House Passes Corporate Governance Legislation with Say-on-Pay Mandate

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

The House passed legislation mandating shareholder advisory votes on executive compensation as part of the overall reform of financial regulation. Final House passage is expected later this week. The vote was 237-185. The legislation builds on the SEC’s executive pay disclosure rules to require that public companies include in their annual proxy to investors the opportunity to vote on the company's executive pay plans. The Corporate and Financial Institution Compensation Fairness Act would also require independent board compensation committees and independent compensation consultants. The legislation further requires all financial institutions, including brokers, dealers and investment advisers, to disclose compensation structures that include any incentive based elements. The measure also requires federal financial regulators to proscribe inappropriate or imprudently risky compensation practices as part of solvency regulation.

A Manager’s Amendment offered by Committee Chair Barney Frank (D Mass) specifically provides that financial companies that do not have incentive-based payment arrangements are not required to make disclosures regarding incentive-based payment arrangements. The Manager’s Amendment also narrows the scope of the regulators’ authority to prohibit compensation structures by rule to allow such prohibitions only of incentive-based payment arrangements, as opposed to any compensation structures or incentive-based payment arrangements, of covered financial institutions

An amendement offered by Rep. Jeb Henserling (R-TX) exempts financial institutions with less than $1B in assets from the incentive-based pay provisions. Another Henserling amendment would requires the GAO to study the correlation between compensation structure and excessive risk-taking and report to Congress within one year of enactment. In that study, the GAO would have to consider compensation structures used by companies from 2000-2008, and do a comparison of companies that failed, or nearly failed but for government assistance, and report on companies that remained viable through the market turmoil of 2007-2008.

An amendment by Mr. Henserling would adds Fannie Mae and Freddie Mac to the list of financial institutions subject to the incentive-based pay provisions, as well as add their oversight regulator, the FHFA, as a financial regulator with rulemaking authority for such provisions. The measure would not set any limits on pay, but will ensure that shareholders have a non-binding and advisory vote on their company's executive pay practices without micromanaging the company. Knowing that they will be subject to some collective shareholder action should give boards pause before approving a questionable compensation plan. The legislation also contains a separate advisory vote if a company gives a new, not yet disclosed, golden parachute while simultaneously negotiating to buy or sell a company.

An amendment by Rep. Mary Jo Kilroy (D-OH) would require at least annual reporting of annual say-on-pay and golden parachutes votes by all institutional investors, unless such votes are otherwise required to be reported publicly by SEC rule.

The non-binding advisory vote approach has been used in the United Kingdom since 2003; and is now used in Australia as well. The policy change is credited with improving management-shareholder dialogue on executive compensation matters and increasing the use of long-term performance targets in incentive compensation.

The draft legislation comes against the backdrop of a growing global consensus that executive compensation must be reformed because it favors excessive risk taking and contributed to the financial crisis. President Obama and the G-20 leaders pledged to pass legislation reforming the financial regulatory system. As part of that legislation, the leaders called for the comprehensive reform of executive compensation to base pay on performance not on excessive risk taking.

According to the G-20, regulations must ensure that compensation structures are consistent with firms’ long-term goals and prudent risk taking

Specifically, the say-on-pay provisions of the House legislation direct the SEC to adopt rules, within one year, requiring that proxies for annual meetings provide for a shareholder advisory vote on the compensation of executives. Similarly, a proxy involving a merger, acquisition or sale of the company must provide for a shareholder advisory vote on any golden parachute agreements. The proxy must disclose the aggregate total of compensation to be paid pursuant to the golden parachute agreement.

A Manager’s Amendment would allow the SEC to exempt certain categories of companies from the say-on-pay requirements where appropriate, taking into account, among other considerations, the potential impact on smaller reporting companies.

The legislation also adds a new Section 10B to the Exchange Act mandating that listed companies have independent compensation committees. The SEC would be authorized to exempt smaller reporting companies from the mandate.

In order to be considered independent, a compensation committee member may not accept any consulting, advisory, or other compensatory fee from the company and cannot be an affiliated person of the company or any of its subsidiaries. The SEC would be authorized to exempt a particular relationship with a compensation committee member from these independence standards.

A Manager’s Amendment clarifies that the compensation committee independence standards apply only to public companies, not to companies that have only an issue of publically registered debt.

The legislation gives the compensation committee sole discretion to retain compensation consultants meeting independence standards to be promulgated by the SEC. The compensation committee would be directly responsible for the appointment, compensation, and oversight of the work of the compensation consultant. However, there is no requirement that the compensation committee implement or act consistently with the advice or recommendations of the compensation consultant. In addition, the hiring of a compensation consultant would not affect the committee’s ability or obligation to exercise its own judgment in carrying out its duties.

A Manager’s Amendment requires that the independence standards for compensation consultants to be promulgated by the SEC are competitively neutral among categories of consultants and preserve the ability of compensation committees to retain the services of members of any such category.

A year after enactment, companies must disclose in their annual proxies if the compensation committee retained an independent compensation consultant. A provision in the original bill requiring company that did not hire a compensation consultant to explain why retaining such a consultant was not in the interests of company shareholders was deleted by a Manager’s Amendment.

The compensation committee would also be authorized to retain independent counsel and other advisers meeting SEC independence standards. As with compensation consultants, the compensation committee would be directly responsible for the appointment, compensation, and oversight of the work of such independent counsel and other advisers. But the compensation committee would not be required to implement or act consistently with the advice or recommendations of such independent counsel and other advisers, and the retention would in no way affect the committee’s ability or obligation to exercise its own judgment.

The legislation orders companies to provide funding, as determined by the compensation committee, to pay compensation consultants and independent counsel and advisers hired by the committee.

The SEC is directed to conduct a study of the use of compensation consultants hired under this Act and submit a report to Congress within two years.

The House adopted a floor amendment offered by Rep. Frank that struck out language prohibiting clawbacks of executive compensation approved by shareholders and inserted language prohibiting rules from allowing financial regulators to require recovery of incentive-based pay under arrangements in effect on the date of enactment

Finally, the legislation directs federal financial regulators, including the SEC and Fed, to jointly prescribe regulations to require banks, brokers and investment advisers to disclose the structures of the incentive-based compensation arrangements for officers and employees of such institution sufficient to determine whether the compensation structure properly measures and rewards performance; is structured to account for the time horizon of risks; is aligned with sound risk management; and meets other criteria as the agencies may determine to be appropriate to reduce unreasonable incentives for officers and employees to take undue risks that could have serious adverse effects.

The federal financial regulators must also jointly prescribe regulations prohibiting compensation structures or bonuses or other incentive-based payment arrangements that encourage inappropriate risks that could have serious adverse effects on economic conditions or financial stability; or could threaten the safety and soundness of the financial institution.

The provisions of this section would be enforced under section 505 of the Gramm-Leach-Bliley Act, which provides for the strong enforcement of GLB’s privacy provisions. Section 505 provides that each functional regulator will enforce the provisions of GLB for the entities they regulate. Thus, by analogy, under the draft legislation, the SEC will enforce the provisions against brokers, dealers, and investment advisers. The SEC and other regulators are also authorized to use the full range of their enforcement powers in case of violations of the draft provisions.

Wisconsin Announces Annual Rules Revision

Wisconsin's 2009 annual rules revision is partly to make nonsubstantive changes to statutory cross references to align the rules with the new Wisconsin Securities Act that took effect January 1, 2009, along with proposing more substantive rule changes (see below).

Public hearing and written comments. A copy of the Notice of Rule-Making Hearing, together with a Proposed Rule-Making Order containing the Public Comment Draft of the proposed rules in line-and strike form, may be reviewed and downloaded from the Division's Web page. Written comments regarding the proposed rules should be directed to, and received by, the Administrator by the September 21, 2009 hearing date, or alternatively, public hearing testimony may be provided at the rule-making hearing.

Questions. Substantive questions on the rule proposals should be directed to Randall Schumann, Attorney, Department of Financial Institutions, Division of Securities, P.O. Box 1768, Madison, WI 53701-1768, tel. (608) 266-3414, or by email. Questions regarding the agency's internal processing of the proposed rules should be directed to Mark, Schlei, Deputy General Counsel, Department of Financial Institutions, Office of the Secretary, P.O. Box 8861, Madison, WI 53708-8861, tel. (608) 267-1705, or by email.

The more significant changes in the proposed rules package are as follows:

* Amending Form D filing requirements for Rule 506 offerings to provide an electronic filing alternative to the existing hardcopy notice filing provision) in light of the SEC's Form D electronic filing mandate that began for securities issuers at the federal level on March 16, 2009. As proposed, issuers would either: (1) file a notice consisting of a photocopy of the Form D filed electronically with the SEC, along with a $200 fee; or (2) make an electronic filing under the Electronic Filing of Form D (EFD) System developed by the North American Securities Administrators Association (NASAA) and operated by PNC Global Investment Servicing or its affiliate, that designates Wisconsin as a state in which the offering is (or will be) made, and allocates a $200 fee to Wisconsin.

* Repealing the definition of "institutional investor" because it duplicates the definition in the Wisconsin securities statute

* Repealing two government securities exemptions, a corporate merger transactional exemption connected to the Internal Revenue Code, and a compensatory benefit plan transactional exemption because of the difference in language and scope of these exemptions in the Wisconsin securities statute

* Providing specific recognition of electronic prospectus delivery modes that comply with federal requirements

* Providing in a broker-dealer/agent registration rule that applicants receiving an exam waiver from taking one of the general securities business exams are not required to take and pass those exams again, but also provides that applicants receiving a waiver from taking the general securities business examinations are still required to pass one of the state law exams, i.e., the Uniform Securities Agent State Law Examination (Series 63) or the Uniform Combined State Law Examination (Series 66)

* Separating two waiver concepts in a preceding examination provision for investment advisers and investment adviser representatives to eliminate a conflict with the succeeding examination provision

* Providing an exemption from registration for supervised persons of noticed federal covered investment advisers if the supervised persons do not have a place of business in Wisconsin, to comply with federal law requirements

* Repealing two investment adviser/investment adviser representative forms as no longer necessary: Form IAR (WI), Application for Renewal of Investment Adviser and Investment Adviser Representative Registration, and Form IAUSR (WI), Acknowledgment of Understanding of Supervisory Responsibilities of Investment Adviser Under Wisconsin Statutes and Administrative Code.

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House Passes Legislation Allowing SEC to Sanction SRO Officials

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

The House has passed legislation, HR 2623, expressly authorizing the SEC to bring actions against persons formerly associated with a regulated or supervised entity, such as an investment company or an SRO, for misconduct that occurred during that association. The bill passed the House unanimously by voice vote. The legislation closes a loophole in the securities laws allowing those who engage in misconduct while working for an entity regulated by the SEC, like a stock exchange, to resign and avoid being held accountable for their wrongdoing.

According to sponsor Rep. Kevin McCarthy, the measure is directed at ensuring that former employees of organizations like the New York Stock Exchange or the Financial Industry Regulatory Authority can be held accountable by the SEC for any misconduct while an employee at these organizations. By clarifying the SEC’s authority to sanction formerly associated persons, he noted, employees at regulated or supervised entities would be held accountable for their actions while in those positions, even if they have moved on to another job.

The legislation was included in a larger piece of securities legislation from the 110th Congress, H.R. 6513, Securities Act of 2008, which passed the House but died in the Senate. The legislation is also included in H.R. 3310, the Consumer Protection and Regulatory Enhancement Act, introduced by Ranking Member Spencer Bachus, who supported HR 2623.

Many provisions of the federal securities laws authorizing the sanctioning of a person who engages in misconduct while associated with a regulated or supervised entity explicitly provide that such authority exists even if the person is no longer associated with that entity and has left his or her job. But according to Rep. McCarthy, there are confusing loopholes so that employees at some regulated or supervised organizations cannot be sanctioned by the SEC after they leave their positions.

The legislation amends the Exchange Act and the Investment Company Act to ensure that the SEC has unambiguous statutory authority to investigate individuals suspected of violating the securities laws, to bring enforcement cases, and have those cases considered on the merits and not be dismissed on an ambiguity because a statute is confusing. No one should be able to violate the securities laws and resign their position knowing that the SEC cannot proceed against them, emphasized Rep. McCarthy, who added that the legislation does not expand or alter the SEC’s current authority, it clarifies it.

According to Rep. McCarthy, the need for the legislation was cast into stark relief by an SEC administrative proceeding against a former AMEX CEO after he had left AMEX. An SEC administrative law judge dismissed the charges after finding that Section 19 (h)(4) of the Exchange Act allows the SEC to sanction individuals while they were still associated with the SRO; but does not provide for sanctioning a former officer or director. The judge specifically noted that Congress has drafted statutes authorizing the SEC to sanction individuals formerly associated with any number of entities, but not in this case. In the Matter of Salvatore Saldano, Aug 20, 2007, Admin Proc File No. 3-12596

The law judge also noted that Section 19(h)(4) of the Exchange Act is unambiguous on its face, referring to the officers and directors of an SRO only in the present. By omitting reference to former officers or directors, in comparison to wording in other parts of the securities laws, the intent of Congress is clear that this section applies only to those who currently hold the position. Both Section 15(b)(6)(A) of the Exchange Act and Section 203(f) of the Advisers Act explicitly cover “any person who is associated, or, at the time of the alleged misconduct, who was associated or was seeking to become associated” with a broker dealer or investment adviser, respectively. When Congress wants to construct a statute to apply to individuals formerly associated with an entity, observed the law judge, it knows how to do so.

Further, the remedies provided in the statute further demonstrated that it applies only to current officers and directors. Section 19(h)(4) provides for removal from office and censure. One who is no longer in office clearly cannot be removed from office, reasoned the law judge, and thus this remedy only applies to current officers and directors. Given the definition of censure as an official reprimand or condemnation, and the order in which the remedies are listed, it is plain from the statutory construction that Congress’s inclusion of censure in Section 19(h)(4) provides a less severe alternative remedy when sanctioning an incumbent officer and director. However, it does not justify expanding the definitions of “officer or director” to those who formerly held the positions, concluded the judge.

House Financial Services and Ag Committee Chairs Reach Agreement in Principle on Derivatives Legislation

The important derivatives regulation piece of the Obama Administration’s proposed legislation to overhaul regulation of the financial markets came closer to fruition as the Chairs of the House Financial Services and the Agriculture Committees agreed on the basic principles of derivatives legislation. The joint concept paper defuses fears of jurisdictional conflicts as the legislation moves forward. The legislative approach agreed to by Chairs Frank and Peterson bridges the differences between those members who want to completely eliminate the OTC derivatives market and those who think that just greater transparency is all that is needed. The principles agreed to by the Chairs include harmonized SEC-CFTC regulation, the mandatory clearing of OTC derivatives, limitations on speculation, coordination with foreign regulators, and a dispute resolution role for the new Financial Services Oversight Council.

Depending on the underlying asset on which a derivative is based, either the SEC or the CFTC, or potentially both, will oversee the regulation of OTC derivative dealers, exchanges and clearinghouses. The statutory and regulatory powers of the SEC and CFTC will be harmonized with respect to the OTC derivative market, including registration requirements for dealers. The agencies will have enforcement authority over products under their jurisdiction; and joint enforcement authority for any products subject to joint jurisdiction.

The Chairs also agreed that the new Financial Services Oversight Council will resolve disputes between the SEC and CFTC over authority over new derivatives products within 180 days. Similarly, the Council will resolve disputes between the SEC and CFTC over joint regulation of derivative products within 180 days. It is envisioned that the Council will include the Fed, the SEC, and the CFTC.

The House leaders also agreed that the legislation will direct U.S. regulators to coordinate with foreign regulators on harmonizing OTC derivative market regulation, including recognized international standards with respect to clearinghouses. In addition, to prevent regulatory arbitrage, the Treasury Department would be authorized to restrict access to the U.S. banking system for institutions of any jurisdiction Treasury finds permits capital-related standards that are lower than the United States or that promote reckless market activity.

There was agreement that derivatives must be cleared by an approved clearinghouse. Exchange trading and trading on electronic trading platforms will be strongly incentivized and encouraged. An exception would be when a regulator determines that the derivatives product is not sufficiently standardized to be cleared or no qualified clearing mechanism exists; or when one party in the transaction does not qualify as a major market participant as determined by the appropriate regulator in consultation with the Financial Services Oversight Council. Also, regulators should be authorized to prohibit or regulate transactions that are not traded on exchange or cleared.

Depending on the underlying asset on which a derivative is based, either the SEC or the CFTC, or potentially both, will oversee the regulation of OTC derivative dealers, exchanges and clearinghouses. Primary oversight authority of the credit default swap clearinghouse, ICE Trust, would be shifted from the Fed to a market regulator within six months of the legislation’s enactment.

Further, the legislation would require all OTC derivative trades to be reported to a qualified trade repository. The draft would also require that regulators act within 180 days on requests for approval as a clearinghouse, exchange or electronic trading platform.

Under the legislation, appropriate regulators will develop margin and capital requirements creating a strong incentive for dealers and users of derivatives to trade them on an exchange or electronic trading platform; or have them cleared whenever possible. Significantly higher capital and margin charges will apply to non-standardized transactions that are not exchange-traded or centrally cleared. Regulators would be permitted to authorize the use of non-cash collateral to satisfy margin requirements.

The concept paper sets out two options on speculation. The first is a limitation on speculation prohibiting any purchase of credit protection using a credit default swap unless the party owns the referenced security; the party has a bona fide economic interest that will be protected by the contract; or the party is a bona fide market maker. Regulators would be authorized to monitor market activity and impose position limit where necessary.

The second option would be to require confidential reporting to the appropriate regulator of all short interest in credit default swaps by OTC derivatives dealers, investment advisers managing over $100 million, and other entities that are deemed major market participants. In order to prevent abuse, the appropriate regulator would be authorized to impose position limits on market participants and ban the purchase of credit protection using credit default swaps by any non-dealer that is not hedging a risk.

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9th Circuit: Investors Could Not Rely on Market Integrity


The Affiliated Ute and fraud on the market reliance presumptions were unavailable to a plaintiff class making market manipulation claims, according to a 9th Circuit panel. The court also found no error in the decision by the district court not to recognize a presumption of reliance based on manipulations that allegedly destroyed the efficiency of the market and the reliability of the market’s price. In the absence of a reliance presumption, the class could not be certified because individual reliance claims would predominate. Desai v. Deutsche Bank Securities Ltd.

The action, more than seven years old and still at the class certification stage, alleged an elaborate scheme in which broker-dealers used securities loan transactions to conceal their manipulative activities to drive up the price of an OTC-traded stock. In a per curiam opinion, the court found that the Affiliated Ute presumption applied to omissions cases rather than market manipulation claims. A fraud on the market presumption was also not available because the company's securities did not trade in an efficient market.

The investors posited an argument described by the appeals court as "novel" to establish a presumption of reliance on "the integrity of the market" in the context of manipulation cases when other presumptions are unavailable. The appellate panel found that no authority required the district court to recognize such a presumption and the lower court did not abuse its discretion in refusing to do so.

In a separate concurrence, Judge O’Scannlain asserted that the panel should have decided definitively, one way or the other, whether the investors were entitled to plead the new "integrity of the market" presumption. The judge stated that in his view, such a presumption would not be valid. However, he asserted that "we must reach the validity of the integrity of the market presumption, for it is at the heart of the legal error Investors claim the district court made in the class certification ruling."

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DC Circuit Sends SEC Back to the Drawing Board on Fixed Indexed Annuities

By Rodney Tonkovic, Wolters Kluwer Associate Writer-Analyst, and N. Peter Rasmussen

A D.C. Circuit appellate panel remanded the SEC's fixed index annuity rule, Securities Act Rule 151A, to the Commission for reconsideration. While the court found that the SEC’s interpretation of the term "annuity contract" in its rulemaking was reasonable, it concluded that the agency failed to properly consider the effect of the rule upon efficiency, competition, and capital formation. American Equity Investment Life Insurance Co. v. SEC.

A fixed index annuity (FIA) is a hybrid financial product. Unlike traditional fixed annuities, the purchaser’s rate of return is not based upon a guaranteed interest rate. In FIAs the insurance company credits the purchaser with a return that is based on the performance of a securities index, such as the Dow Jones Industrial Average, Nasdaq 100 Index, or Standard & Poor’s 500 Index. Depending on the performance of the securities index to which a particular FIA is tied, the return on an FIA might be much higher or lower than the guaranteed rate of return offered by a traditional fixed annuity.

In early 2009, the SEC adopted Rule 151A, which defined the terms "annuity contract "and "optional annuity contract" under the Securities Act. Under the rule, certain indexed annuities would be defined as not being "annuity contracts" or "optional annuity contracts" for purposes of the Section 3(a)(8) exemption if the amounts payable by the insurer under the contract were more likely than not to exceed the amounts guaranteed under the contract.

Initially, the appellate panel disagreed with the annuity issuer's argument that the SEC erred in excluding fixed indexed annuities from the definition of annuity contract. The court found that the SEC's interpretation of "annuity contract" was reasonable under the Chevron analysis because Section 3(a)(8) is ambiguous as to what forms of contracts it encompasses. Further, the SEC's interpretation of the statute was reasonable because the fixed indexed annuities' variability in potential return results in a risk to the investor. Finally, the SEC's decision to not include an analysis of how the annuities are marketed in the rule was not unreasonable because the SEC reasoned that the securities-like structure of fixed indexed annuities "is itself an implicit marketing tool aimed at consumers who wish to participate to some extent in the securities market."

The panel then held that the SEC's analysis of the efficiency, competition, and capital formation effects of Rule 151A as required under Securities Act Section 2(b) was flawed. The Commission argued that it was not required to undertake such an analysis, even though it did in fact do so. The panel found that the Commission's analysis was arbitrary and capricious because it had made no findings on the existing level of competition and efficiency under the existing state law regime. Because it was based on the flawed efficiency analysis, the court found that the SEC's capital formation analysis was similarly arbitrary and capricious. The panel then remanded the matter to the SEC to address the deficiencies of its Section 2(b) analysis.

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Expert Testimony Not Needed to Show Accountant Acted Unreasonably

The SEC acted properly in suspending a former audit firm partner from practice before the Commission under Rule 102(e). Gregory Dearlove was the engagement partner in charge of the 2000 audit of Adelphia Communications Corp. The SEC concluded Dearlove engaged repeatedly in unreasonable conduct resulting in violations of applicable accounting principles and standards. According to the District of Columbia Circuit, the SEC made no error of law in imposing the suspension under Rule 102(e) and substantial evidence supported its findings of fact. Dearlove v. SEC.

The D.C. Circuit rejected Dearlove's contention that the SEC had to hold he violated the common law negligence standard of care, as evidenced by expert testimony, in order to find a Rule 102(e) violation. According to the panel, the appropriate standard of care in this case was supplied by
Generally Accepted Auditing Standards, and the SEC did not need expert testimony to establish the standard of care or to determine whether Dearlove’s conduct was unreasonable. The SEC properly found that Dearlove’s conduct was unreasonable in the circumstances and that it resulted in a violation of professional standards, both GAAS and GAAP.

The court also found that the SEC also did not deny due process to Dearlove by denying his request for a postponement of his hearing. The administrative law judge properly considered the request in light of the broad discretion the agency has in ordering the conduct of its proceedings, concluded the court.

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House Committee Approves Corporate Governance Legislation with Say-on-Pay Mandate

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

The House Financial Services Committee has approved legislation mandating shareholder advisory votes on executive compensation as part of the overall reform of financial regulation. Final House passage is expected later this week. The legislation builds on the SEC’s executive pay disclosure rules to require that public companies include in their annual proxy to investors the opportunity to vote on the company's executive pay plans. The Corporate and Financial Institution Compensation Fairness Act would also require independent board compensation committees and independent compensation consultants. The legislation further requires all financial institutions, including brokers, dealers and investment advisers, to disclose compensation structures that include any incentive based elements. The measure also requires federal financial regulators to proscribe inappropriate or imprudently risky compensation practices as part of solvency regulation.

A Manager’s Amendment offered by Committee Chair Barney Frank (D Mass) specifically provides that financial companies that do not have incentive-based payment arrangements are not required to make disclosures regarding incentive-based payment arrangements. The Manager’s Amendment also narrows the scope of the regulators’ authority to prohibit compensation structures by rule to allow such prohibitions only of incentive-based payment arrangements, as opposed to any compensation structures or incentive-based payment arrangements, of covered financial institutions .

An amendement offered by Rep. Jeb Henserling (R-TX) exempts financial institutions with less than $1B in assets from the incentive-based pay provisions. Another Henserling amendment would requires the GAO to study the correlation between compensation structure and excessive risk-taking and report to Congress within one year of enactment. In that study, the GAO would have to consider compensation structures used by companies from 2000-2008, and do a comparison of companies that failed, or nearly failed but for government assistance, and report on companies that remained viable through the market turmoil of 2007-2008.

An amendment by Mr. Henserling adds Fannie Mae and Freddie Mac to the list of financial institutions subject to the incentive-based pay provisions, as well as add their oversight regulator, the FHFA, as a financial regulator with rulemaking authority for such provisions. The measure would not set any limits on pay, but will ensure that shareholders have a non-binding and advisory vote on their company's executive pay practices without micromanaging the company. Knowing that they will be subject to some collective shareholder action should give boards pause before approving a questionable compensation plan. The legislation also contains a separate advisory vote if a company gives a new, not yet disclosed, golden parachute while simultaneously negotiating to buy or sell a company.

An amendment by Rep. Tom Price (R-GA) provides that compensation approved by a majority say-on-pay vote is not subject to clawback, except as provided by contract or due to fraud to the extent provided by federal law. An amendment by Rep. Mary Jo Kilroy (D-OH) would require at least annual reporting of annual say-on-pay and golden parachutes votes by all institutional investors, unless such votes are otherwise required to be reported publicly by SEC rule.

The non-binding advisory vote approach has been used in the United Kingdom since 2003; and is now used in Australia as well. The policy change is credited with improving management-shareholder dialogue on executive compensation matters and increasing the use of long-term performance targets in incentive compensation.

The draft legislation comes against the backdrop of a growing global consensus that executive compensation must be reformed because it favors excessive risk taking and contributed to the financial crisis. President Obama and the G-20 leaders pledged to pass legislation reforming the financial regulatory system. As part of that legislation, the leaders called for the comprehensive reform of executive compensation to base pay on performance not on excessive risk taking. According to the G-20, regulations must ensure that compensation structures are consistent with firms’ long-term goals and prudent risk taking.

Specifically, the say-on-pay provisions of the House legislation direct the SEC to adopt rules, within one year, requiring that proxies for annual meetings provide for a shareholder advisory vote on the compensation of executives. Similarly, a proxy involving a merger, acquisition or sale of the company must provide for a shareholder advisory vote on any golden parachute agreements. The proxy must disclose the aggregate total of compensation to be paid pursuant to the golden parachute agreement.

A Manager’s Amendment would allow the SEC to exempt certain categories of companies from the say-on-pay requirements where appropriate, taking into account, among other considerations, the potential impact on smaller reporting companies.

The legislation also adds a new Section 10B to the Exchange Act mandating that listed companies have independent compensation committees. The SEC would be authorized to exempt smaller reporting companies from the mandate.

In order to be considered independent, a compensation committee member may not accept any consulting, advisory, or other compensatory fee from the company and cannot be an affiliated person of the company or any of its subsidiaries. The SEC would be authorized to exempt a particular relationship with a compensation committee member from these independence standards.

A Manager’s Amendment clarifies that the compensation committee independence standards apply only to public companies, not to companies that have only an issue of publically registered debt. The legislation gives the compensation committee sole discretion to retain compensation consultants meeting independence standards to be promulgated by the SEC. The compensation committee would be directly responsible for the appointment, compensation, and oversight of the work of the compensation consultant. However, there is no requirement that the compensation committee implement or act consistently with the advice or recommendations of the compensation consultant. In addition, the hiring of a compensation consultant would not affect the committee’s ability or obligation to exercise its own judgment in carrying out its duties.

A Manager’s Amendment requires that the independence standards for compensation consultants to be promulgated by the SEC are competitively neutral among categories of consultants and preserve the ability of compensation committees to retain the services of members of any such category. A year after enactment, companies must disclose in their annual proxies if the compensation committee retained an independent compensation consultant. A provision in the original bill requiring company that did not hire a compensation consultant to explain why retaining such a consultant was not in the interests of company shareholders was deleted by a Manager’s Amendment.

The compensation committee would also be authorized to retain independent counsel and other advisers meeting SEC independence standards. As with compensation consultants, the compensation committee would be directly responsible for the appointment, compensation, and oversight of the work of such independent counsel and other advisers. But the compensation committee would not be required to implement or act consistently with the advice or recommendations of such independent counsel and other advisers, and the retention would in no way affect the committee’s ability or obligation to exercise its own judgment.

The legislation orders companies to provide funding, as determined by the compensation committee, to pay compensation consultants and independent counsel and advisers hired by the committee.

The SEC is directed to conduct a study of the use of compensation consultants hired under this Act and submit a report to Congress within two years.

Finally, the legislation directs federal financial regulators, including the SEC and Fed, to jointly prescribe regulations to require banks, brokers and investment advisers to disclose the structures of the incentive-based compensation arrangements for officers and employees of such institution sufficient to determine whether the compensation structure properly measures and rewards performance; is structured to account for the time horizon of risks; is aligned with sound risk management; and meets other criteria as the agencies may determine to be appropriate to reduce unreasonable incentives for officers and employees to take undue risks that could have serious adverse effects.

The federal financial regulators must also jointly prescribe regulations prohibiting compensation structures or bonuses or other incentive-based payment arrangements that encourage inappropriate risks that could have serious adverse effects on economic conditions or financial stability; or could threaten the safety and soundness of the financial institution.

The provisions of this section would be enforced under section 505 of the Gramm-Leach-Bliley Act, which provides for the strong enforcement of GLB’s privacy provisions. Section 505 provides that each functional regulator will enforce the provisions of GLB for the entities they regulate. Thus, by analogy, under the draft legislation, the SEC will enforce the provisions against brokers, dealers, and investment advisers. The SEC and other regulators are also authorized to use the full range of their enforcement powers in case of violations of the draft provisions.

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Backdated Stock Options Are Not Qualified Performance-Based Compensation

Backdated stock options are not qualified performance-based compensation under IRC §162(m), according to a memo from the IRS Chief Counsel, even if, before or after exercise, the executive reimburses the company for the discount or the option is “repriced” based on the fair market value on the actual date of grant. Further, for purposes of §162(m), the date of grant of a stock option is the date the granting corporation completes the action constituting an offer of sale to an individual of a certain number of shares of stock at a fixed price per share.

Under 162(m), the deductibility of compensation paid to senior corporate officers is limited to $1 million. However, 162(m) excludes performance-based compensation from the deduction limitation; and thus it is not taken into account in determining whether executive compensation exceeds $1 million.

The Chief Counsel cited the legislative history of 162(m), particularly the conference report, which stated that stock options granted with an exercise price that is less than the fair market value of the stock at the time of grant do not meet the requirements for performance-based compensation.

Section 162(m) and its regulations contain very specific requirements that must be met for compensation to qualify as performance-based compensation. One of the requirements is that the amount of compensation the employee could receive under an option must be based solely on an increase in the value of the stock after the date of grant or award. Whether a stock option is qualified performance-based compensation is determined at the time of grant. Subsequent actions such as a repayment by an employee cannot change the fact that the option was issued at a discount. Moreover, the grant and exercise of an option, and a later voluntary repayment of a compensatory amount, are separate transactions for federal tax purposes. Therefore, none of the compensation attributable to the discounted grants qualified as performance-based compensation under § 162(m)

Since the § 162(m) regulations do not provide a standard for determining the grant date, the Chief Counsel looked to the standards in similar tax code regs, as well as an SEC staff accounting letter. The standard for determining the grant date in the IRC regulations, based on the date the corporation completes the corporate action constituting an offer of sale of a certain number of shares of stock to a designated individual at a set price, is an appropriate standard for purposes of § 162(m). Regulations under § 409A were deemed particularly appropriate because of the similarity to 162(m).

The IRS Chief Counsel also relied on a letter of the SEC Chief Accountant, dated September 19, 2006, discussing backdating practices, and advising companies on determining the grant date for financial accounting purposes. Although SEC accounting standards are not controlling for federal tax purposes, noted the Chief Counsel, the letter provides useful background on the practices that led to backdated options and the standards companies used to determine grant dates for financial accounting purposes. The SEC official observed that the grant date for accounting purposes, termed the measurement date, is the date when the individual recipient, the number of shares, and the option price are first known.

The standards under the tax code regulations are more stringent than the accounting standards described in the SEC staff letter, noted the Chief Counsel, because the tax regulations require the completion of all required corporate granting actions. Nonetheless, although SEC accounting standards are not controlling for tax purposes, and are less stringent than existing tax standards, it is reasonable in the circumstances of these cases to use the measurement dates determined by the taxpayers for purposes of their accounting restatements as the grant dates for purposes of § 162(m).

The Chief Counsel described the SEC accounting standard as a reasonable one that is not open to the type of abuse and manipulation to which an ad hoc standard, developed after the fact to rationalize what had been done, is vulnerable. Accordingly, given the lack of specific guidance under § 162(m) for determining the date of grant and administrative concerns, the use of the accounting standard is reasonable. However, the IRS reserved the right, in future cases, to insist on determining grant dates strictly in accordance with the standards under the current § 421 and § 409A regulations.

The Chief Counsel rejected an argument for additional flexibility based upon the lack of an explicit standard for determining a grant date under § 162(m), adding that such
flexibility is ``singularly inappropriate here.’’ The taxpayers not only failed to abide by the longstanding standards for grant dates for statutory options, a closely analogous provision, said the IRS official, but their “flexible” interpretations of the grant date resulted in substantial additional compensation to the executives that was not likely to have been contemplated by the shareholders approving the plan. This casts doubt on the validity of the shareholder approval of the plan, which is also a requirement for treatment as qualified performance-based compensation.

Moreover, noted the Chief Counsel, these taxpayers failed to comply with applicable accounting standards and may have violated state law duties as well. Many state law corporate governance issues arise from option backdating, including the propriety of the executive compensation, whether the requisite disclosures relating to stock compensation was made, and whether shareholder approved plans have been complied with.

House Leaders Sponsor Legislation Allowing PCAOB to Share Information with Foreign Audit Regulators

Legislation allowing the PCAOB to share confidential information with regulators of foreign firms has been introduced by House Financial Services Chair Barney Frank. The measure, HR 3346, was co-sponsored by Rep. Paul Kanjorski, Chair of the Capital Markets Subcommittee. The draft legislation would amend the Sarbanes-Oxley Act to allow the Board to share confidential information obtained in connection with inspections and investigations with foreign audit oversight authorities. A condition of the information sharing permission is that the foreign audit overseer provide appropriate assurances of confidentiality, as determined by the Board. Information may be shared with the foreign regulator when, in the Board’s discretion, when necessary to accomplish the purposes of Sarbanes-Oxley or to protect investors. Sarbanes-Oxley currently authorizes the Board to share information with the SEC and other federal regulators.

The legislation would add a new section to the Sarbanes-Oxley Act defining the term foreign auditor oversight authority to mean any governmental body or other entity empowered by a foreign government to conduct inspections of public accounting firms or otherwise to administer or enforce laws related to the regulation of public accounting firms.

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IASB Proposes New Fair Value Standard, While FCAG Says Fair Value Not Pro-Cyclical

The IASB has proposed significant changes to its fair value accounting standard that would essentially require all financial instruments that do not have basic loan features to be measured at fair value. The proposal would also eliminate the requirement to identify and account for embedded derivatives separately. The IASB’s proposed approach would reduce the complexity that results from the many categories and related impairment methods in current standard IAS 39.

The draft proposes two primary measurement categories for financial instruments: amortized cost and fair value. A financial asset or financial liability would be measured at amortized cost if the instrument has loan features and is managed on a contractual yield basis. All other financial assets or financial liabilities would be measured at fair value. Therefore, the draft proposes that all investments in equity instruments, as well as derivatives on those equity instruments, should be measured at fair value.

Many commenters consider the accounting requirements in IAS 39 for embedded derivatives complex and rule-based. The draft would simplify those accounting requirements by proposing a single classification approach for all financial instruments including hybrid contracts with financial hosts.

The draft defines an embedded derivative as a component of a hybrid contract that also includes a non-derivative host, with the effect that some of the cash flows of the combined instrument vary in a way similar to the cash flows of a stand-alone derivative. If a derivative is attached to a financial instrument, but is contractually transferable independently of that instrument, or has a different counterparty from that instrument, that derivative is not an embedded derivative, but a separate financial instrument.

The exposure draft also addresses investments in contractually subordinated interests, such as tranches. The draft proposes to apply the classification criteria to such investments by requiring that any tranche that provides credit protection to other tranches on the basis of any possible outcome, rather than a probability-weighted outcome, must be measured at fair value because provision of such credit protection is a form of leverage and not a basic loan feature.

At the same time, a high level advisory group jointly formed by FASB and the IASB reported that fair value accounting was not a pro-cyclical cause of the financial crisis. The Financial Crisis Advisory Group, co-chaired by former SEC Commissioner Harvey Goldschmid, said that accounting standards actually led to an understatement of the value of financial assets.

While the crisis may have led to some understatement of the value of mark-to-market assets, noted FCAG, it must be recognized that in most countries a majority of financial institutions’ assets are still valued at historic cost using the amortized cost basis. Those assets are not marked to market and are not adjusted for market liquidity. The overall value of these assets was overstated. Further, the incurred loss model for loan loss provisioning and difficulties in applying the model, delayed the recognition of losses on loan portfolios. The group noted that the results of the US stress tests seem to bear this out. Moreover, the off-balance sheet standards, and the way they were applied, may have obscured losses associated with securitizations of complex structured products.

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SEC Acts to Curb Abusive Short Selling and Enhance Transparency

The SEC made permanent a temporary rule reducing the potential for abusive naked short selling and acted to enhance the public availability of short sale information. Rule 204T was made permanent and new Rule 204 requires broker-dealers to promptly purchase or borrow securities to deliver on a short sale. The temporary rule, approved by the SEC in the fall of 2008, was set to expire on July 31. The SEC is also working with several SROs to make short sale volume and transaction data available through the SRO websites. This effort will result in a substantial increase over the amount of information presently required by Temporary 10a-3T.
That rule, which will expire on August 1, applies only to certain institutional money managers and does not require public disclosure.

The Commission also intends to hold a public roundtable on September 30 to discuss securities lending, pre-borrowing, and possible additional short sale disclosures. The roundtable will consider, among other topics, the potential impact of a program requiring short sellers to pre-borrow their securities, possibly on a pilot basis, and adding a short sale indicator to the tapes to which transactions are reported for exchange-listed securities.

While acknowledging that short selling can play a constructive role by, among other things, contributing to efficient price discovery and increasing market liquidity, the SEC said that short selling can also be used as a tool to manipulate the market.

Rule 204T was approved in response to continuing concerns regarding fails to deliver and potentially abusive naked short selling. In particular, the rule made it a violation of Regulation SHO and imposes penalties if a clearing firm does not purchase or borrow shares to close-out a fail to deliver resulting from a short sale in any equity security by no later than the beginning of trading on the day after the fail first occurs (T+4). An analysis conducted by the SEC which followed the adoption of the close-out requirement of Rule 204T and the elimination of the options market maker exception showed the number of fails declined significantly.

Due to the success of these measures in furthering the Commission's goals of reducing fails to deliver and addressing potentially abusive naked short selling, the Commission has made permanent the requirements of Rule 204T with only limited modifications to address commenters' operational concerns. In a naked short sale the investor sells shares short without first having borrowed them.

In the fall of 2008, the Commission also adopted Rule 10a-3T to require market participants to provide short sale and short position information to the Commission. The rule was temporary so that the SEC could evaluate whether the benefits from the data justified the costs associated with the rule.

Instead of renewing the rule, the Commission and its staff, together with SROs, are working to substantially increase the public availability of short sale-related information through a series of other actions that should provide a wealth of information to the Commission, other regulators, investors, and analysts.

As the work comes to fruition, it is expected that in the next few weeks the SROs will begin publishing on their websites the aggregate short selling volume in each individual equity security for that day. The SROs will also begin publishing on a one-month delayed basis information regarding individual short sale transactions in all exchange-listed equity securities. It is also expected that in the next few weeks the Commission will enhance the publication on its website of fails to deliver data so that fails to deliver information is provided twice per month and for all equity securities, regardless of the fails level.

In addition, the Commission is continuing to actively consider earlier proposals on a short sale price test and circuit breaker restrictions.

The SEC acted against the backdrop of global concerns in this area, recently the UK Financial Services Authority extended the short selling disclosure obligation without time limit. The obligation would have expired on June 30, 2009. The FSA believes that maintaining the disclosure obligation will help continue to minimize the potential for market abuse and disorderly markets in financial sector stocks. It will also enhance transparency in that sector. Disclosures will need to be made if a net short position exceeds 0.25% of a company’s issued shared capital or increases by 0.1% bands above that, for example, net short position reaches 0.35%. 0.45% and so on. The FSA also pledged to continue to engage in an international dialogue on short selling.

The German Federal Financial Supervisory Authority (BaFin) has extended its ban on naked short selling in the shares of financial companies to January 31, 2010. This is BaFin’s third extension of the prohibition, which was adopted in September of 2008.

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Kentucky Revises Rule 506 Policy to Include Electronic Filing

The filing requirements to make a Rule 506 offering in Kentucky were revised. Issuers must submit within 15 calendar days from the date of first sale in Kentucky, a Form D, Form U-2, Uniform Consent to Service of Process, statement from an authorized official that a federal filing was made or will be made contemporaneously, and a $250 check made payable to the Kentucky State Treasurer. HOWEVER, for issuers making an electronic filing with the SEC, the Form U-2 and "statement from an authorized official" requirements are automatically met.

Issuers are also requested to submit to the Kentucky Department of Financial Institutions a copy of all offering materials distributed to offerees. A minimum $250 fee (in addition to the initial notice fee) will be applied to late filings. Form D amendments must be filed including final amendments reporting closed offerings and total sales on the appendix pages.

For more information please see here.

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German Bundestag Approves Legislation Reforming Executive Compensation

As the US House of Representaives prepares to pass corporate governance reform, the German federal parliament, Deutshcr Bundestag, has approved legislation reforming corporate executive compensation. The Act on the Appropriateness of Executive Remuneration (Gesetz zur Angemessenheit der Vorstandsvergütung), is desighed to increase the transparency of the setting of executive pay and realign remuneration packages, particularly bonuses and other variable incentive schemes, with the long-term sustainable success of the company. The legislation was pressed by Germany’s Grand Coalition of Christian Democrats and Social Democrats based on a consensus that executive compensation should embody the principle of good pay for good work, which means that the system of executive compensation must be transparent and oriented to the company’s long-term success.

The legislation embodies the G-20’s recent endorsement of changes in executive pay to ensure that compensation structures are consistent with firms’ long-term goals and prudent risk taking. Specifically, the G-20 said that boards of directors must play an active role in the design, operation, and evaluation of compensation schemes. Compensation, particularly bonuses, must properly reflect risk. Payments should not be finalized over short periods where risks are realized over long periods, said the G-20 communiqué, and firms must disclose comprehensive and timely information about compensation.

Under the German legislation, supervisory boards will be more accountable for executive compensation. For example, the entire supervisory board must set executive compensation, not just a board committee, such as the remuneration committee. Supervisory boards would also be accounatble for unreasonable executive salaries. The total compensation of executives must be reasonable. Executive compensation should also be paired more closely with the individual performance of board members.

In order to promote long-term businss sustainability, stock option holding periods were increased from two to four years. The legislation also provides for a non-binding shareholder advisory vote on executive compensation. The legislaition does not put a fixed ceiling on executive compensation.

In an earlier policy statement on the draft legislation, the European Group for Investor Protection said that the German government considers short-term thinking in the pursuit of maximum executive bonuses to be a major cause of the current financial crisis. The Grand Coalition wants to limit the increase of executive compensation, which the government views as excessive in light of the financial crisis, with the expansion of variable remuneration seen as the major cause of that excessive increase.

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Former SEC Staff Accountant Named IASB Member; Strong Defender of Fair Value Accounting

Former SEC staff accountant Patrick Finnegan has been appointed a member of the IASB to a term that expires in 2014. Mr. Finnegan was also previously CFA Managing Director for the Financial Reporting Policy Group. He has been a consistently a strong defender of fair vale accounting against criticisms that mark-to-market accounting is pro-cyclical and contributed to the financial crisis.

In a letter to the SEC in connection with the Commission’s study of mark-to-market accounting, the new IASB Member said that fair value provides the best representation of economic reality. It provides an early warning system, he noted, and is the only accounting regime that can facilitate the timely correction from previous bad decisions. He does not consider current accounting standards and the application of fair value accounting by financial institutions, in particular, to be one of the causes of the crisis. He also believes that the pro-cyclical effects of fair value are overstated.

The idea that concealing mark-to-market losses will re-instill investor confidence and be an antidote to pro-cyclicality is based on the misconception that observed net income volatility is the sole stimulus to investor perception of the risk of financial institutions. He contended that a more effective way of restoring confidence and ensuring investors do not misinterpret firm performance is to enhance financial statement presentation to enable investors to distinguish between core operating earnings from gains or losses of holding assets. This should be coupled with meaningful disclosures that can convey the inherent uncertainty and margin of error on the valuation of complex financial instruments

In comments at an SEC roundtable on fair value accounting, the then CFA official said that investors are not in favor of accounting by management intent for the simple reason that it allows the issue of moral hazard to creep into the preparation of financial statements. Users are interested in understanding how the economic activities in which the businesses are engaged flow through and affect the reported accounts, he stressed, and not in how management may adjust economic activities to paint a picture as opposed to what actually happened. In his SEC comment letter, Mr. Finnegan said that investors are opposed to the suspension of fair value and believe fair value contributes to transparency in financial institution.

Noting that fair value standards are critical to the integrity of the financial markets, he said that the emphasis should be on helping investors to interpret reported values. Rather than suspension of fair value, he recommends the improvement of fair value reporting presentation and enhancement of associated disclosures. He urged political leaders to resist the temptation to impose regional carve-outs of financial reports since this will reduce the comparability of financial reports for investors.

State Enforcement Action Was Not Removable Under SLUSA

A federal district court (E.D. Mo.) has held that an enforcement action brought by a state in state court was not removable to federal court under the Securities Litigation Uniform Standards Act of 1998 (SLUSA). The defendant brokerage firm had invoked SLUSA in order to remove a civil action brought by the Missouri Securities Commissioner (Commissioner) that sought damages on behalf of customers who purchased action rate securities from the firm. SLUSA makes federal court the exclusive venue for "covered" class actions alleging fraud in the case of certain securities and precludes any such class actions that are based on state law.

Rejecting the defendant’s argument that SLUSA’s removal provision is not limited to those actions that are precluded by the statute, the district court concluded that it lacked subject matter jurisdiction because SLUSA expressly preserves the right of a state to investigate and bring enforcement actions. Removal of the action, therefore, would have denied the state the right, expressly granted to the Commissioner under the Missouri Blue Sky Law, to bring an action in state court for securities fraud. Moreover, the district court noted, the U.S. Supreme Court had directly addressed the issue in Kircher v. Putnam Funds Trust, where the high court held that a covered class action is removable only if it is precluded. Finally, nothing in the legislative history of SLUSA envisions a state enforcement action brought by a state in state court being removed and tried in federal court, the district court reasoned. Accordingly, the state’s motion to remand the matter to state court was granted.

State of Missouri ex rel. Carnahan v. Stifel, Nicolaus & Co., (E.D. Mo. 2009)





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Entire 1st Circuit Will Re-Consider the Issue of What Constitutes a "Statement" Under 10b-5

The 1st Circuit vacated a panel finding in favor of the SEC in SEC v. Tambone. The enforcement action concerned misrepresentations made by two senior executives of the primary underwriter of a mutual fund to investors about excessive trading and market timing. As alleged, the funds entered into arrangements allowing certain preferred customers to engage in short-term or excessive trading, while at the same time, the funds' prospectuses represented that such trading was prohibited. Dismissing the claim, the district court (DC Mass) held that the complaint failed to sufficiently attribute the misleading statements to the two executives. The court also found that the executives had no duty to correct the statements because they were not responsible for the misleading disclosures.

On appeal, the SEC asserted that the use of false and misleading prospectuses to sell securities constituted making a statement. The 1st Circuit panel agreed in December 2008, finding that the executives made implied statements to investors that they believed that the prospectuses were accurate and complete. The court emphasized that, "in light of [an underwriter's] duty to review and confirm the accuracy of the material in the documentation that it distributes, an underwriter impliedly makes a statement of its own to potential investors that it has a reasonable basis to believe that the information contained in the prospectus it uses to offer or sell securities is truthful and complete." Because the prospectuses were false, the implied statements were also false, concluded the panel.

A majority of the 1st Circuit judges voted to vacate the 10b-5 holding and to re-consider the issue of whether the individuals made false statements en banc. Circuit Judges Lipez and Torruella dissented from the grant of en banc review.

The court will not review the panel's findings concerning the Securities Act claims.

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Senate Legislation Would Align Option Accounting Standards with Tax Code and Make Options Part of 162(m) Salary Cap

Bipartisan Senate draft legislation would bring stock option accounting rules and the federal tax code into alignment by requiring that the stock option tax deduction be no greater than the stock option expenses shown on the corporate books each year. Currently, stock options are the only compensation expense where the tax code allows companies to deduct more than their book expenses. The Ending Excessive Corporate Deductions for Stock Options Act, S.1491, would end use of the current stock option deduction under Section 83 of the IRC, which allows companies to deduct stock option expenses when exercised in an amount equal to the income declared by the individual exercising the option, replacing it with a new Section 162(q), which would require companies to deduct the stock option expenses shown on their books each year.

The draft, introduced by Senators Levin and McCain, would also eliminate the favored treatment of executive stock options by making deductions for this type of compensation subject to the same $1 million cap that applies to other forms of compensation covered by IRC Section 162(m), which caps at $1 million the compensation that a company can deduct from its taxes. However, the cap currently does not apply to stock options, allowing companies to deduct any amount of stock option compensation, without limit.

By not applying the $1 million cap to stock option compensation, reasoned Sen. Levin, the tax code created a significant incentive for companies to pay their executives with stock options. It is effectively meaningless to cap deductions for executive salary compensation but not also for stock options.

The measure would apply only to corporate stock option deductions. It would make no changes to the rules that apply to individuals who have been given stock options as part of their compensation. Individuals would still report their compensation on the day they exercised their stock options. They would still report as income the difference between what they paid to exercise the options and the fair market value of the stock they received upon exercise. The gain would continue to be treated as ordinary income rather than a capital gain, since the option holder did not invest any capital in the stock prior to exercising the stock option and the only reason the person obtained the stock was because of the services they performed for the company.

The amount of income declared by the individual after exercising a stock option will likely often be greater than the stock option expense booked and deducted by the corporation who employed that individual. In part, that is because the individual’s gain often comes years later than the original stock option grant, and the underlying stock will usually have gained in value. In addition, the individual’s gain is typically provided, not by the company that supplied the stock options years earlier, but by third parties active in the stock market.

The legislation would put an end to the current approach of using the stock option income declared by an individual as the tax deduction claimed by the corporation that supplied the stock options. It would break that old artificial symmetry and replace it with a new symmetry, noted Sen. Levin, one in which the company’s stock option tax deduction would match its book expense.

The sponsors of the legislation describe the current approach to corporate stock option tax deductions as artificial because it uses a construct in the tax code that, when first implemented forty years ago, enabled corporations to calculate their stock option expense on the exercise date, when there was no consensus on how to calculate stock option expenses on the grant date. The artificiality of the approach is demonstrated by the fact that it allows companies to claim a deductible expense for money that comes not from company coffers, but from third parties in the stock market. Now that U.S. accounting rules require the calculation of stock option expenses on the grant date, however, there is no longer any need to rely on an artificial construct that calculates stock option expenses on the exercise date using third party funds.

It is important to note that the legislation would not affect current tax provisions providing favored tax treatment to incentive stock options under IRC Sections 421 and 422. Under those sections, in certain circumstances, corporations can surrender their stock option deductions in favor of allowing their employees with stock option gains to be taxed at a capital gains rate instead of ordinary income tax rates. Many start-up companies use these types of stock options, because they don’t yet have taxable profits and don’t need a stock option tax deduction. So they forfeit their stock option corporate deduction in favor of giving their employees more favorable treatment of their stock option income. Incentive stock options would not be affected by the legislation and would remain available to any corporation providing stock options to its employees.

The legislation would also allow the old Section 83 deduction rules to apply to any option which was vested prior to the effective date of FASB Standard 123R, and exercised after the date of enactment of the legislation. The effective date of FAS 123R is June 15, 2005 for most corporations. Prior to the effective date of FAS 123R, most companies would have shown a zero expense on their books for the stock options issued to their executives and, thus, would be unable to claim a tax deduction under new Section 162(q). For that reason, the measure would allow these corporations to continue to use Section 83 to claim stock option deductions on their tax returns.

For stock options that vested after the effective date of FAS 123R and were exercised after the date of enactment, the draft takes another tack. Under FAS 123R, these companies would have had to show the appropriate stock option expense on their books, but would have been unable to take a tax deduction until the executive actually exercised the option. For these options, the draft would allow companies to take an immediate tax deduction, in the first year that the legislation is in effect, for all of the expenses shown on their books with respect to these options. This catch-up deduction in the first year after enactment would enable corporations, in the following years, to begin with a clean slate so that their tax returns the next year would reflect their actual stock option book expenses for that same year. After that catch-up year, all stock option expenses incurred by a company each year would be reflected in their annual tax deductions under the new Section 162(q).

Finally, the draft contains a transition rule for applying the new Section 162(q) stock option tax deduction to existing and future stock option grants. This transition rule would clarify that the new tax deduction would not apply to any stock option exercised prior to the date of enactment of the legislation.

33, 34 Act Claimants Not Incompatible, but In-and-Out Traders Are--Out

A class including investors making claims under the Exchange Act as well as Securities Act claimants was properly certified, concluded a 2nd Circuit panel. However, the district judge improperly included "in-and-out" traders who sold their shares before any corrective disclosures were made (In re Flag Telecom Holdings, Ltd. Securities Litigation).

The defendants claimed that the Securities Act claims of loss based on false and misleading statements in the prospectus and the Exchange Act claims of damages resulting from fraudulent periodic reports and public statements by corporate officers. The company reasoned that a showing of losses caused by the 34 Act claimants would support the "negative causation" affirmative defense available under the Securities Act.

The district court rejected this argument, holding that the two sets of claims were not antagonistic to each other because proof of one did not negate an essential element of the other. The 2nd Circuit agreed, as it recognized that securities class actions involving more than one misstatement are far from unusual. In addition, noted the court, "in every litigation of this type, the pool of money available for each individual class member’s recovery is limited to the loss that the individual actually incurred."

The in and out traders could not be included in the class, however. In light of the Supreme Court's Dura holding, in which the high court rejected the view that an inflated purchase price is sufficient to plead loss causation in 10(b) claims, the 2nd Circuit panel concluded that the plaintiffs "have not presented sufficient evidence to demonstrate that the in-and-out traders will even `conceivably' be able to prove loss causation as a matter of law, and that they therefore should not have been included in the certified class."

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2nd Circuit: Computer Hacking Could Be Deceptive Under 10(b)

An individual who allegedly hacked into a corporate computer system and traded on adverse earnings information he obtained before its public release may have engaged in actionable deceptive conduct under Section 10(b). A 2nd Circuit panel reversed (SEC v. Dorozhko) a district court finding that the individual, while perhaps in violation of other state and federal law, had not violated Section 10(b) because he was a corporate outsider who violated no fiduciary duty.

The district court relied on two well-known Supreme Court cases, Chiarella v. U.S. and U.S. v. O'Hagan on insider trading, and the high court's decision in SEC v. Zandford involving the theft of client assets by a broker to conclude that a "breach of a fiduciary duty to disclose or abstain that coincides with a securities transaction" was an essential element of deceptive conduct.

The 2nd Circuit disagreed, as it concluded that none of the Supreme Court opinions relied upon by the District Court—much less the sum of all three opinions—establishes a fiduciary duty requirement as an element of every violation of Section 10(b). While the three decisions all stood for the proposition that nondisclosure in breach of a fiduciary duty satisfied the deceptive device or contrivance, the appeals panel concluded that none of these decisions required the element of a fiduciary relationship, as "what is sufficient is not always what is necessary."

The court stated that if the hacker impersonated a user to gain access, this conduct would be “deceptive” within the ordinary meaning of the word. The panel did not, however, resolve the issue of whether hacking in by avoiding or breaching security systems would also meet that definition. The court remanded the matter to the district court to determine whether the computer hacking in this case involved a fraudulent misrepresentation that was “deceptive” within the ordinary meaning of Section 10(b).

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UK Regulator Rejects Using Financial Accounting Standards to Promote Stability

In an effort to refute the growing global consensus that financial accounting must change because its pro-cyclicality contributed to the financial crisis, the UK accounting overseer said that people proposing to amend accounting rules to make them less pro-cyclical must believe that investors cannot be trusted with the unadjusted numbers produced by the application of accounting standards. In remarks at the Financial Reporting Council’s annual meeting, CEO Paul Boyle emphasized that it is dangerous to give accounting an explicit role in promoting financial stability in addition to its traditional role of providing useful information to investors to inform their investment decision.

One may just as well argue that house price statistics are pro-cyclical, said the executive director, since reports of rising prices drive consumers to make purchase at higher values, thereby further driving up prices, with reports of falling prices having the opposite effect. While acknowledging that current accounting standards need improvement, he urged regulators and policy makers to assess any proposed changes with a clear understanding of the purposes of financial accounting.

In that regard, he said that financial accounting rules and standards are designed to measure the financial performance of a company in as neutral a way as possible. It is not surprising that banks report substantial profits during good times and losses during bad times. This is the job of financial accounting, to reflect the economic cycle, he noted, which is a good characteristic of a financial measurement system. It is not in the public interest to adjust the numbers in the interest of financial stability.

Further, the way in which investors will react to accounting information is not easy to determine in advance since it will be influenced by a number of variables. Thus, it is not reasonable to ask FASB and the IASB to predict those reactions or to predict whether those reactions are good, in making their measurement choices.

Mr. Boyle’s defense of traditional accounting come against the backdrop of efforts by US, Chinese and EU regulators and policy makers to lessen the pro-cyclical effect of certain accounting standards. For example, the Obama Administration’s blueprint for reform noted that certain aspects of accounting standards have had pro-cyclical tendencies, meaning that they have tended to amplify business cycles, adding that the interpretation and application of fair value accounting standards during the crisis raised significant pro-cyclicality concern. Similarly, the Governor of the People’s Bank of China identified fair value accounting as a factor that worked to exacerbate the financial crisis.

At a meeting of G-20 central bankers, Zhou Xiaochuan said that the problems of fair value accounting have been exposed by the current crisis. Governor Zhou recommended implementation of circuit-breakers to stem the pro-cyclicality caused by mark-to-market and fair value accounting in specific situations. Axel Weber, President of the Deutsche Bundesbank indicated that effective reform must also address fair value accounting which, in his view, amplifies the cyclicality of leverage.

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SEC Chair Seeks Enhanced Financial Stability Council to Work with Systemic Risk Regulator

While accepting in principle that the Federal Reserve Board could be the new systemic risk regulator, SEC Chair Mary Schapiro said that the Financial Stability Oversight Council designed to work with the Fed must be strengthened beyond the framework set forth by the Administration’s legislative proposal. In testimony before the Senate Banking Committee, the SEC Chair laid out her vision of the Council as being armed with the tools it needs to identify emerging risks, to establish rules for leverage and risk-based capital for systemically-important institutions. She envisions a Council empowered to serve as a ready mechanism for identifying emerging risks and minimizing the regulatory arbitrage that can lead to a race to the bottom.

To balance the weakness of monitoring systemic risk through the lens of any single regulator, reasoned the SEC official, the Council would permit the assessment of emerging risks from the vantage of a multi-disciplinary group of financial experts with responsibilities that extend to different types of financial institutions, both large and small.

Recently, the Administration proposed legislation naming the Fed as the single regulator to police all systemically important firms and markets as a broad consensus develops on the need for Congress to create a systemic risk regulator. This systemic risk regulator would be authorized to take proactive steps to prevent or minimize systemic risk. The Administration also proposed that the systemic risk regulator should by a Financial Services Oversight Council, whose members would include Treasury, the SEC, the CFTC, and the FDIC. The Council would be authorized to facilitate information sharing and coordination, identify emerging risks, resolve jurisdictional disputes among regulators, and, advise the Fed on identifying firms whose failure could pose a threat to market stability.

The SEC Chair envisions the Council as being authorized to identify institutions, practices, and markets that create potential systemic risks and set standards for liquidity, capital and other risk management practices at systemically important institutions. The systemic risk regulator would then be responsible for implementing these standards. The Council also should provide a forum for discussing and recommending regulatory standards across markets, helping to identify gaps in the regulatory framework before they morph into larger problems. According to Ms. Schapiro, this hybrid approach can help minimize systemic risk in a number of ways.

For example, the Council would ensure different perspectives to help identify risks that an individual regulator might miss or consider too small to warrant attention. These perspectives would also improve the quality of systemic risk requirements by increasing the likelihood that second-order consequences are considered and flushed out. Moreover, the financial regulators on the Council would have experience regulating different types of institutions, including smaller institutions, so that the Council would be more likely to ensure that risk-based capital and leverage requirements do not unintentionally foster systemic risk. Such a result could occur by giving large, systemically important institutions a competitive advantage over smaller institutions that would permit them to grow even larger and more risky. In addition, the Council would include multiple agencies, thereby significantly reducing potential conflicts of interest, such as conflicts with other regulatory missions.

The SEC Chair also envisions the Council monitoring the development of financial institutions to prevent the creation of institutions that are either too-big-to-fail or too-big-to-succeed. She believes that insufficient attention has been paid to the risks posed by institutions whose businesses are so large and diverse that they have become, for all intents and purposes, unmanageable. Given the potential daily oversight role of the systemic risk regulator, it would likely be less capable of identifying and avoiding these risks impartially. Thus, in her view, the Council framework is vital to ensure that the desire to minimize short-term systemic risk does not inadvertently undermine the financial system’s long-term health.

More broadly, the SEC Chair expects both the Council and the systemic risk regulator to work with and through primary regulators of systemically important institutions. The primary regulators understand the markets, products and activities of their regulated entities. The systemic risk regulator can provide a second layer of review over the activities, capital and risk management procedures of systemically important institutions as a backstop to ensure that no red flags are missed.

If differences arise between the systemic risk regulator and the primary regulator regarding the capital or risk management standards of systemically important institutions, she averred, the higher and more conservative standard should govern. The systemic risk regulatory structure should serve as a brake on a systemically important institution’s riskiness, she reasoned, and should never be an accelerator.

In emergency situations, she continued, the systemic risk regulator may need to overrule a primary regulator, such as to impose higher standards or to stop or limit potentially risky activities. However, in order to ensure that authority is checked and decisions are not arbitrary, the Council should be where general policy is set, and only then to implement a more rigorous policy than that of a primary regulator. In the Chair’s view, this will reduce the ability of any single regulator to compete with other regulators by lowering standards, driving a race to the bottom.

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UK Conservative Party Would Abolish the FSA, Create Consumer Protection Agency, and Make Central Bank Systemic Risk Regulator

Noting that the Obama Administration has proposed legislation creating a new Consumer Financial Protection Agency to ensure that there is a regulator whose primary concern is protecting individuals, the UK Conservative Party said that when it reclaims power it will abolish the Financial Services Authority and create a new Consumer Protection Agency and give the regulation of financial institutions to the Bank of England. The policy white paper also said that the central bank would be deemed the systemic risk regulator for the entire financial system. These actions would effectively dismantle the current UK regulatory system that was created in 1997 with the establishment of the FSA as the unitary financial regulator.

In support of the plan, the white paper cites recent testimony of former Federal Reserve Board Governor Frederic Mishkin before the House Financial Services Committee. He said that the skills and mindset required to operate as a consumer protection regulator are fundamentally different from those required by a systemic regulator. Protecting consumers involve setting and then enforcing the appropriate rules under a transparent legal framework, reasoned the former Fed official, and the orientation of an effective systemic regulator must be different from that of a rule-enforcing consumer protection or conduct of business regulator.

The white paper envisions a central bank that would be responsible for macro-prudential regulation, judging and controlling risks to the financial system as a whole. This macro-prudential role will be carried out by a new Financial Policy Committee within the central bank, which would monitor systemic risks, operate macro-prudential regulatory tools and execute the special resolution regime for failing financial institutions.

At the same time, the central bank would also be responsible for the micro-prudential regulation of financial institutions, to be carried out by a new Financial Regulation Division. The policy report cited the practical advantages of combining the two responsibilities within the central bank, noting that central banks need a great deal of information about banks’ balance sheets and behavior in relation to their monetary policy responsibilities and, at the same time, also need such information in relation to their responsibility for maintaining systemic financial stability.

Moreover, micro-prudential regulation can inform macro-prudential risk analysis. For example, if it is found that the exposure of many financial institutions to a particular sector has increased rapidly, this information can be picked up by the financial stability side of the central bank as a warning signal that a potential bubble may be building.

The new division for financial regulation should take a truly risk-focused approach to regulation, which the white paper described as a significant departure from the FSA’s historical approach. This risk-focused regulation would have a clear view of the areas and activities that create the greatest risk in individual financial institutions. For the largest and systemically important institutions this means that the central bank, as the systemic risk regulator, should have an awareness of the risk exposures by type. The central bank would also need to monitor conduct of business issues in so far as they have implications for an institution’s risk profile.

The new Consumer Protection Agency would have a mandate to examine pricing and product suitability as well as competition in financial services and products. Under the CPA, consumer protection would not simply mean following rules. Consumer regulation, like prudential regulation, would require regulatory judgments. While taking a tougher approach to enforcement and, where appropriate, product regulation, the CPA would also consider the consumer benefits of competition and low-priced products. For example, an expensive sales process which makes some products unaffordable may not ultimately be in the interest of consumers.

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