Friday, December 19, 2014

113th Congress: Many House-Passed Dodd-Frank Corrections Bills Were Never Taken Up by the Senate

The below pieces of legislation amending the Dodd-Frank Act passed the House in the 113th Congress by a bi-partisan vote, sometimes an overwhelming bi-partisan vote, but were never taken up the Senate.

Swap Data Repository and Clearinghouse Indemnification Act Correction Act, H.R. 742: Passed House 420-2 on June 12, 2013. Removes an indemnification requirement imposed on foreign regulators by the Dodd-Frank Act as a condition of obtaining access to data repositories.

Swap Jurisdiction Certainty Act, H.R. 1256: Passed House 301-124 on June 12, 2013. Directs the SEC and CFTC to adopt joint regulations on cross-border derivatives transactions under the Dodd-Frank Act.

SBIC Advisers Relief Act, H.R. 4200: Passed House by voice vote on December 2, 2014. Fixes unintended consequence of Dodd-Frank Act by exempting from SEC registration advisers to both small business investment companies and venture capital funds. (bill was included as Title IX of omnibus Job Creation and Reducing Small Business Burdens Act, H.R. 5405, which passed House by vote of 320-102 on September 16, 2014).

Small Business Capital Access and Job Preservation Act, H.R. 1105: Passed House by a vote of 254-159 on December 4, 2013: Exempts advisers to private equity funds from SEC registration so long as they are not over-leveraged. (bill was included as Division II, Title I of the omnibus Jobs for America Act, H.R. 4, which passed House by a vote of 253-163 on September 18, 2014).

Financial Competitive Act, H.R. 1341: Passed House 353-24 on June 21, 2013. Requires the Financial Stability Oversight Council to study the likely effects that will result from differences between the U.S. and non-U.S. jurisdictions’ implementation of the derivative credit valuation adjustment (CVA) capital requirement.

H.R. 5471: Passed House by voice vote on December 2, 2014. Clarifies the Dodd-Frank Act’s treatment of affiliates of non-financial firms that use a central treasury unit (CTU) as a risk-reducing, best practice to centralize and net the hedging needs of affiliates. (bill was included as Title II of omnibus Job Creation and Reducing Small Business Burdens Act, H.R. 5405, which passed House by vote of 320-102 on September 16, 2014).

Restoring Proven Financing for American Employers Act, H.R. 4167: Passed House by voice vote on April 29, 2014. Prohibits the Volcker Rule from being construed to require divestiture of debt securities of collateralized loan obligations. (bill was included as Title VIII of omnibus Job Creation and Reducing Small Business Burdens Act, H.R. 5405, which passed House by vote of 320-102 on September 16, 2014). (bill was included as Title II of H.R. 5461, which passed the House by a vote of 327-97 on September 16, 2014).

Thursday, December 18, 2014

Life Settlement Promoters’ Pre-Sale Efforts Satisfied Howey, NASAA Argues

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

NASAA has urged the Texas Supreme Court to uphold a lower court’s ruling that life settlements sold by Life Partners, Inc. were securities under the Texas Securities Act. Filing a brief as amicus curiae, NASAA argued that the petitioners’ managerial efforts prior to the sales were significant and essential to the success of the investment, thereby satisfying the fourth prong of the Howey test for the existence of an investment contract, and thus a security, under the Texas Securities Act (Life Partners, Inc. v. Arnold, December 12, 2014).

Investment contracts. NASAA noted that Texas courts have applied the Howey test broadly when determining the existence of an investment contract. While Howey’s fourth prong refers to profits derived from the “sole efforts of others,” the Texas courts have adopted a broader approach, requiring only that the managerial efforts by persons other than the investor be “undeniably significant ones,” which affect the failure or success of the enterprise. As framed by NASAA, the case before the Texas Supreme Court turns on the question of whether the efforts undertaken by the petitioners prior to selling their life settlement contracts to investors can be considered under Howey, or whether only the petitioners’ post-sale efforts can be considered.

Flawed reasoning. NASAA criticized the petitioners’ reliance upon the “flawed” reasoning of the D.C. Circuit in SEC v. Life Partners, Inc. (D.C. Cir. 1996), where the court ignored the pre-sale efforts of the promoter in holding that the life settlements at issue were not investment contracts. NASAA observed that the D.C. Circuit’s decision has been roundly criticized by the federal bench as an anomalous and arbitrary departure from the precedents and principles of securities law. Several state courts have also rejected the Life Partners decision, stating that the decision rests upon flawed logic, lacks precedent, or ignores the purposes of the blue sky laws.

Moreover, the rigid rule set down in Life Partners frustrates the investor protection rationale that underlies securities regulation, NASAA argued. NASAA believes that excluding a promoter’s pre-sale activities from consideration when undertaking the Howey analysis will deny investors meaningful disclosures about their potential investments. In NASAA’s view, the rigid pre-purchase/post-purchase distinction set forth in Life Partners results in an inflexible and artificial approach to analyzing an investment, elevating the form of a transaction over its substance and ignoring the U.S. Supreme Court’s direction that the definition of a “security” is a flexible rather than a static principle.

Passive investors. The issue in the present case, NASAA stated, is whether the investors relied on the efforts of the promoter to make a profit, regardless of when those efforts took place. NASAA noted that the investors in the petitioners’ life settlement contracts were, by design, passive investors that relied on the petitioners to undertake the significant efforts required to make their investments profitable. For example, the investors relied on the petitioners’ expertise in selecting, evaluating, and pricing suitable life insurance policies. The investors further relied on the petitioners’ services in making on-going premium payments and collecting the insurance benefits upon a policyholder’s death. Accordingly, the lower court correctly found that the life settlement contracts sold by petitioners satisfied Howey’s four prongs, making them investment contracts under the Texas Securities Act, NASAA argued.

The case is No. 14-0122.

Wednesday, December 17, 2014

Yale Prof Defends Harvard Activist Clinic against Gallagher Paper

[This story previously appeared in Securities Regulation Daily.]

By Anne Sherry, J.D.

A Yale University law professor has stepped in to challenge SEC Commissioner Daniel Gallagher’s argument that the Harvard Shareholder Rights Project’s destaggered board proposal violates securities laws. Jonathan R. Macey’s post on a Harvard-hosted blog counters that the proposal is not fraudulent or misleading and points out the policy implications of threatening shareholders with enforcement actions over their proposals.

Background. Lucian Bebchuk’s Shareholder Rights Project (SRP) has taken aim at classified boards, which force hostile bidders to engage in multiple proxy contests by staggering director reelections so that only one-third of board seats are up for election in any year, by submitting declassification proposals to large-cap companies. Last week, Commissioner Gallagher and former commissioner Joseph A. Grundfest, now with Stanford Law School, published a paper arguing that the SRP proposal cherry-picks from the academic research and can be excluded as materially false or misleading or even subject the university itself to antifraud liability.

No antifraud violation. Professor Macey argues that the SRP proposal does not contain a material omission, as it neither purports to contain a review of the academic literature nor suggests that contrary studies to not exist. He also points out that the 500-word limit under Rule 14a-8 would make it difficult for the SRP to include the kind of references and discussion envisioned by the Gallagher-Grundfest paper. Instead, the shareholder proposal should be viewed in the context of the larger proxy solicitation, where it will appear alongside management’s contrary arguments and solicitation. In fact, Professor Macey states, Netflix’s response to the SRP proposal, which Gallagher and Grundfest cited, listed only studies that support staggered boards. This suggests a double standard where shareholder proposals are expected to be completely self-contained while the company can respond with a one-sided presentation of the research, he wrote.

Chilling effect on shareholder proposals. Another point that Professor Macey raises concerns the policy rationale behind Rule 14a-8. He posits that the rule’s purpose is to improve corporate governance by facilitating shareholder democracy. Accepting Gallagher and Grundfest’s position that the SRP proposal is fraudulent would “have a major chilling effect on the ability of any shareholder to make a shareholder proposal without fear that such shareholder and its advisers will become the target of an SEC enforcement action and a defendant in private lawsuits.” He also questions the inherent premise that the proposal would subject the SRP or Harvard University to antifraud liability, noting that he is unaware of any case or enforcement action taken against a shareholder proponent for fraud and that Gallagher and Grundfest do not cite one. “I am at a loss to imagine why the first such enforcement action ever to be taken would be lodged against proposals whose only alleged fault was not to include an additional reference to contrary studies,” he writes.

Internal tension at SEC. The paper’s real issue is not limited to the SRP proposals, Professor Macey writes, but extends to a criticism of SEC staff for taking a narrow view of no-action relief for companies that wish to exclude shareholder proposals on the basis of misrepresentations and omissions. Professor Macey questions the propriety of a sitting SEC commissioner’s levying accusations at “an academic institution and a professor” as a means of effecting changes in enforcement practices at the agency. To this point, Gallagher and Grundfest would likely counter that Professor Bebchuk is not merely a professor, but also a shareholder activist who has caused the destaggering of nearly 100 corporate boards in the last three years. “There is no ‘professor exemption’ from the requirement that a proxy proposal not be materially false or misleading,” their paper asserts.

Tuesday, December 16, 2014

Staff Grants Relief to Combat Advisers’ Reluctance to Provide Documents to CFP Board

[This story previously appeared in Securities Regulation Daily.]

By John Filar Atwood

The staff of the SEC’s Division of Trading and Markets has expanded a March 2011 no-action position to help the Certified Financial Planner Board of Standards (CFP Board) to obtain documents that investment advisers and brokers currently are reluctant to provide. The CFP Board sought an expansion of the definition of “background documents” because advisers and brokers have been hesitant to provide any documents other than those specifically mentioned in the 2011 letter.

In the 2011 letter to the CFP Board, the staff stated that broker-dealers and registered investment advisers may provide the CFP Board with copies of any customer complaint involving the applicant, and the employer’s response to the customer complaint. It also said that advisers and brokers could provide any statement of claim (including arbitration claims) involving the applicant, and the resolution of the claim (collectively referred to as “background documents”).

More effective investigations. Based on its experience in conducting investigations since March 2011, the CFP Board asked the SEC staff to clarify the definition of background documents to provide comfort to brokers and advisers that certain documents are included within the scope of the definition. Without the clarification, the CFP Board said, it would not be able to process effectively applications of candidates for CFP certification, and efficiently investigate CFP professionals.

In the no-action letter, the staff noted that the original staff position applied to consumer complaints and responses by broker-dealers and investment advisers to those complaints, statements of claim and claim resolution documents. The CFP Board asked that it be extended to include related documents including any attachment or exhibit to, any document referenced in the text of, and any document material to, a complaint, statement of claim, response or claim resolution document.

In granting the relief, the staff noted that the CFP Board would use the background documents to process applications for CFP certification and to investigate and possibly take action against holders of the CFP certification. It also noted that many broker-dealers and investment advisers employ individuals who have obtained the CFP certification, and that more than 70,000 financial planning professionals have obtained the CFP certification.

Sensitive information. The staff stated that the disclosure of background documents to the CFP Board for the purpose of assessing compliance with CFP Board’s ethical standards will be covered by the exception provided by Section 248.15(a)(3) of Regulation S-P. Accordingly, the CFP Board will treat the information contained in background documents as if it were received pursuant to this exception and limit the redisclosure and reuse of the information. The CFP Board said that it recognizes that certain background documents may contain sensitive personal information, and it has procedures in place for safeguarding and properly disposing of the documents.

In addition to the relief granted by the Division of Trading and Markets, the SEC’s Division of Investment Management stated that it will not recommend Commission action against an investment adviser if the adviser discloses background information to the CFP Board in accordance with the no-action letter.

Monday, December 15, 2014

SEC Asks for Chevron Deference to Whistleblower Rule

[This story previously appeared in Securities Regulation Daily.]

By Anne Sherry, J.D.

The SEC has filed another brief asking an appeals court to defer to its rulemaking extending Dodd-Frank’s whistleblower protections to employees who report misconduct internally. The agency argues that the anti-retaliation provision is ambiguous as to whether it covers someone who did not report misconduct to the SEC (Safarian v. American DG Energy Inc., December 11, 2014).

Current landscape. The brief is substantially identical to the amicus brief that the SEC filed in the Liu v. Siemens appeal before the Second Circuit earlier this year. That court did not reach the issue of whether an employee who reports misconduct only internally is protected, instead affirming the dismissal of the whistleblower’s lawsuit on the basis that the Dodd-Frank provision does not apply extraterritorially.

The only appeals court to have ruled on the issue is the Fifth Circuit, which, in Asadi v. G.E. Energy (USA), L.L.C., construed the statute, which defines “whistleblower” as “any individual who provides … information relating to a violation of the securities laws to the Commission,” as unambiguously protecting only those who bring reports of misconduct to the SEC. District courts are split, with some taking the view that other parts of the statute render it ambiguous overall. The Southern District of New York last week adopted the Fifth Circuit’s view.

Chevron deference. The SEC argues that the statute is ambiguous in part because, although the defined term “whistleblower” means an individual who reports wrongdoing to the SEC, one of the protected categories of reporting seems to include internal reporting. Under Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc. (U.S. 1984), the SEC urges, because of this ambiguity, the court should defer to the SEC’s rule as long as it is a reasonable interpretation of the statute. The rule intentionally omits to require that a whistleblower have reported misconduct to the SEC.

Defending its rulemaking in its amicus brief, the agency stresses the importance of internal company reporting in deterring, detecting, and stopping unlawful conduct that may harm investors. It argues that its rulemaking implementing Dodd-Frank’s monetary award provisions was carefully calibrated not to disincentivize employees from reporting internally, and the agency likewise clarified the statute’s anti-retaliation prohibition to protect an employee who engages in whistleblowing whether or not the employee separately reports to the Commission.

The case is No. 14-2734.

Sunday, December 14, 2014

Senate Clears Legislation for President Easing Capital Formation for Community Banks

The Senate passed by unanimous consent and sent to the President for his signature legislation raising the threshold for small bank holding company regulatory relief to up to $1 billion. H.R. 3329 would direct the Federal Reserve to increase the qualifying asset threshold of the Fed’s Small Bank Holding Company Policy Statement from $500 million to up to $1 billion, enabling small bank holding companies with under $1 billion in assets to be regulated under the Small Bank Holding Company Statement, which allows simplified reporting requirements and less stringent capital standards that reflect the traditional banking services that these smaller banks provide. The current policy statement applies only to financial institutions below $500 million in assets. The House passed the legislation earlier this year.

H.R. 3329 provides targeted regulatory relief for small bank holding companies. It conditions the relief on the financial institution not being engaged in any nonbanking activities involving significant leverage and having a significant amount of outstanding debt that is held by the general public. A third condition added by a Senate amendment to H.R. 3329 is that the financial institution cannot have a material amount of debt or equity securities outstanding , other than trust preferred securities that are registered with the SEC. The House agreed to the amendment.

It is estimated that the change will reduce regulatory burdens for 89 percent of bank holding companies, up from 75 percent today. This policy change is supported by the Federal Reserve Board, with Fed Governor Daniel Tarullo calling on Congress to boost the policy statement threshold to $1 billion in a speech in November. It has also been endorsed by the Independent Community Bankers of America and the American Bankers Association.

In his remarks, Governor Tarullo noted that since the policy statement was issued by the Fed one might think that the Board could raise the threshold on its own. However, he explained that Section 171 of the Dodd-Frank Act, the Collins Amendment, effectively eliminates any authority of the Board to extend the capital treatment in the policy statement to holding companies with assets greater than the threshold in effect on May 19, 2010, or to savings and loan holding companies of any size. Thus, legislation was needed to effect these changes.

According to Rep. Blaine Luetkemeyer (R-Mo), the sponsor of the legislation, community banks face unique challenges with regards to capital formation, which is a particular concern at a time when regulators are demanding higher capital levels in response to Basel III. (Cong. Record, May 6, 2014, p. 3425).

Friday, December 12, 2014

Commissioner Gallagher Offers Blueprint for Challenging Harvard’s Destaggered Board Proposals

[This story previously appeared in Securities Regulation Daily.]

By Anne Sherry, J.D.

A provocative paper co-authored by SEC Commissioner Daniel Gallagher describes how companies can seek to exclude shareholder proposals by the Harvard Shareholder Rights Project calling for destaggering (declassifying) boards of directors. The paper argues that the Harvard proposal cherry-picks from the academic research on classified boards and can be excluded as materially false or misleading under Exchange Act Rules 14a-8 and 14a-9.

The paper, whose other author is Joseph A. Grundfest of the Rock Center for Corporate Governance at Stanford Law School, goes on to warn that the SEC could bring enforcement proceedings against Harvard for violations of Rule 14a-9 under the doctrine of respondeat superior. The courts also recognize a private right of action under Section 14(a) for a violation of Rule 14a-9. The views expressed in the paper by Commissioner Gallagher are his own and do not necessarily reflect the views of the SEC or of his fellow commissioners.

Harvard proposal. Lucian Bebchuk’s Shareholder Rights Project (SRP) has taken aim at classified boards, which force hostile bidders to engage in multiple proxy contests by staggering director reelections so that only one-third of board seats are up for election in any year. Bebchuk maintains that staggered boards “are associated with lower returns to shareholders in the event of an unsolicited offer, are more likely to make acquisitions that decrease shareholder value, tend to provide executives with pay that is less correlated with performance, and exhibit lower association between chief executive replacement and performance.” The SRP submitted declassification proposals to 31 large-cap companies for voting in 2014 and expects that these proposals, added to its 2012 and 2013 efforts, will result in about 100 board declassifications by S&P 500 and Fortune 500 companies.

The Gallagher-Grundfest paper challenges the SRP proposal’s presentation of the empirical evidence on staggered boards. One-third of the proposal’s total word count (which, by SEC rule, is limited to 500 words) describes the empirical literature. According to the Rock Center paper, the body of academic research contradicting the proposal is far more substantial than the one opposing study that SRP cites: “The opposing research concludes that studies relied on by the Harvard Proposal are in error because of flawed analytic techniques. This research also documents heterogeneous effects indicating that classified boards are more likely to be beneficial for identifiable categories of corporations.”

Omissions in shareholder proposals. Rule 14a-9 prohibits solicitation via a proxy containing any materially false or misleading statement or omission. Rule 14a-8 permits a company to exclude a shareholder proposal that violates Rule 14a-9. According to Gallagher and Grundfest, “the test for the materiality of an omission in a voting context is whether there is ‘a substantial likelihood that a reasonable shareholder would consider the information important in deciding how to vote.’” The authors posit that the significance of the academic research on whether declassification improves a corporation’s financial performance is clear, and is underscored by the amount of space the SRP devotes to the research in its proposal.

Prospective strategies. There are two prospective mechanisms available to corporations seeking to exclude the proposal from their proxy statement, according to the paper: they can apply for no-action relief from the SEC’s staff or can file a federal lawsuit seeking a declaratory judgment that excluding the proposal will not violate Rule 14a-8. “Simply establishing that the Harvard Proposal omits material information should be sufficient to cause the Commission’s staff to grant no-action requests,” the paper suggests, although it notes that the staff takes a narrow view regarding no-action requests seeking omission of shareholder proposals on the basis of misrepresentations or omissions. “Similarly, a simple showing that the omitted literature is material should be sufficient to support a grant of declaratory relief.”

Securities law violations. In addition to the prospective relieve, the authors warn that Harvard University itself could be liable in SEC enforcement proceedings and private actions alleging Rule 14a-9 violations. Even if the Supreme Court’s decision in Janus restricting Rule 10b-5 liability to the “maker” of a fraudulent statement extends to Rule 14a-9, the paper maintains, the SRP clearly holds “ultimate authority” over the proposal and thus qualifies as its maker. Going a step further, principles of respondeat superior should impute liability for the SRP’s actions to the university itself. Gallagher and Grundfest note that the SRP could publish its analysis of the empirical research in an academic journal without risking legal liability, but by availing itself of SEC rules to influence corporate governance, “the scholars voluntarily subject themselves to standards of legal liability that do not apply in other venues.”

Private plaintiffs may also bring their own action for a Rule 14a-9 violation, the paper continues, with the additional hurdle of demonstrating causation. Under the circumstances, establishing causation by showing that the misleading statement “had a significant propensity to affect the voting process” may be made easier by the SRP’s own description of the role that the clinic and its declassification proposal have played in causing the destaggering of boards at approximately 100 large corporations.

Finally, the authors cite cases in which courts have invalidated shareholder votes and undone charter amendments resulting from materially misleading proxies. Managements that have already destaggered in response to the proposal could petition a court for an order invalidating the votes in favor of, and actually implementing, the destaggering.

Thursday, December 11, 2014

FOREX Fine Will Go for Health Care as U.K. FCA Rebuilds Financial Services Culture

In light of the FOREX and Libor manipulations, the U.K. Financial Conduct Authority is rebuilding a culture within financial services firms that is more centered on consumer needs, with a regulator in place that has the right tools and approach, to uphold and encourage the standards the public has the right to expect. In remarks at the FCA’s Enforcement Conference, Director of Enforcement Tracey McDermott noted that enforcement is not an end in itself. It is one of the tools the FCA has at its disposal to encourage better behavior. It is a blunt tool, perhaps, but a vital one in making plain to all the regulated firms the consequences for those who fail to meet FCA standards. Disappointingly, as illustrated by FOREX, this is not yet second nature. The review of lessons is still, at times, too narrow and too literal.

At the same time, U.K. Treasury said that the government will use the £1 billion of fines collected from banks that broke the foreign exchange (FOREX) rules to create a fund for advanced heath care and community healthcare facilities, In a statement, Chancellor of the Exchequer George Osborne also noted that the government has committed a further £50 million of LIBOR fines over the next 6 years to support military charities and other good causes.

Director McDermott rejects the view that the fines levied by the FCA are too large and unfairly penalize shareholders. In some instances, she noted, financial firms need to be held to account because the failings are corporate as well as individual. The FCA has heard from firms that fines and the focus on conduct has helped them maintain momentum in strengthening their conduct risk frameworks they have in place. The FCA concludes that the publicity that enforcement actions bring focuses minds, particularly at the top of firms.

While it is true that individuals are responsible for actions, she reasoned, they do not operate in a vacuum, Rather, they operate in the culture and the values of the firms that employ them. The firms set the controls that identify the risks in their business and how to manage these risks. Firms also have to ensure that their controls are adequate. Until the rhetoric matches the reality, said the Director, relying on people just doing the right thing won’t get us there.

But individual accountability is important, continued the Director, and it is not just the responsibility of regulators to enforce it. Firms need to think about where risks might arise and how to control them, as well as the need to understand the culture of the subsets of their organization, how they differ and what that means. They also need to think about cross-industry tribal loyalties and how to manage the risks those pose. And where they fall short, particularly where they fail to learn lessons from other action, they should pay the price.

Former Corp Fin Director Offers Views on MD&A

[This story previously appeared in Securities Regulation Daily.]

By Amanda Maine, J.D.

Brian Lane, a partner at Gibson Dunn and a former director of the SEC’s Division of Corporation Finance, participated in a panel on Management’s Discussion and Analysis (MD&A) this year’s AICPA conference on SEC and PCAOB developments.

Good MD&A examples. Lane singled out several Forms 10-Q of various companies which he believed are worthy of emulation. He drew attention to the 10-Q of Brown-Forman Corporation, which was represented on the panel by its vice president and corporate controller, Laura J. Phillips. He praised Brown-Forman’s 10-Q for its use of a “market highlight” section, which provided supplemental information for the company’s largest markets.

Lane also noted that the 10-Q of energy company AES Corporation includes a strategy section, which he advised was helpful to investors because such sections are usually only seen in prospectuses. He also praised AES’s disclosure of “key performance indicators” such as employee and contractor lost time rates.

In addition, Lane drew attention to the 10-Qs of GE and Google. GE’s MD&A makes good use of bullet points, and in Lane’s view, “when you want to create readability, bullet lists are king.” He also praised Google for including as a lead-in to its MD&A a discussion about “Trends in Our Businesses.”

Need for simplification. Fellow panelist John G. Morriss, managing director at TIAA-CREF, noted that the length of company documents has “exploded,” yet it has not correlated with investor understanding of those documents. Lane called for more simplification of MD&A disclosures, noting that the Division of Corporation Finance has not undertaken a project to simplify documentation since 1995. Most issuers’ 10-Qs get bigger every year, Lane stated. Despite calls for more streamlined disclosure, Lane observed that various interest groups in the investor community have called for even more disclosures on issues such as carbon footprints and campaign donations.

Lane also encouraged FASB to do something to make footnotes to the financial statements more investor-friendly. The footnotes are getting more impenetrable every year, he said. They are drafted by accountants for accountants and not for investors, according to Lane.

Disclosure of trends. Lane advocated the disclosure of trends in MD&A, noting that SEC staff currently has a focus on trends. He has also noticed an uptick in clients inquiring about whether something is a trend. As an example, he cited Kodak’s disclosure that the use of film as a trend is decreasing. This is an obvious kind of disclosure, Lane said, but some trends are less obvious, especially those in foreign markets.

The staff in the Division of Corporation Finance has cited a number of trends it would like to see disclosed in MD&A, Lane said. These include trends about cybersecurity and about cash offshore, especially in low tax jurisdictions. He also warned that the phrase “partially offset” is one of the most popular phrases in filings with the SEC, and urged preparers to be sure to quantify what they record as “partially offset” in order to live up to good disclosure expectations. 

Enforcement and MD&A. Lane also briefly addressed the SEC’s enforcement efforts regarding to MD&A. He noted that MD&A cases had been rare and that there had not been one in nearly ten years until recently. In August, Lane explained, the SEC brought a case against Bank of America about certain disclosures the company failed to make in its MD&A about residential mortgage-backed securities. Lane observed that this was a pure MD&A case where there was no fraud involved. Bank of America was fined $20 million, a hefty fine for a non-fraud case, Lane said.

Wednesday, December 10, 2014

Regulators Still Haunted by Risk Concentration

[This story previously appeared in Securities Regulation Daily.]

By Mark S. Nelson, J.D.

Global regulators and the derivatives industry can do more to lessen the threat posed by risk concentration at clearinghouses, CFTC Commissioner Mark P. Wetjen told an audience at the FIA Asia Derivatives conference in Singapore. Wetjen outlined a few proposals that may help clearinghouses, but he raised key questions that must be answered before regulators adopt enhanced disclosure rules. He also said he planned to call a meeting of the CFTC’s Global Markets Advisory Committee to talk more about derivatives clearing and other issues.

Wetjen acknowledged that some in the derivatives markets worry that the CFTC’s rules, and the industry’s more general principles for financial market infrastructures, are too weak. Standardized stress tests could remedy any deficiencies by boosting transparency.

While generally backing further discussion of standardization, Wetjen cautioned that such a move could increase industry confusion over the applicable standards and stifle innovation. Wetjen also said greater transparency about stress test assumptions could result in market manipulations, even when central counterparties’ (CCPs’) disclosures remain anonymous. Wetjen urged the CFTC to issue a concept release on standardization.

Likewise, Wetjen said the CFTC can reduce uncertainty about how CCPs implement their default waterfalls by adopting a new rule and pressing for global harmonization of regulatory standards. He said the CFTC could do its part by seeking public comment on a release, but these issues also could be addressed by an advisory committee.

Wetjen had opened his speech by re-telling the story from a year ago of how a Korean securities firm’s trading glitch caused it to default, resulting in a loss at an affiliated clearinghouse. Wetjen said CCPs have several options for handling these situations via loss mutualization provisions in a default waterfall. In the Korean example, Wetjen said the clearinghouse never had a loss because its default waterfall would have applied its own capital only after using the contributions from non-defaulting members.

Moreover, Wetjen said CCPs should adopt contingency plans to aid their recovery or wind-down in response to systemic events. These plans ensure that key services are not disrupted. The plans also seek to stop one firm’s problems from spreading to the wider market.

Wetjen suggested that the CFTC’s recovery mandates for systemically important firms could be extended in some manner to all CCPs. But as part of the CFTC’s ongoing discussions of these matters, regulators and industry participants should think carefully about whose collateral would be part of a recovery plan and whether certain market participants should ever be exposed to some losses. Wetjen said these discussions should focus on the role of customer collateral from non-defaulting members and on risks often born by pensions and endowments.

Tuesday, December 09, 2014

PCAOB Chair Says Stronger Audits Will Enhance Capital Formation

[This story previously appeared in Securities Regulation Daily.]

By Jacquelyn Lumb

In remarks at the Chamber of Commerce conference on the future of financial reporting, PCAOB Chair James Doty expressed his view that enhancing the relevance of reliability of audits is critical to returning capital providers to long-term funding. To overcome short-term investment strategies and what Doty called the tyranny of the quarterly earnings call, he called for a stronger audit to provide greater confidence that auditors are looking out for investors.

Non-audit services. Doty also talked about the increase in non-audit services. If the current trend continues, he said within 10 years, audits may account for less than 20 percent of the revenue of the global, networked accounting firms. He also noted that all audit firms provide the same audit report in which the engagement partner is anonymous, so there is little competition based on quality. It is not even clear from the audit report how much of the audit was performed by the firm that signs the opinion, he added.

Audit deficiencies. Doty said that the largest accounting firm and many of the smaller firms are capable of high quality auditing, but the rate of problems found by PCAOB inspectors suggests that all of these firms could miss a material misstatement. He reported that out of 219 audits by the four largest firms that were selected for review in the 2013 inspection cycle, the opinions in 85 should not have been issued. He added that the Board’s results are fairly consistent with international results. Doty said these circumstances suggest the need for a deeper examination of how firms can improve audit quality.

Doty believes the Sarbanes-Oxley Act triggered a cultural change in auditors’ view of their accountability. The more audits the Board inspects, the more problems get fixed, and the better the auditor’s execution, he said.

PCAOB initiatives. Doty reviewed some of the Board’s long-term initiatives aimed at avoiding audit deficiencies, including the greater use of economic analysis in its standard setting initiatives, providing support to audit committees, and increasing audit transparency by disclosing the name of the engagement partner and other firms that participated in an audit. If the market knows where and by whom an audit was performed, Doty said it creates an incentive to assure quality.

Naming the engagement partner. Doty noted that auditors in many jurisdictions have grown accustomed to signing audit reports. With the recent adoption of the requirement by the IAASB, reporting the engagement partner’s name will become the norm. The U.S. will likely be the only country in the top 20 financial markets that does not require the disclosure, he advised. Doty also cited recent studies which found that disclosure of the engagement partner’s name makes a difference to the investing public and the markets.

The Board is considering whether the engagement partner’s signature serves a materially greater benefit than simple disclosure. Disclosure may provide the information the public wants without increasing litigation risk, he noted. Doty hopes the Board will adopt a final standard soon.

Auditor’s report. With respect to the Board’s disclosure project on the auditor’s reporting model, Doty said the initiative benefits from the ability to review experiences abroad. Readers of the new U.K. audit reports have applauded some of the results and criticized the boilerplate approach of others, which provides an incentive to compete based on quality, according to Doty.

He said the enhanced U.K. audit reports are the leading edge of a significant wave of change in the audit profession. The International Auditing and Assurance Standards Board recently approved a standard to require enhanced auditor reporting, including key audit matters, which will affect more than 100 jurisdictions. The European Parliament also adopted a broad package of audit reforms, including expanded audit reports. Doty said the Board will study these reforms and adopt elements from the best of them.

Saturday, December 06, 2014

House Clarifies SEC-CFTC Clearing Rules for Affiliate Swap Transactions

The House passed by voice vote a bi-partisan measure, H.R. 5471, which amends the Commodity Exchange Act and the Securities Exchange Act to revise the treatment of affiliate transactions that may be exempt from clearing requirements to authorize such an exemption only if the affiliate enters into the swap to hedge or mitigate the commercial risk of the person that is not a financial entity, provided that an appropriate credit support measure or other mechanism must be used if the hedge or mitigation of commercial risk is addressed by entering into a swap with either: (1) a swap dealer or major swap participant, or (2) a security-based swap with a security- based swap dealer or major security-based swap participant.

The measure was introduced by Rep. Gwen Moore (D-WI) and co-sponsored by Rep. Steve Stivers (R-OH), both key members of the Financial Services Committee. H.R. 5471 was not marked up and reported out by either the Financial Services Committee or the Agriculture Committee, both of which had jurisdiction. Rather, it was brought directly to the House floor and passed.

Senate Report Reveals Possible Systemic Risk in Bank Involvement with Physical Commodities

A bi-partisan Senate report revealed that three major financial holding companies engaged in the physical commodities market at a time when none of the three firms was adequately prepared for potential losses from a catastrophic event related to its physical commodity activities, having allocated insufficient capital and insurance to cover losses compared to other market participants. In this, the report found that new systemic risks have been introduced into the U.S. financial system. The report was prepared by the Senate Permanent Subcommittee on Investigations, chaired by Senator Carl Levin (D-MI).

The investigation focused on the recent rise of banks and bank holding companies as major players in the physical markets for commodities and related businesses. It presents case studies of three major U.S. bank holding companies, Goldman Sachs, JPMorgan Chase, and Morgan Stanley that over the last ten years were the largest bank holding company participants in physical commodity activities.

All three of the financial holding companies examined by the Subcommittee were engaged in a wide range of risky physical commodity activities which included, at times, producing, transporting, storing, processing, supplying, or trading energy, industrial metals, or agricultural commodities. Many of the attendant risks were new to the banking industry, and could result in significant financial losses to the financial institutions. Those activities included trading uranium, operating coal mines, running warehouses that store metal, and stockpiling aluminum and copper.

The investigation also highlights how the Federal Reserve has identified financial holding company involvement with physical commodities as a significant risk, but has taken insufficient steps to address it. The panel concluded that more is needed to safeguard the U.S. financial system and protect U.S. taxpayers from being forced to bailout large financial institutions involved with physical commodities.

In a worst case scenario, the Federal Reserve and ultimately U.S. taxpayers could be forced to step in with financial support to avoid the financial institution’s collapse and consequential damage to the U.S. financial system and economy.

In the activities reviewed by the Subcommittee, the financial companies often traded in both the physical and financial markets at the same time, with respect to the same commodities, frequently using the same traders on the same trading desk. In some cases, after purchasing a physical commodity business, the financial holding company ramped up its financial trading. Indeed, in some cases, financial holding companies used their physical commodity activities to influence or even manipulate commodity prices.

At the hearing, Senator Levin focused on what he called the ``merry-go- round” transactions in which warehouse clients were paid cash incentives to load aluminum from one Metro warehouse into another, essentially blocking the warehouse exits while they moved their metal. The Senator found that those merry-go-round transactions lengthened the queue for other metal owners seeking to exit the Detroit warehouses, accompanied by increases in the Midwest Premium for aluminum.

In another troubling development, JPMorgan proposed an exchange traded fund (ETF) to be backed with physical copper. In filings with the SEC, some industrial copper users charged that the proposed ETF would create artificial copper shortages as copper was stockpiled to back the fund, leading to price hikes and, potentially, manipulation of market prices.  In addition, in each of the three case studies, evidence showed that the financial holding companies used their physical commodity activities to gain access to commercially valuable nonpublic information that could be used to benefit their financial trading activities.

Essentially, the Senate panel found a current lack of effective regulatory safeguards related to financial holding company involvement with risky physical commodities. Financial holding companies currently conduct physical commodity activities under one of three authorities provided in the Gramm-Leach-Bliley Act of 1999, the complementary, merchant banking, and grandfather authorities.

Despite enactment of that law 15 years ago, the Federal Reserve has yet to address a host of pressing questions related to how Gramm-Leach-Bliley should be implemented. For example, the Fed has never issued guidance on the scope of the grandfather authority that allows financial firms that convert to bank holding companies to continue to engage in certain physical commodity activities. The Senate panel found that failure has allowed Goldman and Morgan Stanley to use expansive readings of the grandfather authority to justify otherwise impermissible physical commodity activities.

The Federal Reserve has also failed to specify capital and insurance minimums to protect against losses related to catastrophic events, nor has it clarified whether financial holding companies can use shell companies to conduct physical commodity businesses as Morgan Stanley and Goldman have done in their compressed natural gas and uranium trading businesses. Procedures to force divestment of impermissible physical commodity activities are also opaque and slow.

One key problem is that the Federal Reserve currently relies upon an uncoordinated, incoherent patchwork of limits on the size of the physical commodity activities conducted under various legal authorities, permitting major exclusions, gaps, and ambiguities.

Recommendations. The Senate report sets out a number of recommendations. Broadly, federal bank regulators should reaffirm the separation of banking from commerce, and reconsider all of the rules and practices related to physical commodity activities in light of that principle. Similarly, the Federal Reserve should issue a clear limit on a financial holding company’s physical commodity activities; clarify how to calculate the market value of physical commodity holdings; eliminate major exclusions; and limit all physical commodity activities to no more than 5% of the financial holding company’s Tier 1 capital.

Also, the panel wants the Fed to strengthen financial holding company disclosure requirements for physical commodities and related businesses in internal and public filings to support effective regulatory oversight, public disclosure, and investor protections, including with respect to commodity related merchant banking and grandfathered activities.

Dodd-Frank. The Senate report lists a number of Dodd-Frank Act provisions that have the potential to restrict or reshape bank involvement with physical commodities. Section 171 requires minimum, risk-based capital and leverage standards for federally insured banks, their holding companies, and affiliates. If bank regulators were to determine that physical commodity activities constitute high risk activities, they could impose minimum capital or leverage standards to mitigate the risk associated with conducting such activities and discourage, reshape, or reduce bank involvement.

Section 165 authorizes enhanced supervision and prudential standards for large bank holding companies with assets in excess of $50 billion. It explicitly permits more stringent rules based on a company’s capital structure, riskiness, complexity, or financial activities.

If bank regulators were to determine that physical commodity activities created sufficient risk, they could impose contingent capital, credit exposure, or leverage standards, concentration limits, stress testing, or other measures to minimize risk and discourage, reshape, or reduce bank involvement with physical commodities. Section 619, which codified the Volcker Rule, prohibits banks and their subsidiaries from engaging in proprietary trading as well as hedging or market-making activities that create client conflicts of interest or high risk exposures. Depending upon implementation of the Volcker Rule’s provisions, this section could also restrict and reshape some of the physical commodity activities now undertaken by banks their holding companies, and affiliates.

Section 111 of the law created the Financial Stability Oversight Council (FSOC) whose mission is to identify and address systemic risks to the U.S. financial system. Section 152 created the Office of Financial Research which the FSOC could task with gathering and analyzing data on possible systemic risks caused by bank involvement with physical commodities. If the FSOC were to determine that bank involvement in physical commodities imposed systemic risks to the U.S. financial system, it could recommend or take measures to restrict or restructure those activities.

Finally, Section 620 requires federal bank regulatory agencies to conduct a study of appropriate banking activities. Work on that study is underway. If the study were to conclude that conducting physical commodity activities, in whole or in part, is inappropriate for federally insured banks, their holding companies, or affiliates, the study could recommend measures to reduce, restructure, or even eliminate some of those activities.

Most of the Dodd-Frank provisions are not fully in effect, and the required Section 620 study is not yet complete. Multiple agencies are in charge of their implementation, and multiple outcomes are possible. Depending upon agency implementation, each of these Dodd-Frank provisions offers tools that could be used to discourage, reshape, or reduce bank involvement with physical commodities.

Virginia Adds Prefatory Language to BD Unethical Rule to Avoid Federal Preemption

[This story previously appeared in Securities Regulation Daily.]

By Jay Fishman, J.D.

The Virginia Division of Securities and Retail Franchising within the State Corporation Commission added prefatory language to a broker-dealer/agent unethical practice rule provision to avoid having the provision become federally preempted by the National Securities Markets Improvement Act of 1996 (NSMIA).

Compensation disclosure provision. The provision pertains to Virginia Securities Act rule Sec. 21 VAC 5-20-280 A (32), which deems unethical a Virginia-registered (or required to be registered) broker-dealer’s “failure to advise a customer, both at the time of solicitation and confirmation of sale, of any and all compensation related to a specific securities transaction to be paid to the agent including, commissions, sales charges, or concessions…”

The Division’s concern was that this provision, by requiring compensation disclosures both at the time of solicitation and on confirmation of sale, creates a writing and record requirement specifically at the point of confirmation of sale that may conflict with, or exceed, federal securities law and SEC rule requirements. The Division was particularly concerned that the provision would conflict with NSMIA 15 U.S.C. § 78o(i)(1), which declares that no state law, rule, regulation, or order on broker-dealer bond, capital, custody, margin, financial responsibility, recordkeeping, or reporting requirements may differ or exceed federal requirements.

To avoid possible preemption, the Division added prefatory language limiting application of the compensation disclosure provision to “solicitation of a purchase or sale of over-the-counter unlisted non-NASDAQ equity securities.” The Division, however, reiterated from a December 16, 2013 policy statement that: (1) broker-dealers and broker-dealer agents are not relieved from an obligation to make adequate material disclosures of agent compensation in a securities transaction at the point of sale; and (2) the Division may investigate and bring enforcement against any broker-dealer or broker-dealer agent for failing to make adequate material disclosures about agent compensation at the point of sale.

Thursday, December 04, 2014

Supreme Court Seems Leaning to Require Notice and Comment for Federal Agency Interpretations

The U.S. Supreme Court heard oral argument today in one of the most significant cases in decades for federal regulatory agency process. The case potentially has enormous consequences for the SEC, CFTC and all federal regulatory agencies. The Court is reviewing a DC Circuit ruling that, when an agency has given one of its regulations a definitive interpretation, and later significantly revises that interpretation, the agency has in effect amended the regulation, something it may not accomplish under the Administrative Procedure Act (APA) without public notice and comment. The case invokes a construction of the Administrative Procedure Act. The Department of Labor is the agency in question. But any ruling by the Court would presumably apply to the SEC, CFTC and other federal regulatory agencies. Perez v. Mortgage Bankers Association, Dkt. No. 13-1041.

Some Justices expressed concern that federal agencies could be using interpretations of regulations as a way to bypass the APA’s notice and comment requirement for adopting regulations. Other Justices pointed out that the regulatory landscape has changed fairly dramatically since the enactment of the APA, which intertwines with traditional judicial deference to agency expertise.

Justice Stephen Breyer posed the issue before the Court as whether notice and opportunity for comment is required when a federal agency issues an authoritative interpretation of a regulation that squarely conflicts with the same agency’s prior interpretation. Justice Antonin Scalia added that the question boils down to whether an interpretation that radically alters a prior interpretation is a substantive rule requiring notice and comment. Counsel for the Mortgage Bankers Association Allyson Ho agreed with that submission.

Counsel for the DOL, Deputy Solicitor General Edwin Kneedler, argued that an interpretation does not get transformed into a substantive regulation simply because a prior interpretation interpreted a regulation. You simply have two interpretations of a regulation, said counsel, with the same form and the same agency intent to be interpretive.

The Court is interpreting the Administrative Procedure Act in this action, but the doctrine of judicial deference to agency expertise may also come into play.

Under the Administrative Procedure Act, as noted by DOL counsel, a regulation implementing legislation passed by Congress, what is called a legislative regulation, has the force and effect of law and regulated parties can be sanctioned or held liable for violating the regulation. But that is not true with regard to the interpretation of a regulation by the agency, which is giving the agency’s view of what a provision of law means. The former requires notice and comment, while the latter does not.

Things have changed since the enactment of the APA, noted Justice Scalia. The original APA envisioned that substantive rules would have to be adopted through a public notice and comment process because they would have to be judicially reviewed with deference on the basis of an abuse of discretion. But, the APA envisioned that an agency interpretation of a regulation would not be given deference by the courts and hence did not require notice and comment. Here, we have flip-flopping interpretations of a regulation, noted the Justice, and maybe the Court should not give deference to an agency interpretation of its regulations; and that would be a way to solve the problem of this case. Justice Scalia established in a colloquy with counsel for the DOL that the government wants the Court to give the same deference to legislative regulations and to interpretations.

Justice Elena Kagan expressed concern that more and more federal agencies are using interpretations and guidance to make law, thereby essentially doing an end run around the notice and comment provisions of the APA. On that theme, Justice Sonia Sotomayor said there is a fundamental concern that agencies are bypassing the notice and comment process by using interpretations when they should be using legislative regulations.

Justice Breyer pointed out that, with regard to a legislative regulation, Congress allows the agency to expand the statute through rules. In that case, the agency is exercising delegated congressional authority and courts give quite a lot of deference because the agency knows more about the statute, about what went on in its enactment and what Congress intended. When an agency issues an interpretation of the regulation and then changes its mind, he said, then that deference ``sinks quite a lot,’’something that would not happen with a legislative regulation.

Agreeing, Justice Kagan said that an agency interpretation that has been unstable over time and created an unfair surprise for private parties should not get deference.

Counsel for the Mortgage Bankers Association contended that, when an agency issues an authoritative interpretation of one its regulations, that meaning is what the regulation now is, such that to change that meaning with a subsequent interpretation is to change the regulation itself, thereby requiring notice and comment.

Justice Kagan reasoned that this would also apply to the initial interpretation as well as to the revised interpretation. If you posit that an agency interpretation somehow changes the legislative regulation, then that change happens at the moment the interpretation takes place. According to the Justice, judicial deference is actually stronger with regard to the initial determination then with respect to a revised interpretation. Both interpretations could be viewed as changing the regulation such that notice and comment is necessary.

Wednesday, December 03, 2014

SEC Grants Bank of America Waiver from “Bad Actor” Disqualification

[This story previously appeared in Securities Regulation Daily.]

By Amanda Maine, J.D.

The SEC granted a waiver of disqualification from Regulation D’s “bad actor” provision to entities associated with Bank of America. Absent the waiver, the entities would have been unable to take advantage of Rule 506’s private placement exemption. The waiver is conditioned on the respondents’ retention of an independent consultant to review their policies and procedures related to activities that would be disqualified absent the waiver.

Background. Bank of America, N.A. (BANA), Bank of America Mortgage Securities, Inc. (BOAMS), and Merrill Lynch, Pierce, Fenner & Smith Incorporated (Merrill Lynch) (successor by merger to Banc of America Securities LLC (BAS)) (collectively, the respondents) are wholly-owned subsidiaries of Bank of America Corporation (BAC) that entered into a settlement with the SEC in connection with the with allegations made in a complaint that the SEC filed on August 6, 2013, in federal district court. On August 20, 2014, the SEC and the respondents agreed to settle the proceedings. Merrill Lynch and BOAMS agreed to be enjoined from violating Securities Act Sections 5(b)(1), 17(a)(2), and 17(a)(3), and as part of the global settlement, Bank of America agreed to pay disgorgement of nearly $110 million, pre-judgment interest of over $6 million, and a civil penalty of nearly $110 million (see previous coverage in Securities Regulation Daily, August 21, 2014).

The SEC had alleged that the respondents underwrote prime residential mortgage-backed securities (RMBS) known as BOAMS 2008-A and failed to comply with its representation that each mortgage underlying the securitization complied with the respondents’ underwriting guidelines. The SEC also alleged that the respondents did not disclose the percentage of loans collateralizing BOAMS 2008-A that were originated by third-party mortgage brokers and the risks carried by those loans. In addition, the SEC alleged that the respondents misrepresented material facts about the underlying loans to rating agencies, and that they disclosed certain information about BOAMS 2008-A to some investors but not others in violation of Section 5(b)(1).

Request for relief. According to the request for no-action relief, the injunctions imposed as part of the settlement would designate Merrill Lynch and BANA as “bad actors.” This designation will disqualify Merrill Lynch and BANA from Rule 506’s private offering exemption unless the disqualification is waived under a showing of good cause.

In its request for no-action relief, counsel for Bank of America and Merrill Lynch outlined several arguments in favor of a waiver from disqualification. Counsel noted that the SEC’s complaint alleged violations of civil, non-scienter-based antifraud statutes, so that there was no intent to defraud. Counsel also noted that Merrill Lynch would be subject to the bad actor disqualification as BAS’s successor by merger, even though the SEC did not allege that Merrill Lynch engaged in any of the misconduct. Counsel also argued that the alleged misconduct was limited to a short time period and that the senior personnel involved in the conduct are no longer employed by Bank of America.

Another factor in to support waiver is that remedial steps have been and continue to be undertaken, counsel wrote. Disqualification would also have a significant adverse impact on the firms, their affiliates, sponsored and third party funds, issuers of private placements, customers and clients, according to the requesting letter.

Relief granted. The SEC granted the requested waiver from disqualification. However, the relief is conditioned on the respondents’ retention of a qualified independent consultant, who will conduct a comprehensive review of the policies and procedures relating to compliance with Rule 506. The respondents must provide the consultant with books, records, and personnel as reasonably requested for review by the consultant. The consultant must complete its review and prepare a preliminary report within 360 days, and the respondents must adopt and implement all of the preliminary report’s recommendations within 180 days of receipt of the preliminary report, provided that the recommendations are not unduly burdensome or impractical. The final report will be due 180 days after the implementation of the preliminary report’s recommendations, after which the respondents may apply for a waiver covering the remaining 30 months of the disqualification period.

Tuesday, December 02, 2014

Stein Calls for Enhanced Transparency in Municipal and Private Equity Markets

[This story previously appeared in Securities Regulation Daily.]

By Jacquelyn Lumb

In the keynote address at Columbia University Law School’s recent conference on current issues in securities regulation, Commissioner Kara Stein talked about the importance of transparency in the securities markets and the SEC’s recent efforts to enhance transparency in the municipal and private equity markets. There have been significant improvements in the transparency of the municipal securities markets in recent years, according to Stein, but large gaps remain with significant costs to retail investors.

Municipal securities markets. Stein said in the municipal securities markets, regulators should act to require post-trade pricing disclosure on customer confirmations for principal transactions. Investors do not receive disclosure on their confirmations showing the transaction costs they pay when they buy or sell a municipal security in a principal transaction, she explained, and nearly all customer transactions in this market are principal trades. The MSRB has issued a proposal to provide this disclosure and Stein encouraged comments on the MSRB’s proposal and a related proposal by FINRA.

Stein also called for more disclosure before trading occurs. Firm bid and ask quotes are generally unavailable, she noted, and municipal bond dealers usually do not provide firm quotations electronically. Limited information is available to institutional investors and participating dealers, primarily through alternative trading systems or municipal bond dealers that are broker’s brokers. Stein said ordinary investors should have equal access to this information.

One option is to amend Regulation ATS to require the public disclosure of pricing information, according to Stein. The SEC also could require broker’s brokers to publicly disclose pricing information. These alternatives are worth considering in her view, given the benefits that enhanced transparency would bring.

Private equity markets. Stein said there have also been improvements in transparency in the private equity markets. While investors in private equity tend to be sophisticated, Stein said the range of sophistication varies widely.

Stein noted that the Office of Compliance Inspections and Examinations has identified violations and material weaknesses with respect to fees and expenses at a number of private equity firms. She encouraged advisers to private equity funds to consider improving their disclosure about fees and fund performance. OCIE examinations have uncovered practices relating to the payment of consultants and monitoring agreements that are not disclosed with sufficient detail, if at all. Stein also believes it is fair and reasonable for advisers to explain the assumptions they use when calculating returns.

Exchange-traded funds. She also talked about exchange-traded funds and some of the novel exemptive applications the SEC has received. Actively managed ETFs wish to provide less transparency about their portfolio holdings to prevent competitors from front-running their investment strategies. However, Stein noted that a single trader’s order triggered a flash crash and the precipitous drop in the prices and liquidity of ETFs, and asked whether there are systemic risks that should be monitored. She expressed concern that larger questions are getting lost in the current ETF and exemptive application and exchange listing process. Stein said she has asked Chair Mary Jo White to authorize a request for comments to gain public input on issues relating to exchange traded products.

In closing, Stein noted that history has repeatedly demonstrated that the up-front costs that come from additional transparency are more than made up by increases in liquidity, reliability, and competitive returns. Transparency benefits both retail and institutional investors, she said. As the SEC considers changes in transparency, Stein said it must also be aware of the potential effects on the markets and the financial system.

Sunday, November 30, 2014

1941 AG Committee Report Sheds Light on Congressional Review of Regulations

There have been legislative efforts in the 113th Congress to require that significant federal regulations adopted by the SEC and other agencies be approved by Congress. While Congress has the power to require this, questions about its workability on a practical level have been raised.

In this regard, it may be instructive to look at the 1941 Report of the Attorney General’s Committee on Administrative Procedure. This report was commissioned by President Franklin D. Roosevelt while Frank Murphy was AG and delivered to Congress by AG Robert Jackson. The Committee was chaired by Dean Acheson and contained such luminaries as Arthur Vanderbilt and Walter Gellhorn. Both Frank Murphy and Robert Jackson would serve on the U.S. Supreme Court.

The Committee report notes that the laying of regulations before Congress has not been unknown to the American people. The report cites as an example the Reorganization Act of 1939 relating to Presidential reorganization orders, which had a deferred effectiveness provision that gave Congress the time to nullify any order that it did not wish to become operative. A similar practice with respect to administrative regulations has been employed in the U.K.

But the Committee did not recommend a general requirement that federal regulations be laid before Congress before going into effect. Legislative review of administrative regulations has not been effective where tried. The whole membership of Congress could not be expected to examine the considerable volume of material that would come before them, noted the report, adding that even a joint committee entrusted with the task could not supply an informed check upon the diverse and technical regulations it would be charged with watching.

Saturday, November 29, 2014

Senate and House Leaders Ask Financial Firms for Cybersecurity Plans

In light of reports that more than 500 million records have been compromised due to data security breaches in the U.S. financial sector over the past year, Rep. Elijah E. Cummings (D-MD) and Senator Elizabeth Warren (D-MA) sent identical letters to 16 large financial firms requesting information about recent data breaches and seeking detailed briefings from corporate IT security officers. The Members cited press accounts reporting that law enforcement officials believe the U.S. financial sector is one of the most targeted in the world, and that approximately 80% of hacking victims in the business community didn't even realize they had been hacked until they were told by investigators. The financial firms receiving the letters included Bank of America, Citigroup, Goldman Sachs, ADP, Wells Fargo, and Deutsche Bank.

Specifically, the firms were asked to provide a description of all data breaches that the firm has experienced over the past year, including the date and the manner and method by which the fin first discovered the breaches, the dates the breaches are believed to have begun and nded, and the types of data breached. Also requested are the approximate number of customers that may have been affected by the breaches and the manner in which customers were notified of the breaches. Also, the firms should provide the findings from forensic investigative analyses or reports concerning the breaches and the individual or entities suspected or believed to have caused the data breaches and whether they have been reported to the proper law enforcement agencies. The firms should describe data protection improvement measures taken since the breaches were discovered.

Thursday, November 27, 2014

IASB Strongly Defends IFRS as Essential to E.U. Capital Markets Union

The IASB strongly defended IFRS on many fronts in response to an European Commission consultation seeking to determine the impact of IFRS on the E.U. In a letter to Financial Services Commissioner Jonathan Hill, the IASB said that the adoption of IFRS has brought positive effects in terms of the quality, transparency and comparability of financial reporting, not only within the Union, but also globally, with no less than 114 countries now mandating the use of IFRS for all or most public companies and other major economies (notably Japan and the U.S.) permitting its use in certain circumstances. The letter was signed by IASB Chair Hans Hoogervorst and Michel Prada, Chair of the IFRS Foundation.

The new European Commission that takes office on November 1 has a central goal of creating a Capital Markets Union to move the E.U. more towards equity markets and securities financing and away from the current heavy reliance on bank funding. The IASB posits that the use of a single set of financial reporting requirements is essential to the successful achievement of the Capital Markets Union.

Given the global nature of capital markets and the need for comparability within the E.U. market to mirror internationally-accepted best practice, reasoned the IASB, only IFRS can provide those requirements. The transparent financial reporting provided by companies reporting under IFRS helps participants in capital markets make more efficient and informed resource allocation; and makes investment more attractive to capital providers.

The letter also noted that the use of IFRS globally by E.U. companies, without the need for restatement, has provided them with the benefit of achieving improved group reporting and administrative savings through having to report only under one accounting framework.

The Commission consultation also seeks views on whether it should have more leeway to modify IFRS to be adopted for use in the E.U. The letter notes the very real risks of such flexible endorsement, in particular the negative signal that it would send to the rest of the world. Moreover, modified Standards would not be IFRS, warned the IASB, but rather represent a different framework. Such an approach would have disadvantages. The co-existence of different reporting frameworks would be both confusing and costly, as well as making effective supervision and enforcement of financial reporting requirements of public companies more difficult. As a corollary to this, investors would be deprived of comparable accounts and therefore essential information.

In the E.U., IFRS are adopted on a standard-by-standard basis. The process, which typically takes eight months, is as follows: The IASB issues a standard. The European Financial Reporting Advisory Group (EFRAG) holds consultations, advises on endorsement and examines the potential impact. The Commission drafts an endorsement regulation. The Accounting Regulatory Committee (ARC) votes and gives an opinion. The European Parliament and Council examine the standard. The Commission adopts the standard and publishes it in the Official Journal.