Emergency Economic Stabilization Act Bonus Forfeiture Provision Differs from Similar Sarbanes-Oxley Provision

It should be noted that the forfeiture standards under section 111(b)(2)(B) of the Emergency Economic Stabilization Act differ significantly differ from the forfeiture provisions of section 304 of the Sarbanes-Oxley Act. With regard to financial institutions participating in the Treasury’s troubled asset relief program, section 111(b)(2)(B) states that the firm must provide for the recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.

Section 304 of Sarbanes-Oxley requires the forfeiture by a public company's chief executive officer and chief financial officer of any bonus, incentive-based compensation, or equity-based compensation received, and any profits from sales of the company's securities, during the twelve-month period following a materially non-compliant financial
report. Section 111(b)(2)(B) differs from section 304 because, first, the standard under section 111(b)(2)(B) applies more broadly to the three most highly compensated executive officers in addition to the CEO and CFO.

The EESA statute also applies to both public and private financial institutions, while section 304 applies only to public companies. In addition, while section 304 is exclusively triggered by an accounting restatement; section 111(b)(2)(B is not, nor does the latter limit the recovery period. Further, the EESA provision covers not only material inaccuracies relating to financial reporting, as Sarbanes-Oxley does, but also material inaccuracies relating to other performance metrics used to award bonuses and incentive compensation.

Compensation Committee Given Duties under TARP Regime set up by Emergency Economic Stabilization Act

The Treasury regulations for financial institutions participating in the troubled asset relief program (TARP) under the Emergency Economic Stabilization Act require compensation committees to meet, within 90 days after a purchase under the program, with senior risk officers to ensure that the firm’s incentive compensation arrangements do not encourage senior executive officers to take unnecessary and excessive risks that might threaten the value of the financial institution. After that, the compensation committee must meet annually with senior risk officers to review the relationship between the financial institution’s risk management policies and the executive compensation arrangements. Also, the compensation committee must certify in the firm’s Compensation Disclosure & Analysis required by the SEC that they have done so in order to assure investors and taxpayers that the institutions are complying with the requirements.

Because each financial institution faces different material risks given the unique nature of its business and the markets in which it operates, Treasury advises that the compensation committee should discuss with the senior risk officers the risks that the firm faces that could threaten the value of the financial institution. The compensation committee should identify the features in the financial institution's executive incentive compensation arrangements that could lead covered executive to take such risks. Any such features should be limited in order to ensure that the covered executives are not encouraged to take risks that are unnecessary or excessive.

As noted, the compensation committee must certify that it has reviewed, with the financial institution's senior risk officers, the executive incentive compensation arrangements to ensure that they do not encourage the executives to take unnecessary and excessive risks. According to Treasury, the following statement would satisfy this standard: ``The compensation committee certifies that it has reviewed with senior risk officers the SEO incentive compensation arrangements and has made reasonable efforts to ensure that such arrangements do not encourage SEOs to take unnecessary and excessive risks that threaten the value of the financial institution.''

House Leaders Demand Hedge Funds Drop Opposition to Foreclosure Prevention

In a letter to two hedge funds and the Managed Funds Association, House Financial Services Committee leaders, led by Chairman Barney Frank, expressed their outrage at a report that at least two hedge funds have warned companies servicing mortgages that they should not take advantage of the American Housing Rescue and Foreclosure Prevention Act. In the letter to the MFA, the House leaders asked the association to let them know if any other hedge funds are taking a similar position.

Congress passed overwhelmingly provisions providing for a reasonable modification of mortgages that clearly never should have been granted in the first place to avoid foreclosure and thus lessen the economic damage that a cascade of foreclosures has been doing to the economy, said the leaders. Congress has been criticized by some in the consumer community for not doing more to pressure institutions to avoid foreclosure while minimizing their losses.

In light of this, the House leaders were outraged to read that two hedge funds were instructing the servicers of their mortgages to defy this national program and insist on further socially and economically damaging foreclosures. The Act clearly allows for modification where such changes would involve a lesser loss than foreclosure. It is intolerable for hedge funds, which have been the beneficiary of a lack of regulation, to impede this important national policy. The letters urge the funds to reverse this policy.

Auction Rate Securities Dealers Ask Treasury for Liquidity Facility under Emergency Economic Stabilization Act

As the financial crisis deepens, auction rate securities dealers have asked the Treasury to offer a standby liquidity facility to issuers of such securities, for which the issuers would pay a commitment fee. The dealers maintain that Treasury has the authority to do this under the Emergency Economic Stabilization Act. The auction rate securities market has been frozen for the past eight months, leaving retail investors with long-term bonds that they couldn’t sell.

The dealers group told Treasury that the market collapsed despite the fact that the credit quality of most auction rate securities has not deteriorated significantly. According to the dealers, problems in the auction rate securities market are principally related to illiquidity, deleveraging and dysfunction in the broader financial markets, and not to credit deterioration related to these products specifically.

In the letter to Treasury, the Regional Bond Dealers Association said that the Act authorizes Treasury to take actions that could significantly improve conditions for auction rate securities and could help avoid a circumstance where liquidity constrained banks are forced to buy a large volume of illiquid securities. Specifically, the association cited Section 101 of the Act, which authorizes Treasury to purchase, and to make and fund commitments to purchase, troubled assets; and Section 102, which requires Treasury to establish a program to guarantee troubled assets originated or issued prior to March 14, 2008.

The dealers group believes that either of these authorities, but especially the authority provided in Section 101, allows the establishment of a program under which Treasury would offer the equivalent of standby bond purchase agreements for variable rate demand notes issuers whose liquidity facilities are expiring and for auction rate securities issuers who want to convert their securities to variable rate demand notes to restore liquidity to investors.

Under the program proposed by the association, Treasury would offer a standby liquidity facility to issuers of auction rate securities originally sold before March 14, 2008 secured by whatever assets are currently supporting outstanding auction rate securities. Issuers would pay a commitment fee, in today’s market this fee is typically 0.45 to 0.55 percent, for the facility.

The issuers would exchange new variable rate demand notes backed by the liquidity facilities for outstanding auction rate securities. The association expects that many of the new demand notes would be eligible for investment by money market mutual funds subject to regulation under SEC Rule 2a-7. In the view of the dealers, these actions would open up a new source of demand for issuers whose auction rate securities are generally not currently eligible for investment by these funds.

The dealers group believes that safe, stable variable rate securities supported by a Treasury liquidity facility would appeal to a broad range of investors. It is unlikely that the facility provided by Treasury would be drawn on to a significant extent, said the group, because its mere existence would likely provide confidence to investors and restore normalcy to the market for the affected products.

If it did buy assets under the program, Treasury would earn interest at maximum penalty rates that would likely exceed its own cost of funds and would, in that regard, have a positive carry. In any case, Treasury would earn revenue from commitment fees. More broadly, the proposed liquidity would help an orderly market emerge for hundreds of billions of dollars of assets frozen on the balance sheets of banks, broker-dealers and investors.

PCAOB Suspends Audit Firm's Registration for Numerous Violations of Board Standards

The PCAOB has suspended the registration of an audit firm for at least five years for conducting deficient audits replete with numerous violations of auditing standards and violations of Board audit documentation standards. In conducting the audits of four issuer clients, the audit firm failed to perform the most basic functions and procedures required to evaluate the financial statements. Two audit partners at the firm were barred from the industry for at least five years. The two partners alternated between performing as engagement partner and concurring review partner on the various audits. The firm and its partners settled the action without either admitting or denying the Board’s findings. In the Matter of Jaspers + Hall, PC, Thomas M. Jaspers, CPA, and Patrick A. Hall, CPA., Release No. 105-2008-002.

The Board found that the auditor failed to perform adequate, or sometimes any, audit procedures in areas such as cash, deferred revenue, business acquisition accounting, income taxes, related party transactions, and using the work of specialists. In addition, the firm failed to plan the audits, prepare audit programs, and prepare audit completion documents. The auditor also failed to identify and appropriately address departures from GAAP concerning contingencies. And, finally, the auditor failed to retain audit documentation for the period required by PCAOB standards.

In one audit, the auditor failed to perform sufficient procedures to verify the existence of $155 million in cash, which represented 57 percent of the client’s reported assets. When an account confirmation request to the bank proved unavailing, the auditor failed to perform alternative procedures to verify that the issuer had the cash. Similarly, the auditor also failed to perform any procedures or gather any evidence concerning a reported deferred tax benefit representing 67.7 percent of the issuer’s net earnings.

The audit was deficient in various other respects as well. Specifically, the auditor failed to comply with PCAOB standards requiring it to obtain written representations concerning management's belief that the financial statements were fairly presented in conformity with GAAP. The auditor also failed to document an understanding with the client regarding the services to be performed for each engagement. The auditor also used the work of a valuation specialist in performing the audit but, in violation of PCAOB standards, failed to evaluate the professional qualifications of the specialist, failed to test the data the issuer provided to the specialist, and failed to obtain an understanding of the assumptions used by the specialist in its valuations.

The auditor also violated a PCAOB standard requiring it to retain audit documentation for seven years. The auditor failed to retain significant portions of its documentation for the required period and was unable to provide the documentation in response to the demands of a PCAOB investigator.

In another separate audit, the partners failed to perform any procedures to test the values an issuer assigned to the tangible assets acquired and the liabilities assumed in a business combination. They also failed to perform any procedures concerning the company’s reported acquisition expenses.

The Board found that they also failed to perform any audit procedures with respect to the goodwill that the client initially recorded upon consummating the business combination, but then completely wrote off only three months later. More specifically, the auditor did not review any impairment test on the goodwill and failed to perform any procedures to test management's conclusion that the goodwill should be written off.

In yet another audit, the Board found that the auditor failed to adequately consider the risk of fraud. PCAOB standards on fraud risk require an auditor to gain an understanding of the business rationale for transactions that are outside the normal course of business, or that otherwise appear to be unusual. In violation of those standards, the auditor failed to ascertain the business purpose of several unusual expenses reflected on the issuer’s credit card statements. The auditor failed to evaluate whether those unusual expenses were individually, or in the aggregate, qualitatively material to the client’s financial statements.

UK FSA Sets Best Practices for Executive Compensation at Financial Firms

There is growing concern that inappropriate executive compensation schemes at investment banking and trading firms may have contributed to the present market crisis. Specifically, remuneration structures of firms may have been inconsistent with sound risk management since they frequently gave incentives to pursue risky policies, undermining the impact of systems designed to control risk. With that in mind, the UK Financial Services Authority has set forth best practices for executive compensation. While the FSA has no wish to become involved in setting remuneration levels, since that is a matter for boards, the authority wants to ensure that firms follow remuneration policies which are aligned with sound risk management systems and controls, and also with the firm's stated risk appetite. In a Dear CEO letter, the FSA warned that compensation policies not aligned with sound risk management will be unacceptable.

The FSA wants compensation calculated on profits and not on the basis of revenues. Compensation should take into account a range of risks, including liquidity risk, and not take capital cost into account. Bonuses should not be calculated solely on the basis of financial performance. Rather, in addition to performance, bonuses must take into account risk management skills and adherence to company values.

Importantly, the FSA wants the fixed component of the executive compensation package to be large enough to meet the employee’s essential financial commitments. Also, compensation should never be wholly paid in cash, but rather should be a mix of cash and components designed to encourage good corporate citizenship. Deferred compensation should be calculated on a performance measure averaging over several years.

There must also be sound corporate governance of executive compensation centered on an independent board compensation committee with effective controls of firm-wide compensation policies and even larger individual awards. Risk management must play a strong role in setting compensation, with the compensation of risk managers determined independently of the business area. Along with this, there must be a transparent process for managing conflicts of interest. Further, valuations and risk reporting must be subject to independent verification.

Congress May Form Select Committee to Reform Financial Regulation

The idea of forming a special Congressional committee to reform the entire spectrum of financial regulation is gaining ground as the 110th Congress moves towards a close. In addition to a recent Wall Street Journal piece espousing this idea, in testimony before the House Financial Services Committee, Joel Seligman urged each house of Congress to create a Select Committee to provide a focused and less contentious review of what should be done. The co-author of the prestigious Loss-Seligman-Paredes treatise of securities regulation reasoned that the most difficult issues in discussing appropriate reform of the regulatory system become far more difficult when multiple Congressional committees with conflicting jurisdictions address overlapping issues.

In the reform that is coming, he continued, it is important that all appropriate alternatives be considered, including consolidating regulatory agencies, creating new regulatory agencies and transferring jurisdiction. This type of review is far more likely to succeed before a single Select Committee, presumably including the chairs or appropriate representatives from the existing oversight committees.

In his view, the one reason that the idea of merging the SEC and CFTC has never received serious Congressional consideration is that the SEC and the CFTC were subject to separate Congressional oversight committees. The most likely way in which there can be a mature consideration of the wisdom of consolidation of the SEC and CFTC would be to vest in a single committee in each house of Congress oversight responsibility for all stocks, stock options, and financial futures (or all futures). Similarly, the most likely way there could be mature consideration of broader types of financial regulatory consolidation today would involve vesting in a single committee in each house of Congress oversight responsibility over all relevant financial agencies.

Panelists Address Securities Litigation Landscape

By James Hamilton, J.D., LL.M.

Panelists at the Practising Law Institute's Securities Litigation and Enforcement Institute described a litigation environment that has changed dramatically in recent years. Major Supreme Court decisions such as Dura, Tellabs and Stoneridge have reshaped the scope and pleading requirements for class actions, while the market turmoil has complicated the requirement of pleading firm-specific fraud when stock prices are declining across the board.

Sherrie R. Savett of the Philadelphia firm of Berger & Montague said that the market collapse is not necessarily fatal to plaintiffs in class action fraud cases. She advised that the pleadings should focus on statements made by potential defendants, and suggested that good cases could be made in instances of 1) underwriting failures, 2) failures to disclose exposure before the risk is quantified, 3) accounting improprieties and 4) failure to disclose liquidity problems.

Reed Kathrein of Higgins Berman Sobol Shapiro LLP in San Francisco pointed out that many actions that might have been brought as federal securities class actions are now being brought as derivative claims or actions for breaches of fiduciary duties in state courts. One key problem facing plaintiffs today, Mr. Kathrein noted, is the issue of collectability, as companies file for bankruptcy protection and banks are shuttered. Ms. Savett added that the universe of potential defendants has also been restricted in light of the Stoneridge decision on scheme liability.

Trends

With regard to litigation trends, Bruce G. Vanyo of Katten Muchin Rosenman LLP in Los Angeles observed more than half of the class action cases filed in the first half of 2008, involving claims for more than $4.5 billion, arose from the subprime credit crisis. Much of the activity has been located in New York, as the Southern District of New York has seen nearly as many cases filed in the first half of 2008 as in all of 2007.

Mr. Vanyo did suggest, however, that the common perception that a dramatic stock drop necessarily results in litigation may be misplaced. In the first three months of 2008, only nine percent of issuers who experienced a short-term stock price drop of 30 percent were sued within those 90 days. The number increases to 31 percent, however, if the issuer experienced a 40 percent stock drop.

John P. "Sean" Coffey of Bernstein Litowitz Berger & Grossman LLP in New York suggested that in terms of the decline in traditional securities fraud filings, as opposed to the subprime cases, may be explained in part because of a real decline in fraud. The Sarbanes-Oxley Act has been effective, he said, and the elimination of consulting work from audit firm practice has contributed to better financial reporting.

In terms of the disposition of fraud cases, settlements remain the most common result. Mr. Vanyo said that approximately two-thirds of cases settle, while about a third are dismissed.

Supreme Court Cases

Three recent cases, Dura, Tellabs and Stoneridge, have had a significant impact on securities litigation. With regard to Dura, concerning loss causation, Ms. Savett said that the holding has practically turned the pleading stage of the cases into motions for summary judgment. While she said that the common-sense connection between fraud and loss must be meticulous, she asserted that a "mirror image" relationship between disclosures and stock price changes should not be needed. Experts should be involved from the beginning of the case, she advised.

According to Mr. Vanyo, the result of the Tellabs scienter pleading case was a draw between plaintiffs and defendants. Mr. Coffey said the case could have been a disaster for plaintiffs, as scienter is an element of every case, but that the actual result was not necessarily drastic, as the ruling actually eased the standard in the 1st, 6th and 8th Circuits. Jonathan C. Dickey of Gibson Dunn & Crutcher in New York cautioned, however, that this split between the circuits and the approach to scienter could result in a "balkanization" of securities litigation and circuit-specific pleading.

Finally, Mr. Kathrein described Stoneridge as a case that dealt with reliance rather than particular conduct by the participants. Because the defendants, vendors who contracted with the issuer, made no statements, the plaintiffs could not establish reliance. Although Mr. Kathrein distinguished between third-party conduct in this commercial environment rather than alleged misconduct by financial firms such as investment banks, the panelists largely agreed that Stoneridge significantly narrowed the scope of available defendants.

House Leaders Outline Principles for Regulatory Overhaul

In recent House hearings on the future of financial regulation, leaders of the Financial Services Committee set forth principles for the complete overhaul of the regulatory regime. Rep. Paul Kanjorski, a senior committee member, laid down broad principles to guide reform. He said that transparency must be enhanced regarding complex financial products; and hedge funds and private equity firms must disclose more about their activities. The markets for credit default swaps and other derivatives must also operate more openly and under regulation. Banking and securities must be separate, he continued, and all financial institutions must soundly manage their risks. In his view, regulators must be consolidated into fewer agencies, while enforcement is enhanced at the same time.

There is also a growing consensus for a Financial Products Safety Commission, patterned after the Consumer Products Safety Commission, to vet financial products for investors. Rep. Jackie Spier suggested that, rather than create a new agency; the SEC could be transformed into something capable of protecting investors from overly-risky financial products. In the view of Rep. Ron Klein, a new evolving version of the SEC or CFTC or combination of the two, could give confidence to investors on new complex financial products, or it may have to be a new Financial Product Safety Commission. But in any event, there is a need to rethink and put in place a regulatory and oversight organization that promotes good business practices and gives clear information to consumers so they can make informed investment decisions.

UK Amends Audit Committee Guidance; Factors for Using Multiple Audit Networks Set Out

The UK Guidance for Audit Committees (Smith Guidance) has been amended with a mixture of changes to best practices and additional disclosures to be made in the annual report. The guidance also now includes factors a company should consider when it is contemplating employing firms from more than one audit network to undertake the audit.

The guidance now encourages audit committees to consider the need to include the risk of the withdrawal of their auditor from the market in their risk evaluation and planning. Companies are also encouraged to include in the audit committee’s report information on the appointment, reappointment or removal of the auditor, including supporting information on tendering frequency, the tenure of the incumbent auditor and any contractual obligations that acted to restrict the committee’s choice of auditor.

It is common practice to appoint one firm to audit the parent group and the consolidated group accounts. This firm then uses other firms from within its international network to carry out audit work on components that are needed for group audit purposes. It is common for the same firms to carry out statutory audits of subsidiaries where these are needed.

The guidance recognizes, however, that in some circumstances it may be appropriate to use a firm from more than one audit network to achieve a high quality and cost-effective audit. The company would still appoint a single firm to audit the parent company and the group's consolidated financial statements. However, the group would agree with the group auditor that for some components the audit work that is needed for group audit purposes will be carried out by one or more firms from other networks.

In assessing the use of firms from more than one network, audit committees should consider how the group auditor will assess the independence and professional competence of the firms from other networks. Companies should also consider how the group auditor will ensure that they are familiar with the methodology of the other firms, in order to enable them to evaluate the audit evidence obtained. In addition, the guidance instructs the company to consider the arrangements the group auditor will make with different networks to ensure that they communicate effectively with each other. Finally, the company should examine the overall costs and benefits associated with using firms from more than one network, as well as what costs will be attached to the group auditor assessing firms from other networks, evaluating audit evidence obtained by them, and
addressing any issues.

Fed Gov Kroszner Says Survival of Financial Institutions Hinges on Strategic Risk Management

Financial institutions will not survive the coming radical transformation in financial services unless they implement a strategic risk management framework, in the view of Federal Reserve Board Governor Randall S. Kroszner. In remarks at the annual risk management conference in Baltimore, he said that strategic risk management must be interwoven into all aspects of the firm's business and should be part of the calculus for all decision-making. Strategic decisions about what activities to undertake should not be made unless senior management understands the risks involved, he added.

In building a rigorous strategic risk management framework, he continued, financial institutions must reexamine both their internal practices and their external environment, and understand how closely the two are connected. In other words, external factors have an impact on internal practices, but those internal practices, because financial markets are so interconnected, can in turn have an impact on how the institution is viewed externally.

Whether transactions take place on an organized exchange or in the so-called over the counter market is another important aspect of the strategic risk management choices undertaken by an organization. When contracts are traded on an exchange, clearing and settlement, for example, may have less uncertainty associated with them. In addition, an exchange that has a centralized counterparty can reduce uncertainty about counterparty risk and help avoid market dislocations that can arise from such uncertainty. Thus, market infrastructure and its impact on how organizations are connected to each other can have a large impact on market confidence in times of stress.

Noting that compensation is also linked to risk management, the senior official said that a good risk-sensitive compensation regime, properly embedded in a strong strategic risk management framework, can bring about changes in behavior so that the firm's employees refrain from taking on risk beyond the firm's risk appetite

According to the governor, a risk-sensitive compensation framework will help provide the right employee incentives and establish a better link between the actions of those employees and the firm's overall risk profile. Institutions should be particularly sensitive to employee activities that could either impair access to funding or disrupt liquidity. Directors must understand the consequences of providing too many short-term and one-sided incentives.

He suggested the use of deferred compensation, since the risks of certain investments or trades may not manifest themselves in the near term. It also makes sense to try to match the tenor of compensation with the tenor of the risk profile and, thus explicitly, take into account the longer-run performance of the portfolio or division in which the employee operates.

FASB and IASB Propose Joint Enhancements to Presentation of Financial Statements

Culminating four years of joint effort, the IASB and FASB have proposed enhancing the presentation of financial statements based on the twin principles of cohesiveness and disaggregation. Currently, IFRS and U.S. GAAP provide little specific guidance on the presentation of line items in financial statements, such as the level of detail or number of line items that should be presented. The proposal is designed to create the most transparent, consistent financial reporting possible by creating one common, high-quality global standard for financial statement presentation. Public comment is invited until April 14, 2009.

Cohesiveness would ensure that a reader of financial statements can follow the flow of information through the different statements of an entity; while disaggregation would ensure that items that respond differently to economic events are shown separately. To present a cohesive set of financial statements, a company should align the line items, their descriptions, and the order of presentation of information in the statements of financial position, comprehensive income, and cash flows. To the extent that it is practical, a company should disaggregate, label, and total individual items similarly in each statement. In the view of the Boards, doing so should present a cohesive relationship at the line item level among individual assets, liabilities, income, expense, and cash flow items.

Under the new presentation scheme, the statement of financial position would be grouped by major activities (operating, investing, and financing), not by assets, liabilities, and equity as it is today. The presentation of assets and liabilities in the business and financing sections will clearly communicate the net assets that management uses in its business and financing activities. That change in presentation, coupled with the separation of business and financing activities in the statements of comprehensive income and cash flows, should make it easier for users to calculate some key financial ratios for a firm’s business activities or its financing activities.

Thus, generally, the proposed presentation model would require a company to present information about its business activities separately from information about the way it funds or finances those business activities. Further, a company should further separate information about its business activities by presenting information about its operating activities separately from information about its investing activities. More granularly, a company should present information about the financing of its business activities separately depending on the source of that financing. For example, information about non-owner sources of finance should be presented separately from owner sources of finance.

In the same spirit, a company should present information about its discontinued operations separately from its continuing business and financing activities. It should also present information about its income taxes separately from all other information in the statements of financial position and cash flows. Assets and liabilities would be disaggregated into short-term and long-term subcategories within each category unless an entity believes presenting assets and liabilities in order of liquidity provides more relevant information.

The proposed presentation model eliminates the choice a company currently has of presenting components of income and expense in an income statement and a statement of comprehensive income (two-statement approach) or, alternatively, of presenting information about other comprehensive income in its statement of changes in equity (U.S. GAAP only). Under the new regime, all companies would present a single statement of comprehensive income, with items of other comprehensive income presented in a separate section.

IAASB Issues Practice Alert for Auditors on Fair Value Accounting

As the debate over fair value accounting rages, and the FASB and IASB have moved to ameliorate fair value accounting standards, the International Auditing and Assurance Standards Board has issued a practice alert to assist auditors of financial statements in this time of market uncertainty. The practice alert follows on an earlier PCAOB audit practice alert on matters related to auditing fair value measurements of financial instruments. The IAASB’s practice alert is similar to the PCAOB’s practice alert, which highlighted requirements in the auditing standards related to fair value measurements and disclosures in the financial statements and certain aspects of GAAP that are particularly relevant to the current economic environment. The IAASB focused on IFRS rather than GAAP.

According to the IAASB, obtaining reliable information relevant to fair values in the current climate has been one of the greatest challenges faced by preparers, and conse­quently by auditors. The nature and reliability of informa­tion available to management to support the making of a fair value accounting estimate varies widely, and thereby affects the degree of estimation uncertainty associated with that fair value. If markets become inactive, said the Board, market price information becomes unavailable and estimates need to be made on the basis of other information, often using models, some of which incorporate inputs that are unobservable.

International Auditing Standard No. 545 establishes standards and provides guidance on audit­ing fair value measurements and disclosures contained in financial statements. At the end of day, under IAS 545, the issuer’s management is responsible for establishing an accounting and financial reporting process for determining fair value measurements. The standard deals with the overarching requirement for the auditor to obtain sufficient appropriate audit evidence that fair value measurements and disclosures are in accordance with the entity’s applicable financial reporting frame­work. The auditor must also understand the measurement process, no matter how complex, in order to identify and assess the risks of material misstatement in order to determine the nature, timing and extent of the further audit procedures.

In an illiquid market, the degree of estimation uncertainty increases and affects, in turn, the risks of material misstatement. What may in the past have been a routine valuation problem may become the source of a significant risk. In such circumstances, said the Board, there are limits to the infor­mation that management possesses or can obtain and that therefore may be available to the auditor as audit evidence. Nevertheless, whether inputs are observable or not, preparers of financial statements need to have evidence to support them, emphasized the Board, and auditors need to obtain sufficient appropriate audit evidence recognizing that the evidence may be different from what has previously been available.

While estimation of fair values has proved to be extremely difficult in light of market uncertainty, it has not proved impossible to obtain sufficient information to record these fair values in financial statements. Also, while fair values are commonly thought to relate primar­ily to financial assets and financial liabilities, the use of fair value is more widespread. Depending on the financial reporting framework, the impact of fair value accounting may be seen with regard to management’s determination of pension liabilities, the value of goodwill and intangibles acquired in a business combination, real estate, endowment funds, share-based payments, non-monetary exchanges and other classes of assets and liabilities.

FSA CEO Examines Hedge Fund Valuations and Transparency

While noting that hedge funds were not the catalyst of the market crisis, UK Financial Services CEO Hector Sants said that reform of hedge fund valuations and transparency will be needed to restore investor confidence. In remarks at the 2008 Hedge Fund Conference, he urged hedge funds to comply with the principles adopted by the Hedge Fund Standards Board. The official said that the FSA will take compliance with these standards into account when making judgments on ensuring compliance by hedge fund managers with FSA regulations. The principles are on a comply or explain basis and include valuation, disclosure, and risk management guidelines.

He emphasized that transparent valuations are vital to FSA regulation. The FSA, which supports the IOSCO valuation principles, considers it a best practice for hedge fund managers to compare their policies, sources, and methodology for obtaining values against these and other industry standards. Valuation policies must be regularly reviewed to take account of changes in circumstances. Changes to methodologies arising from current turmoil, for instance in the use of side pockets, need to be disclosed to investors. When portfolios are misvalued, and where performance has been poor, the pressure on hedge fund managers to provide overstated valuations is greatest. In his view, weak systems, inadequate valuation policies and inadequate independent challenge of price verification all increase the susceptibility of firms to the risk of mismarked frauds.

The official urged hedge fund managers to look for guidance in this area to a recent Dear Chief Executive Letter to the CEOs of banks and investment firms with large and/or complex principal trading operations. This letter spoke of valuation processes that were flawed and the need for adequate valuation controls; and sets out prudent valuation principles.
On the transparency front, his remarks focused on the disclosure of contracts for difference and other derivatives. A contract for difference is a share in a derivative product giving the holder an economic exposure to the change in price of a specific share over the life of the contract. Hedge funds are the typical holders of contracts of difference, which allow them to take an economic exposure to a movement in the referenced share at a small fraction of the cost of securing a similar exposure by acquiring the shares themselves

While contracts for difference can provide valuable liquidity to the market, said the CEO, the problems caused by their use on an undisclosed basis must be addressed. In July, the FSA, in an effort to prevent hedge funds and other market participants from using contracts for difference to influence corporate governance and build up undisclosed stakes in companies, proposed requiring disclosure of interests in a company’s shares held through derivatives, such as contracts of difference. The new disclosure regime would make it harder for derivatives holders to build up significant stakes in companies without disclosure. The new regime would also mean greater transparency for issuers and for the market at least in terms of who holds economic interest in them and therefore who their potential shareholders are. The disclosure threshold will be set at 3 percent, in line with the existing disclosure rules.

After consideration, noted the official, the FSA has concluded that this approach remains the best way of addressing the market failures caused by access to voting rights and influence on corporate governance on an undisclosed basis. As expected, the issue has drawn strong and conflicting views from across the spectrum of market participants, including issuers, institutional investors, and hedge funds. The FSA intends to implement the regime, emphasized the CEO, because enhancing disclosure is the right thing to do. The prospective regime will be explained in more detail in a forthcoming feedback statement, as the FSA works with the industry to ensure that the rules are framed in the most effective way.

The Future of Securities Regulation Must Be an Omnibus Code

Just as Generals are always said to fight the last war, regulators are always regulating reactively. The Generals in 1914 before WW I did not foresee that the machine gun would dominate the battlefield; and they had to adjust their strategy and tactics. The regulators did not foresee the potentially destructive power of complex derivatives and now financial regulation must be totally restructured next year. What I do not want to see are many, many smaller pieces of legislation that fix pieces of the markets, like the Harkin bill regulating credit derivatives. What I want to see is a comprehensive, omnibus financial regulation code, similar in design to the 1986 federal tax code, with all regulations logically under the code sections. The vision of Louis Loss may yet be realized. But whatever shape the regulatory reform takes, the blog is committed to following and reporting on the proposals and the bills and the final legislation.

IRS Notice 2008-100 Applies IRC 382 to Loss Corporations Whose Instruments are Acquired under Capital Purchase Program of Emergency Economic Stabilization Act

The IRS has issued Notice 2008-100 apply IRC §382 to loss corporations whose instruments are acquired under the Capital Purchase Program of the Emergency Economic Stabilization Act. Section 382 sets the limit as to how much net operation losses an organization that has just undergone an ownership change can deduct from its income.

Section 382(a) provides that the taxable income of a loss corporation for a year following an ownership change that may be offset by pre-change losses cannot exceed the section 382 limitation for such year. An ownership change occurs with respect to a corporation if it is a loss corporation on a testing date and, immediately after the close of the testing date, the percentage of stock of the corporation owned by one or more 5-percent shareholders has increased by more than 50 percentage points over the lowest percentage of stock of such corporation owned by such shareholders at any time during the testing period.

With respect to any shares of stock of a loss corporation acquired by Treasury pursuant to the CPP, either directly or upon the exercise of an option, the ownership represented by such shares on any date on which they are held by Treasury shall not be considered to have caused Treasury’s ownership in the loss corporation to have increased over its lowest percentage owned on any earlier date.

With two exceptions, such shares are considered outstanding for purposes of determining the percentage of loss corporation stock owned by other 5-percent shareholders on a testing date. The first exception is redemptions of stock owned by Treasury. For purposes of measuring shifts in ownership by any 5-percent shareholder on any testing date occurring on or after the date on which the loss corporation redeems shares of its stock held by Treasury that were acquired pursuant to the CPP, the shares so redeemed must be treated as if they had never been outstanding.

The second exception is the treatment of preferred stock acquired by Treasury pursuant to the CPP. For all Federal income tax purposes, any preferred stock of a loss corporation acquired by Treasury pursuant to the CPP, whether owned by Treasury or another person, must be treated as stock described in section 1504(a)(4) of the Code.

In addition, Notice 2008-100 provides that, for all federal income tax purposes, any warrant to purchase stock of a loss corporation that is acquired by Treasury pursuant to the CPP, whether held by Treasury or another person, must be treated as an option (and not as stock).

Appeals Court Curtails Extraterritorial Application of Federal Securities Laws

A Second Circuit panel has 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.

Foreign investors alleged that a US subsidiary sent false financial information to its Australian parent company, which in turn created and distributed public filings incorporating the false statements. The main issue before the court was what conduct comprised the heart of the alleged fraud.

The appeals panel concluded that actions taken by the parent company in Australia were significantly more central to the fraud, and more directly responsible for harming investors, than the alleged manipulation at the US subsidiary. The parent is the public company with oversight over all corporate operations and the duty to file accurate financial statements to the outside world.

The subsidiary did not send any false numbers to investors, reasoned the court, and those numbers had to pass through a number of checkpoints manned by company personnel at the Australian headquarters before reaching investors. If headquarters had monitored the accuracy of the subsidiary’s numbers before transmitting them to investors, said the panel, the numbers would have been corrected and no investor would have been harmed.

New Jersey Adopts BD, Agent, IA and IA Rep. Changes

Changes clarifying application and post-registration requirements, increasing fees and adding dishonest, unethical practice provisions for broker-dealers, agents, issuer-agents, investment advisers and investment adviser representatives were adopted by the New Jersey Securities Bureau. Other amendments clarify the investment company renewal notice requirement, update statutory references in certain exemption rules, provide correct websites for obtaining particular forms online, modify nomenclature and delete outdated phrases.

The changes took effect October 6, 2008.

For more information go to http://www.njsecurities.gov/

Grassley Asks for Strict Interpretation of Executive Travel Expenses under IRC 162

Fearing that the executive compensation provisions of the Emergency Economic Stabilization Act are becoming window dressing rather than a legitimate attempt to prevent excessive compensation for failed leadership, Senator Charles Grassley has asked that additional restrictions be imposed on the ability of companies to deduct travel expenses under Section 162 of the Internal Revenue Code. In a letter to the Treasury Secretary, he asked that the definition of ordinary and necessary business expenses under the 162 deduction be limited for companies participating in the troubled asset relief program authorized by the Act.

Specifically, the Ranking Member of the Finance Committee recommends that travel and other reimbursable expenses be subject to federal limits under Section 162 for these expenses. The senator emphasized that taxpayers who are struggling to stay in their homes should not be subsidizing first class travel or luxury hotel stays for any employee of a company that is being rescued with taxpayer money. Given the extraordinary regulatory authority Treasury has just exerted under Section 382 for commercial banks, noted the senior member, Treasury surely has the regulatory authority to impose such restrictions here. He asked Treasury to explain if it disagrees. He also asked Treasury to describe what policies and procedures it has implemented to ensure the independence of its advisors and to prevent any current or future conflicts of interest.

In Light of Market Turmoil, Nasdaq Would Suspend Closing Bid Deficiency Test

Noting that the market turmoil has resulted in a number of securities trading below $1, Nasdaq proposes to suspend the bid price and market value of publicly held shares requirements through January 16, 2009. Currently, Nasdaq rules provide that a security will be considered deficient if it fails to achieve at least a $1 closing bid price for a period of 30 consecutive business days. Nasdaq urged the SEC to make the change effective immediately upon Commission approval and waive the usual 30-day operative delay period.

Under the proposal, which must be approved by the SEC, companies would not be cited for new bid price or market value of publicly held shares deficiencies during the suspension period. In addition, the time allowed to companies already in a compliance period or in the hearings process for bid price or market value of publicly held shares deficiencies would be suspended with respect to those requirements.

Following the temporary suspension, any new deficiencies with the bid price or market value of publicly held shares requirements would be determined using data starting on January 19, 2009. Companies that were in a compliance period prior to the suspension would receive the balance of any pending compliance periods in effect at the time of the suspension. Similarly, companies that were in the hearings process prior to the suspension would resume in that process at the same stage they were in when the suspension went into effect. Nasdaq will continue to monitor securities to determine if they regain compliance during the temporary suspension.

Nasdaq is acting to provide this relief because it believes that companies whose shares fell below $1 during this time of market turmoil have not experienced a fundamental change in their underlying business model or their prospects. Rather, the decline in general investor confidence has resulted in depressed pricing for companies that otherwise remain suitable for continued listing. At the same time, current market conditions make it difficult for companies to successfully implement a plan to regain compliance with the price or market value of publicly held shares tests.

Nasdaq further believes that this temporary suspension will permit companies to focus on running their businesses, rather than on satisfying market-based requirements that are largely beyond their control in the current environment. Moreover, the temporary suspension will allow investors to buy shares of some of these lower-priced securities without fear that the company will receive a delisting notification or be delisted in the very near term.

UK and Australia Extend Bans on Short Selling

After a review of its emergency short selling ban, the UK Financial Services Authority decided to keep the ban in place until January 16, 2009, with one change. The FSA prohibits the active creation or increase of net short positions in publicly quoted financial companies. In addition, the original rule required the daily disclosure of all net short positions in excess of 0.25 per cent of the ordinary share capital of the relevant companies held at market close on the previous working day.

The one change relates to the requirements for disclosing significant net short positions in UK financial sector stocks. The FSA accepts that it is not proportionate to require daily disclosures of short positions where there has been no change in a short position. Consequently, going forward, once disclosure of a short position has been made, additional disclosures will only be required when that short position changes. In January 2009, the FSA will publish a Consultation Paper on short selling.

At the same time, the Australian Securities and Investment Commission extended the ban on covered short selling for non-financial securities for a further 28 days until 18 November 2008, when it expects to lift the ban. The ban on financial stocks will continue until 27 January 2009. As part of lifting the ban on non-financials, the Commission will implement disclosure and reporting arrangements that will apply from the time the ban is lifted. These disclosure rules will be announced in the near future.

Senior Senator Questions SEC's Conduct in Bear Stearns Rescue

In a letter to SEC Chair Christopher Cox, Senator Charles Grassley said that he was deeply troubled by allegations that senior SEC enforcement officials may have inappropriately disclosed information about ongoing investigations to outside parties during the Bear Stearns rescue efforts. Specifically, the senator, who is the Ranking Member on the Finance Committee, said that he received anonymous but specific information that the SEC enforcement director gave information to the general counsel of JP Morgan Chase, himself a former SEC enforcement director, about the state of various investigations into Bear Stearns.

According to the allegations, the general counsel had called the director to get assurances and inside knowledge from the SEC to help Morgan’s negotiating position, i.e. how much to bid. The tip alleged that this inside information, gotten through a personal relationship, would be critical in helping Morgan put together a low-ball bid to Bear and the US government. Morgan could cite litigation uncertainties, while having the assurance from the SEC that the risk of litigation was not really that great. This could have materially affected the amount of guarantees that Morgan was able to negotiate from the Federal Reserve.

In view of these allegations, Senator Grassley asked the SEC to provide a detailed summary of each of the SEC investigations pending in February or March 2008 concerning Bear Stearns. The summary should include the dates on which any matter under investigation was opened and/or closed, the dates on which any formal order of investigation was considered and approved or rejected by the Commission, the dates on which any draft notice was ever prepared, regardless of whether it was finalized, and a description of the nature of the potential violations by Bear Stearns or its employees.

The SEC is also asked to provide any and all records of communications between SEC staff and representatives of J.P. Morgan Chase in February or March 2008 related to any of the cases described above. To the extent that no such records exist, the SEC should provide a detailed description of any such contacts that occurred without a record having been made and describe why no record of the communications was made.

The Ranking Member’s concern was heightened by the striking similarity of these allegations to the conduct criticized in an earlier report on the investigation of the SEC’s handling of the Pequot investigation and the termination of Gary Aguirre Such conduct, he said, would reinforce the appearance that enforcement decisions, and disclosures of information about them, are sometimes based not on the merits, but rather on access to senior officials by influential representatives of power brokers on Wall Street. In light of these allegations and the ongoing financial crisis, he emphasized, there has never been a more critical time to take swift action to restore confidence in the SEC Enforcement Division.

Former SEC Chair Levitt Calls for Merging the SEC and CFTC

In a piece in today’s Wall Street Journal, former SEC Chair Arthur Levitt called for the merger of the SEC and CFTC into the Securities Futures Commission with enhanced authority over hedge funds, OTC products and rating agencies. The SFC would also oversee OTC and exchange markets, securities and commodities professionals, mutual funds, corporate reporting, and clearance and settlement systems. Mr. Levitt also believes that boutique investment banks will arise to fill the current void; and should be regulated along global business lines.

In its blueprint for regulatory reform issued earlier this year, the Treasury recommended the merger of the SEC and CFTC in order to provide unified oversight and regulation of the futures and securities industries. According to the blueprint, jegislation merging the CFTC and the SEC should not only call for a structural merger, but also a process to merge regulatory philosophies and harmonize securities and futures regulations and statutes.

In Treasury’s view, a condition precedent to merging the SEC and CFTC would be the harmonization of differences between futures regulation and federal securities regulation, including rules involving margin, segregation, insider trading, insurance coverage for broker-dealer insolvency, customer suitability, short sales, SRO mergers, implied private rights of action, the SRO rulemaking approval process, and the agency’s funding mechanism. Due to the complexities and nuances of the differences in futures and securities regulation, legislation should establish a joint CFTC-SEC staff task force with equal agency representation with the mandate to harmonize these differences. In addition, the task force should be charged with recommending the structure of the merged agency, including its offices and divisions.

Listed Companies Concerned about Short Selling Abuses Urge SEC to Reinstate Uptick Rule

By James Hamilton, J.D., LL.M.

On the heels of the expiration of the SEC’s emergency order banning short selling in hundreds of financial companies, the listed company community favors the implementation of new rules and enhanced disclosure. An overwhelming number of companies urged the SEC to reinstitute the uptick rule, as well as place restrictions on short selling during periods of market volatility. Greater transparency in short-selling is also essential. These views surfaced in a recently released NYSE Euronext study.

Three in four companies believe that short selling should be temporarily prohibited when a stock experiences a certain level of volatility. Of those who favor a temporary prohibition, 24% say short selling activity should be stopped after less than a 10% market decline, while 54% seek a halt to short selling after a 10%-20% decline.

The listed companies also want investment managers to disclose their short selling activity. The lack of short selling disclosure requirements, as well as the support received from regulatory entities by some institutions engaged in short selling, feeds the resentment of companies that believe there are different sets of rules for different businesses.

The almost unanimous desire to bring back the uptick rule is based on a belief that the rule worked for decades to control the ability of short sellers to overwhelm market sentiment. The SEC rescinded the rule in 2007. While it should be re-instituted, issuers also said that the rule must include both on-exchange trading, as well as off-exchange trading and dark pools.

The uptick rule, Rule 10a-1, required that all short sale stock transactions be conducted at a price that was higher than the price of the previous trade. The SEC claims that its staff fully researched the regulation before it was repealed; but some commenters have noted that the research took place during one of the biggest bull markets in history.

There is a growing consensus in Congress to bring back the uptick rule. A House bill, HR 6517, would order the SEC to reinstate the uptick rule within 90 days. In the wake of the elimination of the uptick rule, noted bill sponsor Gary Ackerman, many volatile stocks that the regulation was designed to protect are being driven down as a result of manipulative short sale practices. He believes that the reinstatement of the uptick rule would help curb these abuses and ensure greater stability and confidence in the market. Under a reinstated uptick rule, he continued, fewer companies would fail, less investors would be driven out of the market, and more capital would remain in the stock markets.In a short sale, an investor borrows shares of a stock from a broker, sells it to others, and then hopes to buy it back at a lower price before returning it to the lender.

The difference, if any, is kept as a profit. The uptick rule was designed to prevent short sellers from being the only investors to cause a stock price to decline. Under the rule, a short sale could only be entered after a trade that caused the last price to increase. The uptick rule had been in place since 1938, and Rep. Ackerman does not fully understand why the SEC rescinded

The core provisions of Rule 10a-1 had remained virtually unchanged since its adoption 70 years ago. Over the years, however, in response to changes in the securities markets, including changes in trading strategies and systems used in the marketplace, the SEC had added exceptions to Rule 10a-1 and granted numerous requests for relief from the rule’s restrictions In addition, in rescinding the rule, the SEC noted that decimal pricing increments had substantially reduced the difficulty of short selling on an uptick.

European Investors Consortium Says No More Carve Outs on Fair Value Accounting

Reacting to relief in fair value accounting granted by the IASB and FASB, a consortium of European investor groups said that any further changes in the fair value standard could severely undermine the confidence that users have in the company financial statements. While the Corporate Users Reporting Forum recognizes the need to align the FASB and IASB positions on fair value accounting, there must be no additional amendments to the accounting standards relating to the measurement of financial instruments. The European Commission recently adopted the changes to fair value accounting. The forum said that it would actively oppose any further Commission carve outs from the fair value standard.

Federal Reserve Board Staff Reviews Data on Foreign Private Issuer Deregistration under SEC Rule 12h-6

By James Hamilton, J.D., LL.M.

It has been almost a year and a half since the Securities and Exchange Commission adopted Release No. 34-55540 in which the SEC made it easier for foreign private issuers (FPIs) to deregister and thus terminate their U.S. reporting obligations. In September 2008, the economic research staff at the Federal Reserve Board published International Discussion Paper Number 945, in which the staff provided a tentative review of the economic impact of Rule 12h-6. Following adoption of Rule 12h-6, a FPI may deregister (i) a class of equity security, (ii) a class of debt security, (iii) securities affected by a merger, consolidation, exchange of securities, or other acquisition of assets, and (iv) securities that were the subject of a termination of registration prior to the effective date of Rule 12h-6. Each mode of deregistration requires the FPI to make numerous certifications regarding the deregistration on Form 15F.

The FRB staff study observed that prior to the adoption of Rule 12h-6, there were very few FPI deregistrations. But during the period covered by the study, the authors noted that 80 FPIs planned to avail themselves of Rule 12h-6. The authors also noted that although one purpose of Rule 12h-6 was to make U.S. capital markets more competitive versus global counterparts, the period after adoption of Rule 12h-6 appears to be the first time that FPI deregistrations from U.S. securities laws outnumbered new FPI U.S. registrations.

Based upon analysis of economic data, the authors tentatively concluded that capital markets and FPIs generally still place high value on a U.S. registration. The value of a U.S. registration, however, was greatest for FPIs whose home country securities regulations are weak or whose home country judicial systems are based on civil law or are otherwise inefficient. In these instances, markets reacted negatively to the more lenient deregistration provisions contained in Rule 12h-6. The authors’ data also suggested an insignificant market reaction for FPIs with strong home country securities regulations.

Former SEC Chair Levitt Calls for Expanded Fair Value Accounting as Part of Overall Reform

Anticipating massive regulatory reform of financial market oversight, former SEC Chair Arthur Levitt called for the expansion of fair-value accounting to cover all of the financial instruments, the securities positions and loan commitments, of all financial institutions. In testimony before the Senate Banking Committee, he said that this was one of the biggest steps that regulators and standard setters could take to bring to light a fuller picture of companies’ financial health. The expansion of fair value accounting would come as part of what the former official called the most dramatic rethinking of the financial regulatory architecture since the New Deal.

The former SEC Chair criticized the banking industry for using fair-value accounting as a scapegoat, which he called the financial equivalent of shooting the messenger. If financial institutions were accurately marking the books, he said, they would have seen the problems they are experiencing months in advance and could have made the necessary adjustments.

More broadly, the former official noted that the current crisis has been building for years as the regulatory system failed to adapt to dynamic and potentially lethal new financial instruments. As the markets grew larger and more complex in scope and in products offered, he continued, the SEC failed to keep pace. As the markets needed more transparency, the SEC allowed opacity to reign. As an overheated market needed a strong referee to rein in dangerously risky behavior, the Commission too often remained on the sidelines.

As Congress examines what went wrong, he observed, it will find that a lack of transparency, a lack of enforcement, and a lack of adequate resources all played a key role. Even now, after what markets have undergone the past few weeks, he emphasized, regulators still do not know the full extent of the losses incurred by financial institutions and other companies on mortgage-backed securities. This lack of information about where risk resides is keeping investors suspicious and out of the markets.

That said, the former SEC Chair believes that an adequately staffed and resourced SEC can restore trust in the financial markets and can yet be again the crown jewel of the financial markets that it has been for the past 75 years. In this regard, he urged Congress to increase the SEC’s budget and staffing levels to keep pace with financial innovation.

SEC Urged to Overrule FASB Fair Value Accounting Interpretation

The American Bankers Association has asked the SEC to override recent FASB guidance on fair value accounting, FAS 157-3, and replace it with guidance clarifying that fair value in an illiquid market does not include forced or distressed sales. Adopted to deal with the market turbulence, FAS 157-3 changes FAS 157 to allow reclassifications Events are moving quickly, as the IASB has conformed IFRS to reflect FASB’s changes, and the European Commission has approved the changes.

Both US GAAP and IFRS will now permit entities, in rare circumstances, to reclassify financial instruments that are in the form of securities from their trading portfolio, measured at fair value, to held to maturity, measured at amortized cost and subject to testing for impairment. But reclassification will not be allowed if the fair value option was previously selected. In addition, reclassification to loan category (cost basis) will be permitted if the intention and ability is to hold for the foreseeable future (loans) or until maturity (debt securities).

Describing FAS 157-3 as circular, the ABA said that FASB still refuses to recognize the realities of current markets. While FAS 157-3 begins with improved guidance on the ability to use judgment and the fact that forced liquidations or distressed sales do not represent genuine fair value, 157-3 then requires that liquidity risk from the buyer’s perspective be included in the cash flow calculation. This requirement brings the guidance full circle back to distressed values. The use of distressed sales prices represents neither genuine fair value nor provides useful information to users of financial statements.

The SEC should consider if issuers and their auditors can actually apply the guidance, which is required for third quarter financial statements. In addition to overruling the guidance, the ABA urges the SEC to provide guidance on other than temporary impairment, which FAS 157-3 did not address. The SEC is also asked to suspend the proposal on accounting for securitization, as well as suspend work by standard setters on any projects requiring fair value in any future accounting standards pending Congressional review of the study mandated by the Emergency Economic Stabilization Act.

Congress Heeds SEC's Call for Regulation of Credit Default Swaps

In the wake of a call by SEC Chair Christopher Cox for the regulation of credit default swaps, Senator Tom Harkin will introduce legislation regulating swaps and other financial derivatives that are currently traded with virtually no regulation or transparency. Senator Harkin, chair of the Agriculture Committee, noted that, while swaps contracts function much like futures contracts, they are not regulated as futures contracts because of a statutory exclusion from CFTC authority. Since they do not have to be traded on open, transparent exchanges, it is impossible to know whether credit default and other swaps are being traded at fair value or whether institutions trading them are becoming overly leveraged or dangerously overextended. Financial derivatives like credit-default swaps must be traded on a regulated exchange, said the senator, so that regulators can know the value of the contracts, who is trading them, and if they have enough assets to back the contract.

According to Director of Market Regulation Eric Sirri, the SEC has a great interest in the credit derivatives market because of its impact on the debt and cash equity securities markets and the Commission's responsibility to maintain fair, orderly, and efficient securities markets. In testimony before the House Agriculture Committee, he said that these markets are directly affected by credit default swaps due to the interrelationship between the swap market and the claims that compose the capital structure of the underlying issuers on which the protection is written. In addition, the SEC has seen credit default swap spreads move in tandem with falling stock prices, a correlation suggesting that activities in the OTC credit default swaps market may be spilling over into the cash securities markets.

The Commission's current authority with respect to these instruments, which are generally security-based swap agreements under the CFMA, is limited to enforcing antifraud prohibitions under the federal securities laws. The SEC is prohibited under current law from promulgating any rules regarding credit default swaps in the over-the-counter market. Thus, the tools necessary to oversee this market effectively do not exist.

OTC credit derivatives emerged in the mid-1990s as a means for financial
institutions to buy insurance against defaults on corporate obligations. Credit default swaps are executed bilaterally with derivatives dealers in the OTC market, which means that they are privately negotiated between two sophisticated, institutional parties. They are not traded on an exchange and there is no required recordkeeping of who traded, how much and when. Although credit default swaps are frequently described as buying protection against the risk of default on, for example, corporate bonds, they are also used by investors for purposes other than hedging. Institutions can and do buy and sell credit default swap protection without any ownership in the entity or obligations underlying the swap. In this way, credit default swaps can be used to create synthetic long or short positions in the referenced entity.

Mr. Sirri cautioned that, in crafting any regulatory solution, it is important to keep in mind the significant role credit default swaps play in the financial markets, as well as the truly global nature of that market. Further, the varied nature of market participants and the breadth of this market underscore the importance of cooperation among U.S. and global regulators.

In earlier testimony before the Senate Banking Committee, Chairman Cox said that the credit derivatives market is a regulatory hole that must be closed by Congress. The $58 trillion notional market in credit default swaps is regulated by no one, he emphasized, and neither the SEC nor any regulator has authority over this market. He described a credit default swap buyer as tantamount to a short seller of the bond underlying the swap. Since credit default swap buyers do not have to own the bond or other debt instrument upon which the swap contract is based, they can naked short the debt of companies without restriction. As part of the fundamental reform of the financial system, Congress must provide statutory authority to regulate these products.

UK Legislation Would Set Up Special Resolution Regime for Failing Financial Institutions; FSA Has Central Role

By James Hamilton, J.D., LL.M.

A bill overhauling UK regulation of financial institutions may offer a preview of what US reform legislation may look like. The UK reform bill would, for the first time, establish a permanent special resolution regime, providing the Financial Services Authority with tools to deal with institutions that get into financial difficulties. The bill is heavily based on managing risk, with in-built statutory triggers for regulatory involvement by the Financial Services Authority. The bill embodies the concept of ``heightened supervision’’ under which regulation will intensify concomitant with an increase of risk to the financial institution. The UK does not currently have a permanent statutory regime for dealing with failing financial firms.

Heightened supervision is not a separate supervisory regime or set of powers, explained FSA CEO Hector Sants, but the bill would give the FSA a range of tools, called stabilization options, to mitigate risks when an increase in risk occurs. For example, the FSA could direct transfers of a firm’s business to a private sector purchaser, temporarily to a government-controlled bridge bank, or place a financial institution into temporary public ownership. This could happen upon the triggering of a threshold condition, such as a determination that a firm is failing its regulatory duties and that it is not reasonably likely that the financial institution can bring itself back into compliance. In making this determination, the FSA must discount any financial assistance provided by the government.

Upon a triggering condition, a firm can be placed into a special resolution regime, allowing the FSA to intervene when a bank gets into severe difficulties, including the introduction of an insolvency regime. Upon the financial institution being placed into a special resolution regime, the three stabilization options listed above kick in, and are exercised through what the bill calls stabilization powers, which are the powers to effect the transfer of shares and other securities by operation of law. Once a firm is placed into the resolution regime, assured CEO Sants, the FSA will continue to supervise it in its usual risk-based way.

In a sense, said the FSA CEO, the bill ensures FSA regulation by recognizing the importance of a single regulator making the judgment of whether a financial institution is a going concern. The measure also requires the Treasury, after consulting with the FSA, to issue a code of practice about the use of the stabilization powers

There are two alternative conditions to taking a firm into temporary public ownership. The first is that public ownership is needed to reduce a serious threat to the financial system. The second is that the public interest must be protected when the government has provided assistance to the financial institution. A transfer to temporary public ownership may only be effected through a transfer of shares and securities. Thus, the bill broadly defines securities to include shares and stock; debentures; warrants or other instruments that entitle the holder to acquire such securities.

SEC Requires Disclosure of Hedge Fund and Other Institutional Investors Short Positions into 2009

On an emergency basis, the SEC adopted a new disclosure rule requiring hedge funds and other large investors to disclose their short positions. Prepared by the staffs of the Divisions of Investment Management and Corporation Finance, the new rule was designed to ensure transparency in short selling. Hedge fund managers with more than $100 million invested in securities are required to promptly begin public reporting of their daily short positions. The managers currently report their long positions to the SEC. The rule was to expire on October 16, 2008, after having been extended by the Commission. But the SEC acted to extend the rule to
August 1, 2009, with modifications in the reporting.
(See Release No. 34-58785).

Specifically, under the initial rule, institutional investment managers required to file a Form 13F for the calendar quarter ended June 30, 2008 must file a report on new Form SH with the SEC on the first business day of every calendar week immediately following a week in which it effected short sales. Form SH must be filed electronically on EDGAR, but will not be publicly available for two weeks pursuant to an amended order.

The Commission decided that Form SH should be initially filed on a non-public basis. The agency reasoned that non-public submission of Form SH may help prevent artificial volatility in securities as well as further downward swings that are caused by short selling, while at the same time providing the SEC with useful information to combat market manipulation that threatens investors and capital markets.

Two weeks after the due date for the Forms SH, the Commission will make the Forms available to the public. The SEC believes that by two weeks after the due date the reasons to maintain the information as non-public will have diminished. New Form SH requires disclosure of the number and value of securities sold short for each Section 13(f) security, except for short sales in options, and the opening short position, closing short position, largest intraday short position, and the time of the largest intra-day short position, for that security during each calendar day of the prior week.

In the release extending the required disclosure to 2009, the SEC said that the Form SH weekly filing deadline will be the last business day of the calendar week following a calendar week in which short sales are effected instead of the first business day as originally required. This change is designed to provide filers with additional time to gather and verify the necessary information and file the forms.

Also, Form SH filers will no longer be required to disclose the value of the securities sold short (currently column 5 of Form SH), the largest intraday short position (currently column 7 of Form SH) and the time of day of the largest intraday short positions (currently column 8 of Form SH). The SEC has learned that some of this information has been difficult for filers to obtain. The threshold for reporting short sales or positions will be raised from a fair market value of $1 million to a fair market value of $10 million. Hedge funds will also be required to submit an XML tagged data file to the Commission providing the requested data in order to facilitate the review of the filed data by the Commission staff.

Kentucky Proposes Prohibition on Use of Senior Certifications, Prohibited Practices for BDs and IAs and Requirement for BDs and IAs to Approve a Change in Control

A rule prohibiting broker-dealers, agents, investment advisers and investment adviser representatives from using professional designations and certifications that imply specialized knowledge of senior citizens' financial needs was proposed by the Kentucky Department of Financial Institutions, along with separate rules listing the dishonest, unethical practices for these securities industry persons. A rule requiring broker-dealers and investment advisers to apply for and receive approval for changing their control was also proposed.

A public hearing on the rule proposals will take place on November 21, 2008 at 10:00 a.m. at the Department of Financial Institutions, 1025 Capital Center Drive, Suite 200, Frankfurt, Kentucky. Individuals interested in being heard at the hearing must notify the Department in writing by November 14, 2008 (five working days before the hearing).

Written comments about the rule proposals may be sent to Colleen Keefe, Counsel, at the above address or telephoned to Ms. Keefe at (502) 573-3390 ext. 234, or faxed to (502) 573-2183.

Click here for the Department of Financial Institutions website.

Corporate Finance in Crisis Mode: How the Federal Reserve is Providing Funding to Financial Firms

In the last several weeks the economic crisis that has frozen the credit markets has spurred significant government action in the form of the Emergency Economic Stabilization Act of 2008 (EESA), which has greatly enhanced the powers of both the Federal Reserve Board (FRB) and the Treasury Department. The EESA in essence is a bailout fund to be used broadly to acquire illiquid assets from financial firms and to inject capital into banks. But the EESA is just one of several major pieces of the economic recovery plan.

The Federal Reserve Board (FRB) already had significant power to intervene in the U.S. economy and has done so through both its traditional tools of monetary policy and through various lending facilities directed at specific elements of the financial industry. The FRB's traditional tools include the power to set reserve requirements. The FRB also must approve the discount rate set by the Federal Reserve banks. The FRB, as part of the Federal Open Market Committee (FOMC), also provides guidance to the New York Federal Reserve Bank to conduct open market operations to achieve the desired federal funds rate. The FRB recently announced that it will pay interest on reserves in the expectation that doing so will establish a floor to the federal funds rate. Section 128 of the EESA accelerated the effective date of the FRB's authority to pay interest on reserves to October 1, 2008. Link.

The FRB also has created a number of lending facilities to enhance liquidity generally and to encourage banks and other financial institutions to begin lending again to qualified borrowers. Below are links to FRB lending facilities that address the short term funding needs of banks and the asset-backed commercial paper market, including money market mutual funds.

1. Term Auction Facility

2. Primary Dealer Credit Facility

3. Term Securities Lending Facility

4. Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility

5. Commercial Paper Funding Facility

Hedge Fund Industry Concerned About UK Prime Brokerage in Wake of Investment Bank Collapse

In the wake of the collapse of a major international investment bank, the Managed Funds Association expressed concern about the ongoing viability of the UK’s prime brokerage industry. In a letter to the Governor of the Bank of England, MFA CEO Richard Baker urged the central bank to intervene to expedite the release of billions in assets now frozen in the UK as the result of the insolvency of Lehman Brothers, Inc.

The former House leader also highlighted the systemic risks resulting from the Lehman insolvency, including the loss of an estimated $40-$70 billion in liquidity now frozen at Lehman Brothers International Europe, the potential destabilization of financial firms as assets are moved away from prime brokers, and the potential failure of firms with significant financial exposure to LBIE. In his letter, Mr. Baker recommended an expedited administration process that would reduce systemic risks, inject much-needed liquidity and financial stability into capital markets and keep the UK’s prime brokerage industry viable. Nothing less than the future of the UK’s prime brokerage industry is at stake.

The MFA also noted a marked discrepancy, in terms of confidence and speed of response, between the administrators’ proposals and the protocol promulgated by the Securities Investor Protection Corporation Trustee in the US, who is responsible for the liquidation of Lehman Brothers Inc. The scale of the problem is enormous, said the MFA.

The administration of LBIE has resulted in client assets held by LBIE under prime brokerage arrangements being taken out of the market, with LBIE clients that are hedge funds unable to access their assets, trade them or properly value them. In turn, this is leading to suspensions of fund redemptions and NAV calculations in some cases, which is freezing sections of the market.

In Mr. Baker’s view, the current approach outlined by LBIE administrators involves a lengthy process with no definitive date for distribution of client assets. This process creates systemic risk and adds more uncertainty to global markets. The MFA encourages the Lehman administrator to take immediate action to reduce the uncertainty and mitigate systemic risk by distributing these assets in an expedited manner. The Bank of England must intervene to coordinate and clarify the process and remove obstacles that prevent the quick and orderly release of client assets from LBIE.

More granularly, the MFA proposed a plan to prioritize distribution to LIBE’s clients by reference to the applicable systemic significance of their exposures. The MFA believes that this approach will allow the administrators to distribute assets in the context of systemic risk concern.

The MFA also advocates a combined industry and government response involving the Bank of England, the Financial Services Authority and industry participants to give LBIE’s administrators reassurance regarding their liabilities. This would remove the liability risk component for the administrators, reasoned Baker, and allow them to return client assets without fear of liability to other creditors.

The MFA also proposes enhancing the transparency and clarity of the administration process and related client positions. Also, clarity must be provided for existing short positions and developing a protocol for the closure of these positions in order to allow LBIE clients to manage their exposure to market risk.

In order to unlock as many assets as quickly as possible, the MFA urged the LBIE administrators to prioritize LBIE's prime brokerage clients by reference to the applicable systemic significance of their exposures. For each such client, the administrators should engage with the client to agree on the net sums owed by the client to LBIE (or vice versa) under each agreement to which the client is party with LBIE. Any live short positions should also be closed out, if necessary, by a payment of cash from the client to LBIE (after having taken account of any net sums owed by LBIE to the client). The long segregated assets should then be released to those clients.

Bailout Bill Curtails 162(m) Executive Compensation Deductibility for Troubled Entities

The changes to IRC 162(m) worked by the Emergency Economic Stabilization Act curtail the deductibility of executive compensation for entities participating in the troubled asset purchase program, using SEC criteria, with one notable exception. Under Section 162(m), the deductibility of compensation paid to senior corporate officers, called covered employees, is limited to $1 million. IRS Notice 2008-94.

But the salary deduction is limited to $500,000 for any financial institution or other entity that sells illiquid securities or other assets to the Treasury under the troubled asset relief program, but only if the aggregate amount of the assets acquired exceeds $300 million. For corporations that are subject to SEC Exchange Act reporting, the highest three officers are determined on the basis of SEC shareholder disclosure, with one important difference.

Tracking SEC executive compensation disclosure rules, The five executive officers covered by 162(m)(5) are the chief executive officer, the chief financial officer, and the three highest compensated officers other than the CEO or CFO. For the purpose of determining the high three officers, compensation is defined as it is in the SEC rules to include total compensation without regard to whether the compensation is includible in an executive officer’s gross income. However, unlike the SEC rules that determine the high three officers by reference to total compensation for the last completed fiscal year, the measurement period under 162(m)(5) for purposes of determining the high three officers for an applicable taxable year is that taxable year.

For purposes of § 162(m)(5), including the determination of whether the aggregate amount of assets acquired from an employer exceeds $300 million, two or more persons who are treated as a single employer under § 414(b) (employees of a controlled group of corporations) and § 414(c) (employees of partnerships, proprietorships, etc., that are under common control) are treated as a single employer.

An applicable employer for purposes of § 162(m)(5) is not limited to a publicly traded corporation or even to the corporate business form. Thus, an entity, whether or not publicly traded, is an applicable employer if it sells troubled assets pursuant to the Treasury’s program. Also, unlike the general 162(m) calculation of employee remuneration subject to the deductible limit, 162(m)(5) remuneration includes commissions and performance-based compensation.

Golden Parachutes

The Internal Revenue Code, primarily Section 280G, does not allow the deduction of excessive golden parachute payments to senior executives and imposes an excise tax on such excessive payments equal to 20 percent of the amount of the payment. Section 302(b) of the Act amended § 280G by expanding the definition of a parachute payment to include certain severance payments made to a covered executive of an employer participating in the Treasury’s troubled asset relief program. The provision covers an executive severed from employment by reason of involuntary termination or in connection with any bankruptcy, liquidation, or receivership of an entity selling illiquid assets to the Treasury.