Tuesday, September 02, 2014

Dissenting Commissioners Decry Changes to New Credit Rating Agency Rules

[This story previously appeared in Securities Regulation Daily.]

By John Filar Atwood

Commissioners Michael Piwowar and Daniel Gallagher issued scathing dissents to the adoption last week of new requirements for credit rating agencies, with Gallagher calling them “ill-conceived” and “a fundamental abandonment of the tenets of good government.” Piwowar questioned whether the reforms would have any practical benefit for investors.

New rules. The rules to which the commissioners objected establish new requirements for credit rating agencies in order to provide greater internal governance and transparency, improve the quality of credit ratings, and increase credit rating agency accountability. Implementation of the rules was mandated by the Dodd-Frank Act.

While the new rules contain numerous provisions, Gallagher and Piwowar objected to two sections in particular. First is the requirement that nationally recognized statistical rating organizations (NRSROs) establish, maintain and enforce an internal control structure. Second is the amendment of 1934 Act Rule 17g-5 to mandate the separation of ratings determinations from NRSRO sales and marketing activities.

Internal controls. With respect to internal controls, Gallagher said in dissenting remarks that he favored an approach where the SEC provided guidance on the factors an NRSRO should consider in the release accompanying the rules, along with a statement that the staff would examine internal control structures carefully and would revisit the rules to address any shortcomings. Instead, he noted, the factors are listed in the rule’s text and impose a mandate on NRSROs to take the listed factors into consideration.

Gallagher said that this inappropriately places the focus on the process by which an NRSRO develops its internal controls rather than on the controls themselves. In addition, he believes it creates the potential for a safe harbor by giving an NRSRO deemed to have inadequate internal controls the ability to defend itself by pointing to the factors in the rule text and demonstrating that it took them all into consideration.

Piwowar also favored leaving specific factors out of the rule and possibly prescribing specific standards after seeing how NRSROs handled the new requirements. In his written statement, he said that the rule gives NRSROs no flexibility to tailor their internal control structures to their particular circumstances because it lays out 17 factors they must consider when developing the internal controls.

Separation from sales and marketing. On the issue of separating ratings determination from sales and marketing activities, Piwowar noted that the final rule does not stop with prohibiting sales and marketing employees from participating in ratings determinations, but includes language that prohibits an NRSRO from having an employee involved in the ratings determination process from being “influenced by” sales and marketing considerations. He believes this sets an impossible standard, as any NRSRO that grows its business in any asset class could be said to have the ratings process “influenced by” sales and marketing considerations.

Gallagher, who supported a re-proposal of the rules to address both the internal controls and sales and marketing issues, said the Commission has created a dangerous precedent by creating a catch-all prohibition against someone who is influenced by sales and marketing considerations. The provision lacks any limits to curtail its universal application, he said, adding that he expects courts to strike down the “vague and unverifiable” influence clause.

Other reactions. Other securities industry participants also weighed in on the adoption of the new credit rating agency rules. Dennis Kelleher, president of Wall Street watchdog Better Markets, said that the new rules made at least two significant improvements, citing the provision to prevent sales and marketing incentives from influencing the ratings process, and the inclusion of specific factors that the rating agencies must consider as they develop their internal controls structures. He noted that the SEC has more work to do to eliminate conflicts of interest that persist in the ratings industry, and urged the Commission to adopt a system that will prevent issuers from buying good ratings by selecting and paying the agencies to rate their complex securities.

Americans for Financial Reform (AFR) said that it is pleased that the rules have been finalized, adding that the rules were improved to contain much stronger language addressing the impact of conflicts of interest and sales considerations on the quality of credit ratings. The group noted that conflicts of interest have been a major contributor to deceptive and misleading ratings.

The group said that much remains to be done because the fundamental business incentives of credit rating agencies continue to encourage ratings inflation. AFR believes that the new credit rating rules fall short in requirements for meaningful transparency and consistency of ratings across asset classes. In addition, it said that the new requirements for asset-backed securities have loopholes since they do not appear to cover privately issued structured finance products and certain significant asset classes.

Monday, September 01, 2014

Legacy of Commissioner Barnier Will Be Historic and Harmonized Financial Regulatory Reform

As the new European Commission begins to take shape this month, there will be a new European Commissioner for the Internal Market, essentially the Commissioner for Banking and Securities. It is thus appropriate to reflect on the accomplishments over the last five years of the momentous five-year tenure of Michel Barnier as E.U. Commissioner for the Internal Market. It was during this period that the reforms needed after the financial crisis were enacted and are being implemented. I believe that this makes the Barnier Commisssionership the most weighty in E.U. history.

It is by now evident that the E.U. did financial reform on a piecemeal stand alone basis, rather than passing a Dodd-Frank Act and doing it all with one omnibus legislative vehicle. Given the way the E.U. legislative framework works, this is probably how it had to go. Commissioner Barnier moved these various pieces of legislation through the process and achieved reform, while never forgetting the need for the global harmonization of financial regulation because, after all, this was a global financial crisis.

A partial list of legislation and regulations enacted during the Barnier regime shows the importance of that regime: a revised Accounting Directive, a revised Statutory Audit Directive, a new Recovery and Resolution Directive that parallels the orderly resolution authority in Title II of Dodd-Frank, the European Market Infrastructure Regulation (EMIR) to regulate OTC derivatives markets to parallel Title VII of Dodd-Frank, the Alternative Investment Management Directive to regulate hedge funds and private equity funds, the CRA Regulation to regulate credit rating agencies, and MiFID II. These were difficult to do but, in the end, were enacted.

But above all is Commissioner Barnier’s consistent and unwavering commitment to the harmonization of cross-border financial regulations to prevent regulatory arbitrage. Just recently, he said that the only way to ensure cross-border regulatory convergence and avoid arbitrage is a solid, treaty-based system for regulatory cooperation. Only a treaty-based system could support a mutual E.U.-U.S. assessment of financial regulations that is outcome-based and backed up by specific arrangements to govern E.U.-U.S. regulatory cooperation. That is why Commissioner Barnier supports including an agreement on regulatory cooperation within the framework of the Trans-Atlantic trade negotiations.

Commissioner Barnier also negotiated a Path Forward with the CFTC on derivatives regulation. He recently noted that technical talks with the CFTC are progressing well and he is confident that the E.U and the CFTC will be able to agree on outcomes-based assessments of their respective derivatives regulations and on aligning key aspects of margin requirements to avoid arbitrage opportunities. If the CFTC also gives effective equivalence to third country central counterparties, deferring to strong and rigorous rules in jurisdictions such as the E.U., the European Commission will be able to adopt equivalence decisions very soon, he predicted.

This great work of equivalence and substituted compliance, call it what you wish it means respect for an equivalent regulatory regime, will continue into the next Commission. If nothing else, the G20 will insist on it. This is perhaps the main legacy of Commissioner Barnier, his fierce and unswerving dedication to the goal of the G20 for harmonized cross-border financial regulation and the avoidance of regulatory arbitrage.

Friday, August 29, 2014

Big Four Supports Proposed Going Concern and New Future Viability Statements Based on Sharman Panel

The Big Four generally support the U.K. Financial Reporting Council’s proposed changes to the Corporate Governance Code implementing the recommendations of the Sharman Panel on going concern statements and a new statement on the company’s future longer-term viability. As conceived by the FRC, these would be two separate and distinct statements that would increase the usefulness of financial statements to investors as envisioned by the Sharman Panel. A going concern statement for accounting purposes only would be codified, and a new statement on the company’s ongoing viability past the 12-month going concern statement would be introduced.

The suggested wording of the new provision is that the directors should state whether, taking account of the company’s current position and principal risks, they have a reasonable expectation that the company will be able to continue in operation and meet its liabilities as they fall due, drawing attention to any qualifications or assumptions as necessary. The directors should indicate the period covered by this statement, and why they consider that period to be appropriate.

The Sharman Panel was commissioned to examine the particular challenges faced by directors, management and auditors where companies face going concern and liquidity risks and to consider how such challenges should be addressed in the future. Lord Sharman, Chairman of the Panel, said that, while the work of the Panel emanated from the financial crisis, companies in all sectors can do more to improve their management and disclosure of risks relating to going concern, liquidity and solvency

In their comment letters, the Big Four broadly supported the FRC’s drive to implement the Sharman Panel’s recommendations and achieve better reporting to shareholders. For example, PricewaterhouseCoopers believes that the FRC’s current proposals reflect the Sharman recommendations appropriately and have considerable conceptual merit.

However, it is unclear from the consultation document how the latest proposals will affect the responsibilities of the auditor. In its comment letter, PricewaterhouseCoopers said that the scope of any related reporting by the auditor needs to be reasonably based on the scope of work undertaken for the purposes of the audit. If the reporting is similar to that proposed in the consultation, that is whether the auditor has anything material to add to the directors’ disclosures, then PwC would consider that it may be too ‘loose’.

In particular, because the proposed directors’ disclosures go beyond financial matters, the auditor would in effect be asked to report on matters not directly relevant to the financial statements. PwC is generally and more broadly concerned that auditors are increasingly being expected to include additional statements in the audit report that are not supported by specific work procedures. Even if the parameters are clear in the relevant auditing standards, most users of annual reports will not take these on board, creating another gap between their expectations and auditors’ actual responsibilities, and potentially devaluing the content of the rest of the audit report.

PricewaterhouseCoopers noted that the proposed viability and going concern assessments are closely linked. Each statement is part of the company telling a coherent story about how risks are assessed and managed. Nevertheless, the two statements are distinct and serve different purposes.

PwC said that the relationship between the two needs to be made clearer in the guidance and in the FRC’s communications to the market in relation to the Code; the different purpose of each should also be very clear. Doing so would help to show how the FRC’s proposals are not out of line with the going concern model that is used around the world.

In the view of PwC. going concern will remain at the center of the financial reporting model. In making this assessment, directors must consider all available information about the future, so any material uncertainty must be reflected in the going concern statement regardless of its expected timing. The use of the going concern assumption is a matter of accounting policy, and so it’s important that directors make a clear and definitive statement of the appropriateness of the assumption.

In making a longer term viability statement, said PwC, directors would typically take account of a wider range of risks and associated probabilities, as more risks become relevant over longer time periods. Much of the value of the viability assessment will be in formalizing the need to identify the considerations that are relevant, such as the principal risks affecting solvency, and to decide on the seriousness of each matter identified. This purpose is sufficiently captured by the requirement that viability statements should be framed around an explanation of how the directors have assessed the prospects for the company, including the period covered and why that period is appropriate.

A statement of viability should, naturally, be consistent with the directors’ vision of the future direction of the company. Therefore, PwC believes that the viability statement should, explicitly, be structured around a description of a company’s strategic planning process, giving enough information to allow users to understand the judgments underpinning the plan.

PwC would expect companies to disclose and explain the period covered by the strategic plan (and therefore their viability assessment), the reason why that period has been chosen, the risks they identify, and their views on the likelihood of those risks crystallizing within the chosen period. These disclosures are also likely to be an important element of an annual report which is fair, balanced and understandable.

Despite the safe harbor provisions of the Companies Act, directors generally want to minimize any perceived extension of their liability when making new formal statements. In the case of the viability statement this could lead to unintended consequences such as statements that cover inappropriately short time periods, and/or SEC-style lists of all possible risk factors instead of the expected more tailored and relevant disclosures. To address this, so that directors feel empowered to make useful disclosures, it is vital that they understand what needs to be done.

In the view of PwC, it is likely that much of what would be required to make a viability statement is already part of the strategic planning process of many companies. However, the guidance accompanying the Code should encourage all companies to reconsider the rigor that is applied to the strategic planning process.

In its comment letter, Ernst & Young agreed that companies should make two separate statements, one on whether the directors considered it appropriate to adopt the going concern basis of accounting in preparing the financial statements and one on the broader assessment of the company’s ongoing viability since the two serve different purposes, bring focus to the board’s deliberations and are equally important for users of financial statements.

However, that said, E&Y urged the FRC to set a clearer expectation that the time periods for the assessment should normally be linked to a company’s strategic or business planning cycle or another appropriate period determined by the directors. While the guidance does refer to investment and planning periods as one of the factors a board should consider when determining the period for an assessment, E&Y questioned whether the reference to investment periods will be interpreted consistently by all boards and whether the period for holding long term assets in some sectors, such as extractive industries, could be too long for a realistic viability assessment.

Given the uncertainty, E&Y suggested the reference to investment periods be removed. In addition, the firm noted that further FRC guidance on the location of the viability statement would create consistency and help users find this important statement. E&Y suggested that a logical and user-friendly location for the statement might be as part of the principal risks disclosure. This location could mitigate the risk of boilerplate and separate the statement from the financial statements and the separate statement on going concern basis of accounting.

KPMG noted that the two proposals for the Code contain two binary statements on going concern and long-term viability. This may not be the best approach, said KPMG, and the better approach may be to require disclosure, with explanations, of potential threats that may develop over the longer term and become actual threats to the business. This must be more than a list of risks, said KPMG, but should describe which risks would most impact insolvency over time.

Deloitte supports the new future viability statement that allows boards the flexibility to look forward over a period of time that best fits their business planning and investment cycles. The firm supports having two separate and distinct statements on going concern and future viability.

The viability statement will allow boards to tailor their disclosure to the company’s circumstances within the parameters of existing planning cycles. But with this flexibility will come variability. Deloitte believes that drafting the disclosure will be challenging and that disclosure will evolve over time in response to investor feedback. The FRC should consider adopting some best practices in this area after some experience.

Thursday, August 28, 2014

SEC Proposes 12-Month Pilot Program on Wider Tick Sizes

[This story previously appeared in Securities Regulation Daily.]

By Amanda Maine, J.D.

The SEC announced that the Financial Industry Regulatory Authority (FINRA) and the national securities exchanges have filed a proposal to implement a pilot program that will widen the minimum quoting and trading increments (tick sizes) for smaller companies. The exchanges and FINRA will collect data and provide it to the SEC, who will make the information available to the public. The exchanges and FINRA will assess the impact of the pilot program after 12 months and submit the assessment to the SEC.

Pilot securities. Under the pilot program, pilot securities will consist of common stocks with a market capitalization of $5 billion or less and a closing price of at least $2.00. Their consolidated average daily volume will be 1 million shares or less, and the securities must have a measurement period volume-weighted average price of at least $2.00. The SEC will use stratified sampling to select 400 securities from 27 categories in each test group.

Test groups. The pilot securities will be divided into four groups: a control group and three test groups. Control group securities may be quoted at the current tick size of .01 and traded at any price increment that is currently permitted. Pilot securities in Test Group One will be quoted in .05 minimum increments but may continue to trade at any price increment that is currently permitted. Pilot securities in Test Group Two will be subject to the same quoting requirements of Test Group One but may only be traded in .05 increments, with certain exceptions. Pilot securities in Test Group Three are subject to the same minimum quoting and trading requirements as Test Group Two; however, they will also be subject to a “trade-at” prohibition. Under the prohibition, the plan will prevent a trading center that was not quoting from price-matching protected quotations (and permit a trading center that was quoting at a protected quotation) to execute orders at that level, but only up to the amount of its displayed size. The trade-at prohibition is also subject to certain exceptions.

SEC Chair Mary Jo White called the program “an important step for a valuable initiative that could have meaningful implications for market quality.” The comment period for the proposed pilot program will be open for 21 days.

Wednesday, August 27, 2014

House and Senate Members Ask Fed to Tighten Emergency Lending Proposals

Senators Elizabeth Warren (D-MA) and David Vitter (R-LA), and Representatives Scott Garrett (R-N.J.) and Michael Capuano (D-MA), and colleagues in the Senate and House, sent a bi-partisan letter to Federal Reserve Board Chair Janet Yellen calling for the Fed to strengthen restrictions on its emergency lending authority in its rulemaking implementing Section 1101 of the Dodd-Frank Act.. During the financial crisis, the Fed invoked its emergency lending authority to provide over $13 trillion in loans primarily to a select group of large financial institutions. These loans were long-term and offered at below-market rates in what the lawmakers called a bailout in all but name of financial firms regarded as "Too Big to Fail."

The letter also was signed by 11 additional members of the Senate and House: Senators Sherrod Brown (D-OH), Mark Begich (D-Alaska), Mazie Hirono (D-Hawaii), and Edward Markey (D-MA), and Representatives Walter Jones, Jr. (R-CA), Stephen Lynch (D-MA), Michael McCaul (R-TX), Gwen Moore (D-Wis.), Keith Ellison (D-MN), Leonard Lance (R-N.J.), and Tom Cotton (R-Ark.).

Congress enacted Section 1101 to ensure that such bailouts could not happen again, explained the Senators and Representatives, yet the Fed's proposed rule implementing Section 1101 does not place meaningful restrictions on the agency's emergency lending powers. Under the proposed rule, a financial firm could rely on the Fed’s emergency lending authority indefinitely. This is not acceptable to the lawmakers, who asked that the final rule require that a loan obtained through the emergency lending authority be paid back in full within a set time period, with no rollover permitted. The Fed should also establish procedures for the orderly unwinding of any emergency lending program or facility, which will reinforce the idea that these are truly temporary.

The proposal defines an insolvent financial firm as one that is in bankruptcy proceedings. This definition must be broadened so that the Board could not use its emergency lending program to save a firm that is on the verge of bankruptcy. The purpose of Section 11 is to ensure that firms that would be insolvent absent emergency lending assistance from the Fed would be put into bankruptcy or orderly resolution under Dodd-Frank Title II rather than receiving extended liquidity support.

The proposed rule’s narrow definition of broad-based eligibility must be expanded to inject liquidity broadly into the financial system, said the letter, beyond an authority for emergency lending to only a handful of financial firms.

Senator Wyden Will Move Bi-Partisan Corporate Inversion Legislation in September

Senate Finance Committee Chairman Ron Wyden, (D-OR) will have bi-partisan legislation in place to end corporate inversion mergers sometime in September. In a statement, he emphasized the importance of defining key principles now as Congress pushes forward to finally close this loophole.

While an anti-inversion provision has been part of the Internal Revenue Code since 2004, experience has shown that this provision insufficiently deters inversion given the large tax rate and other tax disparities between the United States and the countries to which formerly U.S.-based multinationals have relocated.

Under current law, U.S. companies can invert and avoid paying U.S. income taxes if a merger transfers just 20 percent of its stock to shareholders of an offshore company. One legislative vehicle is available for Congress right now. It is the Stop Corporate Inversions Act, S. 2360, introduced by Senator Carl Levin (D-Mich.). The measure would raise the 20 percent threshold to 50 percent so that if the majority of a company’s stock remains in the hands of the U.S. company’s shareholders, it is treated as a U.S. company for tax purposes. The bill would also bar companies from shifting their tax residence offshore if their management and control and significant business operations remain in the U.S. There is a companion bill in the House, H.R. 4679, introduced by Rep. Sandy Levin (D-MI).

Banking Committee Ranking Member Urges SEC to Quickly Reform IG for Mining Companies

Senator Mike Crapo (R-ID), Ranking Member on the Banking Committee, urged the SEC to expeditiously update and reform the Commission’s Industry Guide 7, which contains the basic disclosure policy for public mining companies. In a letter to SEC Chair Mary Jo White, also signed by Senators Dean Heller (R-NV) and Jon Tester (D-MT), he said that it is vital for the SEC to move forward in the near-term to realign the U.S. reporting regime for mining companies both for the protection of investors and the removal of competitive harm to domestic mining operations. The letter noted that the text for Guide 7 was first formulated and published over 30 years ago and has not been updated since.

The Ranking Member referenced a speech by Chair White on October 15, 2013 in which she said that the SEC should consider reforming the industry disclosure guides, Guide 7 in particular. The Senators agree with the Chair’s concern that all of these industries have changed drastically since the Guides were published and yet the Guides have not often been revised.

With respect to Guide 7, Chair White also questioned whether the disclosure guidance applicable to public mining companies should be modeled on the international standards given that the international mining community actually has developed comprehensive standards for reporting resources and reserves and several foreign jurisdictions use these standards in their securities laws.

Obviously, said Senator Crapo, this is an important topic for the Commission and its Chair and the Senators want to know what progress the Commission has made in the review of Industry Guide 7 and other Industry Guides. Specifically, they asked for an update on the status of, and a timeline for, the SEC's overall industry guide review, and in particular Guide 7. They would also like a status report and a timeline on any outreach the SEC has done, or plans to do, to the mining industry and other stakeholders, including investors, to get their thoughts on what would be helpful disclosure with respect to the mining industry. Finally, the Senators want an update as to the status of, and a timeline for, when the SEC hopes to provide the revised industry guides to the public.

Tuesday, August 26, 2014

SEC Will Vote on New ABS and NRSRO Rules

[This story previously appeared in Securities Regulation Daily.]

By Jacquelyn Lumb

The SEC has scheduled an open meeting for Wednesday, August 27, at which it will consider the adoption of rules to revise the disclosure, reporting, and offering process for asset-backed securities (ABS). The new disclosure would include information about the assets underlying certain asset classes and would be presented in a standardized tagged format. The rules also would revise the shelf offering process and eligibility criteria for asset-backed securities.

The SEC originally proposed the ABS revisions on April 7, 2010, but the Dodd-Frank Act, enacted in July 2010, required the SEC to adopt a number of additional ABS-related rules. The SEC subsequently re-proposed a portion of its 2010 ABS release to seek comments on the asset-level disclosure provisions. In response to the re-proposal, a number of commenters raised concerns about the sensitivity of some of the asset-level disclosure and urged that it be provided in a manner other than through the public dissemination via EDGAR.

The staff prepared a memorandum summarizing another means of disseminating the asset-level information and reopened the comment period to gain views on the provision of the information to investors and potential investors through restricted access web sites. The comment period on the staff memorandum closed on April 28, 2014.

NRSRO rules. The SEC also will consider at the open meeting the adoption of amendments and rules to implement the Dodd-Frank Act provisions relating to nationally recognized statistical rating organizations (NRSRO), providers of third-party due diligence services for asset-backed securities, and issuers and underwriters of asset backed securities under the Exchange Act. The revisions were originally proposed in May 2011. The rules prescribe the format of a certification that third-party due diligence services would have to provide to each NRSRO that produces a credit rating for an ABS to which the due diligence services relate.

The rules would also implement the Dodd-Frank Act requirement for issuers and underwriters of ABS to make public the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.

Monday, August 25, 2014

House Oversight Chair Cautions SEC on Leaks from Closed Meeting

The House SEC Oversight Chair has asked the Commission to provide, by September 5, its plans to implement all of the recommendations made by an Inspector General report on leaks of confidential information from SEC closed meetings, including any disciplinary action taken against individual employees. In a letter to SEC Chair Mary Jo White, Financial Services Committee Chair Jeb Hensarling (R-TX) also requested SEC plans to soundproof the meeting room or post security outside of the room to prevent unauthorized SEC employees and other individuals from listening to the closed proceedings.

Chairman Hensarling emphasized that leaks emanating from closed meeting deliberations jeopardize all of the SEC’s enforcement work. For example, entities will be less willing to engage in settlement discussions if in so doing they run the risk of the underlying facts of the case entering the public domain. Moreover, SEC Commissioners will be reluctant to engage in a robust dialogue with staff on enforcement matters, thereby leading to less effective enforcement outcomes. 

The FSC Chair also pointed out that, since the SEC conducts all of its investigations confidentially, leakers will render meaningless the SEC’s well-known policy to neither confirm nor deny the existence of any investigation as long as the leaker knows that he or she can speak freely to the press and divulge confidential information without any consequences. Further, when staff depart SEC employment with knowledge of confidential and non-public information they must not use that information to further their own careers.

More broadly, the Chair noted that attendance at closed SEC meetings is a privilege not a right. The SEC’s penalties impact corporate behavior and serve as a warning to all SEC-regulated entities. Mere intellectual curiosity is not sufficient justification for an employee to stop his or her work and attend a closed meeting. He advised that SEC employees who have not played a meaningful and substantial role in the enforcement matter pending before the SEC should not be attending a closed meeting.

Washington Proposes Crowdfunding Rules

[This story previously appeared in Securities Regulation Daily.]

By Jay Fishman, J.D.

The Washington Department of Financial Institutions, Securities Division, has proposed crowdfunding rules for October 1 implementation so that issuers may claim the crowdfunding exemption under Washington’s Jobs Act of 2014.

Comments. Interested persons may submit written comments to Faith Anderson by mail to her attention at Securities Division, P.O. Box 9033, Olympia, WA 98507-9033; by fax to (360) 704-6480; or by email to faith.anderson@dfi.wa.gov. Comments must be received by September 23, 2014.

Proposed crowdfunding rules. The proposed crowdfunding rules would do the following:

• define key terms;

• specify the types of issuers and offerings that may use the exemption;

• mandate the use of the Washington Crowdfunding Form as the disclosure document for offerings under the exemption;

• set forth the requirements for making an initial, amended or renewal exemption filing with the Securities Division;

• establish the escrow agreement requirements;

• specify the information to be included in quarterly reports;

• adopt investor protection measures such as bad actor disqualifications and investor cancellation rights;

• describe the optional role of “portals” in assisting with crowdfunding offerings;

• set forth recordkeeping requirements;

• mandate advertising filings;

• set filing fees;

• list the various crowdfunding offering restrictions under the Washington Jobs Act of 2014 and federal Securities Act, Section 3(a)(11)/SEC Rule 147; and

• establish other rules necessary to implement the crowdfunding exemption.

Sunday, August 24, 2014

Issue of Whether True and Fair Overrides IFRS May Be Turning into Battle of QCs

The issue of whether IFRS incorporates the concept of a true and fair presentation of a company’s financial statements appears to have taken a turn towards a battle of QC opinions with a U.K., shareholders consortium recently questioning a recent U.K. Financial Reporting Council report reaffirming the opinion that IFRS incorporates the concept of a true and fair presentation of a company’s financial statements. This issue is more than an academic concern in the U.S., which has the fairly presents concept in that financial statements must fairly present the company’s situation. True and fair and fairly presents are both judicially created doctrines: true and fair by Lord Hoffman and Dame Arden and fairly presents by Judge Friendly of the Second Circuit.

U.K. investors and the U.K. Shareholders Association have grave concerns over fault lines in the IFRS used by U.K. listed companies. In their view, the FRC paper fails to respond to whether IFRS delivers a true and fair view as required by U.K. company law. The shareholder and investor consortium urged the government to undertake a robust review of the issue.

In its recent report, the Financial Reporting Council affirmed that the requirement that audited financial statements give a true and fair account of a company’s operations remains of fundamental importance under both U.K. GAAP and IFRS and that the true and fair principle can override the mechanistic application of a particular accounting standard. True and fair is all important, said the FRC, such that where directors and auditors do not believe that following a particular accounting policy will give a true and fair view they are legally required to adopt a more appropriate policy, even if this requires a departure from a particular accounting standard.

In a formal statement, the Council emphasized that in order to properly discharge their legal and professional responsibilities, auditors must stand back as they approach finalization of the financial statements and consider whether, viewed as a whole and in view of the issues that they have addressed in the course of the audit, the accounts give a true and fair view. In the U.S., the analogous principle is that financial statements must fairly present the company’s financial picture.

In a report commissioned by the U.K. authorities in light of evolving global standards, Martin Moore Q.C. endorsed the analysis in the opinions of Lord Hoffmann and Dame Arden and confirmed the centrality of the true and fair requirement to the preparation of financial statements in the U.K., whether they are prepared in accordance with international or U.K. accounting standards. In his opinion, Mr. Moore noted that, in relation to the gradual shift over time to more detailed accounting standards, it does not follow that the preparation of financial statements can now be reduced to a mechanistic process of following the relevant standards without the application of objective professional judgment applied to ensure that those statements give a true and fair view.

Directors must consider whether, taken as a whole, the financial statements that they approve are appropriate. Similarly, auditors are required to exercise professional judgment before expressing an audit opinion. As a result, the Moore Opinion confirms that it will not be sufficient for either directors or auditors to reach such conclusions solely because the financial statements were prepared in accordance with applicable accounting standards.

Notwithstanding these contributions, the shareholder and investor groups said that the FRC paper failed to provide clarity over what a true and fair view means and, critically, how one knows that it has been achieved. The FRC paper outlines the availability of an IFRS override to achieve a true and fair view, but (in part due to the lack of clarity over the meaning of true and fair) indicates that in practice the override can only be used where accounts fail to comply with the IFRS Framework, rather than Company Law.

Also, the FRC does not mention the opinion of George Bompass, Q.C., despite its significance as a respected legal opinion on the topic. The Bompass opinion states, in part, that it is questionable whether statutory accounts prepared in accord with international accounting standards will always give a true and fair view. Mr. Moore responded to the Bompass opinion, stating that, while he accepts that international accounting standards does not use the direct language that would satisfy Mr. Bompass, there is no reasonable basis for denying the existence of a true and fair account.

Friday, August 22, 2014

Oregon Proposes Renewable Energy Cooperative Corporation Exemption


[This story previously appeared in Securities Regulation Daily.]

By Jay Fishman, J.D.

The Oregon Finance and Corporate Securities Division proposed rules allowing renewable energy cooperative corporations to claim an Oregon Securities Law registration exemption for their membership shares or capital stock. The proposed rulemaking would restrict the amount that renewable energy cooperative corporations could raise from non-accredited investors, to $750,000 per project, and limit the amount non-accredited investors can invest based on the individual’s net worth.

Renewable energy cooperative cooperatives could draw on lower-net worth investors from well-defined communities, and simultaneously claim other available Oregon exemptions for their membership shares or capital stock, such as the existing accredited investor exemption (e.g., institutional and higher-net worth individuals). Renewable energy cooperative corporations would provide two disclosures to prospective members: (1) a general disclosure discussing the workings of the renewable energy cooperative corporation and the risks associated with developing renewable energy generation facilities; and (2) a specific disclosure discussing the risks of a particular project.

Comment period. Interested persons may email comments on the proposed rulemaking to Shelley.A.Greiner@state.or.us. Comments must be received by 5:00 p.m. on September 12, 2014.

Thursday, August 21, 2014

Argentina Bond Case Saga Continues Post-Supreme Court Ruling

As the Argentina bond saga continues post-U.S. Supreme Court opinion, Reuters reported that a federal judge (SDNY) today said that legislation proposed in the Argentine Congress allowing the government to resume payment to holders of bonds exchanged in a debt restructuring would be in defiance of a court order.

The hedge fund creditors that won the U.S. Supreme Court ruling that the Foreign Sovereign Immunities Act did not immunize Argentina from the post-judgment discovery of information concerning its extraterritorial assets, were not part of the exchange.

The Court was reviewing a Second Circuit ruling that the Republic of Argentina’s decision to pay only holders of the exchange bonds it newly issued, but not holders of its old bonds (including the plaintiff hedge funds), constituted a breach of the pari passu clause contained in the Republic’s 1994 Fiscal Agency Agreement. Based on that holding, the appeals court affirmed an injunction requiring Argentina to make a ratable payment to the plaintiffs in respect of the old bonds whenever it pays any amount due under the terms of the new exchange bonds.

In a second case connected to the Argentina bond issue, the Court declined to review the part of the Second Circuit holding that an equal treatment provision in the bonds barred Argentina from discriminating against the hedge fund bonds. Argentina’s extraordinary behavior was a violation of the particular pari passu clause found in the agreement, said the appeals court, a ruling left standing by the Supreme Court’s denial of certiorari.


Market Expert Shuns Potential Ban on Payment for Order Flow

[This story previously appeared in Securities Regulation Daily.]

By Amy Leisinger, J.D.

Larry Tabb, founder and CEO of capital markets research and consulting firm TABB Group, has submitted a letter to Sen. Carl Levin (D-Mich.), disagreeing with the senator’s request to SEC Chair Mary Jo White that the Commission consider banning payment for order flow to reduce conflicts of interest. In his letter and an accompanying press release, Tabb suggests that any attempt to proscribe this practice would be a “serious mistake” and that lawmakers and regulators should consider unintended consequences. According to Tabb, enhanced disclosure and reporting obligations concerning payment for order flow would be more appropriate than a total prohibition.

Tabb’s conclusions. In response to Sen. Levin’s concerns that these payments create an incentive for brokers to maximize their own profits at the expense of best execution and that consumers are unaware that “the fractions of a cent received by retail brokers per-share add up to a multi-million-dollar conflict of interest,” Tabb agrees that enhanced disclosure on payment for order flow arrangements, together with more informative reports to the SEC, may be necessary. However, he states, “[w]hile payment for order flow does introduce conflicts, banning the practice will only create more challenges and magnify conflicts of interest,” he explains.

Payment for order flow is a legitimate practice governed by the SEC, and order prices must meet national best bid offer requirements while order executions are required to meet the most advantageous price to the client. Further, according to Tabb, retail flow is valuable, and banning the practice of payment for order flow changes not the value of the flow but only how it can be gathered. When a retail order is routed to an exchange, the order will likely trade at either the best bid or best offer, and the investor will either receive the least and or pay the most, respectively, Tabb explains. “Payment for order flow is the tool that helps wholesalers give a portion of that benefit back to investors and retail brokers,” he reasons. Banning these payments would force brokers to either deal in trades directly (raising costs) or to send a valuable asset in the form of an order flow stream to another who would not pay for it (losing revenue), he opines.

While acknowledging that it is, in fact, in the best interests of the retail brokers to obtain as much as they can from their order flow, Tabb notes that brokers also force wholesalers to actively compete on their price improvement statistics. In addition, he states, payment for order flow allows for reductions in commissions and investments in innovation to better serve customers. The process is not perfect, Tabb concludes, but it is “transparent and aboveboard” and allows most investors to get a better price than that available in the market.

Wednesday, August 20, 2014

PCAOB Mulls Standards on Accounting Estimates and Fair Value Measurements

[This story previously appeared in Securities Regulation Daily.]

By Anne Sherry, J.D.

The PCAOB is seeking public comment on standard-setting activities related to auditing accounting estimates and fair value measurements. The Staff Consultation Paper issued yesterday, part of the outreach efforts of the Office of the Chief Auditor, requests information and views on current audit practice, the potential need for changes to existing auditing standards, and possible alternative actions.

Issues with current auditing standards. Several factors point to a potential need for improvement, in the Office’s view, including (1) audit deficiencies noted by the PCAOB and other regulators; (2) changes in financial reporting frameworks relating to accounting estimates, including fair value measurements; (3) changes in the methods used to develop these estimates and measurements, including a growing reliance on third parties; and (4) auditors’ concerns over perceived inconsistencies in the existing standards.

Single standard and alternative approaches. To address these issues, the Office is considering developing and proposing to the Board a single standard to replace AU Sections 342 and 328 and some of the requirements of Section 332. The paper also outlines several alternative approaches, including issuing additional staff guidance; keeping existing standards in place and developing a separate standard on auditing fair value of financial instruments; and enhancing existing standards through targeted amendments. The staff noted that it is continuing to consider these alternative approaches, but posited that a single standard could provide a more comprehensive approach and promote consistency in auditor performance. Also, a single standard aligned with the risk assessment standards could help auditors improve their overall assessments of and responses to risks of material misstatement.

Key dates. The Board will host a meeting of its Standing Advisory Group in Washington, D.C., on October 2 to discuss matters related to auditing accounting estimates and fair value measurements. Comments on the Staff Consultation Paper must be received by November 3.

Tuesday, August 19, 2014

House Panel Approves Bi-Partisan Legislation Mandating Cost-Benefit Analysis of Volcker Rule Updates

The House Financial Services Committee has approved and reported out to the House floor bi-partisan legislation, H.R. 3913, that would require the five federal financial regulators that adopted the Volcker Rule, SEC, CFTC. Fed, FDIC and OCC, to conduct a cost-benefit analysis of any modifications of the Volcker Rule or any future rulemaking undertaken pursuant to the Dodd-Frank Act Volcker Rule provisions. The sponsor of the legislation, Rep. Sean Duffy (R-WI), noted that a cost-benefit analysis of the Volcker Rule was never conducted. However, he continued, the legislation is not retroactive. Thus, H.R. 3913 mandates a cost benefit analysis when the Volcker Rule is updated. It mandates a prospective cost-benefit analysis when the Volcker Rule is modified.

The Chair of the Committee, Rep. Jeb Hensarling (R-TX) supported the bill, noting that, as a general principle, the benefits of a regulation must be weighed against the cost and the Volcker Rule should be no exception. It is a modest and narrowly tailored piece of legislation, added the Chair. However, the Committee’s Ranking Member, Rep. Maxine Waters (D-CA), noted that the bill will discourage any necessary modifications of the Volcker Rule.

After initially being approved by a voice vote, a later and requested recorded vote on H.R. 3913 revealed some bi-partisan support for the legislation.

Sen. Casey Asks Treasury What Non-Legislative Measures Could Stop Corporate Inversions

Senator Robert Casey (D-PA) asked Treasury what actions short of legislation could be taken to stop corporate inversions. In a letter to Treasury Secretary Jacob Lew, he asked how existing regulations and tax laws could be improved in order to better target inversion transactions motivated primarily by tax considerations, rather than inversions motivated solely by business considerations. Specifically, the Senator wants to know what Treasury and the Internal Revenue Service can do right now within existing authorities to more effectively enforce existing anti-inversion penalties. He also asks what additional resources, if any, would be required to support more effective enforcement of current regulations.

Many proposals to address the inversion trend, including a proposal in the Administration’s Fiscal Year 2015 Budget proposals, would enact or amend tax domicile rules based on whether a company’s management and control is based in the United States, or the company maintains significant business activities in the United States. Senator Casey wants to know how easily enforceable these proposals would be, and what additional resources, if any, would be needed to ensure fair, transparent and effective enforcement.

While an anti-inversion provision has been part of the Internal Revenue Code since 2004, experience has shown that this provision insufficiently deters inversion given the large tax rate and other tax disparities between the United States and the countries to which formerly U.S.-based multinationals have relocated.

Under current law, U.S. companies can invert and avoid paying U.S. income taxes if a merger transfers just 20 percent of its stock to shareholders of an offshore company. One legislative vehicle is available for Congress right now. It is the Stop Corporate Inversions Act, S. 2360, introduced by Senator Carl Levin (D-Mich.). The measure would raise the 20 percent threshold to 50 percent so that if the majority of a company’s stock remains in the hands of the U.S. company’s shareholders, it is treated as a U.S. company for tax purposes. The bill would also bar companies from shifting their tax residence offshore if their management and control and significant business operations remain in the U.S. There is a companion bill in the House, H.R. 4679, introduced by Rep. Sandy Levin (D-MI).

IM Staff Reports on Use of Form PF Data

[This story previously appeared in Securities Regulation Daily.]

By Amy Leisinger, J.D.

The staff of the SEC’s Division of Investment Management has issued its second annual report relating to the use of data collected from private fund advisers on Form PF. Under the Dodd-Frank Act, the Commission must report annually to Congress on how it has used the data regarding the operations and strategies of private funds to protect investors and the integrity of the markets. According to the report, during the past year, the SEC staff has used Form PF data to assist in examinations and investigations of private fund advisers, to enhance the Commission’s risk-monitoring activities, to provide guidance to filers, and to work with other regulators concerned with the activities of private fund advisers.

Background. Under the Dodd-Frank Act, the Commission must direct investment advisers to report information regarding the hedge funds and private funds they advise in order to provide a source of data for the Financial Stability Oversight Council (FSOC) to use in monitoring systemic risk. This information must include total assets under management (AUM), use of leverage, counterparty credit risk exposure, and trading practices. The Dodd-Frank Act also provides specific confidentiality protections for proprietary information collected.

In 2011, in consultation with FSOC members, the Commission adopted Form PF and Investment Advisers Act Rule 204(b)-1 to establish filing requirements for private fund advisers. Reporting content and frequency varies based on the amount of the adviser’s AUM and the types of private funds it manages. Most advisers are required to file Form PF once a year and report only basic information regarding the private funds they advise, such as the types of private funds advised and each fund’s size, leverage, liquidity, and performance. Hedge fund advisers also must report information about fund strategy, counterparty credit risk, and trading and clearing activities. Large private fund advisers must report more frequently and provide more detailed information, including data on exposures, geographical concentration, turnover by asset class, and use of leverage, among other things. The Commission has controls and systems in place for the proper handling of confidential Form PF data.

Commission uses of Form PF data. In its report, the staff notes that, in addition to providing Form PF data to FSOC for use in its systemic-risk-monitoring obligations, the Commission itself uses Form PF information in its regulatory programs and investor-protection efforts. Specifically, the report states, Form PF data is used in the SEC examinations and enforcement investigations of investment advisers that manage private funds. The staff will review an adviser’s Form PF filing as a part of a preliminary evaluation and will use the data to track inconsistencies and discrepancies with other documentation, especially those items provided to investors, according to the report.

In addition, the staff observes, the Commission has increased the use of Form PF data in its ongoing risk monitoring and rulemaking activities, particularly in the form of reports generated by the Division of Economic and Risk Analysis (DERA). Examiners use the DERA database to identify advisers engaging in particular activities and to identify red flags, and the Division of Investment Management uses Form PF information to inform policy and rulemaking initiatives with regard to private funds. The staff continues to provide guidance to Form PF filers regarding a variety of filing issues, the report states.

Finally, the report explains, the Commission staff uses Form PF data in conjunction with other agencies and groups during collaborative efforts regarding private funds and advisers. Not only is the data used in connection with FSOC’s systemic risk efforts, the staff adds, but it is also included and addressed in discussions with other federal regulators. The staff has also provided aggregated, non-proprietary Form PF data to the International Organization of Securities Commissions (IOSCO) to provide the organization with a more comprehensive view of the global hedge fund market, according to the report.

Monday, August 18, 2014

Senate and House Companion Bills Would Provide Tax Credit for Angel Investors

Senator Chris Murphy (D-CT) introduced legislation that would provide incentives to angel investors to invest significant capital in startups. The Angel Tax Credit Act, S. 2497, would allow them to claim a tax credit equal to 25 percent of their aggregate qualifying equity investments of $25,000 or more to U.S.-based high-tech startups. Establishing this incentive, said Senator Murphy, would help create a funding pipeline to grow startups and target job growth in the science, technology, and engineering fields so the United States can continue its leadership in these fields. A companion bill, H.R. 4931, has been introduced in the House by Rep. Steve Chabot (R-OH).

Timing of Announcement of Ford Payments Did Not Show Fraud

[This story previously appeared in Securities Regulation Daily.]

By Matthew Garza, J.D.

A Ford investor was unable to convince a Third Circuit panel that the auto maker or an investment trust it created violated Exchange Act Rule 10b-17 through the timing of its announcement of payments to the trust (Gold v. Ford, August 15, 2014, Roth, J.).

Background. The plaintiff held over 21,000 of Ford trust preferred securities that were issued by the auto maker through a Delaware trust in 2002. The trust invested in Ford debt and received quarterly interest payments from Ford in return, which was then distributed to holders of the trust preferred securities. Ford could also suspend quarterly interest for a maximum of 20 quarters under the contract, which it did in April 2009.

Announcement of resumption of the payments took place on June 30, 2010. The plaintiff sold his shares on that day, after Ford’s distribution announcement, but before the New York Stock Exchange set the “ex-distribution date.” That date was set at July 1, meaning the plaintiff was not entitled to a cash distribution made by Ford on July 15, 2010.

Court’s determination. The court said that to show a violation of the Rule 10b-17, which requires issuers to give FINRA a 10-day advance notice of a cash distribution, a plaintiff must plead the 10(b) elements: (1) a material misrepresentation or omission, (2) scienter, (3) a connection with the purchase or sale of a security, (4) reliance, (5) economic loss, and (6) loss causation.

The court found that the plaintiff did not sufficiently plead scienter under the heightened PSLRA standard. The investor argued that Ford’s history of complying strictly with the 10b-17 notice requirement showed the company knew 10b-17 was a “bright line” rule, so deliberately disregarding it was a demonstration of scienter. The court said the assertion speaks too broadly about Rule 10b-17 and would mean that every violation of the notice requirement would establish scienter. “Simply put, missing a deadline is not scienter,” said the court.

The case is No. 13-2328.