Senate Draft Legislation Aims to Reform Securitization

In many ways, the financial crisis was at root a crisis of securitization. While traditional securitization was a successful tool for bundling loans into asset-backed securities, in the last decade it morphed into the short-term financing of complex illiquid securities whose value had to be determined by theoretical models. The inherent fragility of this new securitization model was masked by the actions of market intermediaries, particularly credit rating agencies.

The collapse of structured securitization revealed the ugly reality that, far from managing and dispersing risk, it had increased leverage and concentrated risk in the hands of specific financial institutions. The Obama Administration proposed the reform securitization by changing the incentive structure of market participants; increasing transparency to allow for better due diligence; strengthening credit rating agency performance; and reducing the incentives for over-reliance on credit ratings. Provisions of the Senate draft legislation, Restoring American Financial Stability Act, would implement these goals.

One of the most significant problems in the securitization markets was the lack of sufficient incentives for lenders and securitizers to consider the performance of the underlying loans after asset-backed securities were issued. Lenders and securitizers had weak incentives to conduct due diligence regarding the quality of the underlying assets being securitized. This problem was exacerbated as the structure of those securities became more complex and opaque. Inadequate disclosure regimes also exacerbated the gap in incentives between lenders, securitizers and investors.

There is a growing consensus that we have ``crossed the Rubicon’’ into originate and distribute securitization and there is no turning back to originate and hold. Indeed, restarting private-label securitization markets, especially in the United States, is critical to limiting the fallout from the credit crisis and to the withdrawal of central bank and government interventions. However, no one wants policies that would take markets back to their high octane levels of 2005–07. Thus, the draft legislation aims to put securitization on a solid and sustainable footing. The IMF has recognized that the return to a more robust securitization market will not be instantaneous, since it will take time for the new policies to be put in place and become effective, in part because deleveraging will continue for some time.

The draft reforms the process of securitization by, primarily, requiring companies that sell products like mortgage-backed securities to retain a portion of the risk to ensure that they will not sell garbage to investors, because they have to keep some of it for themselves. The Senate legislation would require companies that sell products like mortgage-backed securities to keep some ``skin in the game’’ by retaining at least 10 percent of the credit risk so that, if the investment doesn’t pan out, the company that made, packaged and sold the investment would lose out right along with the people they sold it to. In addition, the draft would require issuers to disclose more information about the assets underlying asset-backed securities and to analyze the quality of the underlying assets.

Specifically, the draft directs the federal banking agencies and the SEC to jointly adopt regulations requiring any securitizer to retain an economic interest of not less than 10 percent in a material portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers or sells to a third party. In addition, the regulations must prohibit a securitizer from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain with respect to an asset. The regulations must also specify the permissible forms of risk retention and the minimum duration of the risk retention.

The regulations must exempt the securitization of an asset issued or guaranteed by the United States, a federal agency, or a Government-sponsored enterprise, as the federal banking agencies and the Commission jointly determine appropriate. As a catch-all, the draft allows a total or partial exemption of any other securitizations, as may be appropriate in the public interest or for the protection of investors. Also, the regulations must allocate the risk retention obligations between a securitizer and an originator in the case of a securitizer that purchases assets from an originator, as the federal banking agencies and the Commission jointly determine appropriate. The regulations will be enforced by the federal banking agency with respect to any securitizer that is an insured depository institution; and by the SEC with respect to all other securitizers.

The SEC is directed to adopt regulations under the Securities Act requiring issuers of asset-backed securities to disclose for each tranche or class of security information regarding the assets backing that security. In adopting these regulations, the SEC must set standards for the format of the data provided by issuers of an asset-backed security, which must, to the extent feasible, facilitate comparison of such data across securities in similar types of asset classes.

In order to facilitate investors in performing independent due diligence, the SEC regulations must require issuers of asset-backed securities, at a minimum, to disclose asset-level or loan-level data, including data having unique identifiers relating to loan brokers or originators, The issuer must also disclose the nature and extent of the compensation of the broker or originator of the assets backing the security; and the amount of risk retained by the originator or the securitizer of such assets.

The SEC must also adopt regulations on the use of representations and warranties in the market for asset-backed securities that require each credit rating agency to include in any report accompanying a credit rating a description of the representations, warranties, and enforcement mechanisms available to investors how they differ from the representations, warranties, and enforcement mechanisms in issuances of similar securities.

The regulations must also require any originator to disclose fulfilled repurchase requests across all trusts aggregated by the originator, so that investors may identify asset originators with clear underwriting deficiencies. Finally, the Commission must issue regulations relating to the registration statement required to be filed by any issuer of an asset-backed security requiring them to perform a due diligence analysis of the assets underlying the asset-backed security; and disclose the nature of that analysis.

The draft adds a definition of asset-backed security to the Exchange Act to mean a fixed-income or other security collateralized by any type of self-liquidating financial asset, including a loan, a lease, a mortgage, or a secured or unsecured receivable, that allows the holder of the security to receive payments depending primarily on cash flow from the asset, including collateralized mortgage or debt obligations. The term asset-backed security does not include a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.

Dodd Draft Legislation Would Create New SEC Office of Credit Ratings as Key Part of Rating Agency Reform

Credit rating agencies market themselves as providers of independent research and in-depth credit analysis. But in the financial crisis, instead of helping people better understand risk, they failed to warn people about risks hidden throughout layers of complex structures.

Flawed methodology, weak oversight by regulators, conflicts of interest, and a total lack of transparency contributed to a system in which AAA ratings were awarded to complex, unsafe asset-backed securities and other derivatives, adding to the housing bubble and magnifying the financial shock caused when the bubble burst. When investors no longer trusted these ratings during the credit crunch, they pulled back from lending money to municipalities and other borrowers.

The Senate draft Restoring American Financial Stability Act mandates that each nationally recognized statistical rating organization must establish, enforce, and document an effective internal control structure governing the implementation of policies and methodologies they use to determine credit ratings. Further, the SEC must adopt rules requiring credit rating agencies to submit to the Commission an annual internal controls report, containing a description of the responsibility of the management of the rating agency in establishing and maintaining effective internal controls. In addition, the rating agency must assess the effectiveness of the internal controls and the attestation of the CEO.

The legislation would authorize the SEC to temporarily suspend or permanently revoke the registration of a credit rating agency with respect to a particular class or subclass of securities if the Commission finds, after notice and an opportunity for a hearing, that the rating agency does not have adequate financial and managerial resources to consistently produce credit ratings with integrity. In making this determination, the SEC must consider whether the rating agency has failed over a sustained period of time to produce accurate ratings for that class or subclass of securities; and whether the performance of the rating agency has been significantly worse than the performance of other rating agencies during the same time period.

The SEC must also adopt rules separating the ratings from sales and marketing. Specifically, the rules must prevent the sales and marketing considerations of
a rating agency from influencing the production of ratings. The SEC rules must provide for exceptions for small rating agencies when the Commission determines that the separation of the production of ratings and sales and marketing activities is not appropriate.

The Credit Rating Agency Reform Act of 2006 ordered rating agencies to name a compliance officer to ensure compliance with the securities laws and regulations. The draft prohibits these compliance officers from working on ratings, methodologies, or sales and marketing, and from establishing compensation levels except for employees working for them. The SEC may exempt a small rating agency from these limitations upon a finding that compliance with such limitations would impose an unreasonable burden on the agency.

The draft mandates that compliance officers must establish procedures for the receipt and treatment of complaints regarding ratings and the methodologies used to set the ratings, as well as a system to deal with confidential, anonymous complaints from employees or users of credit ratings.

Further, compliance officers must submit to the rating agency an annual report on the agency’s compliance with the securities laws and its own policies, including a description of any material changes to its code of ethics and conflict of interest policies and a certification that the report is accurate and complete. Then, the rating agency must file the compliance officer’s report with the SEC, along with the financial report already required to be furnished to the SEC. The Commission may treat as confidential any information contained in a financial statement upon determining that its publication may harm the rating agency.

The legislation creates an Office of Credit Ratings at the SEC with its own compliance staff and the authority to fine agencies. The Director of the Office of Credit Ratings would report directly to the SEC Chair; and the Office must be adequately staffed with persons with expertise in structured debt.

The Office is required to conduct annual examinations of rating agencies and make key findings public. The draft also requires rating agencies to consider information in their ratings that comes to their attention from a source other than the organizations being rated if they find it credible. The SEC is authorized to deregister an agency for providing bad ratings over time. The Senate draft would allow investors to bring private rights of action against ratings agencies for a knowing or reckless failure to investigate or to obtain analysis from an independent source.

In an effort to improve transparency, the draft would require rating agencies to disclose their methodologies, their use of third parties for due diligence efforts, and their ratings track record.

Senate Restoring American Financial Stability Act Mandates Say on Pay and Strong Compensation Committees

The Obama Administration and the G-20 have determined that corporate governance failures, including compensation that encouraged short-term risk taking, were significant causes of the financial crisis. Bonuses that rewarded short term profits over the long term health and security of the firm, and other incentive-based compensation for executives to take big risks with excess leverage, threatened the stability of their companies and the economy as a whole. Thus, the draft legislation gives shareholders a say on pay and proxy access, ensures the independence of compensation committees, and requires companies to set clawback policies to take back executive compensation based on inaccurate financial statements as important steps in reining in excessive executive pay and helping shift management’s focus from short-term profits to long-term growth and stability.

The Senate Banking Committee draft legislation provides that proxy materials must include provisions for a separate shareholder advisory vote to approve the compensation of company executives. Similarly, a separate shareholder advisory vote is required for golden parachute agreements in connection with a takeover. These non-binding shareholder votes cannot be construed to overrule a decision by the board, to create or imply any change to the directors’ fiduciary duties or create any new duties, or to restrict or limit the ability of shareholders to make proposals for inclusion in proxy materials related to executive compensation.

The Restoring American Financial Stability Act provides shareholders with this 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 draft also directs the SEC to clarify disclosures relating to executive compensation, and require the disclosure of information showing the relationship between executive compensation and the financial performance of the company. There must be disclosure of charts comparing executive compensation with stock performance over a five-year period or another period as the SEC determines.

The draft amends Section 16 of the Exchange Act to require companies to develop and implement clawback policies. Thus, companies must adopt polices to take back executive compensation if it was based on inaccurate financial statements that did not comply with accounting standards and that required an accounting restatement due to the material noncompliance with any financial reporting requirement under the securities
laws. The company must recover from any current or former executive officer who received incentive-based compensation, including stock options, awarded during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.

The draft also directs the SEC to require companies to disclose in their annual proxy statement whether their employees are permitted to engage in hedging by purchasing financial instruments, such as equity swaps, that are designed to hedge or offset any decrease in the market value of equity securities granted to employees by the company as part of employee compensation.

The draft gives shareholders access to management’s proxy card to nominate directors. Providing shareholders a greater role in choosing directors can help shift management’s focus from short-term profits to long-term growth and stability. Specifically, 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.

Corporate governance best practices often specify that the same individual should not serve as board chairman and CEO. In the spirit of the comply or explain concept enshrined in European corporate governance codes, the draft directs the SEC to adopt rules requiring a company to explain in its annual proxy sent to investors the reasons why it has chosen the same person to serve as board chair and chief executive officer or why it has chosen different individuals to serve as board chair and CEO.

Within one year, the draft directs the SEC to adopt rules prohibiting companies from having a board of directors with staggered terms of service unless the shareholders have approved such in advance. The percentage of shareholders required to approve a board of directors with staggered terms of service must be the percentage required by the company for an amendment to the certificate of incorporation or the bylaws. The draft defines a board with staggered terms of service as a board that conducts an annual election for membership in which fewer than all board members are elected.

Companies that already have boards with staggered terms of service not approved by shareholder vote would have to seek shareholder approval at the first annual meeting after the SEC rules are adopted.

In a major corporate governance improvement, the draft mandates independent board compensation committees, as well as mandating the independence of any compensation consultants and legal advisers hired by the committee. This will be a condition of listing on an exchange. 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. Separately, the SEC is directed to adopt rules defining independence for compensation consultants and legal counsel hired by the compensation committee. Also, the SEC is directed to conduct a study and file a report on the effects of using compensation consultants on company performance.

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, prosy 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 draft also gives the compensation committee sole discretion to hire and obtain the advice of counsel and other advisers; and provides that the committee 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 counsel. 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.

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.

SEC rules must allow exchanges to consider exempting a category of issuers from the compensation committee requirements. In determining appropriate exemptions, the exchange must take into account the potential impact of the requirements on smaller reporting companies.

Senate Banking Committee Issues Draft Legislation Reforming US Financial Regulation

The Senate Banking Committee has released draft legislation that would provide a sweeping overhaul of the regulation of US financial services and markets. The draft would provide for joint SEC-CFTC regulation of derivatives, make the SEC self-funding, strengthen the Commission’s powers, better protect investors, and efficiently and effectively regulate the securities markets The Restoring American Financial Stability Act of 2009 would also reform the credit rating agency process by, among other things, establishes a new Office of Credit Rating Agencies at the SEC to enhance rating agency regulation and mandating new rules for internal controls, independence, transparency and penalties for poor performance in order to restore investor confidence in these ratings.

Following the council of systemic risk regulators model employed in the European Union legislation and in the House draft, the Senate legislation would create an independent agency with a board of regulators to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the financial system. The new Agency for Financial Stability could require companies that threaten the economy to divest some of their holdings. The Agency would be composed of, among others, the Chairs of the Fed, SEC and CFTC, with an independent Chair appointed by the President and confirmed by the Senate.

The failures to detect the Madoff and Stanford Financial frauds demonstrated deep deficiencies in the existing securities regulatory structure. The Restoring American Financial Stability Act would provide dozens of new enforcement powers and regulatory authorities. Thus, the SEC will be able to enhance its enforcement programs and gain the tools needed to better protect investors and police the markets.

The draft also provides for strong corporate governance protections, incorporating many of the provisions of Senator Schumer’s corporate governance bill, The Shareholder Bill of Rights Act, S 1074. The draft would require public companies to hold an annual advisory vote on executive compensation policies, as well as require shareholder approval of executive golden parachutes.

Similar to the House legislation, the Senate draft would mandate, for the first time, the federal regulation of derivatives. It would authorize the SEC and CFTC to regulate over-the-counter derivatives so that irresponsible practices and excessive risk-taking can no longer escape regulatory oversight. The draft uses the Administration’s outline for a joint rulemaking process with the new systemic risk regulators, the Agency for Financial Stability stepping in if the SEC and the CFTC cannot agree. The draft mandates central clearing and exchange trading for derivatives that can be cleared and provides a role for both regulators and clearing houses to determine which contracts should be cleared. It requires the SEC and the CFTC to pre-approve contracts before clearing houses can clear them.

Similar to the House draft, the Senate legislation would require the SEC registration of hedge fund and other private fund advisers and disclosure of information to the Commission under a confidentiality regime. Similar to the House draft, the Senate bill would exempt advisers to venture capital funds from SEC registration. The SEC must require hedge fund advisers to disclose the amount of assets under management, their use of leverage and counterparty credit risk exposure, as well as their trading and investment positions, their valuation methodologies of the fund, and any side arrangements or side letters that treat fund investors more favorably than other investors.

The Senate draft orders the Comptroller General to conduct a study and submit a report to Congress on the feasibility of forming a self-regulatory organization to oversee hedge funds, private equity funds, and venture capital funds

The draft would also realize a goal of SEC self-funding. The legislation would allow the SEC to fund its own operations by using the transaction and registration fees it collects in place of a Congressionally-mandated budget. Self-funding will give the SEC access to millions more than is allocated through the Congressional appropriations process.

The SEC is one of only two federal financial regulators that must go through the annual Congressional appropriations process. Federal banking regulators such as the Federal Reserve and the FDIC, on the other hand, can use what they collect in fees, deposit insurance and interest income to fund their operations.

Under the current system, the SEC staff is struggling to keep up with the more sophisticated actors in the market, and the federal government cannot keep starving the SEC’s budget or the agency will ``remain a shadow of its former self,” said Senator Schumer, a key member of the Banking Committee, who noted that the Commission’s ability to retain experienced personnel is an ongoing problem since Wall Street firms are increasingly able to lure the agency’s experts with higher salaries. Mr. Schumer emphasized that the SEC’s chronic under-funding must be addressed in a comprehensive way.

Currently, the SEC raises millions more dollars every year in registration and transaction fees (not including enforcement penalties or settlements) than it is allocated through the appropriations process, he noted, but its budget is limited to the amount approved by Congress. In 2007, though the SEC brought in $1.54 billion in fees, it secured just $881.6 million in funding. Had the agency simply been able to hold onto all the fees it collected, reasoned the senator, it would have represented a 75 percent increase over the budget it was allotted through the appropriations process. SEC Chair Mary Schapiro has already signaled her support for self-funding.

The Madoff fraud revealed that the Public Company Accounting Oversight Board lacked the powers it needed to examine the auditors of broker-dealers. The $65 billion Ponzi scheme also exposed faults in the Securities Investor Protection Act, the law that returns money to the customers of insolvent fraudulent broker-dealers. The Investor Protection Act closes these loopholes and fixes these shortcomings.

Broker-dealers are brought under the PCAOB oversight regime. The Board will inspect the audit reports on broker-dealer financial statements; and will have investigatory, examination and enforcement authority over the auditors of broker-dealers. In addition, brokers and dealers would be brought into the Board’s funding scheme by paying a fee allocation in proportion to their net capital compared to the total net capital of all brokers and dealers that are not issuers, in accordance with the rules of the Board. The draft also authorizes the Board to refer an investigation concerning a broker or dealer’s audit report to the relevant self-regulatory organization. Moreover, the Board is authorized to share with the SRO all information and documents received in connection with an investigation or inspection without breaching its confidential status.

Acting on a recommendation of the Obama Administration, the House draft mandates a federal fiduciary standard for brokers and investment advisers in their dealings with retail customers. Under this harmonized standard, broker-dealers and investment advisers will have to put customers’ interests first. The Senate draft mandates uniform standards for anyone providing customers investment advice, eliminating different standards for broker‐dealers and investment advisers

Similar to the House draft, the Senate legislation would reorder federal-state regulation of investment advisers by raising the SEC registration trigger of assets under management to $100 million. This would effectively move the regulation of thousands of investment advisers from the SEC to the states. The drafts would raise the assets under management trigger from $25 million to $100 million. Thus, the drafts set up state oversight of investment advisers with up to $100 million in assets under management. The $25 million trigger for state regulation was set in the National Securities Markets Improvement Act of 1996.

Because mandatory arbitration of brokerage disputes has limited the ability of defrauded investors to seek redress, the House and Senate drafts would authorize the SEC to bar these clauses in brokerage firm customer contracts.

Similar to the House draft, the Senate legislation contains specific provisions dealing with senior investor protection. The NASAA has long been concerned with the use of misleading professional designations that convey an expertise in advising seniors on financial matters. Many of these designations in reality reflect no such expertise but rather are conveyed to individuals who pay to attend weekend seminars and take open book, multiple choice tests. NASAA has adopted a model rule designed to curb abuses in this area.

The drafts recognize the harm to seniors posed by the use of such misleading activity and establishes a mechanism for providing grants to states as an incentive to adopting the NASAA model rule. The grants are designed to give states 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.

In addition, the Senate draft directs the SEC to adopt rules increasing the financial threshold for an accredited investor under the Securities Act of 1933, bycalculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the SEC determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living. The Comptroller General is ordered to conduct a study and report to Congress on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in hedge funds.

The Senate draft would provide for safe and efficient arrangements for the clearing and settlement of securities, and other financial transactions

Know Your Limits: Government Lawyers Weigh In on Inquiry Notice Case

In late November the U.S. Supreme Court will hear oral argument in an important securities litigation case. The court will address the meaning of "inquiry notice" for limitations purposes in its review of Merck & Co. v. Reynolds, a 3rd Circuit decision arising from the Vioxx litigation. The U.S. District Court for the District of New Jersey had previously dismissed the action on limitations grounds, concluding that there were ample "storm warnings" concerning the safety of Vioxx from press reports and FDA statements. However, Judge Dolores K. Sloviter wrote that the lower court "acted prematurely in finding as a matter of law" that the plaintiffs were on inquiry notice resulting in the dismissal under the statute of limitations.

Initially, the appeals court reaffirmed the standard for inquiry notice in the circuit, stating that the question is "whether the plaintiffs, in the exercise of reasonable diligence, should have known of the basis for their claims depends on whether they had sufficient information of possible wrongdoing to place them on inquiry notice or to excite storm warnings of culpable activity." Judge Sloviter then wrote that with regard to the claimed misrepresentations concerning the safety profile for Vioxx that "the fact that many securities analysts continued to maintain strong growth ratings for Vioxx at the same time that its safety was being questioned is certainly relevant to whether such questions constituted sufficient information of possible wrongdoing to trigger storm warnings."

A significant element of the claim involved a study of Vioxx and naproxen, a non-prescription pain reliever. The study showed a higher rate of heart problems for Vioxx users than for naproxen patients. However, Merck asserted that the disparity could be accounted for by the beneficial effects of naproxen on the cardiovascular system rather than any unreasonable danger associated with Vioxx. She concluded that "there is no reason to suspect that Merck did not believe the naproxen hypothesis" until a Harvard study in 2003 discredited the notion. Accordingly, the panel found that Merck did not know its public statements in 2001 were false.

The SEC and the solicitor general have filed an amicus brief with the high court urging the justices to affirm the 3rd Circuit decision. According to the government brief, the limitations period "does not begin to run until the plaintiff has actually discovered, or in the exercise of reasonable diligence ought to have discovered, facts demonstrating that all the elements of a securities fraud violation can be established." In particular, the government argued, because scienter is an essential element of a Section 10(b) violation, the term “facts constituting the violation” is best construed to include facts demonstrating that the defendant possessed the requisite mental state. While the concept of discovering the relevant facts encompasses constructive as well as actual discovery, the government asserted that "constructive discovery is properly deemed to occur at the time a reasonably diligent investor would have unearthed the relevant facts" and not when such an investor would begin investigating.

The government brief rejected the company's argument that the relevant facts for inquiry notice include only those concerning the defendant’s conduct, and not the defendant’s state of mind. Because the potential plaintiff must be alerted to the possible existence of a violation rather than just a misstatement, the government lawyers stated that "it is particularly clear that the `facts constituting the violation' include facts demonstrating the requisite scienter."

Several organizations have also filed briefs with the court, including the Pharmaceutical and Research Manufacturers of America, the Washington Legal Foundation, the U.S. Chamber of Commerce and the Securities Industry and Financial Markets Association. For example, according to the SIFMA brief, inquiry notice is triggered by awareness of an injury, regardless of whether the plaintiff had knowledge of the defendant's culpability. SIFMA concluded that when "a plaintiff has not conducted any investigation...no purpose would be served by extending the time within which to sue beyond two years from inquiry notice that there was a misrepresentation."

Oral argument is set for November 30, 2009.

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Fierce Debate Rages on Amendment to House Legislation Exempting Smaller Companies from 404(b) of Sarbanes-Oxley

The bi-partisan Garrett-Adler Amendment exempting smaller reporting companies from the internal control auditor attestation requirements contained in Section 404(b) of the Sarbanes-Oxley Act has been criticized by an SEC Commissioner even while it appears to have White House and Treasury support. The amendment is part of the Investor Protection Act that recently passed the House Financial Services Committee. The amendment’s language mirrors legislation Rep. Garrett introduced earlier this year, the Small Business SOX Compliance Relief Act, HR 3775.

Section 404(a) of Sarbanes-Oxley requires that annual reports filed with the SEC must be accompanied by a statement that company management is responsible for creating and maintaining adequate internal controls and a further statement assessing the effectiveness of those controls. Section 404(b) requires the company's outside auditor to report on and attest to management's assessment of the company's internal controls.

Specifically, the Garrett-Adler Amendment would permanently exempt non-accelerated issuers with a market capitalization of $75 million or less from Section 404 (b) of Sarbanes Oxley Act. It only exempts small companies from complying with this one particular subsection of Sarbanes Oxley, while maintaining investor protections by requiring them to continue complying with the rest of the statute. In addition, it requires the SEC and the Comptroller General to conduct a study to determine how the SEC can reduce the burden of complying with Section 404(b) for companies whose market capitalization is between $75 and $250 million. The study must also consider whether reducing the compliance burden or a complete exemption for these companies would encourage them to list on US exchanges in their initial public offerings.

Although the stated intent of Sarbanes-Oxley was to provide investor confidence in the financial markets through greater accountability and disclosure, some members of Congress believe that the Act has had the unintended effect of creating undue and often unbearable burdens on small businesses. According to Rep. Garrett, there is a place for federal oversight, but the weighty cost of compliance under Section 404 is slowly strangling small businesses. It is diverting valuable resources away from other legitimate business needs; creating massive and tedious documentation requirements; and discouraging the public listing of both international and domestic companies on U.S. markets.

The SEC has repeatedly extended the deadline for non-accelerated filers to begin providing audited assessments of their internal controls over financial reporting, an acknowledgement of continued concern about compliance costs. Although reforms were made in 2007 to relax the guidelines for smaller companies, noted Rep. Garrett, businesses of all sizes still report excessive compliance costs. He cited an SEC report from September 2009 that found a majority felt that the costs of compliance outweighed the benefits. This was especially true among smaller companies.

Rep. Adler said that the current small business exemption will expire early next year unless Congress makes it permanent. He emphasized that the amendment will provide stability and predictability for these businesses by permanently exempting them from these costly regulations. In his view, the "one size fits all" regulatory approach to implementing section 404 of Sarbanes Oxley has had a disproportionately negative impact on small and medium sized companies. The current and pending compliance burden has sent many companies to market overseas or dissuaded them from going public on US exchanges. This is one reason, said Rep. Adler, that the White House and Treasury support the amendment.

The broad goal of the amendment is to maintain the high levels of transparency individual investors need to make informed decisions, without damaging market competiveness. These regulations should take into account the different characteristics and limitations of various sized companies, said Rep. Adler, keeping the largest companies in check, while allowing smaller companies to help the economy grow and create jobs.

In remarks during the markup of the legislation, Ranking Member Spencer Bachus echoed the need for these non-accelerated filers to have predictability going forward. He also supports having the SEC study the impact of 404(b) on companies with a market cap between $75 million and $250 million. But the Ranking Member cautioned that Congress must be watchful for possible compliance problems when companies granted the $75 million exemption transition above that amount.

There is growing opposition to the amendment from the SEC, some House leaders and the auditing industry. During the markup, Rep. Paul Kanjorski, Chair of the Capital Markets subcommittee, said that making the 404(b) exemption permanent thwarts the intent of Sarbanes-Oxley and could even be dangerous. He said that Congress intended for all companies to comply with the auditor attestation provisions of section 404; and now, without evidence, the amendment reverses congressional intent. He added that the SEC Chair opposes the amendment.

In recent remarks opposing the amendment, SEC Commissioner Luis Aquilar said that, while the Commission does not generally track companies based on market cap, the SEC does have data on companies that generally have $75 million or less in public float, and the staff estimates that over 6,000 public companies may fall under that threshold. To repeal this part of Sarbanes-Oxley now, he cautioned, would be to throw away a substantial amount of work done by regulators, companies, and private organizations to make compliance with 404(b) more cost-effective.

During the period when the SEC suspended 404(b) for smaller public company compliance, the SEC and PCAOB developed standards, rules and guidance to allow 404(b) to be implemented in a manner that would work for both large and small public companies. A central goal of this work focused on making sure that costs for smaller public companies were not overly burdensome. It would be ironic that, if 404(b) is undercut now, the benefit of all the work done by the SEC and PCAOB will never be realized and smaller public companies would not be able to take advantage of the practical lessons learned from companies that are already complying. He urged the House to strip out the Garrett-Adler Amendment and also urged the Senate not to include what he called ``this deregulatory initiative’’ in its parallel legislation.

Similarly, in a letter to the Committee leadership, the Center for Audit Quality said that it supports the SEC’s position that there be no further delay in Section 404(b) compliance for smaller companies. Further, CAQ believes that the required independent audit of management’s assessment of the effectiveness of a company’s internal controls, as required by section 404(b), has been integral to the achievement of the intended objectives of internal control reporting under Section 404.

Echoing Commission Aquilar, CAQ noted that the SEC and PCAOB initiatives have significantly reduced the cost of complying with the external audit of internal controls required by 404(b). CAQ particularly extolled the PCAOB’s adoption of Auditing Standard No. 5, which enables auditors to focus their effort on those areas that were critical to a company’s internal controls, use their judgment, and scale the procedures necessary to conduct the audit to a company’s particular circumstances.

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SEC Commissioner Pushes Back on Bachus FINRA Amendment to House Legislation

SEC Commissioner Luis Aquilar is deeply troubled by an amendment to the House Investor Protection Act that would transfer oversight of a substantial number of investment advisers from the SEC to an industry self-regulator, FINRA, which he describes as outsourcing regulatory responsibility from the SEC. In remarks at the Institute for Law and Economic Policy, the Commissioner was incredulous that House leaders would vote to outsource core functions of SEC oversight at the same time they are creating a new federal Consumer Financial Protection Agency to buttress protections for consumers. In his view, a government agency subject to Congressional oversight and multiple audits by agencies such as GAO is accountable in ways that an industry organization can never be. The Commissioner also said that the legislation is ``at war with itself’’ because other provisions enhance SEC investment adviser oversight. But he is buoyed by news reports that House Financial Services Committee Chair Barney Frank intends to strip the Bachus Amendment out of the legislation as it heads to the House floor.

Offered by Committee Ranking Member Spencer Bachus, the amendment would allow the SEC to permit or require FINRA to enforce compliance by its members and associated persons with the provisions of the Act. In other words, the amendment would empower FINRA to enforce the fiduciary duty provisions in the Investment Advisers Act against not only broker-dealer members but also against any affiliated investment advisory firm or any associated person. Additionally, the amendment would give FINRA sweeping rulemaking authority.

In a letter to the Committee, the financial planning industry expressed concern that the Bachus Amendment would extend FINRA’s authority to approximately 88 percent of investment adviser representatives and implicate application of the fiduciary duty to investment advice. The industry also claimed that the expansion of FINRA’s authority would be without precedent and the impact of this new oversight structure would be significant. For the first time, FINRA would be granted authority to regulate people and practices outside the scope of the Securities Exchange Act.

Commissioner Aquilar rejected the main argument in favor of putting oversight in the hands of an industry self-regulator, which is that the SEC lacks resources. The issue of resources masks the real situation, he said, since no private organization has the existing resources to expand investment adviser oversight. No one can suggest that FINRA will oversee advisers using the current budget and staff it has in place. Instead, the investment advisers will need to be assessed a bill for this additional oversight. And if advisers have to write a check to someone, he noted, it makes much more sense for that check to go to the SEC since the SEC already has the team and expertise in place. This issue really boils down to whether Congress is going to enhance the SEC by expanding its authority and fortifying its resources, including user fees from advisers, or weaken the SEC, by taking away its direct oversight in order to transfer it to an industry organization

The Commissioner assured state authorities that he continues to support the historic joint state-federal oversight of investment advisers. But injecting an industry organization into the mix dramatically changes the oversight structure in ways that do not make sense, particularly given the other provisions in the proposed legislation. The legislation would transfer oversight over a significant amount of advisers to the states by increasing the threshold requirement for federal registration as well as provides for user fees to pay for oversight. In his view, these two provisions taken together would significantly strengthen the SEC's oversight framework for advisers. Thus, he described the legislation as being "at war with itself" because of the significant transfer of oversight responsibility to FINRA.

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Against Backdrop of Pending Legislation, SEC Chair Pledges Adoption of Shareholder Access Early Next Year

Against the backdrop of draft House legislation designed to provide authorization cover to the SEC’s adoption of shareholder access rules, SEC Chair Mary Schapiro said that she would bring final shareholder access rules to the full Commission for consideration early in 2010. While recognizing that this means that any new rules will not be in effect for the 2010 proxy season, the Chair emphasized that it is far more important that the SEC adopt rules that make sense and are workable than it is for the Commission to act rashly.

In remarks at a recent PLI seminar, she also noted that the SEC wants to enhance the information provided to shareholders who are making voting and investment decisions. The SEC has proposed rules requiring shareholders to be given more information about the qualification of directors and nominees, the structure of board governance, compensation consultant fees and conflicts , and the relationship between a company's overall compensation policies and its risk profile. In addition, the SEC is looking for more timely disclosure of annual meeting voting results. In each of these areas, emphasized the Chair, the goal is better or more timely disclosure, not simply additional disclosure. The Commission believes that investors are not well-served by a proxy statement that is too long to digest.

Recently, the SEC approved changes to NYSE Rule 452 eliminating broker discretionary voting for uncontested elections of directors at shareholder meetings. Previously, Rule 452 had allowed brokers to vote on behalf of their beneficial owner customers in uncontested elections of directors if the customers have not returned voting instructions. The change was designed to enhance corporate governance and accountability by helping assure that investors with an economic interest in the company vote on the election of directors.

In her remarks, the SEC Chair noted that implementation of the revised rule has heightened concerns about shareholder participation and education, which need to be addressed. The SEC staff is working hard on these educational efforts in order to develop pragmatic solutions to these challenges.

The Chair noted that the SEC staff is drafting a concept release on the mechanics by which proxies are voted and the way in which information to shareholders is conveyed. The SEC is looking at the entire process through which proxies are distributed and votes are tabulated in order that the proxy voting system as a whole operates with the degree of reliability, accuracy, and transparency that shareholders and companies have a right to expect.

The staff will be examining whether current SEC regulations adequately address whether votes are cast by those with an economic interest in the securities. In some cases, for instance, brokerage firm customers may cast more votes than the broker is actually entitled to vote on their behalf, something called "overvoting". In other cases, individuals are able to vote shares even though they lack the full economic interest that goes along with share ownership, a process known as "empty voting."

The staff will also examine ways to address the voting rate by retail investors. Retail investors have a history of low participation rates, the Chair noted, but notice and access distribution of proxy materials may contribute to a further reduction in participation rates. This poses a special challenge for companies with broad retail investor bases, she observed, which has fueled a call for client-directed voting under which brokers would be allowed to solicit voting instructions from their shareholder clients in advance of the company proxy materials.

Finally, the concept release will ask about the need to allow beneficial owners of a company's securities to object to having their names and addresses disclosed to the company. Some have urged the SEC to abolish this system and instead permit companies to learn the identities of all of their shareholders so that companies can communicate more directly and cost-effectively with them.

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Chamber of Commerce Opposes Waters Amendment on Shareholder Access

Legislation passed by the House Financial Services Committee would authorize the SEC to implement shareholder access to management’s proxy card to nominate directors for election to the board. The Waters Amendment to the Investor Protection Act would authorize the SEC to implement rules and procedures granting shareholders the opportunity to nominate at least one director to a corporation’s board of directors, a right known as proxy access. In the view of Rep. Waters, the amendment was needed because, without it, the SEC would have most likely faced a lawsuit from corporations and their industry groups alleging that the Commission lacked the authority to grant shareholders this right. The SEC proposes allowing shareholders to include their nominees for director in the company's proxy materials if they have been shareholders of the company for at least one year and satisfy a minimum holdings test based on the company’s market value.

In a letter to Committee Chair Barney Frank, the US Chamber of Commerce criticized the Waters Amendment as federalizing corporate law with a one-size-fits-all approach when what is needed is a flexible state-based approach that allows shareholders and the board to choose a governance structure that works best for the company. Delaware has enacted legislation clarifying the authority of companies and their shareholders to adopt proxy access and proxy reimbursement bylaws, noted the Chamber, and an American Bar Association committee is addressing similar amendments to the Model Business Corporation Act on which 30 state corporate statutes are based. Coming at this time, said the Chamber, the Waters Amendment would deprive shareholders of existing rights and weaken existing corporate governance structures. Moreover, the Waters Amendment would disenfranchise individual investors and empower special interests.

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District Court Went Too Far in Naming Lead Counsel

The 9th Circuit granted a writ of mandamus to vacate part of a lower court order naming one of two firms to serve as lead counsel in a class action fraud suit. While recognizing that the issuance of a writ of mandamus is a "drastic" and "extraordinary" remedy, the appellate panel found clear error in the appointment of a firm not selected by the lead plaintiffs. (In re Cohen v. U.S. District Court for the Northern District of California, link).

Following PSLRA requirements, the district court named an individual and a pension fund as lead plaintiffs. The court then named the firm selected by the pension fund as co-lead counsel, but appointed a firm other than that chosen by the individual lead plaintiff to also serve. The district court stated that after a "review of each firm’s resume, . . . [and] given each firm’s experience with similar actions, these firms were the most qualified counsel for this case.”

On appeal, the court found that the district court's authority under the PSLRA to approve the choice of lead counsel did not extend to the court selecting counsel itself. The panel vacated that portion of the lower court's order, but declined to name the individual's selected firm to choose. Rather, the appellate court directed the trial judge to review the individual lead plaintiff's selection under the appropriate criteria, and should defer to that selection if it was reasonable. "The district court should not reject a lead plaintiff’s proposed counsel merely because it would have chosen differently," concluded the panel.

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House Financial Services Committee Passes Legislation Reforming SEC, PCAOB and SIPC Oversight

The House Financial Services Committee has passed legislation reforming the SEC to strengthen its powers, better protect investors, and efficiently and effectively regulate the securities markets. The failures to detect the Madoff and Stanford Financial frauds demonstrated deep deficiencies in the existing securities regulatory structure. The Act doubles the authorized funding for the SEC over the next 5 years and provides dozens of new enforcement powers and regulatory authorities. Thus, the SEC will be able to enhance its enforcement programs and gain the tools needed to better protect investors and police the markets. The Investor Protection Act, HR 3817, also authorizes the SEC to collect user fees from advisers to cover the costs of compliance examinations and investigations.

The Madoff fraud revealed that the Public Company Accounting Oversight Board lacked the powers it needed to examine the auditors of broker-dealers. The $65 billion Ponzi scheme also exposed faults in the Securities Investor Protection Act, the law that returns money to the customers of insolvent fraudulent broker-dealers. The Investor Protection Act closes these loopholes and fixes these shortcomings.

Broker-dealers are brought under the PCAOB oversight regime. The Board will inspect the audit reports on broker-dealer financial statements; and will have investigatory, examination and enforcement authority over the auditors of broker-dealers. In addition, brokers and dealers would be brought into the Board’s funding scheme by paying a fee allocation in proportion to their net capital compared to the total net capital of all brokers and dealers that are not issuers, in accordance with the rules of the Board. The draft also authorizes the Board to refer an investigation concerning a broker or dealer’s audit report to the relevant self-regulatory organization. Moreover, the Board is authorized to share with the SRO all information and documents received in connection with an investigation or inspection without breaching its confidential status.

The Garrett Amendment would change the name of the PCAOB to Auditor Oversight Board. In addition, the Jenkins-Garrett Amendment would create an ombudsman within the Auditor Oversight Board to act as a liaison between the Board and registered accounting firms and issuers with regard to the issuance of audit reports. The ombudsman would also deal with any problem that registered firms or issuers may have in dealing with the Board resulting from the Board’s regulatory activities, particularly with respect to internal control over financial reporting and audit attestation under Section 404 of Sarbanes-Oxley.

Currently, under the Securities Investor Protection Act, any amount advanced in satisfaction of customer claims may not exceed $500,000 per customer. If part of the claim is for cash, the total amount advanced for cash payment must not exceed $100,000. The draft would increase the cash payout to $250,000 and adjust it for inflation.

In addition, the draft provides that persons who falsely represent, with an intent to deceive or cause injury to another, that they are a member of SIPC or that any person or account is protected by SIPC, is subject to a fine of $250,000 or five years in prison. Similarly, any Internet service provider that transmits or stores any material containing misrepresentation of SIPC membership will be liable for any damages caused thereby, including damages suffered by SIPC, if the service provider knew or should have known that the material contains the misrepresentation and fails to act expeditiously to remove, or disable access to, the material.

An amendment by Chairman Frank would move the regulation of thousands of investment advisers from the SEC to the states. The amendment would raise the assets under management trigger from $25 million to $100 million. And it would authorize the SEC to move it even higher. Thus, the Amendment sets up state oversight of investment advisers with up to $100 million in assets under management. The $25 million trigger for state regulation was set in the National Securities Markets Improvement Act of 1996.

An amendment offered by Ranking Member Bachus would permit the SEC to delegate responsibility to the broker-dealer SRO, FINRA, to enforce compliance by its members and associated persons with the provisions of the Act. In other words, the amendment would empower FINRA to enforce the fiduciary duty provisions in the Investment Advisers Act against not only broker-dealer members but also against any affiliated investment advisory firm or any associated person. Additionally, the amendment would give FINRA sweeping rulemaking authority.

In a letter to the Committee, the financial planning industry expressed concern that the Bachus Amendment would extend FINRA’s authority to approximately 88 percent of investment adviser representatives and implicate application of the fiduciary duty to investment advice. The industry also claimed that the expansion of FINRA’s authority would be without precedent and the impact of this new oversight structure would be significant. For the first time, FINRA would be granted authority to regulate people and practices outside the scope of the Securities Exchange Act.

Acting on a recommendation of the Obama Administration, the draft mandates a federal fiduciary standard for brokers and investment advisers in their dealings with retail customers. Under this harmonized standard, broker-dealers and investment advisers will have to put customers’ interests first. The receipt of compensation based on commission or fees will not, in and of itself, be considered a violation of such standard applied to a broker or dealer or investment adviser. The draft would define retail customers as those receiving personalized investment advice from a broker, dealer, or investment adviser for use primarily for personal, family, or household purposes.

The draft also directs the SEC to facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with brokers, dealers, and investment advisers and adopt rules prohibiting sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that it deems contrary to the public interest and the interests of investors.

Further, the draft directs the SEC to adopt regulations ensuring, to the extent practicable, that the enforcement options and remedies available for violations of the standard of conduct applicable to a broker or dealer providing investment advice to a retail customer are commensurate with those available for violations of the standard of conduct applicable to investment advisers under the Investment Advisers Act.

The legislation sets up a whistleblower bounty program that creates incentives to identify wrongdoing in the securities markets and reward individuals whose tips lead to successful enforcement actions. With a bounty program, there will effectively have more cops on the beat in our securities markets.

Because mandatory arbitration of brokerage disputes has limited the ability of defrauded investors to seek redress, the draft would authorize the SEC to bar these clauses in brokerage firm customer contracts. The Neugebauer Amendment would direct the US Comptroller General to conduct a study on the costs of using the FINRA-operated arbitration system as opposed to the costs of litigation and submit a report to the SEC’s congressional oversight committee in one year. Specifically, the report must determine the percentage of recovery of the total amount of a claim in a FINRA arbitration proceeding.

The Miller Amendment authorizes the SEC and CFTC to establish a joint advisory committee to develop solutions to emerging and ongoing issues in the securities and commodities markets. The advisory committee would also serve as a vehicle for discussion and communication on regulatory issues affecting the SEC and CFTC and the markets and the securities and futures industries.

The draft gives the SEC nationwide service of subpoenas for use in enforcement actions under the Securities Act, Exchange Act, Investment Company Act and Investment Advisers Act. Also, the draft would add a new Section 15F to the Exchange Act to provide for the registration of municipal financial advisers. The SEC is authorized to grant exemptions from the registration mandate.

The bi-partisan Garrett-Adler amendment exempts small businesses from the internal control audit attestation reporting requirements contained in Section 404(b) of the Sarbanes-Oxley Act. The amendment language mirrors legislation Rep. Garrett introduced earlier this year, the Small Business SOX Compliance Relief Act, HR 3775.

Although the stated intent of Sarbanes-Oxley was to provide investor confidence in the financial markets through greater accountability and disclosure, the Act has had the unintended effect of creating undue and often unbearable burdens on small businesses. According to Rep. Garrett, there is a place for federal oversight, but the weighty cost of compliance under Section 404 is slowly strangling small businesses. It is diverting valuable resources away from other legitimate business needs; creating massive and tedious documentation requirements; and discouraging the public listing of both international and domestic companies on U.S. markets.

The SEC has repeatedly extended the deadline for non-accelerated filers to begin providing audited assessments of their internal controls over financial reporting, an acknowledgement of continued concern about compliance costs. Although reforms were made in 2007 to relax the guidelines for smaller companies, businesses of all sizes still report excessive compliance costs, as noted in an SEC report from September 2009 .In summarizing survey responses from businesses regarding the benefits of Section 404 compliance, the SEC said that a majority felt that the costs of compliance outweighed the benefits. This was especially true among smaller companies.

The Waters-Peters Amendment would authorize the SEC to implement rules and procedures granting shareholders the opportunity to nominate at least one director to a corporation’s board of directors, a right known as proxy access. In the view of Rep. Waters, the amendment was needed because, without it, the SEC would have most likely faced a lawsuit from corporations and their industry groups alleging that the Commission lacked the authority to grant shareholders this right.

Congress believes that proxy access is necessary for shareholders to have a meaningful choice in exercising their right to vote for board members, and thus to hold boards accountable. Board nominees are typically selected by the very management that the board is meant to oversee, creating a board indebted to management, potentially weakening the board’s accountability and oversight, and diluting the power of shareholders. The amendment provides shareholders with a meaningful say in the process.

Regulation of proxy access and disclosure is a core function of the SEC and is one of the original responsibilities that Congress assigned to the Commission when it was created in 1934. The amendment would create a new federal right to proxy, but would also ensure that the already-written laws on the right to proxy are upheld.

In an effort to address the revolving door problem, the Castle-Spier Amendment orders the US Comptroller General to conduct a study to review the number of SEC employees who leave the Commission to work for financial institutions regulated by the SEC and file a report within one year with the Senate Banking Committee and the House Financial Services Committee. The report must review the length of time these employees work for the SEC before they leave to work for regulated financial institutions.

The report must also review internal controls and recommend the enhancing of such so as to ensure that SEC employees later employed by regulated firms did not assist those firms in violating any SEC regulations during their SEC employment.

Importantly, the Comptroller General must determine if greater post-employment restrictions are needed in order to prevent SEC employees from being employed by regulated firms when they leave the SEC, as well as whether the number of former SEC employees going to the industry has led to SEC enforcement inefficiencies. The report must also identify any information sharing engaged in by the SEC employees while they worked for the Commission.

The IPA calls for studies of SROs and how they might enhance the SEC’s oversight of advisers. Section 304 specifically mandates a study as to whether the present reliance on self-regulatory organizations promotes efficient and effective governance for the securities markets.

The Hodes Amendment adds a new Title to the Act dealing with senior investor protection. NASAA has long been concerned with the use of misleading professional designations that convey an expertise in advising seniors on financial matters. Many of these designations in reality reflect no such expertise but rather are conveyed to individuals who pay to attend weekend seminars and take open book, multiple choice tests. NASAA has adopted a model rule designed to curb abuses in this area.

The Hodes Amendment recognizes the harm to seniors posed by the use of such misleading activity and establishes a mechanism for providing grants to states as an incentive to adopting the NASAA model rule. The grants are designed to give states 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.

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PCAOB Supreme Court Brief Posits Board's Constitutionality in Face of Appointments Clause and Separation of Powers Challenges

The PCAOB has defended its constitutionality in a brief filed with the US Supreme Court in an action alleging that Sarbanes-Oxley’s creation of the Board violated the Appointments Clause and the separation-of-powers principle of the Constitution. The brief, signed onto by the PCAOB’s counsel, Baker & Botts and MoloLamken, noted that the Board regulates public company auditing, precisely the sort of technical function Congress could have assigned to the SEC itself. Thus, Congress did not violate the Constitution by instead vesting that authority in a board that is subject to the SEC’s comprehensive control.

The Appointments Clause does not require that Board Members be appointed by the President. Rather, they are inferior officers who can be appointed by Heads of Departments. And, the Appointments Clause contemplates that Heads of Departments can be collective bodies like the SEC. The Commission, not its Chair, is the SEC’s “head” for Appointments Clause purposes. Although the Chair has additional administrative duties, noted the brief, the Commission exercises all the SEC’s important regulatory functions as a collective body. It is the Commission, not the Chair, that promulgates rules, authorizes enforcement actions, reviews sanctions, and supervises SROs.

The case, brought by an audit firm, is before the Supreme Court on a grant of certiorari of a split panel ruling of the DC Circuit Court of Appeals that the PCAOB’s creation was constitutional. The Supreme Court will hear oral arguments on December 7, 2009 and a decision is expected during this term. (Free Enterprise Fund and Beckstead & Watts v. PCAOB, Dkt. No. 08-861).

According to the brief, the SEC has broad, pervasive and plenary powers over the Board. For example, no Board rule or sanction takes effect unless the SEC chooses to allow it to do so The SEC can modify Board rules and sanctions as it sees fit, said the brief, and the SEC appoints the Board’s members and controls its budget. The SEC can monitor the Board’s operations and rescind its enforcement authority. Similarly, the SEC can rescind all, or any part, of the Board’s investigative and disciplinary power at any time. Further, since the SEC also has independent authority to investigate and sanction violations, the Commission can reassign rescinded functions to its own staff. Moreover, because the SEC controls Board members’ salaries, it can revoke their compensation upon rescinding their authority.

The SEC’s pervasive control mechanisms under the Act, reasoned the brief, are impossible to reconcile with the petitioners’ theory of independence. Congress made the Board independent from the accounting profession, emphasized the brief, not from the SEC. Congress made the Board separate from the SEC for practical reasons such as salaries and focus, not to free the Board from SEC control.

Similarly, Congress made the Board structurally separate from the SEC because it wanted to create a separately funded entity that was focused solely on audit regulation, and because it wanted the Board to pay private-sector salaries. But Congress did not make the Board independent from the SEC’s control. Whatever inference that could be drawn from the for-cause removal restriction in isolation, it is plainly overcome by the countless other statutory provisions granting the SEC unqualified control.

The brief rejected the claim that Congress violated separation-of-powers principles by giving the SEC rather than the President authority to remove Board members. The Act grants the SEC expansive control mechanisms that are equivalent to at will removal power, posited the brief, and the President has the same authority over the SEC here as elsewhere. The Act thus does not diminish the President’s control in any way.

Furthermore, the removal-follows-appointment rule does not deny the President authority to ensure faithful execution of the laws. It merely requires him to supervise inferior officers in traditional chain-of-command fashion, by supervising the principal officers to whom they report.

Sarbanes-Oxley does not unconstitutionally restrict the President’s traditional chain-of-command authority. The SEC controls each and every exercise of the Board’s authority. And the President has constitutionally sufficient control over the SEC. Indeed, the Act does not diminish the President’s authority over the SEC in the slightest.

And Sarbanes-Oxley grants the SEC multiple powers that are equivalent to at-will removal authority. First, at any time, based on a mere public-interest finding, the SEC can strip Board members of any or all enforcement responsibilities and reassign those functions to its own staff. That unqualified power to abolish an officer’s authority is equivalent to at will removal power.

Petitioners’ concession that the SEC itself is constitutional controls the case. The President has the same control over the SEC’s supervision of the Board that he has over any other SEC function. Because the SEC’s control over the Board is plenary, the President has the same control as he would have if Congress had lodged the Board’s functions in the SEC’s own staff.

If the President has constitutionally adequate control over the SEC, he has constitutionally adequate control over the Board as well. The SEC has ample means to control the Board, including its control over rules and sanctions, its rescission power, its budget control, and its for-cause removal power. If the SEC failed to use any of those myriad tools appropriately, the President could remove the Commissioners for neglect in supervising the Board.

Whatever the precise scope of the President’s authority to remove SEC Commissioners, emphasized the brief, it is capacious enough to enable constitutionally adequate control. Finally, while the Court cannot simply defer to the Executive, acknowledged the brief, the fact that two Presidents have concluded that Sarbanes-Oxley does not undermine their authority surely detracts from the weight of the claim that the Act impermissibly intrudes into the needs of the executive branch.

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Key House Committee Passes Credit Agency Reform Legislation

The House Financial Services Committee has passed bi-partisan legislation reforming the governance and operations of credit rating agencies. The Accountability and Transparency in Rating Agencies Act, HR 3890, enhances the accountability of credit rating agencies by clarifying the ability of individuals to sue such agencies. The Exchange Act is amended to provide that, in an action for money damages against a rating agency, it is enough for pleading any required state of mind that the complaint state with particularity facts giving rise to a strong inference that the rating agency knowingly or recklessly violated the securities laws. In addition, statements made by rating agencies will not be deemed forward looking statements for purposes of the Exchange Act’s safe harbor.

In any private action against a rating agency, the same pleading standards with respect to knowledge and recklessness must apply to the rating agency as would apply to any other person in the same or similar private right of action against such person. The draft also clarifies that the limitation on the SEC or any State not to regulate the substance of credit ratings or ratings methodologies does not afford a defense against civil antifraud actions.
The draft also adds a new duty to supervise a rating agency’s employees and authorizes the SEC to sanction supervisors for failing to do so.

In an effort to improve the governance of rating agencies, the draft requires each rating agency to have a board with at least one-third independent directors whose term of office must be for a pre-agreed non-renewable fixed period of no more than five years. Moreover, the compensation of the directors cannot be linked to the business performance of the rating agency; and must be arranged to ensure the independence of their judgment.

The board must oversee policies and procedures aimed at preventing conflicts of interest and improving internal controls, among other things. They must establish and enforce policies for determining credit ratings, as well as compensation and promotion policies for the agency.
The legislation also contains numerous new requirements designed to mitigate the conflicts of interest that arise out of the issuer-pays model for compensating rating agencies. In addition to enhanced disclosure, the draft significantly enhances the responsibilities and accountability of rating agency compliance officers to address conflicts of interest issues, as well as other internal control and risk management duties.

The draft requires all rating agencies to designate a compliance officer who would report directly to the board and would review all of the agency’s policies to manage conflicts of interest and, in consultation with the board, resolve any conflicts of interest that arise.
The compliance officer must also asses the risk that compliance or lack of such may compromise the integrity of the rating process. Similarly, the compliance officer must review compliance with internal controls with respect to the procedures and methodologies for determining credit ratings, including quantitative models and qualitative inputs used in the rating process, and assess the risk that such compliance with the internal controls or lack thereof may compromise the integrity and quality of the credit rating process.

The draft also requires the compliance officer to be responsible for administering the policies and procedures required to be established by the legislation and, more broadly, ensure compliance with securities laws and SEC regulations. The compliance officer must annually prepare and sign a report on the compliance of the rating agency with the securities laws and its own internal policies and procedures, including its code of ethics and conflict of interest policies, in accordance with SEC rules. This compliance report must accompany the financial reports of the rating agency that are required to be filed with the Commission and must include a certification that the report is accurate and complete.

The compliance officer must also establish procedures for the receipt, retention, and treatment of complaints regarding credit ratings, models, methodologies, and compliance with the securities laws and the policies and procedures required by the Act, as well as provide for the confidential treatment of anonymous complaints by employees, issuers, and investors.

In addition, the compliance officer must set up procedures for the remediation of non-compliance issues found during compliance office reviews, internal or external audit findings, self-reported errors, or through validated complaints. Overall, the procedures must be designed so that ratings that the agency disseminates reflect consideration of all information that comes to the attention of, and is believed by, the agency to be relevant, in a manner generally consistent with the agency’s published rating methodology, including information which is provided or otherwise obtained from issuer and non-issuer sources, such as investors, the media, and other interested parties

An amendment offered by Rep. Waters provides that, just as with independent directors, the compensation of compliance officers cannot be linked to the business performance of the rating agency and must be arranged so as to ensure the independence of the officer’s judgment.

The legislation prohibits compliance officers from determining credit ratings or participating in the establishment of the procedures and methodologies or the models used to determine credit ratings. Compliance officers are also barred from performing marketing or sales functions or from participating in the setting of compensation levels, other than for employees working for them.

When rating agency employees go to work for an issuer whose securities they helped rate, the draft requires the rating agency to conduct a one year look-back into the ratings in which the employee was involved to make sure that proper procedures were followed and proper ratings were issued. The rating agency must conduct a review to determine if any conflicts of interest of the employee influenced the credit rating and revise the rating if appropriate. The draft also requires rating agencies to report to the SEC, and for the SEC to make such reports public, as well as the names of former rating agency employees who go to work for issuers.

The SEC must conduct periodic reviews of the look-back policies of the rating agency to ensure that they are reasonably designed to most effectively eliminate conflicts of interest. The SEC must also review the code of ethics and conflict of interest policies of rating agencies at least annually and whenever the policies are materially modified.

Rating agencies must establish and enforce policies to manage and disclose any conflicts of interest arising from their business. For its part, the SEC must issue rules prohibiting conflicts of interest or requiring the management and disclosure of conflicts of interest relating to the issuance of credit ratings, including conflicts relating to the compensation of the rating agency or to the provision of consulting or advisory services by the agency.

The SEC rules must also require disclosure of conflicts of interest relating to a business relationship and affiliations of rating agency board members with issuers. The Commission must also adopt rules requiring rating agencies to disclose on their websites a consolidated report at the end of the year showing the percent of net revenue earned by the rating agency for providing services other than credit ratings to each person who paid for a credit rating. There must also be disclosure of the relative standing of each person who paid for a credit rating that was outstanding as of the end of the fiscal year in terms of the amount of net revenue earned by the rating agency organization attributable to each such person and classified by the highest 5, 10, 25, and 50 percentiles and lowest 50 and 25 percentiles.

The SEC rules must also require the establishment of a system of payment for each rating agency requiring the structuring of payments in a manner designed to ensure that the agency conducts accurate and reliable surveillance of ratings over time, as applicable, and that incentives for reliable ratings are in place. The rules must also require that a rating agency disclose with the publication of a credit rating the type and number of credit ratings it has provided to the person being rated or affiliates of such person, the fees it has billed for the credit rating, and the aggregate amount of net revenue earned by the rating agency in the preceding two fiscal years attributable to the person being rated and its affiliates. A catch all provision requires the SEC to require the disclosure of any other potential conflict of interest, in the public interest or for the protection of investors.

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House Leader Seeks SEC-CFTC Input as Derivatives Legislation Moves towards Passage

As the House anticipates floor debate on legislation regulating derivatives, Financial Services Committee Chair Barney Frank has asked the SEC and CFTC for input in crafting two important amendments to the legislation. In a letter to SEC Chair Mary Schapiro and CFTC Chair Gary Gensler, Mr. Frank said that he would clarify who can claim the exception from the clearing and trading requirement; and also place solely with the SEC and CFTC the decision on what swaps must be cleared. Specifically, the Frank Amendment would clarify the exception for end-users hedging legitimate business risks. The amendment is designed to make the exception tight enough to prevent speculators from masquerading as end users.

The House Financial Services Committee has approved legislation that would, for the first time ever, require the comprehensive regulation of the over-the-counter (OTC) derivatives marketplace. The OTC Derivatives Markets Act of 2009 (HR 3795), which was approved by a vote of 43-26, represents a key part of a broader effort by Congress and President Obama to modernize America’s financial regulatory system in response to last year’s financial crisis.

There has been some concern over the scope of this end user exception and that it could be manipulated to avoid clearing. This concern would be alleviated by tightening the instructions the legislation gives the SEC and CFTC regarding the exception. Under the draft, there is no self-certification since the bill authorizes the SEC and CFTC to decide if the exception is proper. While the Chair is confident that the vigilance of the SEC and CFTC will prevent scheming firms from getting an exception they are not entitled to, legislative language further tightening the exception would also be useful.

There is also concern that a provision in the draft allowing a clearinghouse to decide if a trade can be cleared could be used by clearinghouses owned by financial firms to assert that swaps are not clearable and thus not required to trade on an exchange. The Frank Amendment would cure the problem by requiring the SEC and CFTC to decide is a trade is clearable.

The Lynch Amendment to the draft was designed to alleviate the problem by restricting a financial firm’s ownership stake in a clearinghouse to 20 percent. But the Agriculture Committee opposes the Lynch Amendment, citing a fear that it may result in an insufficient number of clearinghouses. But, even though his amendment would give the SEC and CFTC the power to decide clearability, the Chair still supports the Lynch Amendment because he believes it is important to reduce the stake that financial firms have in clearinghouses in order avoid conflicts of interest. Thus, he intends to reinsert the Lynch Amendment on the House floor.

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Supreme Court Oral Argument in Fund Fee Case Raises Questions of Judicial Involvement in Determining Fees and Fiduciary Duty of Advisers

Supreme Court Justices questioned the efficacy of having judicial involvement in determining the fairness of the fees investment advisers charge the mutual funds they advise in oral argument in a case questioning the viability the 1982 Gartenberg ruling. Some justices also wanted to know if the fiduciary duty imposed on advisers by Section 36(b) of the Investment Company Act is the same as the fiduciary duty imposed on corporate directors and officers.

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 Second Circuit 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.

The case is on appeal from a Seventh Circuit panel ruling that expressly disapproved the Second Circuit’s Gartenberg approach based on the panel’s view that a fidu­ciary duty differs from rate regulation. The panel held that an investment ad­viser’s fiduciary duty to a mutual fund is satisfied when­ever the adviser has made full disclosure and played no tricks on the board. The panel indi­cated that, so long as such disclosure occurs, the board’s approval is conclusive and Section 36(b) imposes no cap on the amount of compensation that the adviser may receive. The court of appeals denied rehearing en banc, with five judges dissenting. The Supreme Court granted certiorari. Oral argument was held November 2, 2009. (Jones v. Harris Associates L.P., Dkt. No. 08-586).


Justice Kennedy began by asking the investors’ counsel if investment advises are fiduciaries in the same sense as a corporate officers and directors are fiduciaries or do their fiduciary duties differ. The justice is essentially asking if there are different standards, depending on what kind of fiduciary you are. Counsel replied that, while the basic concept is the same, the statutory references to fiduciary duty in the 1940 Act with respect to compensation force one to focus on the fairness of the fee charged. The concept of fiduciary duty in this context goes to the fairness of the fee.

In response to Justice Kennedy’s question on whether the test for an adviser’s compensation would be the same that of a company director or any officer, counsel said that the difference is that in an advisory circumstance the indicia of an arm's-length transaction may be achieved. The directors can fire the head of a company, said counsel, but the investment adviser has appointed the members of the board. Counsel noted the earlier Daily Income Fund case, in which the Court said that the earmarks of an arm's-length transaction are absent.

Justice Stevens asked the Solicitor General why the fiduciary status of an investment adviser is different from the fiduciary status of a president of a corporation. The Government replied that it is different because "fiduciary" in the 1940 Act can mean different things in different circumstances. The chief difference here, and what Congress was intending to counteract, was the inherent structural impediment to arm's-length bargaining between the investment adviser and the board of directors.

Justice Kennedy asked the Solicitor General why Congress used the term "fiduciary" in a very special sense in the 1940 Act because, while the Justice thought a fiduciary has the highest possible duty, apparently the submission is that the investment adviser fiduciary has a lower duty, a lesser duty than to charge a reasonable fee. The Government believes that Congress used the term "fiduciary duty" in 36(b) to counterbalance the lack of arm's-length bargaining that exists between the board of directors and the investment adviser.

The Solicitor General noted that as Section 36(b) was being drafted in 1969 the SEC submitted a memo to Congress explaining that the shift from reasonableness to fiduciary duty largely achieved some procedural objectives of shifting the focus from the board of directors to the investment adviser, and the text of the statute specifically makes it a fiduciary duty with respect to receipt of compensation. The government thinks that one salutary affect of that was to clarify that the Court's burden here, the court's duty here, wasn't just to establish what the single most reasonable fee would be, but whether the bargain fell within the range of what arm's length bargaining otherwise would have achieved. To this argument, Chief Justice Roberts said that, if we are going to have regulation of what fees can be charged, it makes a lot more sense to have the SEC regulate rates than to have courts do it.

Chief Justice Roberts queried counsel for the investors whether technological changes make a difference in terms of disclosures required, noting that all you have to do is push a button and you find out exactly what the management fees are. You look it up on Morningstar and it is right there and you can make whatever determination you'd like, including to take your money out. Counsel said that an investor may know going in what the fee is, but that does not address the problem Congress was intending to address, which is that as larger and larger sums of assets were accreted to the mutual fund, the investor was not obtaining the benefits of economies of scale. The chief justice replied that, investors not getting such benefits could quickly go to another fund. It was then that counsel posited that Congress was trying to protect the company, not the individual investor. The individual investor might lessen the damages that that investor suffers, but the fund, the people remaining, continue to pay excessive fees.

Justice Sotomayor said that using the word "fair fee" is meaningless, because it has to be fair in relationship to something. She understands the Seventh Circuit to be saying that a fair fee is paying market value. Counsel replied that what the court has earlier said is that fair is what is reflective of what an arm's-length agreement would produce

Justice Sotomayor also noted that Congress did not say a reasonable fee. It did say fiduciary duty, and there is a subtle but very important difference between a reasonable fee and a fiduciary duty with respect to fees

Justice Scalia asked investors’ counsel if the fund directors could make the adviser accept a lower fee. Counsel replied that, in practical terms, they could not because the adviser picks the directors. The justice was incredulous that a disinterested board of directors, which is what the statute requires, could not cut the adviser’s fee in half. Counsel said there is no evidence in any record of where that has actually happened. The directors have no leverage.

In a later dialogue with counsel for the adviser, Justice Scalia focused on statutory language that gave courts open-ended discretion. After counsel noted that Section 36(b) instructs courts to give such consideration as they consider due to the deliberations of the board, Justice Scalia called the language "meaningless" and said that it tells courts to make their own judgment. Such consideration as the court deems due, he repeated, give it whatever consideration you feel like. It's utterly meaningless to the justice.

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Former Fed Chair Volcker and SEC Chief Accountant See IFRS Convergence Ahead

In remarks at the recent AICPA-IASC seminar on IFRS, former Fed Chair Paul Volcker extolled the benefits for US companies of one set of global financial accounting standards, while at the same time deploring the hubristic view that US GAAP is the superior accounting standard. After the scandals at Enron, WorldCom and Global Crossing that view is no longer sustainable, said Mr. Volcker. With one global standard, he noted, US companies would not have to recompute their numbers for other countries. More broadly, the global financial system demands one set of financial accounting standards. In reaching this result, he advised the US not to be supine, but rather to engage in a give and take that gets the best results.

SEC Chief Accountant James Kroeker said that IFRS-US GAAP convergence must continue with or without the SEC’s finalization of the roadmap. Regarding the question of leniency for first time adopters of IFRS, the chief accountant said that leniency would be extended in areas of uncertainty as practices under a new standard evolve. But the SEC will not be inclined to be lenient with issuers that simply get it wrong in the early years of IFRS adoption.

Countering criticism that the litigious environment in the US works against the adoption of principles-based accounting standards, the chief accountant posited that, in his view, it would be easier to defend against the allegation of violation of a principles-based standard than the violation of a specific rule. More broadly, he observed that the crisis has highlighted the role of financial reporting and the importance of financial accounting. The SEC is also cognizant of FASB and its priorities, he noted, adding that the SEC places fair value accounting of financial instruments as a top priority, with revenue recognition next in line.

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Bachus Amendment to House Hedge Fund Adviser Legislation Clarifies Fiduciary Duty

An important amendment offered by Financial Services Committee Ranking Member Spencer Bachus to the Private Fund Investment Advisers Registration Act, HR 3818, is designed to protect the fiduciary obligations that investment advisers owe their clients. The legislation gives the SEC the ability to define the term "client" in a broad manner. Rep. Bachus believes that clarifying this language is necessary to avoid unintended consequences. Thus, the Bachus Amendment clarifies that the SEC should not define the term "client" to include investors in a private fund managed by an investment adviser when that private fund has also entered into an advisory contract with the same adviser. According to Rep. Bachus, the Amendment would prevent advisers from being subjected to an irresolvable conflict of interest when they manage a pooled investment with the interest of each individual investor in mind.

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Seven Former SEC Chairs Urge Supreme Court to Uphold Constitutionality of the PCAOB

Seven former SEC Chairs appointed by Presidents of both parties, and representing four decades of SEC leadership, have asked the US Supreme Court to uphold the constitutionality of the PCAOB in an action alleging that the Board’s existence runs afoul of the Appointments Clause. Given the SEC’s pervasive power over the PCAOB, said the amicus brief filed by the Chairs, the Board is not an independent federal agency whose members must be appointed by the President. Congress designed the Board to be independent of the accounting profession, noted the brief, but completely subordinate to the SEC. The SEC’s comprehensive power over the Board enables the SEC to direct the Board’s every action and effectively precludes any Board member from defying the Commission’s policy choices. The former SEC Chairs signing on to the brief include Arthur Levitt, Rod Hills, William Donaldson, Harvey Pitt, and David Ruder.

The case, brought by an audit firm, is before the Supreme Court on a grant of certiorari of a split panel ruling of the DC Circuit Court of Appeals that the PCAOB’s creation was constitutional. The Supreme Court will hear oral arguments on December 7, 2009 and a decision is expected during this term. (Free Enterprise Fund and Beckstead & Watts v. PCAOB, Dkt. No. 08-861).

According to the former SEC leaders, the Board’s design is a logical outgrowth of decades of public-private regulatory partnerships that uniquely characterizes US regulation of the financial markets. Industry SROs have long been subject to SEC plenary control, they noted, and provide the regulatory framework within which Congress designed the PCAOB. Congress built upon decades of experience with these structures in an effort to maintain the distinct advantages that flow from the SROs’ public-private nature while providing needed independence from the regulated profession.

The SEC exercise profound power over the PCAOB. For example, the SEC’s is authorized to disapprove PCAOB rules or budget proposals, reverse the Board’s enforcement decisions, remove Board members and censure the Board, or even rescind its duties altogether The SEC’s complete control over the Board’s budget provides the Commission with one of its most potent tools to control all of the Board’s actions. The SEC must approve the PCAOB’s annual budgets, as well as the user fees established each year to fund the Board The SEC has used this budgeting authority as a means to influence and supervise the Board’s rulemaking and inspection activity. Moreover, the Commission’s actual exercise of its authority in practice confirms that the Board is subject to the Commission’s constant control and oversight in every facet of its operations, noted the brief, just as Congress intended.

In the view of the former Chairs, the profound and pervasive power that the SEC exercises over the Board compels the conclusion that PCAOB Members are not principal officers of the United States who wield power comparable to SEC Commissioners; and therefore the Appointments Clause does not require that they be appointed by the President. Rather, they are inferior officers who can be appointed by Heads of Departments. And, the Appointments Clause contemplates that Heads of Departments can be collective bodies like the SEC.

The former Chairs then specifically refuted the audit firm’s argument that the SEC Chair rather than the Commission as a whole is the “Head” of the SEC within the meaning of the Appointments Clause. They noted that, contrary to the firm’s assertion, the Chair alone does not appoint the SEC’s Division Heads and General Counsel. Indeed, no appointment of major SEC personnel can be made unless the Commission approves the appointment, even when the Chair has the power to initiate the process.

Thus, they maintained that, even when the Chair may initiate an appointment, that action casts no doubt on the fact that the Commissioners collectively are the “Head” of the SEC for Appointments Clause purposes. Moreover, citing their decades of experience, the former officials said that even when an SEC Chair is authorized to initiate an appointment, the Chair routinely solicits input on possible candidates from the other Commissioners. Thus, no meaningful distinction exists, in practice, between whether the Chair or the Commission has the formal power to initiate an appointment.

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Hong Kong SFC Launches Massive Investor Protection Initiative; Starting with Proposed Code for Derivatives Investing

In light of the global financial crisis, the Hong Kong Securities and Futures Commission has launched a multi-pronged offensive to enhance investor protection and provide increased market transparency. The first prong of the offensive is a rulemaking proposal to enhance disclosure to investors about derivatives and other unlisted structured financial products. Later, there will be rulemaking and legislation authorizing the formation of an Investor Education Council and a Financial Ombudsman for dispute resolution. There will also be legislation governing the authorization of products sold to the public.

The proposals are nothing less than a Code intended to cover all unlisted structured products commonly offered to the public in Hong Kong, including equity, credit, and commodity-linked notes, equity-linked investments and equity-linked deposits. In future, where issuers seek authorization in respect of types of unlisted structured products that are new to the market, the Commission will consider these on a case-by-case basis and, where appropriate, consult the new Products Advisory Committee, which would comprise representatives of industry participants and other stakeholders with diverse knowledge and expertise. The Code would also introduce the concept of investors ``with derivative knowledge’’ as determined under criteria listed in the Code. The comment period ends December 31, 2009.

Where necessary, the Commission will engage in further public consultation and publish further guidance on requirements for these types of structured products. The common types of currency-linked and interest rate-linked products issued by banks would fall outside the scope of the Code. Also listed structured products would continue to be subject to the Listing Rules. They are not, and will not be, required to seek the Commission’s authorization.

A broad principle behind the proposed Code is that the investment life-cycle involves multiple parties, such as the product issuer, the selling intermediary and the investor, each of whom must bear some responsibility for the investment that is ultimately made. Issuers would be required to prepare concise and easily understandable summaries of their financial products, what the Commission calls "Key Facts Statements", which would form part of the offering documents. Designed to help investors better understand the products being considered, these would be only a few pages long, which is much shorter than an offering document

The ``Key Facts Statement’’ is a concept akin to the proposal by the Committee of European Securities Regulators (CESR) with respect to the key information document. Both CESR and the Commission intend for these documents to be concise, user friendly and standardized to facilitate comparison between securities products. In principle, noted SFC Chief Executive Martin Wheatly, the Key Facts Statement will comprise part of the offering documents of the product and have equal force and standing as the prospectus, yet it will be limited to only a few pages in length so as to highlight and facilitate investors’ appreciation of the key features and risks of the product.

At the same time, the Commission is aware that some UCITS schemes may already be using a specific form of key factsheet that satisfies their home regulator’s requirement. Since a large proportion of Hong Kong funds are UCITS funds, noted Mr. Wheatly, the SCF would accept these European key factsheet counterparts provided that they provide substantially the same information as required under the Key Facts Statements, and their format and presentation are user friendly and easy to understand.

Selling intermediaries often get incentives from issuers who want their products sold. While there is nothing wrong with salespeople being rewarded for their work, this commercial arrangement poses a potential conflict of interest between the seller and the buyer. The SFC therefore proposes that intermediaries disclose at the pre-sale stage any commissions, fees or other benefits they would earn from the sale of a product. Knowing the rewards or benefits to be received by the selling intermediaries provides greater transparency and provides the investor with relevant information in making investment decision.

The Commission is considering a cooling-off period for some derivative products. This would be a short period, immediately after committing to make an investment, during which investors could change their minds and exit the arrangement. However, to prevent any abuse of the process, investors would have to bear some costs attached to this exit option, such as administrative fees, applicable unwinding costs and any decline in underlying market value of the product during the cooling-off period. The SFC has suggested that the cooling-off period apply only to longer-term products with no ready secondary market. This is because these are the types of products where a cooling-off period might be of most benefit as an investor protection measure. Where products already have an active and liquid secondary market, such as mutual funds, investors could exit the investment if they subsequently change their minds.

Another proposal relates to investor profiling. As part of the know-your-client procedures, intermediaries would be required to seek each client's knowledge of derivatives and characterize those with such knowledge as clients with derivative knowledge. Additionally, the professional investors regime will be reviewed to consider whether or not the assessment criteria for qualifying as a professional investor should be revised.

The proposed Code provides three alternative avenues by which investors may be regarded as having knowledge of derivatives. First, they may have undergone training or attended courses on derivative products. Second, they may have prior trading experience in derivative products, or, third, they may have work experience related to derivative products.

Under the proposed Code, if an investor is not characterized as a client with derivative knowledge, the intermediary could not promote any unlisted derivative products to such a client under any circumstances. When clients who do not have derivative knowledge wish to purchase an unlisted derivative product on their own initiative, the intermediary should warn them about the proposed transaction and provide appropriate advice to them, including assessment of suitability of the transaction, taking into account the client’s personal circumstances such as total portfolio, asset concentration and exposure to a particular market or asset class. The warning and communications with the client should be recorded. However, intermediaries would not be required to seek information about a client’s knowledge of derivatives if no services with respect to unlisted derivative products are envisaged to be provided to that client.

Regarding valuation, the Commission believes that it would be helpful for investors assessing the performance of a structured product if they were provided with regular information about the prevailing market value of their investments. Thus, the Code would require that issuers or their agents make available indicative valuations of structured products on a daily basis throughout their terms. Such indicative valuations would be determined in good faith, on an independent basis, and must be fair and reasonable.

The Commission similarly proposes that, except for structured products with a short term of one month or less, issuers should provide liquidity by way of making firm price quotations for the structured product available to investors at least weekly. Such quotations should be fair and reasonable.

The Commission ensured that the enhanced proposed Code does not represent product or merit regulation, where the regulator judges the merits of an investment product before it is marketed. Similar to the SEC and the FSA, the SFC does not believe that the regulator should become the final judge of the soundness or suitability of a product. In an extreme case, product regulation could be obstructive to market innovation because the regulator may substitute its own preferences for those of investors. Limiting approvals of products to those judged suitable for all types of investors would result in a narrower selection of products available to investors and militate against Hong Kong’s reputation and status as an international financial center.

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New Mexico Proposes Rules to Coordinate with Adoption of New Securities Act

New rules and amendments to existing rules were proposed by the Securities Division of the New Mexico Regulation and Licensing Department to coordinate with the State's new Securities Act that takes effect January 1, 2010. The proposals are anticipated to also become effective on January 1, 2010.

The proposed rules and amendments would affect federal covered securities, exemptions for securities and transactions, registration of securities and licensing of broker-dealers, sales representatives, investment advisers and investment adviser representatives.

For more information, please see here.