all the rulemaking is
crafted, noted the former GC, will help determine whether Title III assists
capital formation for small ventures or becomes a dead letter. The former SEC official
urged the Commission to rigorously analyze the anticipated compliance costs for
relying on Title III.
In evaluating the costs, advised the
former General Counsel, the SEC should include such items as the costs an
intermediary will incur to build and maintain a compliance infrastructure
sufficient to survive SEC and FINRA inspections, as well as any costs to
address the heightened risks arising from the higher standard of liability Title
III carries compared to other private offerings. The SEC should then determine
the estimated fraction of the proceeds that would be consumed by those costs at
varying offering sizes allowed by Title III. If, after a rigorous cost
analysis, the SEC decides that those costs could render impractical the use of
Title III, it should state this in order to alert Congress so that legislators
can consider if additional legislation is needed.
Federal Court Rules Financial Company Had No Duty to Disclose Receipt of SEC Wells Notice
A federal judge ruled that a securities fraud action could not
be based on a financial company’s failure to disclose receipt of a Wells Notice from
the SEC. At best, said the court, a Wells Notice indicates not litigation but
only the desire of the SEC Enforcement staff to move forward, which it has no
power to effectuate. This contingency
need not be disclosed. While the investors claimed to want to know about the
Wells Notice, a corporation is not required to disclose a fact merely because a
reasonable investor would very much like to know that fact. (Richman v. Goldman
Sachs Group, Inc., SD NY, 10 Civ. 3461, June 21, 2012.)
The SEC provides a target of an investigation with a Wells
Notice whenever the Enforcement Division staff decides, even preliminarily, to
recommend charges. The party at risk of an enforcement action is then entitled,
under SEC rules, to make a Wells submission to the SEC, presenting arguments
why the Commissioners should reject the staff’s recommendation for enforcement.
In the court’s view, a party’s entitlement to make a Wells
submission is obviously based on recognition that staff advice is not
authoritative. Indeed, continued the court, the Wells process was implemented
so that the Commission would have the opportunity to hear a defendant’s
arguments before deciding whether to go forward with enforcement proceedings. Thus,
receipt of a Wells Notice does not necessarily indicate that charges will be
filed.
Item 103 of Regulation S-K requires a company to describe any
material pending legal proceedings known to be contemplated by governmental
authorities. Exchange Act Rule 12b-20 supplements Regulation S–K by requiring a
person who has provided such information in a statement or report to add such
further material information as may be necessary to make the required statements,
in light of the circumstances under which they are made, not misleading.
A Wells Notice may be considered an indication that the staff
of a government agency is considering making a recommendation, noted the court,
but that is well short of litigation that would have to be disclosed. Moreover,
the investors did not show that the company’s nondisclosure of the receipt of
Wells Notice made prior disclosures about ongoing governmental investigations
materially misleading; or that it breached a duty to be accurate and complete
in making
disclosures.
The court rejected the argument that the company had an
affirmative legal obligation to disclose receipt of the Wells Notice under
Regulation S-K, Item 103. There is nothing in Item 103 which mandates
disclosure of Wells Notices, emphasized the court. Item 103 does not explicitly
require disclosure of a Wells Notices, and no court has ever held that this regulation
creates an implicit duty to disclose receipt of a Wells Notice. When the regulatory investigation matures to
the point where litigation is apparent and substantially certain to occur, said
the court, then Section 10(b) disclosure is mandated. Until then, disclosure is
not required.
FINRA Rule 2010, and NASD Conduct Rule 3010 explicitly require
financial firms to report an employee’s receipt of a Wells Notice to FINRA
within 30 days. There is no dispute that the firm was bound by and violated
these regulations by failing to disclose receipt of the Wells Notice within 30
days.
However, federal courts have cautioned against allowing
securities fraud claims to be predicated solely on violations of NASD rules
because such rules do not confer private rights of action. The court reasoned
that these historic precedents are applicable to FINRA rules, since FINRA is the
NASD’s successor.
Tuesday, June 26, 2012
French Legislation Taxing Non-Resident Investment Funds While Exempting Domestic Funds Violated EU Law on Free Movement of Capital
French legislation taxing
dividends paid to non-resident collective investment funds at 25 percent, while
exempting domestic funds from the tax, violated EU law prohibiting restrictions
on the movement of capital between Member States and between Member States
and the US ,
ruled the European Court of Justice. A difference in the tax treatment of dividends
according to an investment fund’s place of residence
may discourage non-resident funds from
investing in French companies and also
discourage French investors from buying shares in non-resident funds. In
addition, the court said that there was no overriding public interest that
justified the difference in tax treatment of resident and non-resident undertakings for collective investments in
transferable securities funds (UCITS). The
case was brought by collective investment funds from the United States and three EU Member
States that had invested in
shares in French companies and received dividends from those shares subject to the
withholding tax. Santander Asset Management SGIIC SA, et al. v. Ministre
du Budget, des Comptes publics, de la Fonction publique et de la RĂ©forme de l’État,
European Court of Justice, May 10, 2012, Cases C-338/11 to C-347/11.
The difference in treatment introduced by the legislation
could not be justified by the need to preserve the coherence of the French tax
system in the absence of any direct link between the exemption from withholding
tax on nationally sourced dividends received by a resident UCITS and the
taxation of those dividends as income received by the shareholders. Similarly,
the French Government failed to put forward any evidence to substantiate
its claim that taxation affecting solely and specifically non-resident UCITS is
justified by the need for effective fiscal supervision.
The Court also rejected the argument that bilateral conventions
on the avoidance of double taxation concluded between the French Republic and
the Member State or non-Member State concerned ensure that shareholders in
resident and non-resident UCITS receive similar tax treatment. That argument,
said the Court, is based on the incorrect premise that shareholders in resident
UCITS are themselves resident for tax purposes in France, whereas the
shareholders in US and other non-resident collective funds are resident for tax
purposes in the US or other State in which the UCITS concerned is established.
In fact, said the Court, it is not unusual for a shareholder
in a UCITS which is not resident in France to be resident for tax purposes in
France or for a shareholder in a UCITS resident in France to be resident for
tax purposes in the US or another EU country. Under the contested legislation,
nationally-sourced dividends paid to a resident distributing UCITS are exempt
from tax even in cases in which the French
Republic does not exercise its tax
jurisdiction over the dividends redistributed by such a UCITS, in particular
when they are paid to shareholders who are resident for tax purposes in the US or another Member State .
At the same time, nationally-sourced dividends paid to non-resident
distributing UCITS are taxed at a rate of 25 percent irrespective of the tax
situation of their shareholders. The Court concluded that the criterion for
determining the tax treatment established by the legislation at issue is not
the tax situation of the shareholder but solely the resident status of the
collective investment fund.
Texas Proposes Changes to Accredited Investor, Finder and Successor Registration
Amendments to the exemption for individual accredited investor sales, and to the application procedures for finders and successor entity securities dealers and investment advisers were proposed by the Texas State Securities Board.
The statement required for limited use advertisements in connection with individual accredited investor sales would exclude the value of the person's primary residence from that person's net worth calculation.
Finders would be no longer register using the procedures for securities dealers but instead follow application procedures proposed specifically for them.
The types of structural changes initiating successor registration for securities dealers or investment advisers would be separately identified to allow dealers or advisers whose structural changes are less comprehensive to file an amendment rather than a new application.
The statement required for limited use advertisements in connection with individual accredited investor sales would exclude the value of the person's primary residence from that person's net worth calculation.
Finders would be no longer register using the procedures for securities dealers but instead follow application procedures proposed specifically for them.
The types of structural changes initiating successor registration for securities dealers or investment advisers would be separately identified to allow dealers or advisers whose structural changes are less comprehensive to file an amendment rather than a new application.
IASB Chair Says Board Will Examine Goodwill and Other Comprehensive Income Standards under Principles
In remarks at an Amsterdam
accounting seminar, IASB Chair Hans Hoogervorst described pragmatism as practiced by the Board
to be looking very carefully at any possible undesirable use of IFRS. Whenever the
Board is confronted with a high degree of uncertainty, he averred, it will act
with great caution. For example, if the standards were to provide too much room
for recognition of intangible assets, the potential for mistakes or abuse would
be immense. In such circumstances, he believes that it is better for the
accounting standards to require more qualitative reporting than pseudo-exact
quantitative reporting. The Chair said
that it is nonsense to advise that accounting standards should not be
set from an anti-abuse perspective. If
the IASB sees ample scope for abuse in a standard, he pledged, the Board will
do something about it, adding that there are sufficient temptations and
incentives for creative accounting as it is.
While the P&L is the
traditional performance indicator on which many remuneration and dividend
schemes are based, the meaning of other comprehensive income is unclear. It
started as a vehicle to keep certain effects of foreign currency translation
outside net income and gradually developed into a parking space for unwanted fluctuations
in the balance sheet. There is a vague notion that other comprehensive income
serves for recording unrealized gains or losses, but a clear definition of its
purpose and meaning is lacking.
But that does not make it
meaningless, said the Chair, especially for financial institutions with large
balance sheets. Other comprehensive income can contain very important
information. It can give indications of the quality of the balance sheet. It is
very important for investors to know what gains or losses are sitting in the
balance sheet, even if they have not been realized.
In the future, other
comprehensive income will most certainly be an important source of information
about insurance contracts. Recently, both the FASB and the IASB proposed that
changes in the insurance liability due to fluctuations in the discount rate
would be reported in other comprehensive income. Many of the Boards’
constituents requested them to do so.
Both preparers and users wanted
to prevent underwriting results being snowed under by balance sheet
fluctuations. As a result, other comprehensive income will become bigger and
will contain meaningful information, such as indications of duration mismatches
between assets and liabilities.
This decision for the use of
other comprehensive income was not easy to make. Board member Stephen Cooper
showed in what the Chair called a
``razor-sharp analysis’’ that in this presentation, both net income and other
comprehensive income, if seen in isolation, might give confusing information.
The IASB Chair said that the
Board will try to tackle some of these problems with presentational improvements,
but added that a full picture of an insurer’s performance can only be gained by
considering all components of total comprehensive income. The Board will point this out
explicitly in the Basis for Conclusions of the new standard.
More fundamentally, the Board will look at the distinction between net income and other comprehensive income during the upcoming revision of the Conceptual Framework. Board constituents have asked the IASB to provide a firm theoretical underpinning for the meaning of other comprehensive income and the Board will try to do so. For now, while it may not always be clear how important other comprehensive income exactly is, net income is not a very precise performance indicator either. Both need to be used with judgment, especially in the financial industry.
Finally, the Chair said that
the Board will take another look at goodwill in the context of the
post-implementation review of IFRS 3 Business
Combinations. Although the accounting standards do not permit the
recognition of internally generated goodwill, he noted, the standards do
require companies to record the premium they pay in a business acquisition as
goodwill. This goodwill is a mix of many things, including the internally
generated goodwill of the acquired company and the synergy that is expected
from the business combination.
Most elements of goodwill are
highly uncertain and subjective, observed the Chair, and they often turn out to
be illusory. The acquired goodwill is subsequently subject to an annual
impairment test. In his view, these impairment tests are not always done with
sufficient rigor. Often, share prices reflect the impairment before the company
records it on the balance sheet, he cautioned, which means that the impairment
test comes too late.
Monday, June 25, 2012
Hong Kong SFC Enforcement Director Outlines Special Remedies to Combat and Rectify Fraudulent Securities Market Misconduct
Fraudulent
securities market misconduct is a special kind of fraud causing diffused damage
across a wide spectrum of interests and persons and thus demands remedies
beyond general deterrence, said Hong Kong Securities and Futures Enforcement
Director Mark Steward. In remarks at an Asia Pacific Summit on fraud and
corruption, he said that the prescription for tackling securities fraud on the market
requires broad civil and criminal remedies to identify wrongdoers, chase down
assets and proceeds, identify the nature and quantify the extent of damage or
loss, identify victims, and secure remedial outcomes as well as ensure that those
who perpetrate and assist in fraud and misconduct, including those who help to
hide it from detection, are made to pay for the costs of rectification.
Criminal
prosecution of perpetrators, where appropriate, is by no means last but it
ought not to be the only measure. The need for civil remedies is also necessary
because criminal sanctions are not always available especially if perpetrators
are not in the jurisdiction or cannot be brought into the jurisdiction. This is a real issue in a market as
international as Hong Kong ’s, he noted.
General
deterrence alone is not enough, he explained, because, unlike the theft of
valuable property, the damage caused by market misconduct fraud may not even be
detectable. Or if there is loss, its
cause in fraud is unlikely to be discernible.
And damage may well continue to impair the investment. That is why
identifying the nature and extent of damage caused by fraud is a necessary
component of any anti-fraud strategy.
According
to the Director, there are at three distinct components to market fraud. First,
market misconduct is perpetrated almost anonymously by market participants
whose identities are shielded from other market participants by the automated
matching systems of the exchanges. A second related distinction is the anonymity
of the victims, which makes the problem of fraud in the markets an acute one. A
third distinction is the way market fraud undermines the market’s singular
function as a place where reliable
prices are set, a storehouse of value for savings and investments and a place
upholding high standards of fairness. Market
misconduct fraud prejudices these functions and impairs the confidence needed
to support them, he observed, and may also give rise to tangible losses to innocent
investors.
Given
the nature of market misconduct, the Commission is deeply engaged in not only
sending deterrent messages, he emphasized, but also in remedying the
consequences of securities market fraud and misconduct on the well-being of the
market’s important functions and to protecting the interests of all market
participants.
This means that, in tandem with traditional deterrent remedies, the
SFC is actively pursuing civil sanctions to tackle, not only the wrongdoer, but
also the consequences of the wrongdoing so that the reputation of the market as
a safe and fair place and a reliable guide to price and value can be restored.
Turning
to specific actions, the Director noted that the Hong Kong Court of Appeal recently
ruled that the Court of First Instance, in the exercise of its civil
jurisdiction, can determine whether a person has contravened a market
misconduct provision and that the function of making these types of findings is
not the sole preserve of a criminal court or the Market Misconduct
Tribunal. The defendant in that case, a New York based hedge
fund, is appealing this decision to the Court of Final Appeal. The Commission is confident the Court of
Appeal decision will be upheld.
Another
action recently reached what the Director called ``a milestone conclusion.’’ The
action was to freeze the IPO proceeds of a Cayman Islands
entity with a Mainland business, listed in late 2009 raising approximately $1
billion in capital from both institutional and retail investors. It had no Hong Kong
resident directors, said the Director, and is controlled by Taiwanese
interests. The SFC was concerned that a number of statements made in its IPO
prospectus were not true.
The
initial action led to orders freezing approximately $832 million which derived
from subscriptions to the IPO prospectus. The Commission then alleged the IPO
prospectus included false statements and that the company’s turnover,
profitability and cash and cash equivalent balances were grossly overstated in
the IPO prospectus. The SFC initiated action to recover the balance and to
obtain orders requiring the company to repurchase shares issued or bought by
the public shareholders.
After
the trial started, the company conceded that its prospectus contained
materially false or misleading statements and acknowledged that it contravened
section 298 of the Securities and Futures Ordinance, which prohibits the
disclosure of information likely to induce a person to subscribe for or
purchase shares if the information is materially false and the person knows or
is reckless as to whether the information is false. It is a market misconduct provision, noted
the Director.
The
company has also agreed to pay the sum of approximately $197 million into court
so that, together with the $832 million, there is a total of a little over $1
billion to fund a full repurchase offer to all public shareholders,
approximately 7,700 investors, at the suspension price.
This
outcome, once executed and accepted by the shareholders, said the Director, will
effectively repair the damage caused to those shareholders who were in no
position to be able to detect the false information in the prospectus for
themselves and who were victims. Under Commission remedial measures, the
company will be obliged to return all of the paid up capital it received from
its public shareholders as a consequence of the false statements contained in
its prospectus at its last traded price.
North Dakota Proposes to Incorporate NASAA Policy Statements
Statements of policy of the North American Securities Administrators Association (NASAA) would be applied to registered and exempt securities offerings in North Dakota as appropriate, as proposed by the North Dakota Securities Department.
The following policy statements would be incorporated: Asset-Backed Securities, Cattle-Feeding, Church Bonds, Church Extension Funds, Commodity Pool Programs, Corporate Securities Definitions, Debt Securities, Equipment Programs, Health Care Facility Offerings, Impoundment of Proceeds, Loans and Other Material Affiliated Transactions, Mortgage Programs, Oil and Gas Programs, Direct Participation Programs—Omnibus Guidelines, Options and Warrants, Preferred Stocks, Promoter’s Equity Investment, Promotional Shares, Real Estate Investment Trusts, Real Estate Programs, Risk Disclosure Guidelines, Specificity in Use of Proceeds, Underwriting Expenses and Underwriter’s Warrants, Unequal Voting Rights, Uniform Disclosure Guidelines for Cover Legends and Unsound Financial Condition.
The following policy statements would be incorporated: Asset-Backed Securities, Cattle-Feeding, Church Bonds, Church Extension Funds, Commodity Pool Programs, Corporate Securities Definitions, Debt Securities, Equipment Programs, Health Care Facility Offerings, Impoundment of Proceeds, Loans and Other Material Affiliated Transactions, Mortgage Programs, Oil and Gas Programs, Direct Participation Programs—Omnibus Guidelines, Options and Warrants, Preferred Stocks, Promoter’s Equity Investment, Promotional Shares, Real Estate Investment Trusts, Real Estate Programs, Risk Disclosure Guidelines, Specificity in Use of Proceeds, Underwriting Expenses and Underwriter’s Warrants, Unequal Voting Rights, Uniform Disclosure Guidelines for Cover Legends and Unsound Financial Condition.
Virginia Adopts Private Fund Adviser Exemption
Private fund advisers are exempt from investment adviser registration requirements in Virginia if neither the advisers nor their advisory affiliates are subject to “bad boy” disqualification provisions under Rule 262 of federal Regulation A, and the advisers electronically file through the IARD the SEC-filed reports and amendments required for exempt reporting advisers by Rule 204-4 of the Investment Advisers Act of 1940, as well as a $250 fee. The exemption takes effect when the reports and fee are filed and accepted by the IARD on the State’s behalf, assuming the exemption’s other conditions are met. NOTES: (1) Investment adviser representatives employed by or associated with exemption-eligible investment advisers are, themselves, exempt from investment adviser representative registration if they do not otherwise act as investment adviser representatives; (2) Investment advisers that become ineligible for the private fund adviser exemption must, within 90 days following their ineligibility, register or notice file as investment advisers (as applicable) in Virginia; and (3) Federal covered investment advisers, i.e., private fund advisers registered with the SEC, are ineligible for the exemption and, therefore, must comply with Virginia notice filing requirements.
UK Sharman Panel Breaks New Ground on Auditor Going Concern Opinions
In
a seminal report on auditors and going concern, the UK Sharman Panel
recommended a process to produce a going concern opinion that envisions a key
role for company directors, audit committees and auditors. The panel would also
require the going concern assessment process to focus on
solvency risks and liquidity risks, as well as identifying risks to the entity’s business model or capital
adequacy that could threaten its survival. The
Sharman Panel wants to move away from a model where the
company only highlights going concern risks when there are significant doubts
about its survival, to one which integrates the going concern reporting with
the directorial discussion of strategy and principal risks.
Lord Sharman said that the aim of the directors’
assessment and reporting of going concern risks is not primarily to inform
outsiders of distress. Rather, it is to ensure that the company is managed to
avoid such distress, while still taking well-judged risks. That judgment must
rest with the directors, emphasized Lord Sharman, and regulators and policy
makers must encourage them to discharge their duties in that regard with skill
and in good faith. Therefore, in reaching its recommendations, the Panel’s
primary purpose has been to reinforce responsible behavior in the management of
going concern risks for companies.
Essentially the Sharman
Panel recommends a model for auditor reporting on going concern in which there
is an explicit statement in the auditor’s report that the auditors are satisfied
that, having considered the assessment process, they have nothing to add to the
disclosures made by the directors about the robustness of the process and its
outcome. The Panel’s final recommendation
in relation to the auditor’s role is therefore an enhanced one in which, in
addition to addressing the basis of accounting and material uncertainty disclosures,
the auditor also considers the directors’ going concern assessment process and narrative
disclosures about the going concern status of the entity and includes a
statement in the auditor’s report as to whether the auditor has anything to add
to or emphasize in relation to the disclosures made by the directors about the
robustness of the process and its outcome.
The
Panel found strong support for regular and more nuanced disclosure in narrative
reporting, compared to the current more binary approach to reporting on going concern
in the financial statements. The moment when a company moves from being a going
concern to a gone concern is dependent on a variety of interrelated factors,
noted the Panel, and it is therefore important to articulate the assumptions,
caveats and sensitivities associated with the going concern status of the
entity well before significant doubts about its ability to continue as a going
concern emerge.
The
report recommended that the Financial Reporting Council consider moving UK auditing
standards towards inclusion of an explicit statement in the auditor’s report as
to whether the auditor has anything to add to the disclosures made by the
directors about the robustness of the process and its outcome, having
considered the directors’ going concern assessment process. The Sharman group
also urged the FRC to encourage the IAASB to accommodate this approach to the international
auditing standards.
Similarly,
the Panel recommended that the FRC engage with the IASB and the IAASB to agree on
a common international understanding of the purposes of the going concern
assessment and financial statement disclosures about going concern, and of the
related thresholds and descriptions of a going concern.
The Panel also recommended
that the audit committee report
illustrate the effectiveness of the process undertaken by the directors to
evaluate going concern by confirming that a robust risk assessment has been
made, providing an explanation of the material risks to going
concern considered and how they have been addressed.
The
report noted that the success of audit committees in tightening up corporate
governance in the past means that they are seen as the most appropriate type of
body to implement these improvements. The Sharman panel noted that reporting by
audit committees and auditors on the directors’ assessment of going concern
should engender greater confidence in the process that is undertaken.
The Panel recommends that
the going concern assessment reflect the right focus on solvency risks, not
only on liquidity risks, including identifying risks to the entity’s business model or
capital adequacy that could threaten its survival, over a period that has
regard to the likely evolution of those risks given the current position in the
economic cycle and the dynamics of its own business cycles. Also, the going
concern assessment should be more qualitative and longer term in outlook in
relation to solvency risk than in relation to liquidity risk; and include
stress tests both in relation to solvency and liquidity risks that are
undertaken with an appropriately prudent mindset. Special consideration should
be given to the impact of risks that could cause significant damage to the
community and environment.
In
its preliminary report, the Panel posited that an expectation gap exists
between what stakeholders expect and what directors and auditors actually
deliver. This expectation gap may result from an expectation that the absence
of disclosure by directors, and the absence of a modified audit opinion in
respect of the going concern status of the company, can be taken as a guarantee
that the company will not collapse or fail. The Panel concluded from the
comments received that there is a risk that there is not a sufficiently common
understanding, in relation to going concern assessments, about the going
concern threshold or the
degree of conviction with which a going concern statement is required to be
made or about the purpose for which the assessment is made.
The Sharman report was
initiated by the Financial Reporting Council, the UK counterpart to the PCAOB. Lord
Sharman, Chairman of the Panel, said that, while the work of the Panel emanates
from the financial crisis, companies in all sectors can do more to improve
their management and disclosure of risks relating to going concern, liquidity
and solvency. There should also be early identification and attention to
economic and financial distress, he noted. 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. The other two members of the Panel are Roger Marshall, Interim Chair of
the FRC’s Accounting Standards Board, and David Pitt-Watson, Chair of Hermes
Focus Funds, and former Finance Director of the Labor Party.
SEC Division of Risk, Strategy, and Financial Innovation Issues Staff Guidance on Economic Analysis in Rulemaking
High-quality
economic analysis is an essential part of SEC rulemaking, said the Division of Risk, Strategy, and
Financial Innovation and the Office of the General Counsel in recently
published guidance designed to ensure that decisions
to propose and adopt regulations are informed by the best available information
about a the economic consequences, and allows the Commission to meaningfully
compare the proposed action with reasonable alternatives. The staff noted that
the SEC has long recognized that a rule’s potential benefits and costs should
be considered in making a reasoned determination that adopting it is in the
public interest
The staff emphasized that
every economic analysis in SEC rulemakings should include the following four
elements: (1) a statement of the need for the proposed action; (2) the
definition of a baseline against which to measure the likely economic
consequences of the proposed regulation; (3) the identification of alternative
regulatory approaches; and (4) an evaluation of the benefits and costs, both
quantitative and qualitative, of the proposed action and the main alternatives
identified by the analysis.
On the first element, the
release must clearly identify the justification for the proposed regulation. In some circumstances, there
will be more than one justification for a particular rulemaking. Frequently,
the proposed rule will be a response to a market failure that market
participants cannot solve because of collective action problems. Other justifications for
rulemaking can include, among others, improving government processes,
interpreting provisions in statutes the Commission administers, and providing exemptive
relief from statutory prohibitions where the Commission concludes that doing so
is in the public interest.
Additionally, OMB’s Circular
A-4, implementing Executive Order 12866, recognizes that Congressional
direction to adopt a regulation is, itself, an independent justification for
rulemaking. The SEC staff has considered the recommendation in the Commission’s Inspector General
Report No. 499 that even where Congress directs the Commission to engage in
rulemaking, the Commission should identify a market failure or other compelling
need for rulemaking apart from the Congressional directive, and concluded that
this is unnecessary.
Instead, the staff believes the better approach is set
forth in Executive Order 12866, which states that agencies should promulgate only
such regulations as are required by law or are made necessary by
compelling public need, such as material failures of private markets to protect
or improve the health and safety of the public, the environment, or the
well-being of the American people. In the staff’s view, the Executive Order
clarifies that a statutory mandate and a market failure are alternative possible
justifications for a rule.
Although having concluded
that the SEC is not obligated to identify a justification for rulemaking beyond
a Congressional mandate, the staff acknowledged that there may be circumstances
in which it could be useful to do so. For example, where Congress has itself
stated that the mandate to engage in rulemaking is premised on a market failure
or other compelling social need, the rulemaking release may identify that
justification and attribute it to Congress in its description of the statutory
mandate and explain how the rule, including any discretionary choices the
Commission is making in the rulemaking, responds to the market failure or other
compelling need that Congress identified.
On the second element of a
baseline, the economic consequences of proposed rules, potential costs and
benefits including effects on efficiency, competition, and capital formation, should
be measured against a baseline, said the SEC staff, which is the best
assessment of how the world would look in the absence of the proposed action. The
baseline serves as a primary point of comparison for an analysis of the
proposed regulation. An economic analysis of a proposed regulatory action
compares the current state of the world, including the problem that the rule is
designed to address, to the expected state of the world with the proposed
regulation or regulatory alternatives in effect.
On the third element, the
release should identify and discuss reasonable potential alternatives to the
approach in the proposed rule. Reasonable alternatives include only those that
are available to the SEC and not those that the SEC lacks the authority to implement.
On the fourth element, said
the guidance, rulewriting staff should work with the SEC staff economists to
identify and describe the most likely economic benefits and costs of the
proposed rule and alternatives; quantify those expected benefits and costs to
the extent possible; and, for those elements of benefits and costs that are
quantified, identify the source or method of quantification and discuss any
uncertainties.
To achieve this objective,
rulewriting staff should engage with staff economists at the earliest stages of
rulemaking to determine whether there are areas in which monetization or other
quantification can reasonably be undertaken and, if so, whether the Division of
Risk, Strategy and Financial Innovation has the available resources necessary
to develop such data. Before issuing a proposing release, staff should identify
any specific data that would be necessary for or that would assist in
quantification, and should consider various mechanisms by which to seek such
data. The proposing release should also include a request for such data.
When particular benefits or
costs cannot be monetized, advised Division staff, the release should present
any available quantitative information: for example, quantification of the size
of the market affected, or the number and size of market participants subject
to the rule. Even without hard data, quantification may be possible by making
and explaining certain assumptions. For example, if proposed rules would enable
the operation of a new trading system, it may be reasonable to assume the
system will attract a percentage of all market volume. With that assumption,
reasoned staff, the cost-benefit analysis could then estimate a distributional
effect of a certain magnitude. It is important to make assumptions and the
rationales for them explicit and, where alternative assumptions are plausible,
to include analysis based on each.
Division staff noted that
court decisions addressing the economic analysis in SEC regulations have
likewise stressed the need to attempt to quantify anticipated costs and
benefits, even where the available data is imperfect and where doing so may
require using estimates and extrapolating from analogous situations.
When monetization or other
quantification is possible, said the Division staff, the proposing release
should include those numbers and solicit comment on them, and the adopting
release should address any comments on those numbers, including any data
submitted to challenge them. When quantifying costs and benefits, staff should
describe the measurement approach used, include references to statistical and
stakeholder data if available, and specify the timeframe analyzed.
Sunday, June 24, 2012
Ranking House Members Urge SEC to Implement Dodd-Frank Conflict Minerals and Resource Extraction Regulations by July 1
In a letter to SEC Chairman Mary
Schapiro, 58 members of the House of Representatives, including many Ranking
Members, asked that the SEC schedule a vote on the final regulations implementing
Sections 1502 and 1504 of the Dodd-Frank Act by July 1, 2012. If a vote cannot
be scheduled by this date, the Members request that Chairman Schapiro respond
to the letter by June 29, 2012 with an explanation regarding the extended delay
in adopting the implementing regulations and provide a definitive date for a
vote on these two sets of regulations.
The signatories to the letter
included Rep. Ed Markey (D-MA), Ranking Member of the Natural Resources
Committee; Rep. Barney Frank (D-MA), Ranking
Member of the Financial Services Committee, Rep. Howard Berman (D-CA), Ranking Member of
the Foreign Affairs Committee, Rep. Jim McDermott (D-WA), Ranking Member on the Ways and Means Committee's
Subcommittee on Trade; and Rep. Maxine Waters (D-CA), Ranking Member of the
House Financial Services Committee's Subcommittee on Capital Markets.
Under the resource extraction regulations
implementing Section 1504 of Dodd-Frank, companies engaged in the commercial
development of oil, natural gas, or minerals would have to disclose in their
annual SEC reports all payments made to either the United States or a foreign
government, at the project-level. Under the conflict minerals regulations
implementing Section 1502 of Dodd-Frank, companies using minerals such as tin
and gold would have to disclose what measure they are taking to avoid making
payments to rebel groups or military units in the Democratic Republic of the Congo or
an adjoining country. This would help consumers and investors make more
informed decisions about the products that they purchase and the companies in
which they invest. Section 1502 requires SEC-reporting companies to disclose the
measures they use to certify that their products do not contain conflict
minerals.
The SEC published proposed regulations
to implement these provisions of Dodd-Frank in December 2010, noted the
members, adding that unfortunately the SEC has not yet finalized the process by
releasing final, enforceable versions of the sets of regulations, both of which
had a statutory deadline of April 17, 2011.
There is no clear reason for
the delay, said the Members. The comment period for both sets of regulations
closed over a year ago. The SEC has had more than enough time to consider and
respond to all of the substantive comments from industry, investors and others,
said the Members. The issues involved are too serious to allow further delay, posited
the Members, adding that if the regulations are not soon adopted some companies
will not have to file their first reports until the summer of 2014, four years
after the enactment of Dodd-Frank. The letter emphasized that the regulations move the issues of secret payments and the use of conflict minerals out of the shadows and into the open to help fight corruption and increase government accountability. The regulations will also provide material information to investors to reduce risk and increase choices for ethical investments.
Saturday, June 23, 2012
SEC Adopts Regulations Implementing Dodd-Frank Compensation Committee and Advisers Provisions
Implementing Section 952 of the
Dodd-Frank Act, the SEC adopted regulations directing the exchanges to
establish listing standards requiring each member of a company’s compensation
committee to be an independent member of the board of directors. The regulations
do not require that exchanges establish a uniform definition of independence. Given the wide variety of issuers that are
listed on exchanges, said the SEC, exchanges were given the flexibility to develop
independence requirements appropriate for the issuers listed on each exchange.
Although this provides the exchanges with flexibility to develop the
appropriate independence requirements, the Commission reminded that the independence
requirements developed by the exchanges will be subject to review and final SEC
approval pursuant to Section 19(b) of the Exchange Act.
In addition, when developing
their own definitions of independence applicable to compensation committee
members, the exchanges must consider relevant factors, including a director’s
source of compensation, including any consulting, advisory or compensatory fee
paid by the issuer; and whether a director is affiliated with the issuer, a
subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.
The regulations also direct the
exchanges to adopt listing standards providing that the compensation committee
may, in its sole discretion, retain or obtain the advice of a compensation adviser. The compensation
committee will be directly responsible for the appointment, compensation and
oversight of the work of any compensation adviser retained by the committee. Further,
each listed issuer must provide for appropriate funding for payment of
reasonable compensation, as determined by the compensation committee, to any
compensation adviser retained by the committee. According to the SEC, the regulations
may not be construed to require the compensation committee to implement or act
consistently with the advice or recommendations of any adviser to the
compensation committee or to affect the ability or obligation of a compensation
committee to exercise its own judgment in fulfillment of its duties.
Moreover, SEC regulations do not
require compensation committees to retain or obtain advice only from
independent advisers. The committee may
receive advice from non-independent counsel, such as in-house counsel or
outside counsel retained by management, or from a non-independent compensation
consultant or other adviser, including those engaged by management. Nor do the
regulations require a compensation committee to be directly responsible for the
appointment, compensation or oversight of compensation advisers that are not
retained by the compensation committee, such as compensation consultants or
legal counsel retained by management.
Section 10C(b) of the Exchange
Act, added by Dodd-Frank, provides that
the compensation committee of a listed issuer may select a compensation adviser
only after taking into consideration the five independence factors specified in
the statute as well as any other factors identified by the Commission. In accordance with Section 10C(b), these
factors would apply to the selection of compensation consultants, legal counsel
and other advisers to the committee. The
statute does not require a compensation adviser to be independent, only that
the compensation committee of a listed issuer consider the enumerated
independence factors before selecting a compensation adviser.
The SEC regulations require a
compensation committee to take into account the five factors enumerated in
Section 10C(b)(2), as well as one added by the Commission, which is any
business or personal relationships between the executive officers of the issuer
and the compensation adviser or the
person employing the adviser. This would
include, for example, situations where the chief executive officer of an issuer
and the compensation adviser have a familial relationship or where he chief
executive officer and the compensation adviser (or the adviser’s employer) are
business partners. The SEC agreed with
commentators who stated that business and personal relationships between an
executive officer and a compensation adviser or a person employing the compensation
adviser may potentially pose a significant conflict of interest that should be considered
by the compensation committee before selecting a compensation adviser.
The
five statutory factors are the provision of other services to the issuer by the
person that employs the compensation adviser; the amount of fees received from
the issuer by the person that employs the compensation adviser, as a percentage
of the total revenue
of that person; the policies of the person that employs the compensation adviser
that are designed to prevent conflicts of interest; any business or personal
relationship of the compensation adviser with a member of the compensation
committee; and any stock of the issuer owned by the compensation adviser.
The SEC believes that these six
factors, when taken together, are competitively neutral, as they will require
compensation committees to consider a variety of factors that may bear upon the
likelihood that a compensation adviser can provide independent advice to the
compensation committee, but will not prohibit committees from choosing any
particular adviser or type of adviser. The
factors should be considered in their totality, said the SEC, and no one factor
should be viewed as a determinative factor of independence
Neither Dodd-Frank nor the
implementing regulations require a compensation adviser to be independent, only
that the compensation committee consider the enumerated independence factors
before selecting a compensation adviser.
Compensation committees may select any compensation adviser they prefer,
including ones that are not independent, after considering the six independence
factors.
Changes to Item 407(e)(3) of
Regulation S-K will require issuers to disclose in their proxy statements whether
the work of any compensation consultant that has played any role in determining
or recommending the amount or form of executive and director compensation has
raised a conflict of interest, and if it had, disclose the nature of the
conflict and how it is being addressed.
Constitutionality of CFPB and FSOC Established by Dodd-Frank Challenged in Federal Court Action
A Texas bank has challenged the constitutionality of the Dodd-Frank Act in federal court, focusing on Title X, which created the Consumer Financial Protection Bureau and Title I, which established the Financial Stability Oversight Council. The main contention is that the sweeping and essentially unlimited and judicially unreviewable powers the Act bestows on the Bureau and the FSOC violates the Constitution’s separation of powers doctrine. State National Bank of Big Spring , et al. v. Geithner, et al., US District Court for the District of Columbia .
Thecomplaint states that the Dodd-Frank Act effectively delegates unlimited power
to the CFPB to regulate practices that the Bureau deems to be unfair,
deceptive, or abusive, thereby granting the Bureau vast authority over consumer
financial product and service firms, such as the plaintiff bank. The Act does not define unfair or deceptive
acts or practices, leaving those terms to the CFPB to interpret and enforce
either through ad hoc litigation or through regulation. The Act does not
provide meaningful limits on what the CFPB can deem an abusive act or practice.
While the Act allows the CFPB to define and enforce these standards through
rulemaking, noted the complaint, Director Richard Cordray has already announced
that the Bureau will define and enforce them primarily through ad hoc ex post
facto enforcement.
The
bank contends that Dodd-Frank eliminates the constitutional checks and balances
that would ordinarily limit the CFPB’s exercise of these broad and undefined
powers, thereby violating the separation of powers doctrine. For example, Congress
has no power of the purse over the CFPB, which the Act allows to essentially
fund itself by unilaterally claiming funds from the Federal Reserve Board. The
Director, who cannot be removed at the pleasure of the President, determines the
amount of funding the Bureau receives from the central bank and then the Fed must
transfer those funds to the Bureau. In addition to allowing the CFPB to fund
itself, alleged the bank, the Act prohibits Congress from even attempting to
review the Bureau’s budget.
Judicial
oversight is limited by Dodd-Frank provisions requiring the courts to grant the
same deference to the CFPB’s interpretation of federal consumer financial laws that
they would if the Bureau were the only agency authorized to apply and interpret
or administer the provisions of federal consumer financial law. The CFPB’s
regulatory authority is further insulated from accountability to the very
agency in which it is housed by provisions stating that no regulation adopted by
the CFPB can be subject to review of or approval of the Fed.
Similarly,
the FSOC is given sweeping power and unbridled discretion to pick which
non-bank financial firms are systemically important, thereby subjecting the
firm to enhanced federal regulation. The FSOC determination is not subject to
meaningful judicial review. While a firm designated by FSOC as systemically
important may appeal to a federal district court, noted the complaint, the
appeal is limited to the question of whether that determination was arbitrary
and capricious. Section 113 of Dodd-Frank forbids the courts to review whether
FSOC’s action was in accordance with law.
The
bank argues that Title I’s open-ended grant of power and discretion to FSOC,
combined with the elimination of judicial review of FSOC’s judgments, and the
inclusion of members neither appointed by the President nor confirmed by the
Senate, gives FSOC the unfettered discretion to determine which non-bank
financial firms are systemically important, violates the separation of powers
and is unconstitutional.
Friday, June 22, 2012
Treasury Pursues Frameworks with Japan and Switzerland for Effective FATCA Compliance
The
Department of the Treasury has jointly issued statements with Japan and Switzerland
expressing mutual intent to pursue a framework for intergovernmental
cooperation to facilitate the implementation of the Foreign Account Tax
Compliance Act (FATCA) and improve international tax compliance based on the
existing bilateral tax treaties between the U.S.
and Japan and Switzerland .
The
statements offer a framework for cooperation to facilitate FATCA implementation
by supplementing direct reporting under FATCA by Japanese and Swiss financial
institutions with exchange of information on request pursuant to the bilateral
income tax treaty with Japan
and Switzerland .
FATCA
was enacted in 2010 as part of the Hiring Incentives to Restore Employment
(HIRE) Act. FATCA requires foreign financial institutions to report to
the IRS information about financial accounts held by U.S.
taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial
ownership interest. In order to avoid withholding under FATCA, a participating
FFI will have to enter into an agreement with the IRS to identify U.S. accounts, report certain information to the
IRS regarding U.S.
accounts, and withhold a 30 percent tax on certain U.S.-connected payments to
non-participating FFIs and account holders who are unwilling to provide the
required information. Registration will take place through an online
system that will become available by Jan. 1, 2013. Foreign financial
institutions that do not register and enter into an agreement with the IRS will
be subject to withholding on certain types of payments relating to U.S.
investments.
FATCA
is an important part of the U.S.
government’s effort to improve tax compliance. The intergovernmental framework
announced provides a second model for implementing FATCA in a way that
addresses domestic legal impediments and reduces burdens on financial
institutions, said Acting Assistant Secretary for Tax Policy Emily S. McMahon.
The
framework contemplated in the joint statements represents a second model for an
intergovernmental approach to improving tax compliance and implementing FATCA
(Model II). Model II establishes a framework of direct reporting by
foreign financial institutions to the Internal Revenue Service , supplemented
by information exchanged between the Japanese and Swiss governments and the United States
government upon request.
Previously,
the Treasury Department jointly issued a statement with France , Germany ,
Italy , Spain and the United Kingdom expressing mutual
intent to pursue a government-to-government framework for implementing
FATCA. The model contemplated in the prior joint statement (Model
I) differs from the model just announced in that it contemplates
reporting by foreign financial institutions (FFIs) to their respective
governments, followed by the automatic exchange of this information with the
United States. Treasury, in consultation with the jurisdictions
participating in the joint statement issued in February, has been developing a
model agreement that will serve as the basis for bilateral agreements with
countries interested in adopting the intergovernmental framework contemplated
in Model I and aims to publish this model soon.
Both
intergovernmental models for implementing FATCA represent an important step
toward addressing legal impediments to financial institutions’ ability to
comply with the regulations. The frameworks contemplated in the joint
statements will serve as alternative models for the United States ’ work with other
countries, as Treasury officials continue to engage in discussions with foreign
governments about the effective and efficient implementation of FATCA by their
financial institutions.
Thursday, June 21, 2012
In letter to SEC Chair, and In Light of Facebook IPO, House Leader Wants Dialogue on Fundamental Reform of the IPO Process
In light of the
substantial flaws in the IPO process revealed by the Facebook IPO, Chairman Darrell
Issa (R-CA) of the House Oversight Committee wants to begin a dialogue with the
SEC to fundamentally transform the regulation of the IPO process. In a letter
to SEC Chair Mary Schapiro, Chairman Issa emphasized that Congress must revisit
the Securities Act of 1933, which has given investment banks almost 60 years to
enjoy what is essentially flawed legislation fraught with conflicts of interest
and incentives to misprice shares. Among other things, he asked the SEC to take
advantage of the vast technological improvements to protect investors while
unleashing capital formation. More broadly, given the fierce global competition
for capital, he noted, the continued protection, over-regulation and coddling
of US financial firms will lead to a weakening of US financial markets.
The oversight chair
then posed a series of specific questions that he wants Chairman Schapiro to
answer by July 3, 2012. The Committee on Oversight and Government Reform is the
principal oversight committee of the House with broad authority to investigate
any matter at any time under House Rule X.
Chairman Issa asks
if the exercise of substantial initial pricing discretion provided to
underwriters and issues in the 1933 Act can lead to pricing errors and
conflicts of interest. Specifically, he asks if the pricing discretion
exercised in the Facebook IPO harmed retail investors. Regarding underpricing
and allocations, he asked the SEC to provide a summary of internal or external
research the Commission has relied on with regard to IPO overpricing and
underpricing throughout the past 20 years. The oversight chair also wants to
know if the vast majority of shares go to institutional investors and wants to
see summary data on the allocation of IPO shares over the past 20 years to
institutional investors.
The House leader
also had a number of questions regarding barriers to communicating with
investors. He noted that the Securities Act enables underwriters to determine
the price of the issuance while they develop support from select potential
investors under protection from public debate on the issuers’ valuation. The
protection from public debate arises out of the restrictions to communicate
outside of the prospectus. These communications restrictions generally fall
within the quiet period. Separately Securities Act Rule 175, in the view of
Chairman Issa, fails to properly carve out analyst research reports made by on
or behalf of an issuer from Rule 10b-5 liability. As a result of Rule 175, he
averred, analyst research is withheld from retail investors.
It seemed to him
that the liability construct provided under Securities Act Rule 175 needlessly
prevents ordinary investors from receiving valuable information on IPOs. Chairman
Issa asked the SEC if it recognizes that the quiet period rules and liability
under Rule 175 provide institutional investors an informational advantage over ordinary
investors. Similarly, he asked the Commission if the quiet period is more and
more difficult to enforce given the advances in information technology.
Specifically, he requested SEC comment on the costs and benefits of enforcing
restrictions on communication in light of current technology. More broadly, he
wants to know if the restrictions on communication in the Securities Act
inhibit price discovery in the IPO process.
Chairman Issa also
asks the SEC to explain how restricting the access of ordinary investors to
marketing materials from an issuer protects them. He queries if the quiet
period is intended to protect ordinary investors from themselves.
He also questioned if analysts working in the research departments of brokerage firms suffer potential liability under Rule 175(a) if their analysis fails to accurately predict the performance of an IPO issuer. He asked if the SEC believes that it is reasonable to expect that analyst estimates are accurate ex-post and that any liability should be associated with something as unrealistic as predicting the future. Further, he wonders if subjective requirements for a reasonable basis and good faith open the door to needless and excessive litigation and prevent ordinary investors from receiving valuable information.
He asks the SEC if
it believes that, under the Section 27A safe harbor for forward-looking information,
these same analysts can provide earnings estimates for public companies without
being subject to liability if their earnings fail to meet the estimates. The
SEC should explain the substantive basis for treating analysts of an IPO issuer
differently than the analysis of a public company. Finally on this theme,
Chairman Issa asks the SEC if it would, consistent with Section 27A, consider
amending Rule 175 to provide a broad safe harbor for forward-looking
information about the issuer.
On the issue of
market price and fair market value, Chairman Issa asks for an explanation on
why the SEC considers market price to be the best determinant of market value
and contrast this approach with the non-market approach applied to traditional IPOs.
He asks if the common post-IPO pop in share price reflects artificial underpricing
and whether the pop reflects positively or negatively on securities market
efficiency. He queries if the SEC has the authority to impose a market-based IPO
price determination process without legislation.
Further, the SEC
should address whether a market-based auction model would eliminate the pricing
discretion exercised by the underwriter and the issuer. More particularly,
would the SEC ask Congress for the complete abandonment of the non-market based
approach provided by the 1933 Act in favor of a market-based approach, such as
a Dutch auction that the issuer opens to all market participants. The SEC is
requested to provide the Committee with information on whether allowing short
selling within the Dutch auction could act to eliminate concerns over puffing by
opening up the IPO to a broader set of initial investors.
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