House Passes Legislation Codifying Dodd-Frank Deruvatives End User Exemption and Ending Indemnification

The House of Representatives has passed by an overwhelming bipartisan vote of 411-12 H.R. 634, the Business Risk Mitigation and Price Stabilization Act, which codifies an exemption for non-financial end users that use derivatives in their commercial businesses from the margin requirements of the Dodd-Frank Act. The House also passed, by a strong bipartisan vote of 420-2, the Swap Data Repository and Clearinghouse Indemnification Act, H.R. 742, which would ensure that U.S. and foreign regulators can share necessary swaps data to increase market transparency and facilitate global regulatory cooperation.

The Dodd-Frank Act requires swap data repositories and clearing organizations to make data available to foreign regulators. But, under Dodd-Frank, this data-sharing can happen only if foreign regulators agree to indemnify the U.S. entity and U.S. regulators for any corresponding litigation expenses that might arise. Foreign regulators have been unwilling or unable to agree to such indemnification agreements under their own legal structures. Agriculture Committee Chair Frank Lucas (R-Okla) has noted that some jurisdictions don’t have the concept of indemnification, so the indemnification provisions prevent the necessary data-sharing. To ensure that U.S. and foreign regulators have access to derivatives data, H.R. 742 would eliminate the indemnification provisions that would otherwise impede the necessary data-sharing arrangements.

Last year, the SEC recommended that Congress consider removing the indemnification requirement added by the Dodd-Frank Act. The indemnification requirement interferes with access to essential information, said Ethiopis Tafara, then Director of the SEC Office of International Affairs, including information about the cross-border OTC derivatives markets. In removing the indemnification requirement, Congress would assist the SEC, as well as other U.S. regulators, in securing the access it needs to data held in global trade repositories.

H.R. 634 ensures that end users can continue to use derivatives to hedge business risk, such as the cost of fuel. There is a broad consensus that Congress never intended for nonfinancial end-users to be required to post margin under Dodd-Frank. Legislative history indicates that Dodd-Frank intended to exempt end-users from margin requirements. However, there is regulatory uncertainty around the issue because, while the SEC and the CFTC would exempt end-users from margin, the Federal Reserve has issued regulations that would capture many end-users.

House Ag Committee Ranking Member Collin Peterson (D-Minn) said that the legislation was needed because the banking regulators, unlike the SEC and CFTC, ignored the will of Congress and required end-users to post margin. Rep. Mike McIntyre (D-NC) said that true end-users use derivatives to protect from losses and ensure stability and not to engage in speculation, adding that H.R. 634 will not apply to the major financial institutions. This is a critical bill, he emphasized, to ensure that the intent of Congress is not ignored

Senator Tom Udall Named to Appropriations Post Overseeing SEC and CFTC Funding

Senator Tom Udall (D-NM) has been named the Chairman of the Senate Appropriations Financial Services and General Government Subcommittee, which has jurisdiction over the annual funding for financial-related agencies including the Department of Treasury, the SEC, the CFTC and the Internal Revenue Service. In a statement, Senator Udall said that as Chairman he will work hard to support small businesses, expand rural broadband, protect consumers and ensure the safety of the financial markets. Senator Udall was named to oversee the SEC and CFTC funding by Chairwoman Barbara Mikulski (D-MD) of the full Senate Appropriations Committee. 

House Passes Bi-Partisan Legislation Requiring Congruent SEC-CFTC Regulations on Cross-Border Derivatives Transactions

The House of Representatives passed the Swap Jurisdiction Certainty Act (HR 1256) by a bi-partisan vote of 301-124, which would direct the SEC and CFTC to adopt joint regulations on the oversight of cross-border derivatives transactions. The legislation is sponsored by Rep. Scott Garrett (R-NJ), Chair of the House Capital Markets Subcommittee. Chairman Garrett noted that H.R. 1256 brings additional transparency and clarity to the swaps market to benefit both consumers and taxpayers.  Specifically, the legislation would require the SEC and CFTC to have identical cross-border derivatives regulations; would require a formal regulation to be issued; and would authorize the SEC and CFTC to regulate swaps transactions between U.S. and foreign entities, if the regulators are concerned about the importation of systemic risk.

If U.S. regulators get the cross-border application of Dodd-Frank wrong, warned Chairman Garrett, the swaps trade could move permanently to foreign jurisdictions, and end-users could see the costs of the financial tools they need to compete in a global marketplace dramatically increase.  The Swap Jurisdiction Certainty Act will ensure that domestic and global swaps regulations are coherent and complementary, and it offers a common-sense approach with broad bi-partisan support, added Rep. Mike Conaway (R-TX), Chair of the House Commodities and Risk Management Subcommittee.

Full Agriculture Committee Chair Frank Lucas (R-OK) has noted that H.R. 1256 would also provide that no guidance from the Commissions in this area would have the force of law. Rep. David Scott (D-GA) said that the legislation addresses issues around the extra-territorial application of the Dodd-Frank Act. Non-U.S. persons would not be subject to the Dodd-Frank Act if, as determined by the Commissions, they are subject to an equivalent derivatives regulatory regime in a G-20 country. Chairman Conaway has noted that the bill allows the SEC and CFTC to designate other jurisdictions outside f the G-20 as equivalent and thus eligible for the exemption. 

Rep. Jeb Hensarling (R-TX), Chair of the full Financial Services Committee, noted that   ultimately H.R. 1256 will do two important things. First, it will tell the SEC and CFTC that they need to issue one joint rule when it comes to U.S. end-users being able to access global markets. Not one suggestion and one rule or two different rules, but one rule.  Second, H.R. 1256 creates, with regard to the nine largest markets, a presumption that their regimes are broadly equivalent to the U.S. and not immediately deny access.  Now at any given time, said Chairman Hensarling, if the CFTC and SEC come to the conclusion that these regimes are not broadly equivalent, that somehow they present risks to the U.S. economy, with the stoke of a pen they can change that presumption.

House Report No. 113-103 to accompany H.R. 1256 noted that Title VII of the Dodd-Frank Act seeks to regulate the over-the-counter derivatives market in much the same way that equities and futures exchanges are regulated. Because the OTC market is global, Title VII raises questions about the extent to which U.S. regulations will apply to swap and security-based swap transactions that take place outside the U.S.

According to the House Report, Title VII's plain language makes clear that Congress intended it to apply outside the U.S. only in certain limited circumstances. Section 722 of Dodd-Frank directs that provisions relating to swaps will not apply to activities outside the U.S. unless those activities have a direct and significant connection with activities in, or effect on, commerce of the United States or contravene anti-evasion rules promulgated by the CFTC.

The House report states that the comments and actions of U.S. regulators indicate that they are considering regulations that would result in Title VII being applied more broadly than Congress intended. Further, the Dodd-Frank Act requires both the CFTC and the SEC to issue rules on the extraterritorial scope of Title VII, creating the possibility of two different, potentially conflicting, regulatory regimes. To ensure that one rule is issued to govern the extraterritorial application of Title VII of the Dodd-Frank Act and to ensure that the CFTC and SEC focus their resources and regulatory efforts on jurisdictions that are not broadly equivalent with the U.S. swaps regime, the House passed the Swap Jurisdiction Certainty Act.

H.R. 1256 harmonizes the cross-border approaches by requiring the CFTC and SEC to jointly issue the same rule related to the cross-border application of the Dodd-Frank Act within 270 days of the bill's enactment. This joint rule would have to be promulgated in accordance with the Administrative Procedures Act. H.R. 1256 ensures that operating entities in foreign countries or administrative regions with broadly equivalent regimes for swaps will not be subject to U.S. rules. Finally, H.R. 1256 requires that the SEC and CFTC jointly provide a report to Congress if they determine that a foreign regulatory regime is not broadly equivalent to United States swap requirements.

Obama Administration Position. The Obama Administration issued a Statement of Policy opposing the passage of H.R. 1256. The Administration believes regulators should be given the time necessary to complete their work. The Administration consequently opposes passage of H.R. 1256, which would preempt ongoing work and slow the implementation of these vital reforms.

The Administration said that the Dodd-Frank Act puts in place a number of requirements that bring transparency to and enhance the stability of derivatives markets. These reforms will collectively strengthen the weak and outdated regulatory regime that played a significant role in the crisis that caused devastating damage to the U.S. economy. As part of the significant progress the SEC and CFTC are making with a number of derivatives-related reforms, emphasized the Administration, the regulators are already coordinating to address the issues raised in H.R. 1256, while taking into account the characteristics of the particular markets they regulate. Given these ongoing coordination efforts, passage of the bill would be premature and disruptive to the current and ongoing implementation of the reforms.

German Court Sentences Insider Trader to Five Years in BaFin Enforcement Action

In a trial concerning market manipulation and insider trading based on charges brought by the German Federal Financial Supervisory Authority (BaFin), a Regional Court (Landgericht) sitting in Munich handed down a prison sentence of five years and three months to the insider trader. The court also ordered the defendant to pay a fine of €3.5 million as restitution for injured parties. The Public Prosecutors’ Office in Munich continues its investigations into a number of other suspects that is believed to run into double figures. The action demonstrates the increasing attention that German authorities are giving to insider trading.

Together with others, the convicted businessperson committed fraud concerning a capital increase. He provided falsified bank confirmations to the responsible registration court thereby bringing about an incorrect registration concerning a capital increase. Subsequently, knowing that there had been no capital increase, the defendant carried out share transactions. By issuing contrary buy and sell orders, he generated a share price that did not correspond with the actual supply and demand of the shares. The trader was also involved with others in using false information to attract investors to a company. He used the demand generated by this action to sell his shares via his wife’s securities account and an investment firm.

FSOC Can Urge But Not Command

Recent commentary on the SEC's proposed reforms of money market fund regulation hinted that if the  SEC's final regulations in this are not strong enough then the Financial Stability Oversight Council can step in and strengthen them. It is not clear and indeed is highly doubtful that the FSOC can enhance an SEC regulation that it finds wanting. While Senator Bob Corker (R-TN), one of the key authors of the Dodd-Frank Act that created the FSOC, has indicated that FSOC had the power to act on money market reform if the SEC did not act, it is unclear if that power would extend to augmenting SEC action. Indeed, FSOC urged the SEC to act since FSOC believes  that the SEC is the appropriate body to act on money market fund reform. It is true that FSOC has a broad mandate to monitor and prevent systemic risks to the financial system, but it is arguable if that broad authority can be granularly applied to fine tune an SEC regulation.

When FSOC  proposed a set of recommendations for market fund reform late last year, then FSOC Chair Treasury Secretary Tim Geithner noted that, if at any point the SEC has a majority to go forward,  FSOC would suspend its work and let the SEC go forward. Indeed, he added, FSOC would prefer for the SEC to take this back and move forward. Fed Chair Ben Bernanke, an FSOC member, said that the SEC should make the ultimate regulations on money market reform. 

At recent house hearings, Rep. Spencer Bachus (R-AL) lamented that FSOC does not seem to have the authority to mandate that the SEC and CFTC coordinate regulations on cross-border derivatives. FSOC can urge coordination but cannot command it. Senator Mark Warner (D-VA) has similarly expressed disappointment with FSOC's lack of authority to direct federal agenies to coordinate the regulatory implementation of Dodd-Frank.

In Letter to Congress, Business Roundtable Urges Congress to Include Financial Regulatory Arbitrage Issues in Trade Talks with E.U.

In a letter to the Chairs House Financial Services and Ways and Means Committees and the Senate Banking and Finance Committees, the Business Roundtable asked that issues around the negotiation of a comprehensive Transatlantic Trade and Investment Partnership (TTIP) agreement with the European Union (EU) should include regulatory arbitrage and regulatory dissonance issues. The TTIP has the potential to substantially boost economic growth and create U.S. jobs.

Given the critical role that financial services plays in both the U.S. and E.U. economies, and the continuing prevalence of transatlantic barriers and insufficient regulatory coherence in the sector, said the Roundtable, the United States should include financial services market access and regulatory cooperation issues in the negotiations. The Roundtable warned that failing to do so would represent a significant missed opportunity for the United States.  More generally, the TTIP is too big of an opportunity to exclude any sector from the negotiations.

For example, the negotiations will provide an opportunity to address market access barriers that keep U.S. businesses from enjoying full opportunities in Europe.  They will also provide a forum to discuss new rules and mechanisms to enhance regulatory coherence and cooperation,


The business group urged Congress to support the negotiation of a comprehensive TTIP that covers all sectors of the economy, and to oppose any U.S. legislative or regulatory proposals that would take the nation in the opposite direction, thereby undermining the global competitiveness of large U.S. banks and U.S. companies that rely on their financing to do business around the world.

House Panel Examines Role of Proxy Advisory Firms, Former SEC Chair Pitt Testifies

Hearings before the House Capital Markets Subcommittee revealed a growing consensus that proxy advisory firms have become the de facto standard setters for U.S. corporate governance and need to either adopt best practices and core principles or be regulated by the SEC. Subcommittee Chair Scott Garrett (R-NJ) emphasized that Congress must ensure that the proxy system works for US investors. The proxy system and the distribution of proxies have become quite complicated and many investors have come to rely exclusively on the recommendations of proxy advisory firms to vote their shares on proxy questions. Chairman Garrett analogized the growth in the influence of proxy advisory firms to the rise of the use of credit rating agencies before the financial crisis.

Proxy Advisory Firms. Chairman Garrett also mentioned that SEC staff interpretations have essentially allowed institutional investors to outsource their proxy voting duties to supposedly independent proxy advisory firms. The result is that proxy advisory firms currently wield an enormous amount of influence over the proxy voting process. The Chair also remarked on the conflict of interest issues around proxy advisory firms. They have no duty to provide advice in the best interests of shareholders and do not factor shareholder value into their recommendations. All that said, Chairman Garrett said that proxy advisory firms serve a valuable role in corporate governance, but should not be enshrined as sole guardians of proxy corporate governance.

Rep. Brad Sherman (D-CA) said that the real battle is between crony capitalism and free market capitalism, which demands that shareholders need good advice and freedom from frivolous lawsuits. Shareholders should not be deprived of proxy advice, he reiterated. Rep. Sherman fears that we are moving to the lowest common denominator on shareholder right, adding that Congress must ensure that shareholders have the information they need and have the protection that a well-drafted corporation statue can provide.

Rep. Robert Hurt (R-VA) noted that proxy advisory firms must be sufficiently transparent and accountable. As the SEC has acknowledged, he observed, there can be conflicts of interest when proxy advisory firms provide recommendations and other services, such as management consulting services.

Rep. David Scott (D-GA) said that, given the many recent failures of corporate governance, it is imperative that Congress examine all of the issues around which proxy advisory services make recommendations. He also queried why only two companies, ISS and Glass Lewis, handle 97 percent of the proxy advisory market. Rep. Scott is, like other members of the subcommittee, concerned about proxy advisory firms providing consulting services in addition to proxy voting recommendations, thereby leading to potential conflicts of interest. He questioned what policies and procedures proxy advisory firms employ to ensure that their recommendations are independent and not influenced by any consulting fees that they get from issuers. Rep. Scott further noted that the SEC has not taken any action in the wake of the staff study.

In his testimony, former SEC Chair Harvey Pitt said that proxy advisory firms exercise extensive but unfettered influence over corporate governance and indeed have become the de facto arbiters of U.S. corporate governance. They are powerful but unregulated, he added, and serious conflicts of interest permeate their operations.

Chairman Pitt emphasized that effective and transparent corporate governance encouraging meaningful shareholder communication is critical. Informed and transparent proxy advice can help corporate governance only if the advice being provided is solely motivated by the advancement of the economic interest of investors.

Eschewing federal regulation of proxy advisory firms, Chairman Pitt, testifying on behalf of the U.S. Chamber of Commerce, recommended the adoption of industry best practices and core principles. The Chamber has suggested best practices, he noted, and these are standards that the industry should embrace and follow. He urged the SEC and the institutional investor community to lend support to a code of best practices.

Chairman Pitt also testified that two 2004 SEC no-action letters, ISS and Egan-Jones, had the legal effect of permitting registered investment advisers to rely exclusively on a proxy advisory firm‘s general policies and procedures pertaining to conflicts of  interest, as opposed to any specific conflicts a proxy advisory firm might have with respect to a particular issue or a particular company about which the proxy advisory firm might make a recommendation to determine if the proxy advisory firm was independent and could be relied upon to cast a vote for the investment adviser, without the adviser being deemed to have violated Rule 206(4)-2 of the Investment Advisers Act or any other provision of the federal securities laws. Earlier this year at a Chamber event, Chairman Pitt had said that, taken together, the two no-action letters create a regulatory environment in which portfolio managers believe that if they outsource the proxy vote they have avoided major problems under Rule 206(4)-6 and their own fiduciary obligations.

Picking up on Chairman Pitt’s point that many institutional investors have essentially outsourced their proxy votes to proxy advisory firms, Chairman Garrett asked who is the fiduciary duty owed to, to which Mr. Pitt replied the fiduciary duty remains with the institutional investors. They cannot divest themselves of it, he said, adding that the NALs are the vehicle by which they try to outsource the duty. To Chairman Garrett’s question of whether the proxy advisory firm has a duty to investors, Mr. Pitt responded that the firms have a duty akin to fiduciary duty, a duty of truthfulness, which is not the same as a fiduciary duty.

Testifying on behalf of the Society of Corporate Secretaries and Governance Professionals, Darla Stuckey, referring to the SEC concept release, said that proxy advisory firms are one of the few participants in the proxy voting process that are not generally required to be registered or regulated by the SEC. There is no accountability by proxy advisory firms even though, given the current structure of the proxy system, they control anywhere from 20-40% of the vote collectively on routine matters at widely held companies. When proxy advisory firm recommendations come out, large blocks of votes are cast almost immediately in automated voting decisions. These ripple out both from clients that follow the main policy of each advisory firm, she noted, and those that have so-called custom policies that are tweaked based on simplistic mechanical inputs.

While proxy advisory firms are not beneficial owners of any company’s shares, reasoned the corporate secretaries society,  the two largest proxy advisory firms each effectively control a portion of the vote that is much larger than the Schedule 13D threshold (5%), and even larger than the 10% affiliate status threshold, yet they are not subjected to any kind of regulatory regime. The Society pointed out that proxy advisory firms may produce reports with material misstatements and omissions without any legal consequences for the firm.

Similarly, proxy advisory firms’ voting policies are also unregulated. There is no regulatory regime that governs the manner in which these firms develop their policies or form the recommendations they make. The policy development process at proxy advisory firms is not sufficiently transparent, contended the Society, and it is not clear who actually participates in the process.

The Society believes that proxy advisory firm voting influence undermines the integrity of the voting system for a number of reasons, including that proxy advisory firms are subject to conflicts of interest and make factual mistakes in their analysis, with the effect that their voting guidelines are erroneously applied to the company’s proposal and the voting recommendation is inaccurate. Proxy advisory firms are actually subject to four types of conflicts of interest, maintained the Society. The first occurs as a result of proxy advisory firms selling services to both institutional clients and issuers. The second conflict arises when proxy advisory firms make favorable recommendations on

proposals submitted by their own investor clients. The third conflict stems from proxy advisory firms’ interest in recommending certain proposals that are likely to expand their influence and future market. The fourth may arise when an owner of a proxy advisory firm takes a position on a proxy voting issue and the firm also issues a voting recommendation on that issue (this applies to Glass Lewis only since it is owned by a major public pension fund).

The Society recommended that proxy advisory firms be required to become registered investment advisors. In this way, the practices and procedures of such firms would be subject to SEC examination, which should provide additional discipline and accountability to the system. Once registered, proxy advisory firms would need to establish to an oversight authority that they are following their procedures and would need to provide factual support for the bases of their disclosures.

In his testimony, former SEC Chief Accountant Lynn Turner said that in today’s global markets an asset manager may invest in dozens of capital markets, and in thousands of public companies. For example, at Colorado PERA, the fund makes and manages

investments on a global basis in 7,000 to 8,000 companies. The proxies for these companies may involve the election of numerous directors, approval of compensation and acquisitions, shareholder initiatives submitted for shareholder approval, and any number of additional matters.

Many mutual or pension funds do not have unlimited staff who can read thousands of proxies and then research and submit an informed vote on the issues as required. Mr. Turner said that it would take well over a hundred staff, at a very significant cost to vote 8,000 proxies in a global market place. That would be a cost that would have to be passed on to investors, he noted, significantly increasing their fees, and reducing their investment returns, and ultimately, the amounts they are trying to save for retirement.

Instead, the funds rely, in part, on research they can buy from ISS and/or GL or others, along with their own research and proxy voting guidelines, to make a decision on how to vote.

Justice Goldberg Captured Essence of Business Judgment Rule in Tender Offer Advisory Committee Dissent

In a dissent  to the report of the SEC's Tender Offer Advisory Committee in 1983, former Supreme Court Justice Goldberg had some timely observations on the business judgment rule. Justice Goldberg said that assertions that golden parachutes are justified by the business judgment rule are without foundation because they are based upon a misconception of the rule. The business judgment rule was designed to safeguard not the personal interests of managers, he noted, but rather the good faith judgment of managers as to what is in the best interests of the corporation. Managerial judgment must and should not be affected or tainted by a conflict of interest. Simply put, the business judgment rule is fashioned to permit latitude to managers of corporations in the ordinary good faith conduct of business affairs in the interest of the corporation, where there is no self-dealing or other conflict of interest involved.

In Wake of SEC-FINRA Investor Alert, Senate Panel Launches Inquiry into Pension Stream Investments

In the wake of an SEC-FINRA Investor Alert about investments in pension streams, the Senate Labor and Pensions Committee began an inquiry focused on these investments and possible fraud. In a letter to the National Association of Attorneys General, Chairman Tom Harkin (D-Iowa) and Ranking Member Lamar Alexander R-TN) said that there may not be full disclosure around the practice of purchasing pension revenue streams. For example, while some of these arrangements come with very high fees, there is no clarity on whether these fees are fully disclosed.

There may also be requirements linking the purchase of pension revenue streams with the purchase of other financial products. More broadly, the Senators are concerned that innocent investors who purchase the rights to the pensions on a belief that they are worthy and legal investments are being misled or even defrauded by the brokers of these arrangements.

The letter is designed to elicit information on which companies are offering these investments and where the companies are incorporated, as well as details on how these arrangements are structured. The Senators also want information on whether and how many enforcement actions have been brought in this area.

Bi-Partisan Senate Legislation Would Reform the Federal Regulatory Process

A bipartisan Senate bill would modernize the Administrative Procedure Act by strengthening cost-benefit analysis across all federal regulatory agencies, improving transparency in the rulemaking process, and providing a more rigorous examination of facts underlying the most expensive rules. The Regulatory Accountability Act, S. 1029, was introduced by Sens. Rob Portman (R-Ohio) and Mark Pryor (D-Ark). Senators Susan Collins (R-Me), Bill Nelson (D-Fla), Joe Manchin (D-WVa), Angus King (I-Me), Kelly Ayotte (R-NH), Mike Johanns (R-Neb), and John Cornyn (R-Tex) are original cosponsors of the bill. A bipartisan House companion bill,HR 2122, was introduced by Rep. Bob Goodlatte (R-Va) and Rep. Collin Peterson (D-Minn), Ranking Member on the Agriculture Committee.

The legislation would codify the duty of independent federal agencies, such as the SEC and the CFTC, to analyze the costs and benefits of new regulations. It would also require agencies to adopt the least costly or most cost-effective approach to achieve their objectives. To hold agencies accountable, the bill would permit a judicial check on an agency’s cost-benefits analysis of major regulations. This review would be deferential, but the courts would ensure that agencies do not rely on irrational assumptions or treat cost-benefit analysis as a mere afterthought.

Designed to open the regulatory process to greater transparency, the Act invites early public participation on major rules and requires agencies to disclose the data they rely upon. It also would ensure that agencies use sound scientific and technical data to justify new rules, in keeping with the President’s directive that agencies should use the best available science to craft regulations.

 The legislation would also require agencies to follow a more evidence-based approach in crafting regulations that will cost more than $1 billion annually. These high-impact rules are relatively rare (the White House identified seven in development last year), but the cost of getting them wrong is steep. The legislation would give stakeholders access to an agency hearing to test the key disputed facts underlying these rules. It will take some additional work on the front end, noted Sens. Portman and Pryor, but the result will be lower costs and more stable regulatory outcomes.

This legislation heeds President Obama’s recent call for public participation and open exchange before a rule is proposed. Prior to proposing any major rule, regulators would be required to issue a simple notice explaining the problem that they intend to address and inviting the public to submit information on the need for a new rule and potential options the agencies should consider before proposing a rule. To improve the quality of new rules, agencies would be required to use the best available scientific, economic, and technical information. The sponsors believe that this is consistent with the President’s statements in Executive Order 13563.

The legislation would also cut back on what the senators call the “misuse” of guidance documents, which are described as agency directives written outside the normal public process of notice and comment, while allowing their legitimate use to continue. Specifically, it would adopt the good-guidance practices issued in a final OMB bulletin on January 25, 2007, and ensure that agencies do not use guidance to skirt the public input required to write new rules.

The legislation builds well-recognized best practices for regulatory analysis, integrating cost-benefit analysis into each step of the rulemaking process, as well as judicial review, in the case of major rules. These principles are drawn from the long-standing, partisan executive-order framework created by the Reagan and Clinton Administrations and reaffirmed by President Obama in January 2011. Those principles would be made permanent, enforceable, and applicable to independent federal agencies, which are currently exempt.

The legislation requires the SEC, the CFTC, and other federal agencies to adopt the least-costly regulatory alternative that would achieve the policy goals set by Congress. It permits agencies to adopt a more-costly approach only if the agency demonstrates that the alternative is more cost-effective in the long term. This directive would reinforce the Executive Order 13563’s instruction to federal agencies to minimize regulatory costs and tailor regulations to impose the least burden on society.

For high-impact regulations, defined as those costing $1 billion or more a year, the cost of getting underlying facts wrong is substantial and warrants additional scrutiny, posited Sens. Portman and Pryor. The legislation would give parties affected by billion-dollar rules access to an administrative hearing to test the accuracy of the evidence and assumptions underlying an agency’s proposal. The scope of the hearing would be limited to disputed factual issues, which, if misapprehended by the agency, could impose unnecessary burdens on the economy.

Parties affected by major rules (those involve $100 million) would also have access to hearings, unless the agency concludes that the hearing would not advance the process or would unreasonably delay the rulemaking.

As a consequence of the administrative hearing, high-impact rules would bejudicially reviewed under a substantial-evidence review, which, while still highly deferential, allows judges reviewing these rules to ensure that agency justifications are supported byevidence that a reasonable mind could accept as adequate to support a conclusion based on the record as a whole. This standard would also apply to major rules that undergo the formal hearing procedure.

E.U. Court of Justice to Hear UK Challenge to E.U. Short Selling Directive

It is being reported that the E.U. Court of Justice is scheduled to hear the U.K. challenge to the Short Selling Regulation next month. The U.K. government has launched a judicial challenge to the E.U. Short Selling Regulation on the grounds that the Regulation bestows too much discretionary power on the European Securities and Markets Authority ESMA). In its complaint filed with the Court of Justice of the E.U., the U.K. noted that Article 28 of the Regulation gives ESMA intervention powers in exceptional circumstances, requiring ESMA to prohibit or impose conditions on the entry by persons into short sales or to require such persons to disclose such positions if the transactions pose a threat to the orderly functioning and integrity of the financial markets, or to financial stability with cross-border implications. The measures are valid for up to three months, but ESMA is empowered to renew them indefinitely. The measures prevail over any previous measures taken by a competent authority pursuant to the Short Selling Regulation. United Kingdom v. Council of the European Union, Case No. C-270/12.

The United Kingdom argues that  Article 28 is unlawful because the criteria as to when ESMA is required to take action under the Article entail a large measure of discretion. giving ESMA a wide range of choices as to what measure or measures to  impose and what exceptions to specify, and these choices have very significant economic policy implications.

The factors which ESMA must take into account contain tests which are   highly subjective, said the U.K., and ESMA is empowered to renew its measures without any limit on their overall duration. Even if Article 28 did not involve ESMA in making macroeconomic policy choices, which it does, said the complaint, ESMA nonetheless has a broad discretion as regards the application of policy to any particular case.

Article 28 purports to empower ESMA to impose measures of general application which have the force of law, contrary to the previous decisions of the Court. Also, Article 28 purports to confer on ESMA a power to adopt non-legislative acts of general application, contended the U.K., whereas under organic E.U. law the Council of the European Union has no authority to delegate such a power to a mere agency. To the extent that Article 28 would be interpreted as empowering ESMA to take individual measures directed at natural or legal persons, it would be ultra vires.

Very importantly, the U.K. believes that Article 28 can be judicially severed from the remainder of the Short Selling Regulation, thereby leaving the remainder of the Regulation intact.

European Commission Directs ESMA to Propose Standards under EMIR by September 25

With the SEC having recently proposed regulations implementing the cross-border derivatives provisions of the Dodd-Frank Act, in a letter to ESMA Chair Steven Maijoor, Jonathan FaulI, Director General of the European Commission Internal Market, directed ESMA to propose standards implementing the cross-border provisions of Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR) by September 25, 2013. In June 2012, ESMA decided to postpone the development of these standards, which deal with the application of EMIR to transactions between U.S. and other non-EU entities with a direct, substantial and foreseeable effect within the Union. Given the connection between these standards and the ongoing discussions with the SEC, CFTC and other international regulators on the coordination of the implementation of OTC derivative markets reforms, noted the Director General, it was indeed crucial to have more visibility about these developments before defining these standards, which will be part of the EU response to these international developments.

In accordance with E.U. legislation, the Commission may set a new time limit for the delivery of these standards. In the view of the senior official, the progress made in the international discussion over the past months in the framework of the OTC Derivatives Regulators Group permit setting a new deadline for the development of these standards. After consultation with ESMA staff, the end of September 2013 seems a realistic deadline.

Bi-partisan House Legislation Would Expand Tick Sizes in Wake of Decimalization

Rep. David Schweikert (R-AZ), a primary author of the JOBS Act  has introduced the Spread Pricing Liquidity Act, HR 1952, to give small companies with limited market capitalization greater access to public equity.  According to Rep. Schweikert, the bill responds to overwhelming evidence that wider ticks for small-cap companies will stimulate liquidity, encourage capital formation, and grow jobs. The  Congressman said that  the SEC has been inactive on this issue. He also noted that since the introduction of decimalization the number of public companies has decreased by one-third.

The introduction of decimalization a decade ago changed all stock quotes to a penny. This penny quoting is widely believed to be the direct cause of the erosion of the economic infrastructure required to support small-cap stocks, said Rep, Schweikert. He added that such narrow spreads create a disincentive to provide liquidity at the best price, which results in smaller quoted sizes and thinner markets. In addition, narrow tick sizes also create inefficiencies and detrimentally affect the price discovery process.

He believes that wider tick sizes will increase investor confidence by reducing the number of price points at which stocks are traded and by limiting computer trading behaviors. Wider ticks favor long-term investors and stock pickers over short-term traders. In addition, they will lead to investment in the securities ecosystem necessary to provide visibility to companies going public and support them in the aftermarket.

The Spread Pricing Liquidity Act allows companies with public float of less than $500 million and average daily trading volume under 500,000 shares to select to have their securities quoted at increments of either 5 or 10 cents, while maintaining trading between the quoted ticks.

The bill includes a multi-tiered phase-in, with the change occurring for companies with public float of less than $100 million and average daily trading volume under 100,000 shares at inception. After three months, that threshold will rise to include companies with public float of less than $250 million and average daily trading volume under 250,000 shares. After a further three months, the threshold will rise again to the stated public float of less than $500 million and average daily trading volume under 500,000 shares.

The Act includes an opt-out for companies after six months, and a re-opt in a full year later, and provides a three month grace period for companies cresting through either the float or volume thresholds before they revert to trading at traditional increments.

The bill disallows exchanges from charging maker/taker fees, and requires the SEC to report to Congress on the effectiveness of wider ticks for small-cap companies nine months after implementation.

PCAOB Frames Audit Quality Issues

One of the greatest concerns facing the PCAOB, and indeed more broadly the SEC and the financial markets, is that the external audit report has essentially become a pass/fail exercise replete with meaningless boilerplate of litte value to investors and other users of financial statements. A PCAOB staff memo recently framed the discussion of audit quality indicators for the Standing Advisory Group, which the staff defines as measures that provide insight into financial statement audit quality. In November 2012, the Board identified a project to develop audit quality measures as a priority project for 2013, with a longer-term goal of tracking such measures with respect to domestic global network firms and reporting collective measures over time.

The staff’s initial thinking is that an audit quality definition, framework, and related audit quality indicators are an integrated construct.

Over the years, many organizations have sought to define audit quality, with little consensus. While the Board’s  initial purpose is to seek SAG member input on possible audit quality indicators, the Board recognizes the need to ground discussion with the working definition of audit quality developed by the staff. For purposes of the discussion, staff defines audit quality as meeting investors’ needs for independent and reliable audits and robust audit committee communications on financial statements, including related disclosures; assurance about internal control; and going concern warnings.

It is axiomatic that any definition of  audit quality must be based on concepts that are already widely accepted, rather than trying to break new conceptual ground. At  the most basic level, the audit quality framework includes three segments: audit inputs, processes, and results. The staff views these segments as intuitive and conceptually aligned with much of the existing work on audit quality completed by other organizations.

E.U. Mandates Rotation of Credit Rating Agencies for Structured Financial Products

As the SEC considers the best approach to assuring conflict of interest free credit rating agencies, the Council of the European Union has adopted a Directive and a Regulation mandating the rotation of credit rating agencies for the rating of structured financial products. The adoption of the legislation follows agreement reached with the European Parliament.

The Directive and Regulation amend existing legislation on credit rating agencies in order to reduce investors' over-reliance on external credit ratings, mitigate the risk of conflicts of interest in credit rating activities and increase transparency and competition in the sector. Specifically, the Directive amends current Directives on the activities and supervision of financial institutions for occupational retirement provisions, on undertakings of collective investment in transferable securities (UCITS) and on hedge funds and other alternative investment fund managers (AIFM) in order to reduce the financial institutions' reliance on external credit ratings when assessing the creditworthiness of their assets.

The Regulation introduces a mandatory rotation rule obliging issuers of structured finance products with underlying re-securitized assets who pay credit rating agencies for their ratings (the issuer pays model) to switch to a different agency every four years. An outgoing rating agency will not be allowed to rate re-securitized products of the same issuer for a period equal to the duration of the expired contract, though not exceeding four years.

Mandatory rotation will not apply to small credit rating agencies, or to issuers employing at least four credit rating agencies, each rating more than 10 percent of the total number of outstanding rated structured finance instruments.

A review clause provides the possibility for mandatory rotation to be extended to other instruments in the future. Mandatory rotation is not a requirement for endorsement by the E.U. of U.S. or other third country credit rating agencies. Due to the complexity of structured finance instruments and their role in contributing to the financial crisis, the Regulation also requires issuers to engage at least two different credit rating agencies for the rating of structured finance instruments.

To mitigate the risk of conflicts of interest, the Regulation also requires CRAs to disclose

publicly if a shareholder with 5 percent or more of the capital or voting rights holds 5 percent or more of a rated entity. And to ensure the diversity and independence of credit ratings and opinions, the regulation prohibits ownership of 5 percent or more of the capital or the voting rights in more than one CRA, unless the agencies concerned belong to the same group.

Senator Warren Asks SEC for Data on Settlement of Enforcement Actions

In a letter to SEC Chair Mary Jo White, Senator Elizabeth Warren (D-MA), a key member of the Senate Banking Committee, asked for an analysis and/or internal research the Commission has done on trade-offs to the public between settling an enforcement action without admission of guilt and going forward with litigation necessary to obtaining such an admission.

In an earlier letter to U.S. Attorney General Eric Holder, Senators Mark Warner (D-VA) and Robert Corker (R-TN), also key members of the Banking Committee, voiced their concern that the DOJ is restricting its enforcement actions based on the size of the culpable financial institution, that is to say that DOJ is indicating that large, complex financial institutions will escape prosecution because their size indicates that an enforcement action against them will negatively impact the U.S. economy. The Senators ask if it is the position of the DOJ that some financial institutions are large enough that their management is above prosecution in the case of a serious crime.

U.S. and Global Hedge Fund Groups Seek Guidance on German High Frequency Trading Legislation

In a letter to the German Federal Financial Supervisory Authority (BaFin), U.S. and global hedge fund associations asked the regulator to issue guidance under the High Frequency Trading Act to clarify that where an investment management firm trades on a German organized market or multi-lateral trading facility on behalf of funds that it manages, neither the investment management firm nor the funds on whose behalf it trades are dealing for their own account, meaning that they are therefore not subject to the definition of the Act and the associated licensing regime.

In their joint letter, the U.S. Managed Funds Association and the London-based Alternative Investment Funds Association explained that an investment manager, a distinct legal entity, is a fiduciary responsible for implementing a hedge fund’s investment strategy and trading securities on a fund’s behalf. The investment manager trades securities as a customer of an intermediary; accordingly, the investment manager is the indirect member of a trading venue. 

 

Senators Thune and Toomey Urge SEC to Promptly Implement JOBS Act Elimination of Ban on General Solicitation

In a letter to SEC Chair Mary Jo White, Senators John Thune (R-SD) and Pat Toomey (R-PA) urged the SEC to promptly implement Section 201 of the JOBS Act, which ends the ban on general solicitation in private offerings. The Senators were encouraged by the commitment that Chairman White demonstrated during her Senate confirmation process to see that the Commission completes these important rulemakings. The Commission should act expeditiously, they said. The letter was also signed by Rep. Patrick McHenry  (D-NC), Chair of the House Oversight Subcommittee of the Financial Services Committee.

The overall purpose of the JOBS Act was to facilitate capital formation to help small businesses and entrepreneurs invest, expand and create jobs. As proponents of the JOBS Act, the Senators and Chairman McHenry believe that the regulation proposed by the Commission last August accomplishes this goal. The proposal properly implements Congress’ intent to remove the general solicitation ban in a consistent manner for all types of issuers conducting private offerings under Rule 506.

Paragraph (b) of Section 201 clearly effectuates this by providing that all issuers subject to other federal securities laws will be able to conduct private offerings pursuant to amended Rule 506. The proposed rule ensures that all purchasers of securities under Rule 506 are accredited investors, they noted, and follows Congress’ policy objectives to require that issuers take reasonable steps to verify that the purchasers are accredited investors. The Senators and Chairman McHenry emphasized that additional or more prescriptive requirements would overturn Congress’ intent and they strongly urged the Commission not to do so.

Obama Administration Opposes SEC Regulatory Accountability Act

While reaffirming its commitment to smart and effective regulations and the value of cost-benefit analysis, the Obama Administration opposes passage of the SEC Accountability Act, H.R. 1062, because its burdensome and disruptive new procedures would impede the ability of the SEC to protect investors, maintain orderly and efficient markets, and facilitate capital formation. In a Statement of Policy, the Administration said that H.R. 1062  would add onerous procedures that would threaten the implementation of key reforms related to financial stability and investor protection.

H.R. 1062 would direct the SEC to conduct time resource intensive assessments after it adopts or amends major regulations before the impacts of the regulations may have occurred or be known. According to the Administration, the bill would add analytical requirements that could result in unnecessary delays in the rulemaking process, thereby undermining the ability of the SEC to effectively execute its statutory mandates.

The Administration is committed to a regulatory system that is informed by science, cost-justified, and consistent with economic growth. Through efforts including Executive Order 13579,  the Administration is taking important steps to encourage independent agencies to follow cost-saving and burden-reducing principles in their reviews of new regulations, and to examine their existing rules to identify those that should be modified, streamlined, or repealed.

By a vote of 235 to 161 the House of Representatives passed the SEC Regulatory Accountability Act, H.R. 1062. Seventeen Democrats voted to pass the bill. Rep. Scott Garrett (R-NJ), Chairman of the Financial Services Subcommittee on Capital Markets, introduced the SEC Regulatory Accountability Act, which would require the SEC to conduct robust cost-benefit analysis on each new rulemaking to ensure that its costs do not outweigh its benefits, and would make certain that all new and existing regulations are accessible, consistent, written in plain language, and easy to understand.

Executive Orders. The legislation is designed to essentially codify Executive Orders issued by President Obama reforming the regulatory process.  Chairman Jeb Hensarling (R-TX) of the Financial Services Committee said that in many respects the Act carries out Executive Order 13563.
President Obama issued two Executive Orders during his first term on the reform of the federal regulatory process. Executive Order No. 13563 set out general requirements directed to executive agencies concerning public participation, integration and innovation, flexible approaches, and science. It also reaffirmed that executive agencies should conduct a cost-benefit analysis of regulations. Executive Order No.13579 states that independent regulatory agencies, such as the SEC, should follow EO No. 13563. To facilitate the periodic review of existing significant regulations, EO No. 13579 said that independent regulatory agencies should consider how best to promote retrospective analysis of rules that may be outmoded, ineffective, insufficient, or excessively burdensome, and to modify, streamline, expand, or repeal them in accordance with what has been learned.

There is a debate over whether EO No. 13579 directed independent regulatory agencies to conduct a cost-benefit analysis of regulations. The use of the word “should’’ in the Executive Order has led some to conclude that it is not mandatory. Thus, as an independent agency, the SEC is not clearly required to follow Executive Orders No. 13563 and 13579, but former SEC Chairman Mary Schapiro indicated that the Commission would abide by the Executive Orders  and in Senate confirmation hearings testimony SEC Chair–Designate Mary Jo White acknowledged that the SEC should seek to assess the economic impacts of its contemplated rulemaking.

UK FRC Proposes Guidance on Financial Instruments for Outside Auditors of Company Financial Statements

In light of the financial crisis and changes to international auditing and accounting standards, the UK Financial Reporting Council proposed revisions to its guidance for outside auditors of company financial statements on financial instruments. Generally, the auditor must obtain an understanding of how the firm manages and controls its exposure to financial instruments, including how the firm ensures that all instruments are accurately recorded, that the valuations are accurate and reviewed, that risk limits are applied, and that duties are segregated between those transacting, settling and accounting for financial instruments. Risk management and professional skepticism are important components of the revised guidance.

           

For firms transacting financial instruments, an understanding of the firm’s related risk management processes and risk appetite may identify risks of material misstatement. It is not the job of the auditor to determine the amount of risk a firm should take or how it should monitor and manage risk, said the FRC, but it is important for the auditor to consider and develop a point of view on this because poor risk management processes can affect the audit in a number of indirect ways by, for example, exposing  a firm to levels of risk that breach legal or regulatory restrictions. Importantly, poor risk management can make it more difficult to obtain an understanding of the impact of financial instruments on the firm as a whole. And, in extreme circumstances, inadequate risk management can increase the risk of a going concern problem. For example, financial instruments losing value or becoming illiquid can threaten the ability of the entity to continue as a going concern.

The guidance posits that professional skepticism is necessary to the critical assessment of audit evidence and assists the auditor in remaining alert for possible indications of management bias. Professional skepticism can include questioning contradictory audit evidence and the reliability of documents, as well as questioning responses to inquiries and other information obtained from management and those charged with governance. It also includes being alert to conditions that may indicate possible misstatement due to error or fraud and considering the sufficiency and appropriateness of audit evidence obtained in light of the circumstances.

The proposed guidance states that maintaining professional skepticism throughout the audit is necessary if the auditor is to reduce the risks of overlooking unusual circumstances, over generalizing when drawing conclusions from audit observations, or using inappropriate assumptions in determining the nature, timing, and extent of the audit procedures and evaluating the results thereof.

In addition, evaluating audit evidence for assertions about financial instruments requires

considerable judgment because the assertions, especially those about valuation, may be based on highly subjective assumptions or be particularly sensitive to changes in the underlying assumptions. For example, valuation assertions on financial instruments may be based on assumptions about the occurrence of future events for which expectations are difficult to develop or about conditions expected to exist a long time. Thus, competent persons could reach different conclusions about valuation estimates or estimates of valuation ranges. Considerable judgment also may be required in evaluating audit evidence for assertions based on features of the financial instrument and applicable accounting principles, including underlying criteria, that are both extremely complex.

The need for professional skepticism increases with the complexity of financial instruments, said the FRC, for example, with regard to evaluating whether sufficient appropriate audit evidence has been obtained, which can be particularly challenging when models are used or in determining if markets are inactive. Professional skepticism also ratchets up with evaluating management’s judgments, and the potential for management bias, in applying the firm’s applicable financial reporting framework, in particular management’s choice of valuation techniques, use of assumptions in valuation techniques, and addressing circumstances in which the auditor’s judgments and management’s judgments differ. Moreover, a good dose of professional skepticism is needed in drawing conclusions based on the audit evidence obtained, for example assessing the reasonableness of valuations prepared by management experts and evaluating whether disclosures in the financial statements achieve fair presentation.

In planning the audit, the auditor must focus on understanding the accounting and disclosure requirements and understanding the financial instruments to which the firm is exposed, and their

purpose and risks. The auditor must determine whether specialized skills and knowledge are needed in the audit and also evaluate the system of internal control in light of the firm’s financial instrument transactions and the information systems that fall within the scope of the audit.

More specifically, the auditor must understand the nature, role and activities of the internal audit function and management’s process for valuing financial instruments, including whether management has used an expert or a service organization.

Determining materiality involves both quantitative and qualitative considerations. When

planning the audit, materiality may be difficult to assess for a firm using particular financial instruments given some of their characteristics. In particular, some financial instruments can be assets or liabilities depending on their valuation and this may change over the course of the audit.

Under the guidance, a firm’s policies for accounting for financial instruments must take into account the different purposes for which they can be transacted, such as trading or hedging. Relevant accounting standards may be under review and firms need to monitor developments to ensure the correct accounting requirements, including possible transitional arrangements, are complied with. Having regard to disclosure requirements is important as they can play a key role in making transparent the levels of holdings of financial instruments, as well as their purpose and the underlying risk profile.

The FRC posits that it may be appropriate for the auditor’s understanding of relevant industry and regulatory factors to include inquiry of management as to whether there have been discussions with regulators during the year about their policies in respect of financial instruments, and whether management has reviewed its processes in the light of those discussions. For example the regulator may have expressed a view that the entity’s valuations appear out of line with those of other entities or are not sufficiently prudent. The auditor can review relevant correspondence, if any, with regulators.

For a regulated firm in the financial sector, it may be appropriate for the auditor to

discuss matters related to the firm’s use and disclosure of financial instruments directly

with the regulator in bilateral and/or trilateral meetings. In May 2011, the FSA published a Code of Practice for the relationship between the external auditor and the regulator. The Code of Practice sets out principles that establish, in the context of a particular regulated firm, the nature of the relationship between the regulator and the auditor.

While intended to mitigate risk, inappropriate hedge transactions can cause significant financial loss if the risks are not properly identified or managed. A simple example might be the hedging of baskets of bonds or shares with an index, if the basket does not match the index closely, price movements may not offset each other, therefore increasing risk not reducing it. Another example might be hedging of possible future price movements. For example, an airline that purchases all its future fuel needs for the next two years at forward prices, will suffer if the price then falls over the next two years, because unhedged competitors will benefit from a cost advantage.

Thus, auditing financial instruments may require the involvement of one or more experts or specialists, for example, in the areas of understanding the operating characteristics and risk profile of the industry in which the company operates and understanding the business rationale for the particular financial instruments used, the related risks and how they are managed. The involvement of experts or specialists may be needed especially when the financial instruments are complex or the firm is engaged in the active trading of complex financial instruments.