Monday, September 15, 2014

Center for Audit Quality Actively Embraces SEC Disclosure Initiative

The Center for Audit Quality embraces the SEC’s new and important disclosure initiative as one of the key components in the audit quality ecosystem, along with effective audit committees. In recent remarks at a public accountants seminar in Singapore, CAQ Executive Director Cindy Fornelli noted that disclosure effectiveness has been a subject of great interest for SEC Chair Mary Jo White.

The CAQ shares Chair White's view that disclosure can be improved, she observed, adding that effective disclosure is a hallmark of world-class capital markets. It is very important that financial disclosure is meaningful and as tailored as possible, and optimized in terms of how and where it is delivered. To this end, she  noted that the CAQ has launched a new initiative with the Institute for Corporate Responsibility at the George Washington University School of Business, called the Initiative on Rethinking Financial Disclosure.

This initiative will harness the power of team competition.  Several teams of graduate students at the School of Business are analyzing annual reports from prominent companies. This fall, they will present the SEC with their findings on how to improve these communications. A winning team will be selected by a panel of experts.

Shareholders Have Right to Open McGraw-Hill’s Books to Investigate Ratings Violations

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

Shareholders of The McGraw-Hill Companies, Inc. (McGraw-Hill) have the right under state law to inspect the company’s books for evidence of possible violations in the ratings for mortgage-backed securities, a New York appellate court has held. Reversing the decision below, the court granted the petitioners’ request for the purpose of investigating claims that Standard & Poor's Financial Services LLC (S&P), a McGraw-Hill subsidiary, issued inflated credit ratings on the securities in order to garner business from the issuers (Retirement Plan for Gen. Empls of the City of N. Miami Beach v. McGraw-Hill Cos., September 11, 2014, per curiam).

Optimistic credit ratings. The petitioners allege that McGraw-Hill’s management directed S&P as a credit rating agency to undertake a strategy of fraudulently issuing positive ratings on residential mortgage-backed securities and other complex financial products. As the complex mortgage-backed securities industry grew, McGraw-Hill allegedly directed S&P to further provide optimistic credit ratings in an effort to attract more business from the issuers and gain more revenue from the other services that S&P provided.

Books and records request. In November 2011, one of the petitioners made a written demand upon McGraw-Hill under the New York Business Corporation Law (BCL) and the common law to inspect books and records relating to the board of directors' oversight and management of S&P and the board's independence. Among other things, the demand sought records concerning policies and procedures regarding the board's oversight of S&P's policies and procedures for issuing credit ratings for mortgage-related securities; and policies and procedures for addressing and managing conflicts of interest, particularly those arising out of the "issuer pays" model for issuing credit ratings.

The parties then engaged in a series of discussions to determine whether they could compromise on the scope of the demand, but McGraw-Hill refused to produce any documents not specifically required under BCL Sec. 624, namely, a record of shareholders, shareholder meeting minutes, and profit and loss statements. When the discussions ultimately proved unfruitful, the petitioners went to court. The Supreme Court denied the petition, finding that the petitioners should have first made a demand upon McGraw-Hill and then, once McGraw-Hill rejected the demand, should have commenced a shareholders' derivative action rather than filing a petition under BCL Sec. 624.

Proper purposes. On appeal, the appellate court reversed, noting that New York law provides shareholders with both statutory and common law rights to inspect a corporation's books and records so long as the shareholders seek the inspection in good faith and for a valid purpose. The shareholders had a proper purpose because they sought to investigate alleged mismanagement and breaches of fiduciary duty by McGraw-Hill’s board in failing to oversee purported wrongdoing by S&P. This alleged wrongdoing, according to the petitioners, exposed McGraw-Hill to substantial potential liability in multiple civil actions and investigations.

Rejecting McGraw-Hill’s contentions, the court reasoned that investigating alleged misconduct by management and obtaining information that may aid legitimate litigation are, in fact, proper purposes for a request under BCL Sec. 624, even if the inspection ultimately establishes that the board had engaged in no wrongdoing. Moreover, because the common law right of inspection is broader than the statutory right, the petitioners were entitled to inspect books and records beyond the specific materials delineated in the statute. Accordingly, the appellate court reversed and remanded the matter for a hearing to determine which records were relevant and necessary for the petitioners' purposes.

The case is No. 12438 650349/13.

Saturday, September 13, 2014

New Financial Services and Stability Czar Established for E.U.

In a groundbreaking move, the new European Commission will have a Commissioner for Financial Services, Financial Stability and Capital Markets, with complete oversight of securities and banking regulation across the E.U. This was generally and formerly the Internal Market portfolio filled by Michel Barnier, except that the new proposed Commissioner, Lord Hill of the U.K., will have a specific financial stability mandate. One reason for the creation of the new portfolio is to ensure that the Commission remains active and vigilant in implementing the new Directives and Regulations enacted in the wake of the financial crisis, especially supervisory and resolution rules for financial firms.

In just a few years the EU has put forward an ambitious and unprecedented series of regulatory and supervisory reforms to secure financial stability and improve the supervision of financial markets. Therefore, the Commission feels that the time has come to focus the existing expertise and responsibility in one place. The next frontier will also be to develop and integrate capital markets which are a better source of credit than bank credit when it comes to financing innovative projects and long-term investment.

The Commissioner for Financial Stability, Financial Services and Capital Markets will also be responsible for relations with the European Banking Authority (EBA); the European Insurance and Occupational Pensions Authority (EIOPA); the European Securities and Markets Authority (ESMA); the European Systemic Risks Board (ESRB) and the Single Resolution Board (SRB, which should be operational from 2015.

The final list of Commissioners-designate was adopted by the E.U. Council. The next and final step is that the European Parliament has to give its consent to the entire College of Commissioners.

Friday, September 12, 2014

New NASAA Working Group Aims to Improve BD Fee Disclosures

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

NASAA has formed a joint working group of state securities regulators and industry representatives in an effort to develop improved disclosures of broker-dealer fees. The formation of the working group follows a NASAA survey in April that uncovered not only a wide disparity in how broker-dealers disclose their fees to customers but also certain questionable practices regarding markups.

Mission. “Investors have a right to know how much they are paying for these services,” said NASAA President Andrea Seidt in a news release. “Our goal is to develop a model fee disclosure that is simple to read, easily accessible, and can be used effectively by investors to understand and compare fees.”

Model disclosure. The working group will consider various options in carrying out its mission, including development of a model fee disclosure form, accessibility and transparency guidelines, uniformity in fee language, and recommendations on how to notify customers of fee changes. When exploring model fee disclosure, the working group will focus on several areas, including presentation, customer comprehension, and timing and methodology of fee disclosure. The working group will also take into consideration the different types of firms comprising the industry, including wirehouse firms, independent broker-dealers, clearing firms, and introducing firms.

Membership. In addition to members of NASAA’s Broker Dealer Section, the working group will include representatives from FINRA, the Securities Industry and Financial Markets Association (SIFMA) and the Financial Services Institute (FSI). The working group will also include broker-dealer representatives from Signator Investments Inc., Prospera Financial Services, LPL Financial, Wells Fargo Advisors, Edward Jones, and Bank of America/Merrill Lynch.

Lack of uniformity. NASAA’s survey was prompted by actions taken by state securities regulators in Connecticut involving inappropriate fees charged by broker-dealers. A project group within NASAA’s Broker-Dealer Section conducted the survey by collecting select fee data from 34 broker-dealers starting in 2012. The survey found that disclosures explaining fees to clients ranged from a single paragraph to seven pages in length. Initial fee disclosures also lacked uniformity, whether by method of disclosure, terminology used, or location of the disclosure.

Questionable markups. In addition, the survey results revealed questionable markups on the fees charged to investors. For example, the project group contacted a clearing firm for a number of the broker-dealers in the survey pool to discern how much the broker-dealer was actually charged for various services and compare those underlying costs with fees charged to the customer. The data revealed that the broker-dealers had reaped a significant windfall by charging high markups for services delivered to their customers. In one case, a broker-dealer charged customers $500 to receive securities in certificate form, more than eight times the $60 cost the clearing firm had charged the broker-dealer for the same service.

Thursday, September 11, 2014

Rep. Hensarling Worries Anew About Financial Regulations

[This story previously appeared in Securities Regulation Daily.]

By Mark S. Nelson, J.D.

House Financial Services Committee Chairman, Jeb Hensarling (R-Tex.), gave a speech yesterday at The Allan P. Kirby, Jr. Center for Constitutional Studies and Citizenship at Hillsdale College in which he reiterated his worries about the growth of federal regulatory agencies’ power generally, and the emergence of new, less transparent financial regulators. Chairman Hensarling’s remarks singled-out the Financial Stability Oversight Council (FSOC) and the Consumer Financial Protection Bureau (CFPB), both Dodd-Frank Act creations, for his strongest criticism.

Chairman Hensarling called the FSOC the “least transparent” of federal agencies that is not among those handling national security or defense matters. Hensarling said he is concerned about the opaque nature of the FSOC’s mostly closed-door meetings and the potential breadth of its recommendations.

The chairman also said he views the Dodd-Frank Act’s reply to the 2008 financial crisis as moving too far to limit risk. Instead, Hensarling says the government should be promoting entrepreneurial risk-taking.

Said Hensarling: “The raison d’etre of the Dodd-Frank Act was the risk of the ‘shadow banking system.’ Yet a far greater danger is instead posed by the ‘shadow regulatory system.’”

As for the CFPB, the chairman said its “Orwellian” name suggests its wide reach. “Arguably, the Bureau is the single most powerful and least accountable federal agency in our nation’s history,” said Hensarling. He noted the CFPB has one appointed director who lacks accountability to the president or to Congress because he can be removed only for cause, and the CFPB skirts the congressional appropriations process. He also noted that the CFPB by law gets deference from courts.

Chairman Hensarling also said the CFPB is now engaged in a broad effort to gather financial data on consumers. The chairman likened this effort to the recently revealed surveillance efforts of the National Security Agency.

The chairman urged passage of the REINS Act, more aggressive use of the congressional budget process, and renewed efforts to expand federalism via use of the Tenth Amendment.

Wednesday, September 10, 2014

House Members Urge New Approach to CLOs and Risk Retention Regulations

Leading House Members are concerned about provisions on open market collateralized loan obligations (CLOs) in the proposed Dodd-Frank risk retention rules and their potential adverse effect on credit availability. In a bi-partisan letter to SEC Chair Mary Jo White and Fed Chair Janet Yellen, Rep. Scott Garrett (R-NJ), Chair of the Capital Markets Subcommittee of the Financial Services Committee, and Rep. Jim Himes (D-CT), a leading member of the Committee, expressed specific concern that the approach outlined in the rc-proposal of the risk retention rules requiring CLO managers to retain 5 percent of the CLO's fair value could impede the issuance of new CLOs. With very limited balance sheets, noted the letter, very few CLO managers could retain a 5 percent share of a CLO.

The House members want to ensure that the risk retention requirements are properly tailored to the unique structure of open market CLOs, which are a vital source of corporate finance. The letter was also signed by Rep. Patrick McHenry, Chair of the Oversight and Investigations Subcommittee. Open market CLOs do not engage in originate to distribute securitizations, noted the House Members, and so simply applying the standard risk retention rules designed for such securitizations to open market CLOs does not make sense.

The legislators asked the SEC and Fed to consider a new approach to risk retention that envisions the creation of a qualified open market CLO that would have to meet a series of strict criteria designed to protect investors and to ensure that a CLO's portfolio is conservatively invested, and that the interests of the CLO manager is aligned with the CLO investors. The House Members believe that this approach could provide a workable solution tor most managers of open market CLOs and ensure the continued flow of credit to companies.

This modified risk retention requirement would apply only to CLOs that meet specific criteria. For example, the portfolio would have to consist almost entirely of U.S. dollar denominated senior secured commercial loans and could contain no re-securitizations or derivatives other than basic interest rate or FX hedges. The portfolio would also have to be diversified such that no more than 3.5 percent of a CLO's assets could relate to any single borrower, and no more than 15 percent of its assets could relate to any single industry, thereby reducing the chance that a few individual defaults could cause significant losses for a CLO investor. The borrowing companies would have to be overwhelmingly based in the United States. The CLO's equity would have to equal at least 8 percent of the value of its assets, which would provide, a substantial cushion for CLO debt investors.

Even more, the qualified CLO approach would require managers of open market CLOs to retain 5 percent of the equity of a qualified CLO rather than 5 percent of fair value. In the view of the House Members, this level of retention would still be a significant commitment for thinly capitalized CLO managers, and would still likely force some managers out of the market. However, this approach would allow most CLO managers to continue to participate in this important market, thereby avoiding a dramatic reduction in CLO financing and resulting harms to the public interest.

PCAOB Alerts Auditors to Standards on Testing Revenue

[This story previously appeared in Securities Regulation Daily.]

By Anne Sherry, J.D.

Its inspections staff having observed significant audit deficiencies with respect to revenue, the PCAOB has issued a Staff Audit Practice Alert highlighting requirements for testing revenue recognition, presentation, disclosure, and controls. The alert notes that the auditing matters are likely to remain relevant under the converged FASB/IASB accounting standard on revenue recognition set to take effect at the end of next year.

Importance. The alert points to the importance of revenue as a driver of a company’s operating results. PCAOB standards require auditors to presume that improper revenue recognition is a fraud risk, and many fraudulent financial reporting cases have involved intentional misstatement of revenue. Because of revenue’s importance, it is a significant area of focus in PCAOB inspections. Inspections staff continue to observe frequently significant audit deficiencies with respect to revenue, according to the alert.

Issues discussed. The practice alert addresses issues surrounding testing revenue recognition, presentation, and disclosure, including testing the recognition of revenue from contractual arrangements; evaluating the presentation of revenue as gross versus net; testing whether revenue was recognized in the correct period; and evaluating whether the financial statements include the required disclosures regarding revenue. Other aspects of testing revenue include responding to fraud risks; testing and evaluating controls over revenue; applying audit sampling procedures to test revenue; performing substantive analytical procedures to test revenue; and testing revenue in companies with multiple locations.

Particular personnel. The paper urges auditors to take note of the matters discussed in planning and performing audit procedures, and audit firms to revisit their audit methodologies and implementation of those methodologies to assure compliance with PCAOB auditing standards. It is particularly important for the engagement partner and senior engagement team members to ensure that engagement teams appropriately implement the auditing standards and for engagement quality reviewers to focus on these matters in their reviews, the staff noted. Finally, audit committees may wish to discuss with their auditors their approach to auditing revenue.

Tuesday, September 09, 2014

SEC Decision Not to Appeal Stanford Ponzi Case Shines Spotlight on Finality of Three-Judge Panel Rulings

The SEC’s decision not to appeal the ruling of a three-judge panel in the Stanford Ponzi scheme to the full DC Circuit sitting en banc or the Supreme Court brings into stark relief the fact that in the federal judicial system the ruling of a three-judge panel of a US Circuit Court of Appeals is the final word over 99 percent of the time. In this case, the panel ruled that investors in the Stanford Ponzi scheme were not customers of the broker-dealer within the meaning of the Securities Investor Protection Act and that the SEC could not compel SIPC liquidation. Three US Senators, David Vitter (R-LA), Roger Wicker (R-MS) and Thad Cochran (R-MS) had urged the SEC to appeal the DC Circuit panel ruling.

An en banc rehearing by a full US Circuit Court of Appeals is becoming as rare or even rarer than the US Supreme Court granting certiorari in a case. A Wall Street Journal editorial recently noted that, since the 1990s the full D.C. Circuit has chosen to rehear merely one or two—and sometimes zero—of the 500 or so cases heard every year. I have read that the US Supreme Court grants certiorari in less than one percent of the petitions it gets. This leaves a three-judge panel as effectively the final arbiters of constitutional and federal regulatory cases of vast and sometimes momentous importance, cases that sometimes have billions of dollars at stake.

Monday, September 08, 2014

House Oversight Chairs Question FSOC SIFI Designation of Insurers

The Chair of the House Capital Markets Subcommittee, Rep. Scott Garrett (R-NJ), and six other members of Congress, including Rep. Spencer Bachus (R-AL), Chair Emeritus of the Financial services Committee, have serious concerns over the lack of empirical analysis leading up to the Financial Stability Oversight Council designation of insurance companies as systemically important financial institutions (SIFIs). In a letter to Treasury Secretary Jacob Lew in his capacity as FSOC Chair, the members noted that FSOC has devoted far less effort to empirical analysis, stakeholder outreach, and transparency in its consideration of insurance companies for SIFI designation than it has for asset management firms. They said that this disparate treatment has created uncertainty in the insurance industry and raised concern that FSOC’s approach to insurance companies is to designate first and ask questions later.

In contrast, while the Council’s treatment of the asset management industry remains problematic, the Office of Financial Research did publish a report on that industry in an effort to conduct a thoughtful analysis. No similar analysis has been done of the insurance industry. Another example of disparate treatment is that, while FSOC has refocused its examination of the asset management sector from asset managers to products and activities, no such similar refocus is underway in the insurance sector

The House leaders are especially disappointed that the OFR has not acted on a recommendation by its Advisory Subcommittee to conduct a detailed study to determine whether and where systemic risk issues may arise in the insurance industry and how such risks are currently being handled.

All that said, the House members asked Secretary Lew to direct the Office of Financial Research to act on the recommendation to conduct a detailed study to determine whether and where systemic risk issues may arise in the insurance industry and how such risks are currently handled in the regulatory framework before designating any additional insurance companies as SIFIs. They also asked him to hold a public conference on the insurance industry similar to the asset management conference held back on May 19, 2014 to better understand the unique risks, challenges and business models of insurance companies. Finally, the Secretary should direct FSOC staff should be directed to undertake a more focused analysis of industry-wide products and activities to assess potential risks associated with the insurance industry, just as the Council is currently doing with regard to the asset management industry before designating one more insurer as a SIFI.

Securities Industry Backs Senate Bill Incentivizing Cyber Sharing

The securities industry strongly supports a Senate bill that would provide a federal tax incentive to businesses and firms that share cyber information. In a statement, SIFMA said that the Cyber Information Sharing Tax Credit Act (S. 2717 ), introduced by Senator Kirsten Gillibrand (D-NY), would address critical cyber security vulnerabilities and incentivize businesses of all sizes to join sector-specific information sharing organizations, known as Information Sharing and Analysis Centers, or ISACs. The bill would provide refundable tax credits for all costs associated with joining the ISACs. The refundable tax credit would cover personnel participation costs, product and service costs directly related to sharing information with the ISAC, as well as other costs reasonably associated with participation.

Senator Gillibrand said that membership in an ISAC will give a small business access to real-time alerts about ongoing cyber threats to their systems, or newly discovered vulnerabilities in their networks that hackers might exploit, along with technical advice on how to protect against these attacks and eliminate their vulnerabilities..

Noting that Cybersecurity is increasingly a major threat to national security and the U.S. financial system, SIFMA said that these information sharing forums, such as the Financial Services ISAC, are critical to the collective cyber defense effort as they enable the industry and government to share threat information and coordinate response protocols.

Friday, September 05, 2014

Sneak Peek at Securities Cases to Be Heard by Supreme Court

[This story previously appeared in Securities Regulation Daily.]

Mark S. Nelson, a legal analyst in the Federal Securities Solutions group at Wolters Kluwer Law & Business, has published a video preview of the securities cases now pending in the Supreme Court. The preview builds on a recent webinar Nelson co-presented with Principal Analyst Jim Hamilton reviewing last year’s Supreme Court decisions for securities practitioners and looking ahead to the upcoming term.

The Supreme Court’s October 2014 term will begin in just over a month from today and already we can expect decisions in three securities cases. Two cases focus on different aspects of Securities Act Section 11: one case will examine the reach of so-called American Pipe tolling, while another case will look directly at the pleading requirements under this provision. A third case may fix the limits of the Sarbanes-Oxley Act’s anti-shredding provision.

Each of these cases involves questions of practical significance to securities lawyers and their clients. These cases also will likely require the Supreme Court to look carefully at earlier, sometimes ambiguous, opinions in order to reach a decision. Nelson’s video explains key aspects of each case and reviews precedents the court may find critical to answering these complex securities law questions.

Thursday, September 04, 2014

Crowdfunding Advocate Urges SEC to Make Private Placement Investments More Widely Available

[This story previously appeared in Securities Regulation Daily.]

By Jacquelyn Lumb

CrowdFund Intermediary Regulatory Advocates (CFIRA), a trade organization that supports the crowdfunding industry, has written to the SEC about the accredited investor standard for purchasers of private securities. In CFIRA’s view, the current standard excludes investors who should be considered appropriate buyers of private securities, such as certified public accountants, chartered financial analysts, registered investment advisers, and others who may not meet the net worth threshold but have the knowledge and experience to evaluate the merits and risks of an investment. The over-arching objective of the federal securities laws is that investors are able to make an informed decision, CFIRA noted. CFIRA does not oppose the use of a financial test to determine investor qualification for private offerings, but recommended that the SEC include an additional standard for qualification based on an investor’s ability to make an informed decision.

CFIRA noted the anomaly of preventing a young investment broker who does not meet the net worth threshold from buying securities in Regulation D offerings, but being able to sell them to clients. The same is true for registered investment advisers, CPAs, and attorneys who advise high net worth clients. These professionals should be viewed as able to fend for themselves based on their education, training, accreditation, and licensing, regardless of annual income or net worth, in CFIRA’s view.

CFIRA also believes that investors who choose to take and pass a standardized test on private placements should be eligible to invest. The test could be similar to the Series 82 examination administered by FINRA, CFIRA explained, and offered its assistance in creating such a test.

Wednesday, September 03, 2014

House Members Urge New Approach to CLOs and Risk Retention Regulations

Leading House Members are concerned about provisions on open market collateralized loan obligations (CLOs) in the proposed Dodd-Frank risk retention rules and their potential adverse effect on credit availability. In a bi-partisan letter to SEC Chair Mary Jo White and Fed Chair Janet Yellen, Rep. Scott Garrett (R-NJ), Chair of the Capital Markets Subcommittee of the Financial Services Committee, and Rep. Jim Himes (D-CT), a leading member of the Committee, expressed specific concern that the approach outlined in the rc-proposal of the risk retention rules requiring CLO managers to retain 5 percent of the CLO's fair value could impede the issuance of new CLOs. With very limited balance sheets, noted the letter, very few CLO managers could retain a 5 percent share of a CLO.

The House members want to ensure that the risk retention requirements are properly tailored to the unique structure of open market CLOs, which are a vital source of corporate finance. The letter was also signed by Rep. Patrick McHenry, Chair of the Oversight and Investigations Subcommittee. Open market CLOs do not engage in originate to distribute securitizations, noted the House Members, and so simply applying the standard risk retention rules designed for such securitizations to open market CLOs does not make sense.

The legislators asked the SEC and Fed to consider a new approach to risk retention that envisions the creation of a qualified open market CLO that would have to meet a series of strict criteria designed to protect investors and to ensure that a CLO's portfolio is conservatively invested, and that the interests of the CLO manager is aligned with the CLO investors. The House Members believe that this approach could provide a workable solution tor most managers of open market CLOs and ensure the continued flow of credit to companies.

This modified risk retention requirement would apply only to CLOs that meet specific criteria. For example, the portfolio would have to consist almost entirely of U.S. dollar denominated senior secured commercial loans and could contain no re-securitizations or derivatives other than basic interest rate or FX hedges. The portfolio would also have to be diversified such that no more than 3.5 percent of a CLO's assets could relate to any single borrower, and no more than 15 percent of its assets could relate to any single industry, thereby reducing the chance that a few individual defaults could cause significant losses for a CLO investor. The borrowing companies would have to be overwhelmingly based in the United States. The CLO's equity would have to equal at least 8 percent of the value of its assets, which would provide, a substantial cushion for CLO debt investors.

CFTC Says It Properly Approved CME Rule in Swap Reporting Dispute

[This story previously appeared in Securities Regulation Daily.]

By Lene Powell, J.D.

In a conflict over whether derivatives clearinghouses may require swap data reporting to their own captive swap data repositories, the CFTC said it properly approved a CME Group rule that set forth such a requirement, and that rival depository DTCC’s assertion that the CFTC’s approval of the CME rule was “arbitrary and capricious” was wrong (DTCC Data Repository (U.S.) LLC v. CFTC, August 28, 2014).

Swap reporting dispute. As part of comprehensive swaps reform, the Dodd-Frank Act created a new entity, "swap data repository" (SDR) which provides a central facility for swap data reporting and recordkeeping. All swaps must be reported to registered SDRs. The Depository Trust & Clearing Corporation (DTCC) and the CME Group both have registered repositories.

Against the opposition of DTCC, the CME Group gained CFTC approval in March 2013 to require that information about swap transactions to be reported to its own captive data repository. Under the approved CME rule, for all swaps cleared by the CME's clearing house, the CME reports creation and continuation data to CME's own swap data repository. At the request of a swap counterparty, the CME will also send a duplicate of the data to a second SDR.

In May 2013, DTCC sued the CFTC in federal district court, arguing that the agency’s approval of the CME rule and withdrawal of previously published staff-issued FAQs violated the Commodity Exchange Act (CEA) and Administrative Procedure Act (APA), as well as pro-competitive core principles and mandates of the Dodd-Frank Act. Specifically, DTCC contended that the Commission violated the APA by not conducting full notice and comment rulemaking proceedings and not preparing cost-benefit analyses for the withdrawal of the FAQs and the review of CME Rule 1001. DTCC asked the court to declare the CFTC's approval of the CME rule void.

CFTC’s approval of the CME rule. Both sides moved for summary judgment. In its memorandum, the CFTC said that it properly approved CME Rule 1001 using normal statutory procedures for approving a registered entity’s self-regulatory rule, rather than APA notice-and-comment rulemaking procedures applicable to CFTC regulations.

First, said the CFTC, CME Rule 1001 was not a CFTC rule, but a self-regulatory rule of an entity registered with the CFTC. Under 7 U.S.C. § 7a-2(c), the applicable statutory standard for self-regulatory rule approvals, the CFTC was required to approve the CME rule unless it found that the rule was “inconsistent” with the CEA or CFTC regulations. Because it was not, the CFTC’s approval of the rule was “perfectly legitimate” under the APA.

Second, the CFTC did not amend its own regulations by approving the CME rule. The FAQs issued by the CFTC were a non-binding staff interpretation, and thus the CFTC was not required to engage in notice-and-comment rulemaking before reaching conclusions that differed from statements in the FAQ. The CFTC’s Part 45 regulations do not grant entities a right to select the SDR that receive swap data, as asserted by DTCC. In fact, the CFTC deliberately declined to create a right to select the SDR, because in practice such a rule could give an SDR substantially owned by swap dealers—like DTCC’s SDR—a dominant market position with respect to swap data reporting within its asset class or even all swaps.

The CFTC noted that because all SDRs are registered with the CFTC and subject to the same requirements, the CFTC does not have a stake in which SDR receives the swap data, only that the data is reported to an SDR.

Pro-competitive mandates. The CFTC said the court should reject DTCC’s claim that the CFTC was arbitrary and capricious for approving CME Rule 1001, notwithstanding DTCC’s arguments about anticompetitive effects. First, the CFTC was not required to undertake an antitrust analysis under 7 U.S.C. § 19(b) before approving the CME rule. That statutory section applies only to rules of a contract market or registered futures association, and CME Rule 1001 is a rule of CME Clearing, a registered derivatives clearing organization (DCO), which is neither a contract market nor a futures association.

In addition, although the CFTC was not required to conduct an antitrust analysis under 7 U.S.C. § 19(b), the agency did consider the substantive points that DTCC raised related to that section, along with Core Principle N, a provision that forbids a DCO from adopting any rule that results in an “unreasonable restraint of trade,” or imposing any “material anticompetitive burden,” unless necessary or appropriate to achieve the purposes of the CEA. The record before the agency indicated that DTCC—not CME—received the lion’s share of cleared swap data reporting. The CFTC considered market power in individual asset classes for CME, and concluded that CME did not have market power in either interest rate swaps or credit swaps, or in the provision of clearing services for swaps by CFTC-registered DCOs.

As to DTCC’s contention that CME’s market share of cleared swaps has grown with the passage of time, the CFTC observed that this was not in the administrative record when the CFTC was considering CME Rule 1001, and was therefore not properly before the court.

The case is No. 1:13-cv-00624-ABJ.

Tuesday, September 02, 2014

Dissenting Commissioners Decry Changes to New Credit Rating Agency Rules

[This story previously appeared in Securities Regulation Daily.]

By John Filar Atwood

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

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

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

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

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

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

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

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

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

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

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

Monday, September 01, 2014

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

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

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

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

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

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

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

Friday, August 29, 2014

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thursday, August 28, 2014

SEC Proposes 12-Month Pilot Program on Wider Tick Sizes

[This story previously appeared in Securities Regulation Daily.]

By Amanda Maine, J.D.

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

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

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

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

Wednesday, August 27, 2014

House and Senate Members Ask Fed to Tighten Emergency Lending Proposals

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

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

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

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

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

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

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

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

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