New Mexico Proposes Rule Revisions to Align with New 2010 Securities Act

Rule amendments were proposed by the New Mexico Securities Division to align the rules with adoption of the new New Mexico Uniform Securities Act that takes effect January 1, 2010. The rule changes are likewise anticipated to become effective on January 1. Many of the proposed changes are nonsubstantive, updating rule references to reflect the correct section and subsection numbers of the new Act, lower-casing certain words like "director" and the first letter of the first word of certain subsections. A number of the substantive amendments are being made to the investment adviser rules. Please note that upon adoption a fair amount of CCH paragraph numbers will shift to correspond to different rules than they do now.

Interested persons may submit written comments about the rule proposals to Marianne Woodard, Attorney, Securities Division, New Mexico Regulation and Licensing Department, 2550 Cerrillos Rd., Toney Anaya Bldg 3rd Floor, Santa Fe, NM 87505. Alternatively, comments may be faxed to (505) 984-0617. Comments must be received by December 7, 2009.

For the text of the proposed rules please see http://www.rld.state.nm.us/securities/rulechange.html

California Amends National Security Exchange Names and Functions to Match Federal Changes

The names and functions of certain national security exchanges, stock exchanges, markets and related entities were amended by the California Department of Corporations to reflect changes made to the National Security Exchange names and functions at the federal level, effective December 10, 2009. The changes include: (1) adding the NASDAQ Global Market to the national securities exchange list and deleting references to the interdealer quotation system of the National Association of Securities Dealers, Inc.; (2) adding the New York Stock Exchange AMEX to the national securities exchange list and deleting references to the Emerging Company Marketplace; (3) adding Tier I of the NYSE Arca to the national securities exchange list and deleting references to the Pacific Stock Exchange; (4) adding Tier I of the NASDAQ OMX PHLX and deleting references to Tier I of the Philadelphia Stock Exchange; (5) adding the electronic service operated by the Pink Sheets LLC or the OTC Bulletin Board and deleting references to the National Daily Quotation Service; (6) adding the Pink Sheets LLC, the OTC Bulletin Board and the NASDAQ Stock Market LLC and deleting references to the National Quotation Bureau; (7) repealing the exemption from registration for securities listed on the Chicago Board Options Exchange; (8) repealing the exemption for securities listed on the Pacific Stock Exchange; and (9) changing references from the National Association of Securities Dealers, Inc. to the Financial Industry Regulation Authority.

For more information please see http://www.corp.ca.gov/

Hong Kong Securities and Futures Commission Official Looks at Regulation of Dark Pools

Noting that the SEC has made dramatic proposals to light up dark pools, Martin Wheatley, Executive Director of the Hong Kong Securities and Futures Commission said that the proposals have far-reaching implications and require careful study and thorough discussions with the industry before being adopted. While dark pool operations in Hong Kong are still relatively small, he said, the Commission has begun a study to identify the appropriate ways for alternative trading venues to develop in Hong Kong. His remarks were made at Trade Tech Asia 2009.

In an effort to increase transparency in dark pools, the SEC would require real time reporting from dark pools for their executed trades and actionable indications of interests to be displayed in the public quotation system. Dark pools in the U.S. are currently required to publicly display stock quotes if their trading volume exceeds 5 percent of the volume of a particular stock. But the new plan would reduce the threshold to 0.25 percent.

The growth of dark pools in Asia has been impeded by the fact that, unlike in the U.S. and in Europe, Asian exchanges are considered national interests and hence accorded an almost exclusive franchise to operate a stock market domestically. That said, the Executive Director believes that a case can still be made for dark pools to operate in Asia because they are not really exchanges. Dark pools can offer something exchanges cannot, that is, a wide range of order types including algorithmic trading tools. Thus, it is arguable that dark pools are not competing with exchanges, but play a complementary role in offering a different type of service or servicing a different segment of the market.

While acknowledging the benefits of anonymity and speed in dark pools, the SFC official also pointed out there are issues of best execution, price discovery, fragmentation, and transparency, The main issue being debated is that a lack of transparency in dark pool operations deprives the public of fair access to information about the best available prices to some market participants and thus results in a two-tiered market.

Since the dark pool is an institutional market, he emphasized, regulators must study the pros and cons of integrating this institutional trading venue and the trading venue offered by stock exchanges before making any policy changes. The primary focus here should be whether the two-tiered market has created difficulties for regulators to conduct market surveillance. If the presence of dark pools has affected the ability of regulators to supervise the market, he warned, regulators must work together with the industry to identify ways to address this.

The growth of dark pools also calls for a review of the best execution policy since the fragmentation of pricing data makes it difficult for investors to know where they are likely to get the best price for their orders. In some markets, there are rules requiring an exchange to route an order to another exchange or liquidity pool if there is a better price. But such order routing usually incurs costs to investors.

Price discovery is a major function of an exchange market and the efficiency with which it is carried out depends on whether orders from a diverse set of participants are properly integrated so as to achieve reasonably accurate price discovery and reasonably complete quantity discovery. Most of the dark pools determine execution prices with reference to exchange produced prices. If dark pools continue to grow and account for a significant portion of market share, reasoned the official, it will affect the price discovery function currently performed by the exchange market. The question is how can fair market prices be obtained if most transactions are executed on non-displayed markets.

Despite an IOSCO initiative to examine potential regulatory issues associated with dark pools, Mr. Wheatley does not anticipate the international harmonization of dark pool regulation. This is because dark pools have a different appeal to different jurisdictions and, thus, the corresponding regulatory regime will be quite different.

The world’s major financial exchanges have asked the G-20 to examine the erosion of price discovery and dark pools, arising from recent trends. The concerns were voiced in a letter to the Financial Stability Board, which the G-20 has designated as a key player in assuring the cross-border consistency of financial regulation legislation. The letter was signed by William Brodsky, CEO of the CBOE, in his role as Chair of the World Federation of Exchanges. It was endorsed by, among others, NASDAQ, NYSE Euronext, the London Stock Exchange, and the Tokyo Stock Exchange.

House Legislation Would Provide for Extraterritorial Reach of Federal Securities Laws

Perhaps obviating the need for US Supreme Court review of a case involving the extraterritorial reach of the federal securities laws, House draft legislation would provide for the transnational reach of the antifraud provisions of the Securities Act, the Exchange Act, and the Investment Advisers Act. At the Court’s invitation, the Solicitor General and the SEC filed a brief in which they urged the Court not to take the case, partially because of the pending legislation. The Investor Protection Act, HR 3817, passed the Financial Services Committee this month and could be voted on by the full House in December as part of overall financial reform. There is currently no companion provision in the Senate draft legislation, the Restoring American Financial Stability Act. The case, Morrison v. National Australian Bank, Ltd., Dkt. No. 08-1191, is scheduled for a Supreme Court conference on November 24, 2009, at which time the Court will consider whether to hear it.

Section 215 of the Investor Protection Act would amend the federal securities laws to provide that US district courts have jurisdiction over violations of the antifraud provisions that involve a transnational fraud if there is conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurred outside the U.S. and involved only foreign investors, or, conduct occurring outside the U.S. that has a foreseeable substantial effect within the U.S.

In Morrison, a Second Circuit panel ruled that the US federal securities laws did not apply to foreign investors alleging fraudulent statements by a foreign issuer when the conduct in the US was merely preparatory to the fraud and the acts directly causing loss to investors occurred in a foreign country. This is the so-called foreign-cubed securities fraud action, said the appeals panel, and it is judged by the same standard of any extraterritorial application of the federal securities laws, which is whether actions in the US directly caused the loss to investors. The panel described itself as an American court, not the world’s court, which cannot expend resources resolving cases that do not affect Americans or involve fraud emanating from America. Morrison v. National Australian Bank, Ltd., CA-2, No.07-0583, Oct. 23, 2008

The rapid globalization of financial markets in recent years has cast into stark relief issues surrounding the international reach of US securities laws. Since the federal securities laws are silent on their international reach, federal courts developed tests, including the conduct test, which focuses on the nature of the conduct within the US as it relates to carrying out the alleged fraudulent scheme

A three-way split has developed among the federal Circuit Courts of Appeal as to the proper scope of jurisdiction when conduct within the US results in fraud in connection with a transaction outside the US. The predominant difference among the Circuits is the degree to which the US-based conduct must be related causally to the fraud and the resulting harm to justify the application of the federal securities laws.The Third, Eighth and Ninth Circuits have held that jurisdiction may be exercised when conduct within the US furthered the alleged fraud The Second, Fifth and Seventh Circuits have established a more restrictive test, holding that jurisdiction may be exercised only when conduct occurring within the US directly caused the alleged losses.

Finally, the District of Columbia Circuit has adopted the most stringent test, holding that jurisdiction is proper only when the fraudulent statements or misrepresentations originate in the United States, are made with scienter and in connection with the purchase or sale of securities, and directly cause the harm to those who claim to be defrauded, even if reliance and damages occur elsewhere.

NYSE Forms Corporate Governance Commission as Legislation Looms

Against the backdrop of pending federal legislation on corporate governance, the NYSE has formed a Commission on Corporate Governance to address U.S. corporate governance reform and the overall proxy voting process for public companies. Chaired by Larry Sonsini of Wilson, Sonsini Goodrich & Rosati, the Commission will take a comprehensive look at the multitude of issues facing directors, management, stockholders, regulators and other constituencies in the on-going public debate about best practices for corporate governance. The Commission will bring together experts and representatives from corporations, stockholder advocacy groups, and regulators in an effort to forge a consensus on a variety of today’s most controversial corporate governance issues. Other members of the Commission will be former Delaware Vice Chancellor Stephen Lamb, now a Paul Weiss partner, former SEC Mike McAlevey, former Deputy Director of the SEC Division of Corporation Finance, now Chief Corporate, Securities and Finance Counsel at GE, Peter Mixon, CalPERS General Counsel, and Hye-Won Choi, Head of Corporate Governance at TIAA-CREF.

Specifically, the Commission will examine stockholder access to corporate proxy cards, including recent developments in state law and the proposed initiatives by the SEC, the overall efficacy and transparency of the proxy voting process, and the role of proxy advisory services, institutional investors and individual investors within the proxy process. More generally, the Commission will review the roles of, and relationships, accountability and communications among, directors, management, stockholders and other corporate stakeholders. Very broadly, the Commission will look corporate governance structures and corporate mechanisms impacting the governance of the corporation.

Senate Draft Legislation Would Overrule Supreme Court Precedent and Allow Private Right of Action for Aiding and Abetting Securities Fraud

The Senate draft legislation, Restoring American Financial Stability Act, would enable investors to sue persons who aid and abet securities fraud. The draft amends Section 21D of the Exchange Act to provide that, in implied private civil securities fraud actions, any person that knowingly or recklessly provides substantial assistance to another person in violation of the securities antifraud rule or any other SEC rule or regulation must be deemed to be in violation to the same extent as the person to whom such assistance is provided.

This draft provision appears to overrule legislatively the US Supreme Court’s 1994 opinion in Central Bank of Denver v. First Interstate Bank that there is no implied private right of action against secondary actors who aid and abet securities fraud. Derivatively, it apparently also overrules the Court’s 2008 ruling in Stoneridge Investment Partners, Inc. v. Scientific-Atlanta, Inc., where the Court held that secondary non-speaking actors said to have participated with a company in a securities fraud scheme were not liable in a private action under Rule 10b-5

Until the Central Bank ruling, every circuit of the Federal Court of Appeals had concluded that a private right of action for securities fraud allowed recovery not only against the person who directly undertook a fraudulent act, the primary violator, but also anyone who aided and abetted the actor. A five-Justice majority in Central Bank narrowed the scope of the antifraud rule by holding that its private right of action extended only to primary violators.

The Stoneridge Court relied on the earlier Central Bank ruling. These aiding and abetting issues arise when secondary actors engage in conduct with the purpose and effect of creating a false appearance of material fact to further a scheme to misrepresent the company’s revenue. The argument is that the financial statement the company released to the public was a natural and expected consequence of the non-speaking actor’s deceptive acts. Had the actors not assisted the company, the theory goes, the company’s auditor would not have been fooled, and the financial statement would have been a more accurate reflection of the company’s financial condition. That causal link is sufficient to apply a presumption of reliance to the secondary actors.

Citing the Central Bank ruling, the Stoneridge Court observed that, since Rule 10b-5 implied private right of action does not extend to aiders and abettors, the conduct of a secondary actor must satisfy each of the elements or preconditions for liability.

On one level, the Stoneridge opinion represented an affirmation of the ruling in Central Bank. The Stoneridge Court noted that, in Central Bank, the Court said that allowing the aiding and abetting action would mean that defendants could be liable without any showing that investors relied upon the aider and abettor’s statements or actions. Allowing investors to circumvent the reliance requirement would disregard the careful limits on 10b–5 recovery mandated by earlier cases.

The Court also noted that the decision in Central Bank led to calls for Congress to create an express cause of action for aiding and abetting within the Exchange Act. Congress did not follow this course. Instead, in section 104 of the Private Securities Litigation Reform Act of 1995 (PSLRA), Congress directed prosecution of aiders and abettors by the SEC. The Court construed this to be a conscious decision by a Congress aware of the Central Bank ruling not to legislatively expand the scope of Rule 10b-5 to private rights of action by investors. With the Restoring American Financial Stability Act, the Senate Banking Committee would change the legislative framework and allow private rights of action for aiding and abetting securities fraud.

If the provision is in the final legislation it would have broad implications for investment banks and accountants and other secondary actors. For example, relying on the Central Bank opinion, a Fifth Circuit panel said in an Enron-related case that secondary actors, such as investment banks and accountants, who act in concert with public companies in schemes to defraud investors cannot be held liable as primary violators of Rule 10b-5 unless they directly make public misrepresentations; owe the shareholders a duty to disclose; or directly manipulate the market for the company’s securities through practices such as wash sales or matched orders. This was the ruling the panel in an action alleging that investment banks engaged in transactions that allowed Enron to misstate its financial condition. (Regents of the University of California v. Credit Suisse First Boston, 06-20856, March 19, 2007).

At most, said the appeals court, the banks could have aided and abetted Enron’s deceit by making its misrepresentations more plausible but their conduct did not rise to primary liability under Rule 10b-5. And, under the Supreme Court’s Central Bank ruling, there is no private action for secondary aiding and abetting liability under Rule 10b-5. The investment banks owed no duty to Enron’s shareholders, emphasized the panel.

House and Senate Draft Legislation Would Expand PCAOB Jurisdiction

The Madoff fraud revealed that the Public Company Accounting Oversight Board lacked the power it needed to examine the auditors of non-public broker-dealers. House and Senate draft legislation would close this loophole and bring the auditors of non-public broker-dealers under the PCAOB oversight regime. The legislation would thus provide the Board with authority over the auditors of all brokers-dealers, not just the auditors of public broker-dealers, who would have 180 days to register with the PCAOB.

Additionally, like public companies, brokers-dealers would pay an accounting support fee in proportion to the broker-dealer’s net capital compared to the total net capital of all brokers and dealers that are not issuers. The Board would have investigatory, examination and enforcement authority over the auditors of all broker-dealers The PCAOB would also be authorized to refer investigations to FINRA or other defined self-regulatory organizations and share with them all information and documents received in connection with an investigation or inspection without breaching its confidential status.

Both drafts would also authorize the PCAOB to share information under a confidential regime with foreign regulatory authorities engaged in the investigation and prosecution of violations of applicable accounting and auditing laws without waiving any privileges the SEC may have with respect to such information. Both drafts define a foreign auditor oversight authority as any entity empowered by a foreign government to conduct inspections of public accounting firms or otherwise to administer or enforce laws related to the regulation of public accounting firms.

Both House and Senate draft legislation give the Board discretion to share information with foreign oversight authorities under an investor protection standard so long as they provide assurances of confidentiality to the Board. However, the Senate draft would also require the foreign authorities to describe their information systems and controls, as well as describe the laws and regulations of the foreign government that are relevant to information access.

The House draft, but not the Senate, would enhance the ability of the PCAOB to access the audit work of foreign public accounting firms when they perform audit work, conduct interim reviews, or perform other material services upon which a registered public accounting firm relies in the conduct of an audit or interim review. This statutory change is designed to resolve international conflicts that have impaired the PCAOB’s ability to fulfill its statutory obligation to inspect non-U.S. registered public accounting firms.

The Garrett Amendment to the House legislation would change the name of the PCAOB to Auditor Oversight Board. In addition, the Jenkins-Garrett Amendment would create an ombudsman within the Auditor Oversight Board to act as a liaison between the Board and registered accounting firms and issuers with regard to the issuance of audit reports. The ombudsman would also deal with any problem that registered firms or issuers may have in dealing with the Board resulting from the Board’s regulatory activities, particularly with respect to internal control over financial reporting and audit attestation under Section 404 of Sarbanes-Oxley. There are no comparable provisions in the Senate draft.

The Putnam Amendment to the House draft provides that nothing in the Sarbanes-Oxley Act provisions creating the PCAOB affects the Board’s obligations, if any, to provide access to records under the Right to Financial Privacy Act. The amendment also provides that nothing in those Sarbanes-Oxley provisions authorizes the Board to withhold information from Congress or prevents the Board from complying with a federal court order in an action commenced by the US or the Board. There is no comparable Senate provision.

Key UK Committee Urges EU to Go Slow on Financial Stability Legislation

The UK Treasury Committee has urged the European Union to take more time on legislation establishing a systemic risk regulatory framework centered on a new European Systemic Risk Board and new European Supervisory Authorities for banking and securities, replacing CESR and other Lamfalussy Level 3 committees. The UK Committee has concerns about the size and composition of the Board and unease about the power the European Supervisory Authorities would have to override the decisions of national regulators. Similarly, there are concerns that the European Commission will have unilateral power to declare an emergency, which will further empower the Supervisory Authorities to direct national regulators.

The European Commission proposed the detailed legislative reform proposals in September of 2009. The EU Presidency is pressing for their adoption by ECOFIN at the European Council meeting on December 2. The Treasury Committee considers that to be much too fast for the adoption of a systemic risk framework that should last for many decades. There must be proper time for consideration.

The Commission proposed that the Board would carry have macro prudential oversight to look for systemic weaknesses in the financial system, while the sectoral Supervisory Authorities would co-ordinate micro prudential regulation. The Board, composed of central banks with voting rights and national regulators without such, would not have any direct power; its task will be to monitor systemic risk and issue warnings to appropriate authorities.

The fast track timetable for the legislation would be less worrying if the proposals were without controversy, said the Committee, but they are not. In fact, the Committee found cause for serious concern about the size and composition of the Board and the delegation of discretionary power to the European Supervisory Authorities to override the decisions of national regulators. There are also concerns that the Commission would have unilateral power to declare an emergency, which will empower the supervisory authorities to further direct national regulators. Significantly, the proposals do not appear to give due weight to ECOFIN’s own earlier admonition that the measures should not impinge on the fiscal responsibilities of the Member States.

The legislation, for example, would authorize the Securities Supervisory Authority to settle disagreements when there is a dispute between national regulators as to practices and, if its decision is not accepted by a national regulator, to adopt an individual decision addressed to an individual market participant. In the Committee’s view, this comes very close to giving the Supervisory Authority the power to directly regulate individual market participants. There is also fear that the Securities Authority could fundamentally undermine the proven system of takeover regulation in the UK, since it could issue guidelines undermining the flexibility given to national regulators and disrupt effective takeover regulation.

While UK Finance Services Secretary Lord Myners envisions that the Supervisory Authorities will not regulate individual firms but rather will work to achieve common regulatory standards, the committee said that the regulations as currently drafted would allow them to override the decision of a national regulator and to direct individual institutions.

Also, the legislation authorizes the Commission to declare an emergency when the financial stability of the markets is threatened. Once an emergency has been declared, a Supervisory Authority can adopt individual decisions requiring competent authorities to take the necessary action in accordance with the legislation to address any risks that may jeopardize the orderly functioning and integrity or stability of the financial markets by ensuring that financial institutions satisfy the requirements laid down in the legislation. If the competent authorities do not act, the Supervisory Authority has a reserve power to direct individual financial institutions.

New IFRS 9 for Financial Instruments Adopted, EFRAG Delays Endorsement Advice to European Commission

The International Accounting Standards Board has adopted new IFRS 9 for the accounting for financial instruments, as part of its project to replace IAS 39. The new standard enhances the ability of investors and other users of financial information to understand the accounting of financial assets and reduces complexity. IFRS 9 uses a single approach to determine whether a financial asset is measured at amortized cost or fair value, replacing the many different rules in IAS 39. The approach in IFRS 9 is based on how a firm manages its financial instruments, its business model, and the contractual cash flow characteristics of the financial assets. The Board also decided not to bifurcate hybrids containing embedded derivatives.

The new standard requires a single impairment method to be used, replacing the many different impairment methods in IAS 39. Thus, IFRS 9 improves comparability and makes financial statements easier to understand for investors and other users. Firms must apply IFRS 9 for annual periods beginning on or after 1 January 2013. But early adoption is permitted. To facilitate early adoption, a firm that applies IFRS 9 before financial reporting periods beginning before the first of January 2012 is not required to restate comparatives. Commenting on IFRS 9, IASB Chair David Tweedie said that the Board delivered on its commitment to the G-20 and stakeholders internationally to provide an improved financial instrument standard for the classification and measurement of financial assets for use in 2009.

The Board decided to consider the classification and measurement of financial liabilities separately. IFRS 9 therefore prescribes the classification and measurement of financial assets only.

In adopting IFRS 9, the Board’s goal is neither to increase nor decrease the application of fair value accounting to financial instruments, but rather to ensure that financial assets are measured in a way that provides useful information to investors. Whether firms will have more or fewer financial assets measured at fair value as a result of applying IFRS 9 will depend on the nature of their business and the nature of the instruments they hold.

Generally, the IASB noted that the more risky financial assets a firm holds the more likely it is that those financial assets will be measured at fair value. For example, the IASB will not require that the loan book of banks be held at fair value. As a result, the final standard will likely result in financial institutions that undertake traditional banking activities applying less fair value accounting rather than more.

The category into which the asset is classified determines whether it is measured on an ongoing basis at amortized cost or fair value. The business model test is applied first in determining whether a financial asset is eligible for amortized cost measurement. The Board confirmed that to be eligible for amortized cost measurement an asset must have contractual cash flow characteristics representing principal and interest. IFRS 9 includes examples of the application of that principle to particular financial assets. All equity investments must be measured at fair value.

Unquoted equity instruments, and derivatives over such instruments, must be measured at fair value, however, in limited circumstances, cost may be an appropriate estimate of fair value. IFRS 9 contains guidance on when cost may be an appropriate estimate of fair value. However, measurement of fair value will be subsequently addressed as part of the fair value measurement project.

A firm is required to reclassify affected financial assets only if its business model changes. The exposure draft had proposed prohibiting reclassification. The Board removed the prohibition on reclassification of financial instruments in response to comments that a change in business model should result in reclassification. Thus, companies would be able to reclassify financial instruments out of the fair value option when making their new designations. To ensure full transparency, the Board would require appropriate disclosures and presentation of any reclassifications

If a financial asset is eligible for amortized cost measurement, a firm can elect to measure it at fair value if it eliminates or significantly reduces an accounting mismatch.

If a firm holds a tranche in a structure it must determine the classification of that tranche by looking through to the assets ultimately underlying that portfolio and assess the credit quality of that tranche compared with the underlying portfolio. If an entity is unable to look through, then the tranche must be measured at fair value.

The Board concluded that there will be no bifurcation of an embedded derivative where the host is a financial asset. Thus, a hybrid non-derivative host contract with an embedded derivative with a host that is a financial asset is not separated. Such contracts are classified in accordance with the classification criteria in their entirety. There is no change to the accounting for hybrid contracts if the host contract is a financial liability or a non-financial item.

IAS 39 had split the instrument, with the embedded derivative being measured at fair value and the non-derivative host being measured at amortized cost or as an executory contract using accrual accounting. While recognizing that separating an embedded derivative from its host contract can provide useful information for users of financial statements, the Board was also cognizant of the important goal of simplifying the accounting for financial instruments. The Board concluded that the additional information gained from separating the components of the contract did not justify the significant additional costs and complexity that separation entails.

EFGAG Endorsement Advice

A key advisory panel has urged the European Commission to delay the endorsement of the new international financial instrument accounting standard, IFRS 9. The European Financial Reporting Advisory Group (EFRAG) decided that more time should be taken to consider the output from the IASB project to improve accounting for financial instruments. Therefore, at this stage, EFRAG would not finalize its endorsement advice to the Commission on IFRS 9.

On November 2, EFRAG issued draft endorsement advice seeking input from constituents. EFRAG provides advice to the European Commission on the endorsement of new or amended IFRSs and comments on proposed IFRSs and IASB discussion papers and consultative documents. EFRAG also attends various IASB Working Group meetings as an observer.

The IASB adopted new IFRS 9 for the accounting for financial instruments, as part of its project to replace IAS 39. The new standard enhances the ability of investors and other users of financial information to understand the accounting of financial assets and reduces complexity. IFRS 9 uses a single approach to determine whether a financial asset is measured at amortized cost or fair value, replacing the many different rules in IAS 39. The approach in IFRS 9 is based on how a firm manages its financial instruments, its business model, and the contractual cash flow characteristics of the financial assets.

In its draft endorsement advice, EFRAG sought comment on a number of issues involving the application of IFRS 9. EFRAG’s initial assessment of IFRS 9 is that it meets the technical criteria for endorsement. In other words, it is not contrary to the true and fair principle and it meets the criteria of understandability, relevance, reliability and comparability.

EFRAG is assessing the costs for both preparers and users on implementation of IFRS 9 in the EU, both on initial adoption and in subsequent years. Some initial work has been carried out, and comments will be used to complete that assessment. EFRAG’s initial assessment is that preparers could incur significant year-one costs arising from the initial adoption of IFRS 9, and moderate ongoing costs. For users, application of IFRS 9 is likely to involve significant additional costs in year-one and, for some users, moderate ongoing incremental costs. But EFRAG added that IFRS 9 would reduce complexity in the classification and measurement aspect of reporting financial instruments; and the benefits to be derived from that are likely to exceed the costs involved.

Since IFRS 9 requires firms to determine the fair value for unquoted equity instruments, there is concern that requiring such instruments to be measured at fair value might result in measures that are not sufficiently reliable. While IFRS 9 may cause some reliability concerns, the majority of EFRAG members concluded that those concerns would be mitigated by existing disclosures requirements in IFRS 7.

Similarly, EFRAG noted that IFRS 9 will not be free from some significant comparability concerns, such as with the treatment of tranched securities. Nevertheless, the majority of EFRAG members believe that most significant issues of comparability are partially mitigated by disclosure requirements. While some comparability concerns may remain thereafter, EFRAG does not consider those concerns significant.

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White Paper Available on the Restoring American Financial Stability Act

The Senate Banking Committee has released draft legislation providing for a sweeping overhaul of the regulation of US financial services and markets. The overhaul of the US financial regulatory system is based on the themes of regulating systemic risk, enhancing transparency and disclosure, delinking executive compensation from excessive risk, expanding consumer and investor protection, and preventing regulatory arbitrage. The draft provides for the regulation of hedge funds, and OTC derivatives, as well as draft legislation on a new resolution authority to unwind failing financial firms. The legislation provides for major corporate governance reforms, such as shareholder advisory votes on compensation and enhanced compensation committees. The draft also envisions a completely reformed securitization process playing an important role in the financial markets. A new independent regulator would be created with authority to make sure that consumer protection regulations are written and enforced.

Click here for white paper on the Restoring American Financial Stability Act.

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Senate Draft Legislation Aims to Reform Securitization

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Restoring American Financial Stability Act provides shareholders with this powerful opportunity to hold accountable executives of the companies they own, and a chance to disapprove where they see the kind of misguided incentive schemes that threatened individual companies and in turn the broader economy.

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

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

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

The draft gives shareholders access to management’s proxy card to nominate directors. Providing shareholders a greater role in choosing directors can help shift management’s focus from short-term profits to long-term growth and stability. Specifically, within, 180 days of enactment, the SEC must issue rules permitting the use by shareholders of management proxy solicitation materials for the purpose of nominating individuals to the board of directors, under such terms and conditions as the Commission determines are in the interest of shareholders and the protection of investors.

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

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

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

In a major corporate governance improvement, the draft mandates independent board compensation committees, as well as mandating the independence of any compensation consultants and legal advisers hired by the committee. This will be a condition of listing on an exchange. In determining the independence of compensation committee members, SEC rules must require exchanges to consider the source of compensation and any affiliation with the company or any of its subsidiaries.

SEC rules must also allow an exchange to exempt a particular relationship from the independence requirements, taking into consideration the size of an issuer and any other relevant factors. Separately, the SEC is directed to adopt rules defining independence for compensation consultants and legal counsel hired by the compensation committee. Also, the SEC is directed to conduct a study and file a report on the effects of using compensation consultants on company performance.

The compensation committee has sole discretion to hire and obtain the advice of a compensation consultant and is directly responsible for the compensation and
oversight of the work of the consultant. However, the compensation committee cannot be required to implement or even act consistently with the advice or recommendations of the compensation consultant. At the end of the day, nothing can affect the ability or the obligation of a compensation committee to exercise its own judgment in the fulfillment of its duties.

Further, prosy or consent solicitation materials for an annual or special meeting of shareholders must disclose if the compensation committee retained or obtained the advice of a compensation consultant; and whether the work of the compensation committee has raised any conflict of interest and, if so, the nature of the conflict and how it is being addressed.

The draft also gives the compensation committee sole discretion to hire and obtain the advice of counsel and other advisers; and provides that the committee is directly responsible for the compensation and oversight of the work of the consultant. However, the compensation committee cannot be required to implement or even act consistently with the advice or recommendations of counsel. At the end of the day, nothing can affect the ability or the obligation of a compensation committee to exercise its own judgment in the fulfillment of its duties.

The legislation directs companies to provide appropriate funding, as determined by the compensation committee, for the payment of reasonable compensation to a compensation consultant; and to independent legal counsel or any other adviser to the committee.

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

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Senate Banking Committee Issues Draft Legislation Reforming US Financial Regulation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The drafts recognize the harm to seniors posed by the use of such misleading activity and establishes a mechanism for providing grants to states as an incentive to adopting the NASAA model rule. The grants are designed to give states the flexibility to use funds for a wide variety of senior investor protection efforts, such as hiring additional staff to investigate and prosecute cases; funding new technology, equipment and training for regulators, prosecutors, and law enforcement; and providing educational materials to increase awareness and understanding of designations.

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

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

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

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

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

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

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

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

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

Oral argument is set for November 30, 2009.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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SEC Commissioner Pushes Back on Bachus FINRA Amendment to House Legislation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Chamber of Commerce Opposes Waters Amendment on Shareholder Access

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

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

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District Court Went Too Far in Naming Lead Counsel

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

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

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

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