Jim Hamilton’s World of Securities Regulation

Former TIAA-CREF Chair Endorses Mandatory Auditor Rotation in Letter to PCAOB

2012-02-11T14:37:00.003-06:00

The PCAOB and the SEC should impose mandatory audit firm rotation after ten years, said a former Chair of TIAA-CREF, which would coincide with the second statutorily required rotation of the managing auditor. In a letter to the PCAOB, John Biggs said that mandatory auditor rotation produces a kind of real time peer review. The outgoing auditor wants the work papers to be complete and of high quality with all problems clearly resolved, he reasoned, while the new firm reviews them and could either challenge their results, or start with fresh eyes. Mr. Biggs was Chair and CEO of TIAA-CREF from 1993 to 2002 and has served on the audit committees of major US companies.

If mandatory auditor rotation is deemed too strong a medicine, the former Chair recommends at a minimum that the SEC require in the proxy that the company disclose the years of tenure of the audit firm, which he believes is important to users of the financial statements. In his view, requiring proxy disclosure of the tenure of a company’s auditor might alone increase the likelihood that audit committees would consider their obligations under the Sarbanes-Oxley Act to appoint an auditor with a fresh point of view.

He noted that the two audit firm rotations during his decade of leadership at TIAA-CREF strengthened the audit and did not result itself in higher fees. It also instigated a healthy review of the firm’s financial management policies and practices. Mr. Biggs described this auditor rotation experience in testimony before the Senate Banking Committee chaired by Senator Paul Sarbanes as the committee was considering the auditing provisions of what became the Sarbanes-Oxley Act.

He recommended rotation in that testimony, which he believed would limit a seriously flawed business model of the auditing profession. In fact, many of the other provisions of Sarbanes-Oxley that were adopted were designed to correct that model. In particular, the Act eliminated the abusive use of the audit relationship and the brand names of the firms to sell non-audit services of all types; from technology consulting to tax advice to executive relocation services. Mr. Biggs regrets that the Sarbanes Committee did not include rotation in the legislation.

In his Senate testimony, Mr. Biggs noted the benefits of rotation for the issue of auditor independence. Auditor rotation would reduce dramatically the financial incentives for the audit firms to placate management. If the audit firm has a kind of virtual perpetuity of millions in fees every year, he said, the present value of that relationship is enormous: On the other hand, if the audit firm has a limited term the present value is cut by two-thirds or more, he emphasized, and in the final year of a five-year term it has little value.

His testimony also stressed the peer review aspects of mandatory auditor rotation. Had rotation been in effect at Enron in 1996, and Arthur Andersen had known that a new auditor would be appointed for 1997, and that the new auditor would do an exhaustive review of the former audit work papers, he posited, it is likely that Arthur Andersen would have assured that transactions and documentation were fully transparent. A thorough real-time peer review would be truly effective.

European Securities Commissioner Asks Financial Regulators to Confine Volcker Rule to US Territory and Exempt Trading in EU Gov. Securities

2012-02-10T12:31:00.000-06:00

In a letter to federal financial regulators implementing the Dodd-Frank Volcker provisions, EU Commissioner for the Internal Market Michel Barnier requested that the Volcker Rule be given no extraterritorial reach and remain confined to the US. He also said that the proposed exemption to the proprietary trading ban for trading in US Government securities should not be limited to trading in US government bonds. All government bonds have similar features and functionalities, he reasoned. The absence of an exemption for non-US bonds would have a negative impact on the liquidity of non-US sovereign markets, he posited, which would be even more significant if the Volcker regulations were to apply to foreign banks beyond their US territorial presence. The Commissioner urged that EU Government securities be given the same treatment as US Government securities under the final Volcker regulations.

The Commissioner emphasized that the principles of proportionality and non-discrimination should be respected throughout the Volcker regulations. In his view, it is questionable to consider subjecting non-US banks with a minimal presence in the US to burdensome reporting and compliance requirements that would require them to actively demonstrate that they do not fall within the scope of the Volcker Rule, or that the transactions they are involved in meet the requirements of the rule. While he fully shares the US commitment to financial reform within the G-20 context, Commissioner Barnier insists that such reforms should be undertaken in a spirit of mutual trust and cooperation so that regulatory overlaps and direct implications for other jurisdictions are avoided. The Commissioner stands ready to engage in a dialogue with US regulators around the regulations implementing the Volcker Rule as codified in Dodd-Frank.

More broadly, he noted that the proposed regulations raise a number of concerns and would appear to have implications that are disproportionate in light of the objective that the rule is trying to achieve. The draft has an extensive, global scope, he noted, which would seem to lead to a number of unintended, non justifiable consequences for non-US banks, markets and institutions.

While he appreciates the desire to avoid loopholes, the Commissioner urged US financial regulators to reconsider their approach and limit the scope of the Volcker Rule only to the territory of the United States. Moreover, the current exemption for non-US banks as well as for activities outside of the US would appear very restrictive. As a consequence, it appears that the regulations would be applied well beyond the US activities of non-US banks, without any justification being provided.

The Commissioner also observed that the regulations could have significant ramifications for financial markets outside the US, particularly if some of the elements lead to uncertainty for financial intermediaries. This not only relates to proprietary trading outside the United States, he said, but also to market making. Given the absence of a clear delimitation between what constitutes banned proprietary trading and allowed market making, reasoned the Commissioner, there is a real risk that banks impacted by the Volcker Rule, as proposed to be implemented, would also significantly reduce their market making activities, thereby reducing liquidity in many markets both within and without the United States.

SEC Staff 2005 NAL on Special Purpose Vehicles Created by Registered Investment Adviser Has Post-Dodd Frank Viability

2012-02-09T19:48:00.003-06:00

The Division of Investment Management advised that a 2005 SEC staff no-action letter on the registration of a special purpose vehicle created by a registered investment adviser continues to represent the staff’s position after the Dodd-Frank Act repeal of the exemption previously provided to private fund advisers by Section 203(b)(3) of the Investment Advisers Act. The SEC has historically treated a registered adviser’s registration with the Commission as effectively covering associated persons of the adviser. (American Bar Association, Business Law Section, January 18, 2012)

In a December 8, 2005 letter addressed to the American Bar Association’s Subcommittee on Private Investment Entities, the staff took a similar approach with respect to certain special purpose vehicles created by a registered adviser. In that letter, the staff stated that it would not object if the special purpose vehicle did not separately register as an investment adviser, subject to four conditions. First, the private fund adviser establishes the special purpose vehicle to act as the fund’s general partner or managing member. Second, the special purpose vehicle’s formation documents designate the investment adviser to manage the private fund’s assets. Third, all of the investment advisory activities of the special purpose vehicle are subject to the Investment Advisers Act and the regulations adopted under it. Fourth, the special purpose vehicle is subject to SEC examination.

Having satisfied these conditions, the special purpose vehicle would look to and essentially rely upon the registered adviser’s registration with the SEC in not submitting a separate Form ADV. The staff explained that any disciplinary history that the special purpose vehicle would have been required to disclose on Form ADV, had it registered separately as an investment adviser, would be disclosed on the registered adviser’s Form ADV.

House Passes Legislation Curbing Use of Inside Information by Legislative and Executive Branches, Drops Grassley Political Intelligence Provision

2012-02-09T11:08:00.004-06:00

The House passed legislation barring members of Congress from profiting on inside information they obtain as part of the job and that is not readily available to the public. The vote was 417-2. A different version of the legislation earlier passed the Senate by a vote of 96-3. The dispute over the applicability of insider trading laws to Congress centers largely on the issue of whether Congress owes a legally enforceable fiduciary duty to the source from which they receive material, non-public information. The Stop Trading on Congressional Knowledge (STOCK) Act, S 2038, makes it explicit that Members and staff owe such a duty under the federal securities laws. A floor amendment offered by Senator Richard Shelby (R-Ala) extending the prohibition on insider trading to the executive branch and independent agencies was approved by a 58-41 vote; and was retained in the House version.

Specifically, the legislation provides that, for purposes of insider trading prohibitions under the Securities Exchange Act, the prohibition against Members of Congress and employees of Congress using inside information for personal benefit states a duty of trust and confidence. HR 2038 authorizes the SEC to issue regulations implementing the legislation and otherwise ensuring that Members and staff are subject to insider trading prohibitions. Nothing in the Act diminishes an existing legal obligation of Members and staff and makes clear that the STOCK Act does not limit or otherwise alter existing securities laws.
HR 2308 also makes conforming changes to the Commodity Exchange Act to ensure that the insider trading prohibitions under that Act apply.

The House bill, but not the Senate, amends Section 21A of the Securities Exchange Act to provide that persons covered by the legislation may not purchase securities that are the subject of an initial public offering in any manner other than is available to members of the public generally.

The House removed a provision in S 2038 requiring political-intelligence practitioners to disclose their activities for the first time and make them adhere to the same registration requirements of lobbyists. This provision was added to the legislation by Senator Charles Grassley (R-Iowa) and was approved by a vote of 60-39.The House legislation replaces Grassley’s disclosure requirements with a study of the industry. Senator Grassley said he was extremely disappointed that the House killed the provision.The Senate clearly voted to try to shed light on an industry that’s behind the scenes, he noted, and if the Senate language is too broad, as opponents say, why not propose a solution instead of scrapping the provision altogether. Senator Grassley hopes to see a vehicle for meaningful transparency through a House-Senate conference or other means. If Congress delays action, the political intelligence industry will stay in the shadows, he said.

US and EU Partners Agree to Reciprocal Exchanges to Facilitate FATCA Implementation

2012-02-08T18:43:00.001-06:00

The United States, France, Germany, Italy, Spain and the United Kingdom have agreed to explore a common approach to FATCA implementation through domestic reporting and reciprocal automatic exchange based on existing bilateral tax treaties. It is envisioned that the United States and a FATCA partner country would enter into an agreement pursuant to which the FATCA partner would agree to pursue implementing legislation to require foreign financial institutions in its jurisdiction to collect and report to the authorities of the FATCA partner the required information; enable FFIs established in the FATCA partner to diligently identify US accounts; and automatically transfer to the United States the information reported by the FFIs.

In return, the United States would agree to eliminate the obligation of each FFI established in the FATCA partner to enter into a separate comprehensive agreement directly with the IRS, provided that each FFI is registered with the IRS or is excepted from registration pursuant to the agreement or IRS guidance. The US would also allow FFIs established in the FATCA partner to comply with their reporting obligations under FATCA by reporting information to the FATCA partner rather than reporting it directly to the IRS and eliminate U.S. withholding under FATCA on payments to FFIs established in the FATCA partner by identifying all FFIs in the FATCA partner as participating FFIs or deemed-compliant FFIs, as appropriate.

The US would also identify in the agreement specific categories of FFIs established in the FATCA partner that would be treated, consistent with IRS guidelines, as deemed compliant or presenting a low risk of tax evasion. The US would also commit to reciprocity with respect to collecting and reporting on an automatic basis to the authorities of the FATCA partner information on the U.S. accounts of residents of the FATCA partner.

In addition, as a result of the agreement with the FATCA partner, FFIs established in the FATCA partner would not be required to terminate the account of a recalcitrant account holder; impose passthru payment withholding on payments to recalcitrant account holders;impose passthru payment withholding on payments to other FFIs organized in the FATCA treaty partner or in another jurisdiction with which the United States has a FATCA implementation agreement.

More broadly, the US, France, Germany, Italy, Spain and the United Kingdom would commit to develop an effective alternative approach to achieve the policy objectives of passthru payment withholding that minimizes burden and commit to working with other FATCA partners, the OECD, and the EU, on adapting FATCA in the medium term to a common model for automatic exchange of information, including the development of reporting and due diligence standards.

Proposed Regulations Implementing FATCA Recognize the Challenges

2012-02-08T17:31:00.001-06:00

The Treasury Department and the Internal Revenue Service have issued proposed regulations implementing the Foreign Account Tax Compliance Act (FATCA). The regulations lay out a step-by-step process for U.S. account identification, information reporting, and withholding requirements for foreign financial institutions (FFIs), other foreign entities, and U.S. withholding agents. According to IRS Commissioner Doug Shulman, the proposed regulations take into account the implementation challenges of affected financial institutions while allowing for a smooth and timely roll-out of the law. Comments must be received by April 30, 2012.

The proposed regulations implement FATCA’s obligations in stages to minimize burdens and costs consistent with achieving the statute’s compliance objectives. The rules and implementation schedule are also adjusted to allow time for resolving local law limitations to which some FFIs may be subject. FATCA registration will take place through an online system which will become available by Jan. 1, 2013. Foreign financial institutions that do not register and enter into an agreement with the IRS will be subject to withholding on certain types of payments relating to U.S. investments. The Treasury and IRS pledged to continue to work closely with businesses and foreign governments to implement FATCA effectively.

FATCA was enacted in 2010 by Congress as part of the Hiring Incentives to Restore Employment (HIRE) Act. FATCA requires FFIs to report to the IRS information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest.In order to avoid being withheld upon under FATCA, a participating FFI will have to enter into an agreement with the IRS to identify U.S. accounts, report certain information to the IRS regarding U.S. accounts, verify its compliance with its obligations pursuant to the agreement, and ensure that a 30-percent tax on certain payments of U.S. source income is withheld when paid to non-participating FFIs and account holders who are unwilling to provide the required information.

FATCA will effectively compel foreign financial institutions, broadly defined to include banks, hedge funds, investment companies and securities and commodities firms, to enter into an agreement with the IRS requiring them to report annually certain customer information and to withhold and pay to the IRS a 30% withholding tax on customers of those institutions who are US companies or US citizens that have not supplied certain information to the foreign financial institution. Thus, FATCA will compel foreign financial institutions to screen their existing customer database to identify clients that are US companies or individuals who are US persons.

Using Fannie and Freddie Guarantee Fees to Fund Further Extension of Payroll Tax Credit is Problematic Says Banking Industry

2012-02-08T17:12:00.001-06:00

The banking industry has asked Congress not to further increase the credit risk guarantee fees (G-fees) levied by Fannie Mae and Freddie Mac as an offset for further extension of the payroll tax holiday. In a letter to Rep. Dave Camp and Senator Max Baucus, co-chairs of the Conference Committee on the Temporary Payroll Tax Cut Continuation Act, the American Bankers Association warned that the two government sponsored enterprises are in federal conservatorship, have flawed business models and thus are troubled vehicles on which to place the expectation of a long-term revenue stream. Further, more increases to the G-fees would complicate the already significant task of ending the conservatorship and enacting meaningful GSE reform.

The legislation enacted at the end of last year extending the payroll tax holiday for two months used a 10-basis-point increase in the G-fees for a period of ten years as an offset for the cost of extending the tax holiday, unemployment benefits, and Medicare reimbursements. Using any portion of the G-fees for this purpose creates a number of significant concerns. The ABA urged the conference committee not to consider the use of G-fees for any further extension of the payroll tax holiday or for any other purpose than the intended use of offsetting the risk associated with the guarantee being provided by Fannie Mae and Freddie Mac.

New Jersey Permits IAs Without Custody to File Notarized Certificate Attesting to Financial Statement Accuracy

2012-02-08T14:36:00.006-06:00

Investment advisers without custody of their clients' funds or securities may include in their IA registration applications filed with the New Jersey Securities Bureau a "notarized certification" attesting to the accuracy of their financial statements; the Securities Bureau will accept the notarized statement for investment advisers without custody in lieu of a certified statement of the applicant's most current financial condition as of a date within 60 days of the application, or a certified financial statement as of the last fiscal year-end for applicants having been in business for at least one year.

Senate Legislation Would Close Swap Loophole and Align Tax Code and Securities Law Treatment of Stock Options

2012-02-08T13:53:00.004-06:00

Senate legislation would align the tax code and securities law treatment of stock options, prevent corporate income tax deductions for stock options that exceed the expense shown in SEC-filed financial statements, close the offshore swap payments loophole, and require annual country-by-country reporting by SEC-registered corporations on employees, sales, financing, tax obligations, and tax payments. In addition, the measure would require anti-money laundering programs for hedge funds and private equity funds to ensure that they screen clients and offshore funds.

Introduced by Senator Carl Levin, (D-Mich), Chair of the Armed Services Committee and Senator Kent Conrad ( D-ND), Chair of the Budget Committee, the Cut Unjustified Tax Loopholes Act, S 2075, would also establish a penalty for corporate insiders who hide offshore holdings by authorizing a fine of up to $1 million per violation of securities laws.

As part of measures to combat offshore and tax shelter abuses, the Senate legislation would close an existing tax loophole that allows credit default swap payments to escape taxation if sent from the United States to persons offshore, such as an offshore hedge fund or foreign bank. The Act would close this swap loophole by treating credit default swap payments sent offshore from the United States as taxable U.S. source income. Another provision would increase publicly available information about multinational corporations by requiring them to include basic information on a country-by-country basis in their filings with the SEC to increase transparency and facilitate IRS inquiries into transfer pricing, foreign tax credits, and abusive offshore tax shelters.

The legislation would increase publicly available information about multinational corporations by requiring them to include basic information on a country-by-country basis in their filings with the SEC to increase transparency and facilitate IRS inquiries into transfer pricing, foreign tax credits, and abusive offshore tax shelters.

S 2075 would also eliminate favored tax treatment of corporate stock option deductions, in which corporations are currently allowed to deduct a higher stock option compensation expense on their tax returns than shown on their financial statements by prohibiting corporations from taking a tax deduction that exceeds the expense shown on their books. The legislation would allow corporations to deduct stock option compensation on their tax returns in the same year it is recorded on the company books, without waiting for the options to be exercised.

The Act would also establish rebuttable presumptions to combat offshore secrecy in US. tax and securities law enforcement proceedings by treating non-publicly traded offshore entities as controlled by the U.S. taxpayer who formed them, sent them assets, received assets from them, or benefited from them when those entities have accounts or assets in non-FATCA institutions, unless the taxpayer proves otherwise.

In addition, the legislation would strengthen FATCA by clarifying when, under the Foreign Account Tax Compliance Act, foreign financial institutions and U.S. persons must report foreign financial accounts to the IRS.

In a significant change, S 2075 would make corporate stock option deductions subject to the existing $1 million cap in Section 162(m) of the IRC on overall corporate deductions for compensation paid to the top executives of publicly held corporations. But there would be no change to stock option compensation rules for individuals or for incentive stock options used by start-up companies and small businesses.

Stock options are the only type of compensation where the federal tax code lets a company deduct more than the expense shown on in its financial statements. The legislation would align the GAAP treatment of stock options under FASB financial accounting standards with how options are treated under the Internal Revenue Code.

The legislation would bring stock option accounting and tax rules into alignment, so that the two sets of rules would apply in a consistent manner. It would accomplish that goal by requiring the corporate stock option tax deduction to reflect the stock option expenses as shown on the corporate books each year.

Specifically, the measure would end use of the current stock option deduction under Section 83 of the Code, which allows corporations 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 as shown on their books each year.

Georgia Proposes Clarifications to Recently Adopted Securities Rules

2012-02-08T12:03:00.005-06:00

Clarifications to some of the rules adopted on December 8, 2011 to conform to the Georgia Uniform Securities Act of 2008 were proposed by the Georgia Office of the Secretary of State.

Submitting public comments. Interested persons may submit written comments about the proposed rule amendments up until 5:00 on March 2, 2012. Comments may either be mailed to the Commissioner of Securities, Securities Division, 2 Martin Luther King, Jr. Drive, S.E., 802 West Tower, Atlanta, Georgia 30334; faxed to (404) 656-0513; or emailed to SECRules@sos.ga.gov. Please reference on each comment the number for the proposed rule of the comment (e.g., SEC-2012-01 through 12 (whichever rule no. 01 through 12 applies)).

Hearing. A hearing on the rule proposals will be held at 9:35 a.m. on March 7, 2012, in Room 810, Suite 802 West Tower at 2 Martin Luther King, Jr. Drive, S.E., Atlanta, Georgia 30334.

Summary of the proposals. The following descriptions comprise the clarifications being proposed:

* The filing date for Georgia's limited offering exemption corresponding to SEC Rule 505 would be changed to 15 business days after the receipt of consideration or the delivery of a subscription agreement. Currently, the filing date is 15 business days before the receipt of consideration or the delivery of a subscription agreement.

* The new non-profit organization securities exemption would mandate that NASAA's Church Bond and Church Extension Fund Policy Statements be applied to offerings made under the exemption.

* The new Invest Georgia exemption would be available only to for-profit business entities.

* The "electronic filing with designated entity" and "application renewal" rules for investment advisers and investment adviser representatives would eliminate the "grace period" for filings due each December.

* Investment adviser contract, written exam, recordkeeping and supervision rules would clarify that these rules apply to investment advisers or investment adviser representatives registered or required to register in Georgia.

* Typographical errors would be corrected in investment adviser application and abandoned application rules.
*

Senior ESMA Official Outlines Credit Rating Agencies Regulation and Examines Proposed Revisions

2012-02-07T19:58:00.004-06:00

On July 1, 2011 the European Securities and Markets Authority assumed responsibility for the day to day supervision of registered credit rating agencies. In December of 2011, ESMA conducted the first on-site inspection of the three main rating agencies, for which ESMA expects to publish an examination report by the end of the Q1 2012. According to remarks by Verena Ross, ESMA Executive Director, during 2012 ESMA will finalize the establishment of the reporting data tools provided by the Credit Rating Agencies Regulation and of the central database, an essential disclosure facility for investors. ESMA is also in the process of performing the assessment of the regulatory framework of several non-EU countries and agreeing to suitable cooperation arrangements with the respective regulators in order to ensure the endorsement of the overwhelming majority of third-country ratings currently used for regulatory purposes in the EU.

Regarding proposed revisions to the Regulation, the senior official allowed that some of them would have a positive effect on the overall framework for rating agency supervision, starting with the new disclosure provisions. Issuers, sponsors, and originators of structured finance instruments would have to disclose information on the credit quality and performance of underlying asset pools. Also, rating agencies would disclose to ESMA the fees received from each of their clients and their general pricing policy.

Another important contribution of the new proposal, said the Director, concerns the prevention of conflicts of interest. For example, rating agencies could not issue credit ratings when their major shareholders have interests in the rated entity or when the rated entities are major CRA shareholders themselves. Major CRA shareholders would also be limited in their ability to provide consultancy or advisory services to the rated entity. While it will be important to get the exact provisions right, said the senior official, reducing any real or apparent conflicts of interest between rating agencies and their shareholders is an important step in the right direction.

Another positive proposal would require ESMA to introduce a harmonized rating scale to be used by all CRAs registered in the EU. The uniform rating scale would establish comparable metrics for all existing rating scales. Such metrics would contribute to the transparency, interoperability, and comparability of the rating process and could enhance competition in the sector.

However, a problematic proposal would require ESMA to assess new draft methodologies as a condition for their entry into force. In the Director’s view, this new proposed role for ESMA could create serious tensions with the requirement of non-interference and independence. One possible alternative could be to have detailed principle-based industry standards for rating processes, whose application could then be monitored by ESMA as part of its on-going supervision process to ensure that rating agencies respect these commonly agreed industry standards.

The proposal requires ESMA to renew by June 1 2014 the assessment of compliance of third countries with the amendments. The Regulation currently in force already requires ESMA to judge dynamically the adequacy of the regulatory framework in non-EU countries when compared to the EU Regulation, namely that the third-country legal framework achieves similar regulatory effects and meets the same objectives as the EU Regulation.

By adding a tight deadline and by making a direct reference to the amendments, noted Director Ross, the proposed assessment would not only run into difficulties since at the moment several of the new proposals are not part of the G20 and IOSCO framework, but might also create incredulity around ESMA's intentions and good faith in the continuing ongoing third-country assessment process that it is currently engaged in under the existing Regulation.

ESMA Chair Emphasizes Role of Investor Protection in Planned Suitability Guidance

2012-02-07T14:31:00.003-06:00

As part of a broad effort to protect investors, specifically retail investors, the Chair of the European Securities and Markets Authority said that ESMA is currently consulting on guidelines to clarify aspects of the MiFID Directive’s suitability and compliance function requirements in order to improve due diligence on gathering information on the client’s background when providing suitable investment advice. In recent remarks, Steven Maijoor said that the guidelines aim to foster convergence of practices in this area across the European Union. ESMA is also developing guidelines on remuneration practices focused on the remuneration practices of investment firms from an investor protection point of view relating, as they do, to the MiFID conduct of business risks and conflicts of interest rules when providing investment services.

Chairman Maijoor also noted that in December of 2011 ESMA issued its first investor protection warning, specifically warning retail investors against dealing with unauthorized firms and individuals offering foreign exchange investments, and alerted retail investors to the main risks involved in forex trading. Given the size of the forex market, and increasing retail investor participation in it, ESMA viewed this pro-action as an essential part of its enhancing investor protection.

He noted that ESMA has established a new Financial Innovation Standing Committee to assist ESMA in fulfilling its investor protection duties. The Committee will facilitate a co-ordinated approach to the regulation of new or innovative financial activities. Through regular data collection on consumer trends, the Committee will seek to identify potential risks to investor protection and financial stability in the financial innovation area; and then produce a risk mitigation strategy.

Critical to this effort will be the MiFID revision proposal empowering both ESMA and national regulators to intervene to protect investors from inappropriate products or services by banning products. This proposal, explained Chairman Maijoor, was developed for a new world of rapid innovation, complex financial markets and products, and increasing retail investor participation in these financial markets. He emphasized that all these developments necessitate the need for higher levels of investor protection.

The key challenge for ESMA is the co-ordination of any action taken by national authorities. ESMA will need to take account of the fact that some national initiatives may be appropriate to address specific national risks, but that other market failures will raise common concerns across the EU. This means, said the Chair, that ESMA will have to manage the inevitable differences and coordinate with national regulators in order to avoid national action creating fragmentation and consumer confusion in the market.

MiFID already sets a high level framework for an investment firm’s organizational requirements, but the Chair praised the European Commission for further specifying the relevance of organizational controls at the stage when firms design their general policies and decide which products are to be offered to clients. This has translated, in part, into the new MiFID concept of ``management body’’. ESMA is considering how this concept can be translated into some form of guidance for firms on internal controls around product development.

The UCITS Directive regulates European mutual funds and allows funds to be marketed to retail investors on a cross-border basis. The revised UCITS IV Directive and its implementing legislation entered into force on 1 July 2011. One of the key reforms of the UCITS IV package is the introduction of the Key Investor Information Document to replace the simplified prospectus.

According to the ESMA Chair, this document is already helping retail investors make informed investment decisions by setting out, in a user-friendly and readable way, key information on such elements as the investment policy, risk and reward, charges and past performance. ESMA’s predecessor, CESR, made a significant contribution to the development of the detailed content and format of this key document through its technical advice provided to the Commission.

The Chair said that ESMA is developing guidelines on the requirements applicable to Exchange Traded Funds (ETFs) that fall under the UCITS Directive. While ETFs offer benefits like low costs of diversification of investor investments, he noted, there are also risks that need to be addressed. Therefore, some of ESMA’s key proposals include an obligation on ETFs to include an identifier in their name and provide additional disclosure, as well as a general strengthening of the standards on collateral received in securities lending activities. ESMA will also set out options on how best to allow investors that buy ETFs in the secondary market to be able to dispose of their units. The guidelines should be issued this summer.

The Chair reminded that many other exchange-traded products compete with ETFs, including notes and certificates, and may not offer the same regulatory protections as are afforded under the UCITS framework. The Packaged Retail Investment Products initiative, including the proposed inclusion within MiFID’s scope of structured deposits, represents a real step forward with respect to improved disclosures and consistent selling practices for competing products. ESMA fully supports this initiative, especially where it delivers consistent investor protection regardless of the legal form of products. However, ESMA said there is a case for also addressing the manufacture and management of such product.

First Circuit Panel: No Sarbanes-Oxley Whistleblower Protection for Employees of Public Companies' Contractors

2012-02-07T11:28:00.003-06:00

In a case of first impression, a First Circuit panel reversed a district court's decision on the scope of those subject to protection under the Sarbanes-Oxley Act's whistleblower provision. The plaintiffs, who alleged unlawful retaliation by their corporate employers, were two employees of private companies acting under contract as advisers to and managers of mutual funds. At issue was the scope of employees subject to protection under SOX Section 806, and the district court concluded that employees encompasses employees of private companies that are contractors or subcontractors to public companies and who engage in protected activity. The district court limited its interpretation to employees reporting violations related to fraud against the shareholders. The court then granted the employers' motion to certify for interlocutory appeal the issue of the whistleblower provision's applicability to the plaintiffs. Lawson v. FMR LLC, No. 10-2240,

The panel stated that it interpreted the statute differently and reversed the district court's decision. The panel concluded that only the employees of the defined public companies are covered by the whistleblower provisions, and if Congress intended a broader meaning, it could amend the statute. First, the principles of statutory interpretation led the panel to interpret the provision as unambiguously in favor of limiting its protection only to employees of public companies. The panel observed that the plain words of the title and captions of the section, which refer to protection for employees of publicly traded companies, are statements of congressional intent and strongly conflicted with the plaintiffs' interpretation.

The text of Section 806 identifies covered employers as having a class of securities registered under Exchange Act Section 12 or as filing file reports with the SEC pursuant to Exchange Act Section 15(d). These public companies, the panel explained, may not retaliate against their employees who engage in protected activity. Section 806 also lists representatives of employers, including contractors and subcontractors, who are also barred from retaliating against employees of a public company. It did not logically follow, the panel stated, that retaliation against employees of contractors and subcontractors was barred.

The panel then observed that Congress explicitly enacted broader protection for whistleblowers in other SOX provisions, such as in Section 1107's prohibition against retaliation against informants, but chose different and more limited language for Section 806. Also, in portions of SOX where Congress addressed the private entities and their employees, it did so explicitly. In short, as the panel wrote: ``Had Congress intended to extend § 1514A whistleblower coverage protections to the employees of private companies that have contracts to provide investment advice to funds organized under the Investment Company Act, it would have done so explicitly. In that regard, the panel noted earlier federal whistleblower protection statutes that explicitly extended their coverage to employees of contractors.’’ The panel also cited the Supreme Court's admonition to lower courts not to give securities laws greater scope than allowed by their text.

The panel's interpretation was bolstered further by the legislative history of this and other sections of SOX. According to the panel, the Senate committee report for the bill that became Section 806 was primarily concerned with the collapse of Enron, and only mentioned protecting employees of publicly traded companies who reported fraud. Section 806 was later amended by the Dodd-Frank Act to extend whistleblower coverage to employees of public companies' subsidiaries and employees of statistical rating organizations. The panel viewed this amendment and the associated remarks by senators as confirming its interpretation the only covered employees are those of publicly traded companies. The panel then determined that, since the term employee was not ambiguous, it would not defer to any contrary determination by an administrative agency.

In a dissent, Judge Thompson said that the panel's unwarranted restriction on the intentionally broad language of the Sarbanes-Oxley Act would bar a significant class of potential whistleblowers from legal protection. The dissenting judge read the text as including the contractors' employees in this case. The judge did not find any restriction limiting the statute's application to employees of publicly held companies and remarked that the majority's interpretation rendered the word contractor in the statute superfluous in a way that contradicted previous analyses of statutes in the First Circuit. The judge also noted that Congress was explicit where it intended to regulate public entities only, and that the choices of different mechanisms for different entities supported the plaintiffs' reading of statute. Continuing, the dissent stated that the title of the statute gets the majority nowhere. The judge viewed the title as merely describe a specific application of a generally applicable statute.

This post was contributed by my colleague Rodney Tonkovic

Federal Judge Who Questioned SEC Settlement of Enforcement Action Now Indicates Approval

2012-02-07T09:26:00.001-06:00

A federal judge who earlier questioned the settlement of an SEC enforcement action has now indicated that he will approve the settlement agreement based on the SEC’s response to the court’s concerns enunciated in a letter of December 20, 2011. SEC v. Koss Corporation, No. 2L11-cv-00991, ED Wis). In a Feb. 1, 2012 letter to the SEC, Judge Randa said that the Commission’s response largely satisfied the court’s concerns. The SEC indicated that it is willing to submit revised final judgments to include the consent provisions.

In the view of the court, the revisions of the “final judgments” are necessary to comply with the governing case law of the Court of Appeals for the Seventh Circuit. Therefore, the court accepted the SEC’s offer to revise its proposed final judgments as stated, citing Blue Cross and Blue Shield Ass’n v. Am. Express Co., 467 F.3d 634, 636-37 (7th Cir. 2006). Further, although continuing to question whether the judgments will be final judgments, the court said it would not withhold its approval based on that concern, citing See SEC v. Sachdeva et al, No. 10-747 (ED Wis Jan. 11, 2011). The court requested that the SEC file the revised documents by Feb. 16,2012.

In its Dec. 20, 2011 letter, the court asked the SEC to provide a written factual predicate for why the agency believes the court should find that proposed final judgments in an enforcement action alleging that a company prepared materially inaccurate financial statements and lacked adequate financial controls are fair, reasonable, adequate, and in the public interest. Citing Judge Rakoff’s opinion in SEC v. Citigroup Global Mkt. (SD N.Y. Nov. 28, 2011), Judge Randa had specifically requested that the SEC provide a written factual predicate addressing the adequacy of the proposed final judgment provision regarding disgorgement by the company’s CEO.

The company and its CEO consented to the entry of an injunctive order without admitting or denying the SEC’s allegations. As part of the settlement, the CEO agreed to reimburse the company incentive-based compensation pursuant to Section 304 of the Sarbanes-Oxley Act, which requires CEOs and CFOs to disgorge bonuses and other incentive-based compensation in cases of accounting restatements resulting from material non-compliance with SEC financial reporting requirements.

In his first letter to the SEC, Judge Randa noted that the Commission has alleged that the CEO, who was also the company’s CFO, failed to oversee the accounting and financial functions of the company. The SEC relies upon the separate consent documents of the company and the CEO, and has filed proposed final judgments as to each defendant. The letter requested that the SEC address concerns raised by the proposed final judgments and provide a written factual predicate for why it believes the court should find that the proposed final judgments are fair, reasonable, adequate, and in the public interest.

The consent document states that the CEO will be required to reimburse the Company for $242,419 in cash and 160,000 of options, and that bonus reimbursement, together with his previous voluntary reimbursement of bonus amounting to $208,895 represents the CEO’s entire fiscal year 2008, 2009, and 2010, incentive bonuses. Without any factual predicate for how those disgorgement terms were determined and what more, if anything, could have been subject to disgorgement, said Judge Randa in his earlier letter, the court could not assess their fairness and the extent to which they serve the purpose of disgorgement, which is to deprive the violator of unjust enrichment and thereby further the deterrence objectives of the securities laws.

Moreover, the court was concerned that the proposed judgments are not final judgments because they do not expressly state the disposition of the claims against the parties; e.g., dismissal without prejudice, while including a provision for the retention of jurisdiction over the enforcement of the terms of the settlement agreement. With respect to the retention of the Court’s jurisdiction.

Major Changes Proposed to Japanese Companies Act to Enhance Corporate Governance

2012-02-06T18:26:00.003-06:00

A number of significant changes have been proposed to Japan’s Companies Act, many of which would enhance corporate governance, transparency and independence. Companies would have to appoint one or more independent directors and independent audit committees would be established. The audit committee would be composed of three members, with an independent majority.

In a letter to the Ministry of Justice, the International Corporate Governance Network, while applauding the proposal to require a minimum of one independent director, urged that companies be required to have a minimum one-third independent directors on their boards.. The ICGN believes that one of the principal features of a well governed corporation is the exercise by the board of directors of independent and objective judgment. In order to provide such judgment, reasoned the network, boards of directors of public companies must consist of a sufficient number of independent outside directors.

The ICGN also supports the proposal to amend the Companies Act to ensure the independence of outside directors. At the same time, the proposal does not cover affiliated companies or key business partners. In line with the response of the Asian Corporate Governance Association, the network asked the Ministry to review whether the proposal should also include a reference to affiliated companies or key business partners.

The consultation proposes a 10-year cooling-off period before an executive director, executive officer, or manager of the company or its subsidiaries can join the company’s board as an outside director. The ICGN stated that former employment with the same company can impact the independence of outside directors. However, the ICGN’s own corporate governance principles recognize that taking into account an appropriate cooling-off period can act as a counterbalance to former employment. Former employment can impact the independence of directors unless there is an appropriate period of years between the end of the executive role and joining the board.

Under the proposal, directors who are audit committee members must be elected separately from other directors by resolution of the Shareholders Meeting. Further, the dismissal of directors who are audit committee members must be by special resolution of a Shareholders Meeting. The compensation of audit committee members must be determined separately from the compensation of other directors.

California Extends Public Comment Date for Private Fund Adviser Exemption

2012-02-06T11:52:00.004-06:00

The public comment period for the following private fund adviser exemption was extended from February 20, 2012 to March 25, 2012. While no public hearing is currently scheduled, Comments may be mailed to the Department of Corporations, Attn: Karen Fong, Office of Legislation and Policy, 1515 K Street, Suite 200, Sacramento, CA 95814, or emailed to regulations@corp.ca.gov, or faxed to (916)-322-5875.

An exemption from investment adviser registration was proposed for private fund advisers by the California Department of Corporations. The exemption, if adopted, would replace the currently effective de minimis exemption that has been extended by emergency for 90 days from January 18, 2012 and anticipated to become inoperative on June 28, 2012. The proposed exemption would require private fund advisers to meet certain conditions, including the advisers not being subject to specified "bad boy" disqualification provisions, submitting SEC-filed reports required by Rule 204-4 of the Investment Advisers Act of 1940, and paying the $125 adviser registration fee to make the exemption effective for one year. Additional requirements would apply to private fund advisers to 3(c)(1) funds.

Senate Hearings Examine IRS Letter Rulings Allowing Mutual Fund Investments in Commodities, Levin Urges Use of Economic Substance Doctrine

2012-02-06T09:31:00.003-06:00

Senate hearings have examined the use of IRS letter rulings enabling U.S. mutual funds to use offshore shell corporations and financially engineered notes to make commodity investments, despite longstanding tax code restrictions. According to Senator Carl Levin (D-MI), Chair of the Investigations Subcommittee, by issuing the private letter rulings that it has in the mutual fund area, the IRS is undermining its own longstanding efforts to go after sham corporations and transactions used to avoid paying tax. For most of the 70 years they have been in existence, said Senator Levin, mutual funds were not significant participants in U.S. commodity markets. But Six years ago mutual funds began petitioning for and receiving IRS private letter rulings that, for the first time, enabled them to invest heavily in commodities, despite restrictions in Section 851(b)(2) of the Internal Revenue Code.

Senator Tom Coburn (R-OK) said that the private letter rulings are an ad hoc way for the IRS to approve of the various tax structures used to set up these mutual funds, effectively allowing funds to use creative structures to facilitate commodity investments that would otherwise not be allowed. Even more, said Senator Coburn, some are concerned that as these rulings let mutual funds increase these investments, it can lead to excessive speculation into commodities.

In June 2011, the IRS suspended issuance of private letter rulings in this area pending a review of the policy issues. In his testimony, IRS Commissioner Douglas Shulman noted that the IRS notified the mutual fund industry that it would not issue further private letter rulings until the staff could look at the overall set of issues and consider guidance of broader applicability. That remains the IRS’ current posture.

Pressed by Senator Levin to apply the codified economic substance doctrine, which allows the IRS to disregard transactions that have no substantial nontax purpose, to its review and to these transactions, Commissioner Shulman resisted, calling the doctrine a very specific tool that the IRS applies carefully. The economic substance doctrine is very fact intensive, noted the Commissioner, and has typically been raised in other circumstances, not with specific taxpayers who have been granted private letter rulings. Further, he said that the IRS does not need to raise the doctrine in its policy review, and can probably allow or disallow this type of conduct without implicating the economic substance doctrine.

Chairman Levin maintains that mutual funds have not offered any substantial business or economic purpose for creating these offshore controlled foreign corporations or constructing commodity-linked notes. He said that their only purpose is to serve the mutual funds’ effort to re-characterize the resulting income as derived from securities, so they can make unlimited commodity investments while retaining their privileged tax status.

Commissioner Shulman explained that, in order to maintain its tax status, a mutual fund must derive 90 percent of its income from investments that meet the qualifications of Section 851, which generally requires that investments be related to stock, securities, or foreign currencies. The term “securities” is specifically defined in Section 851 by cross reference to the definition of that same term in the Investment Company Act of 1940. It is the scope of that definition, and particularly its application to investments providing indirect exposure to commodities, that have been the focus of the approximately 70 private letter rulings that were the subject of this hearing.

By late 2005, he explained, the investment markets had developed to a point where many mutual funds felt the need to add exposure to commodity prices to their investment portfolios. As a result, they requested guidance from the IRS as to whether investments made to achieve this exposure would qualify for the 90 percent income test. The IRS was unable to find any authoritative guidance on the proper scope of the definition of security from either the SEC or the CFTC. This situation resulted in the IRS being asked to issue private letter rulings addressing specific proposed mutual fund commodity-related investments based on the IRS’s own best interpretation of the tax law, including cross-references to the 1940 Act.

In December 2011, Senator Levin and Coburn sent a joint letter to the IRS urging it to permanently halt the further issuance of private letter rulings that allow mutual funds to circumvent the income source restrictions in Section 851(b)(2) of the Internal Revenue Code and make unlimited indirect investments in commodities and to reevaluate the tax treatment of all mutual funds currently allowed to treat indirect commodity investments as income derived from securities under Section 851.

At the hearing, Senator Coburn noted that by calling a timeout the IRS has provided a useful opportunity to talk about how to resolve these important matters. The practices used by mutual funds are entirely legal, and even blessed by the IRS, he noted, which means that we are left with a question of policy, not a question of compliance with the law.

Section 851(b)(2), which has been in the tax code since mutual funds got started in the 1930s, restricts the types of income that mutual funds are allowed to obtain in exchange for favorable tax treatment. Senator Levin observed that mutual funds abiding by this section’s income source restrictions do not have to pay corporate income taxes like other corporations. He said that this tax break collectively saves the mutual fund industry billions of dollars each year. The statute requires that 90 percent of a mutual fund’s gross income must be derived from securities, interest, or foreign currency investments. That means not more than 10 percent of their income can come from alternatives like commodities.

This 90 percent rule has been in place for decades, emphasized the oversight chair, in 2006 the mutual fund industry began pressing the IRS to permit it to use complex financial transactions that would, in essence, enable funds to get around the rule and engage in commodity investments beyond the 10 percent limit. In response, from 2006 to 2010, the IRS issued 72 private letter rulings allowing the mutual funds to whom the letters were addressed to use either wholly-owned offshore corporations or financial instruments called commodity linked notes to make unrestricted commodity investments, notwithstanding the 10 percent limit in Section 851. The IRS private letter rulings said that the mutual funds could treat the income from those sources, not as income from a commodities investment, but as income from a securities investment in the stock of the company they owned or in the note they designed to avoid the restrictions of Section 851.

In addition, the IRS has issued private letter rulings stating that mutual funds can use commodity-linked notes to invest in commodities and treat the resulting income as from a securities investment, even though the notes were created for the sole purpose of investing in commodities and end-running Section 851. By treating this type of income as derived from securities rather than commodities, said Senator Levin, the IRS has elevated form over substance, enabled mutual funds to use agents as though they were independent actors, and use financial engineering to do indirectly what the law doesn’t let them do directly. The result is opening the door to increasing commodity speculation, he emphasized.

Emily McMahon, Treasury Acting Assistant Secretary for Tax Policy, noted that a private letter ruling is a determination issued by the IRS to a particular taxpayer that interprets and applies the tax laws to the taxpayer’s particular set of facts. As a matter of policy and practice, the Treasury Department does not participate in the consideration or issuance of private letter rulings. She added that Treasury and the IRS are considering the possibility of issuing published guidance on the subject of commodity-related investments by mutual funds.

The official further noted that the extent to which investors should be able to obtain exposure to commodity price fluctuations through investments in mutual funds is not fundamentally a tax policy issue. The Code provisions in question do raise, however, the issue of whether Treasury and the IRS should be required to interpret a non-tax statute, the Investment Company Act, that does not otherwise fall within their jurisdiction in order to determine the availability of favorable tax treatment under the Code.

The SEC has not issued any guidance of which Treasury is aware that addresses whether the financial instruments described in the IRS private letter rulings are securities for 1940 Act purposes. At the same time, Treasury is not aware of any action the SEC has taken to preclude mutual funds from making these investments. She said that administering the relevant Code provisions under these circumstances is challenging from both a practical and a policy perspective.

UK Prime Minister Rejects Idea of Employee Seat on Company Compensation Committee

2012-02-04T12:07:00.005-06:00

UK Prime Minister David Cameron has rejected a Labor Party proposal that an ordinary employee sit on a company board compensation committee, noting that having an employee on the committee would break an important principle of not having people on a remuneration committee who will have their own pay determined. The Prime Minister also endorsed performance-based pay, such as bonuses. He said that there are people working in offices and factories who want performance-related pay and who, if they meet some targets, would like to have a bonus at the end of the year. The Prime Minister described this as pro-aspiration and pro-doing the right thing for your family. Labor Party Leader Edward Milliband has stated that having an ordinary employee on a company’s remuneration committee would bring transparency to the process and a dose of realism to decisions on executive compensation. The colloquy with Mr. Milliband took place during a House of Commons question and answer period on Feb. 1, 2012.

In recent remarks to the Social Market Foundation, Mr. Milliband called for a revolution in transparency about executive compensation so that company shareholders and others can come to a view about what is justified. As part of transparency, a change is needed on who makes the decisions about pay. In this regard, the Labor Party Leader said that an employee should sit on the remuneration committee of every major company. In his view, this simple reform would help forge a new compact between workers and employers and build trust that salaries at the top are deserved and that long term decisions are being made.

On the broader topic of combating short-termism, Mr. Milliband urged a tripartite approach to examine why institutional investors seem to be managed as if the only important issue was the next quarterly announcement, whether shareholder voting rights should always be the same from day one of ownership, and how the tax system can encourage and discourage short-term behavior.

Corporate Secretaries Society Calls for SEC Regulation of Proxy Advisory Firms

2012-02-04T11:26:00.002-06:00

The Shareholder Communications Coalition has asked the SEC to erect a regulatory framework for firms providing proxy advisory services to institutional investors in connection with annual or special shareholder meetings. The Coalition is composed of the Business Roundtable, National Investor Relations Institute, and the Society of Corporate Secretaries & Governance Professionals. In a letter to the SEC, the Coalition urged the Commission to adopt regulations on conflicts of interest by proxy advisory firms, disclosure by these firms regarding the standards, procedures, and methodologies used to formulate voting recommendations, and the correction of factual errors in the information used by these firms to develop their recommendations. The Coalition also asked the SEC to consider requiring proxy advisory services to register as investment advisers under the Investment Advisers Act.

Proxy advisory firms are typically retained by mutual fund and hedge fund asset managers, pension plans, and other institutional investors to provide voting recommendations and otherwise assist in voting by these institutional investors, which range widely in size of assets under management.

According to the Coalition, recent public statements by SEC officials indicate that the agency intends to move forward with a rulemaking proposal to address the role of proxy advisory firms. This proposal and other upcoming rulemakings will follow the SEC's issuance of a Concept Release on the proxy system in July 2010.

In the Coalition’s view, new SEC regulations should include minimum standards of professional and ethical conduct for the proxy advisory community. The regulations should also require full disclosure of conflicts of interest by proxy advisory firms. For example, firms should disclose relationships with clients who are proponents of the shareholder proposal or a vote no campaign whenever the firm is issuing a recommendation to other clients in favor of the same proposal or campaign.

In addition, regulations should address whether a proxy advisory firm should be allowed to offer consulting services to a company for which it is providing recommendations on how investors should vote their shares. If a proxy advisory firm is allowed to offer consulting services to such companies, the SEC should consider regulations ensuring a complete separation of proxy advisory activities from all other businesses of the firm, including consulting and research services.

Given the tremendous influence of proxy advisory firms, continued the group, there is also a need for greater transparency about the internal procedures, standards, methodologies and assumptions they use in developing recommendations, especially when they apply policies without considering industry-specific or company-specific circumstances. Proxy advisory firms should be required to keep a public record of all their voting recommendations. They should also disclose the underlying data and the rationale used to generate specific voting recommendations.

Proxy advisory firms should also be required to provide companies with draft reports in advance of distribution allow companies to review the factual information in the reports. Companies should be able to respond to any factual errors, which would then be corrected by the advisory firm. Proxy advisory firms should also be required to disclose promptly and publicly any errors made executing or processing voting instructions on a particular proxy vote.

Republican Senators Will File an Amicus Brief in Court Challenge to Cordray Recess Appointment as CFPB Director

2012-02-03T16:32:00.001-06:00

Thirty-nine Republican Senators have signed a letter indicating their intent to file an amicus brief and join a court challenge to the recent recess appointment of Richard Cordray as Director of the Consumer Financial Protection Bureau. In the letter, the Senators, including Senate Minority Leader Mitch McConnell (R-KY), said that President Obama’s January 4, 2012 recess appointments of individuals to lead the Consumer Financial Protection Bureau and National Labor Relations Board were unprecedented and unconstitutional. A number of Ranking Members also signed the letter, including Senator Orrin Hatch of the Finance Committee (R-Utah), Senator Charles Grassley (R-Iowa) of the Judiciary Committee, Senator Susan Collins (R-Maine) of the Homeland Security and Governmental Affairs Committee, Senator John McCain (R-AZ) of the Armed Services Committee, and Senator Richard Lugar (R-IN)of the Foreign Relations Committee.

NYSE Tightens Rule 452 Broker Voting of Corporate Governance Proxy Proposals

2012-02-03T15:33:00.001-06:00

In light of legislative and regulatory action, as well as trends disfavoring broker voting of uninstructed shares, the NYSE will no longer continue the practice under Rule 452 of allowing member organizations to vote on corporate governance proxy proposals without specific client instructions. Thus, in a Memo to members, the NYSE said that proposals that the Exchange previously ruled as “Broker May Vote” including proposals to de-stagger the board of directors, majority voting in the election of directors, eliminating supermajority voting requirements, providing for the use of consents, providing rights to call a special meeting, and certain types of anti-takeover provision overrides, that are included on proxy statements going forward will be treated as “Broker May Not Vote” matters.

Rule 452 governs when Exchange member organizations may vote customer shares without specific client instructions. In the past, the Exchange has ruled certain corporate governance proposals as “Broker May Vote” matters for uninstructed customer shares when the proposal in question is supported by company management. But recently, the approach to broker voting of uninstructed shares has narrowed through changes in Exchange rules as well as through legislative action. For example, the Exchange amended Rule 452 in 2010 to prohibit brokers from voting uninstructed shares in the election of directors (other than directors of an SEC-registered investment company); and the Dodd-Frank Act codified this approach. In addition the Dodd-Frank Act specifically prohibited brokers from voting uninstructed shares on executive compensation.

Senate Passes Legislation to Curb Use of Inside Information by Members of Congress and Staff, Shelby Amendment Extends Ban to Executive Branch

2012-02-03T10:46:00.003-06:00

The Senate passed legislation barring members of Congress from profiting on inside information they obtain as part of the job and that is not readily available to the public. The vote was 96-3. The dispute over the applicability of insider trading laws to Congress centers largely on the issue of whether Congress owes a legally enforceable fiduciary duty to the source from which they receive material, non-public information. The Stop Trading on Congressional Knowledge (STOCK) Act, S 2038, makes it explicit that Members and staff owe such a duty under the federal securities laws. A floor amendment offered by Senator Richard Shelby (R-Ala) extending the prohibition on insider trading to the executive branch and independent agencies was approved by a 58-41 vote. The House has been considering companion legislation,but House Majority Leader Eric Cantor (R-VA) said that he intends to schedule consideration of the Senate-passed STOCK Act on the House floor next week.

S 2038 would also prohibit senior executives at the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation from receiving bonuses during any period of conservatorship for those entities on or after the date of enactment.

Specifically, the legislation provides that, for purposes of insider trading prohibitions under the Securities Exchange Act, the prohibition against Members of Congress and employees of Congress using inside information for personal benefit states a duty of trust and confidence. HR 2038 authorizes the SEC to issue regulations implementing the legislation and otherwise ensuring that Members and staff are subject to insider trading prohibitions. Nothing in the Act diminishes an existing legal obligation of Members and staff and makes clear that the STOCK Act does not limit or otherwise alter existing securities laws.

The Shelby Amendment provides that if you are an executive branch or independent agency official and you currently file financial disclosure reports, you must comply with the public reporting requirements in the legislation. The amendment also contains an exemption for certain military personnel. Senator Shelby said that the insider reporting requirements should extend to members of the executive branch who arguably have even greater access to confidential information and who are already required to file annual financial reports.

An amendment offered by Senator Chuck Grassley (R-Iowa), and approved by a 60-39 vote, would define political intelligence operative and require such operatives to register and disclose affiliations in the same way that lobbyists are required to do.

A public perception has developed that Congress is not covered by insider trading laws, and worse, has exempted itself from them, said Senator Joseph Lieberman (I-Conn.), the sponsor of the legislation. This is not true, he noted, but the legislation eliminates ambiguities in current insider trading rules that might make it harder to prosecute a member of Congress than a member of the public for using inside information for personal benefit.

HR 2308 also makes conforming changes to the Commodity Exchange Act to ensure that the insider trading prohibitions under that Act apply.

Senator Leiberman noted that the legislation provides that within 30 days of any stock trades disclosure forms must be filed with the Senate and also online. He noted that the SEC has made clear in congressional testimony and in discussions with the Senator’s staff that that kind of periodic requirement for disclosure of trades in securities will help them do the job Congress wants them to do to ensure that insider trading laws are not being violated and, of course, will keep the public informed. Cong. Record, Feb. 2, 2012, S298.

Senator Susan Collins observed that there are disputes among the experts about whether this legislation is necessary, but Congress feels that a very strong message should be sent to the American public that Members of Congress are not exempt from insider trading laws, and that is exactly what the legislation does.

Within12 months of enactment, the STOCK Act directs the GAO to submit a report to Congress assessing the role of political intelligence in the financial markets and the extent to which investors are using access to Congressional insiders and other federal employees to inform their investment decisions. This report is intended to shed light on the practice and better inform any future Congressional action in this area.

The report must discuss what is known about the prevalence of the sale of political intelligence and the extent to which investors rely on such information; as well as what is known about the effect that the sale of political intelligence may have on the financial markets. The report must also examine the extent to which information which is being sold would be considered non-public information and the legal and ethical issues that may be raised by the sale of political intelligence. Importantly, any benefits from imposing disclosure requirements on those who engage in political intelligence activities must be discussed, as well as any legal and practical issues that may be raised by the imposition of disclosure requirements on those who engage in political intelligence activities.

Treasury Will Work to Satisfy EU Privacy Concerns Regarding Provision of FATCA Information and Gradually Phase In FATCA Regulations

2012-02-02T19:20:00.001-06:00

The Foreign Account Tax Compliance Act can be implemented in a way that is not overly burdensome when compared to its benefits and, over time, will serve as a complement and a catalyst to the ongoing global efforts to combat offshore tax evasion, said a senior Treasury official. In remarks at the annual meeting of the New York State Bar Association tax section, Acting Assistant Secretary for Tax Policy Emily McMahon said that Treasury is aware that FATCA imposes significant new duties on foreign financial institutions, but also noted that FATCA was enacted in the wake of serious offshore tax evasion.

She said that proposed FATCA regulations are in the final stages of clearance at Treasury and the IRS. The regulations will phase in the FATCA reporting requirements gradually over an extended transition period. The regulations will also build upon prior notices to further minimize FATCA’s administrative burden and better focus on circumstances presenting a higher risk of tax evasion.

After examining the due diligence standard for review of pre-existing accounts, the regulations set a higher threshold for further investigation into potential US ownership. Regarding new accounts, the regulations align the FATCA review with the procedures firms already follow to comply with anti-money laundering and know your customer rules.

To further focus FATCA on higher-risk firms, the proposed regulations will expand the category of firms deemed FATCA-compliant. Also, recognizing the obstacles global financial firms will face in bringing all of their affiliates into compliance, the regulations will provide temporary relief from the requirement that all members of an affiliated group be participating or deemed compliant foreign financial institutions.

Recognizing that FATCA components conflict to varying degrees with the privacy laws of other countries, Treasury is willing to arrange for government-to-government exchanges of information under reciprocal agreements. In order to avoid direct reporting, a financial institution would report the FATCA information to its home country government, which would then report the information to the IRS.

The official noted that the US already has a network of agreements providing for tax information exchanges with over 60 countries, either as part of an income tax treaty or in the form of a Tax Information Exchange Agreement. Treasury recognizes that bilateral solutions envision reciprocity. But the official noted that the ability of the IRS to provide this information to another government is conditioned on the US having in place a tax information agreement with that other government. In any event, FATCA compliance must be based on the principle of reciprocity when financial institutions based in other countries are required to provide the IRS with FATCA information.

Broadly, FATCA has three core elements: enhanced due diligence, information reporting, and potential withholding on US source payments. FATCA requires foreign financial institutions to enter into an agreement, which Treasury calls an FFI agreement, under which the firm agrees to conduct due diligence to indentify accounts of US persons and foreign entities with significant US ownership, to annually report information about its US account holders to the IRS, to close any US account if the holder refuses to waive foreign legal protections that would prevent reporting, and withhold pass through payments that the FFI makes to recalcitrant account holders and to other firms that have not entered into FFI agreements.

If a FFI does not enter into a FATCA agreement or fails to comply with its terms, US financial institutions must withhold US tax at a rate of 30 percent from the gross amount of a broad range of US source payments to the financial institution and the gross proceeds from its sales of US securities.

MSRB Urges SEC to Include All Municipal Securities, as Defined in 1934 Act, Within Volcker Rule Governmental Obligations Exemption

2012-02-02T13:06:00.005-06:00

The Municipal Securities Rulemaking Board urged the federal financial regulators implementing the Dodd-Frank Volcker Rule provisions to broaden the governmental obligations exemption from the proposed regulation’s restriction on proprietary trading to include all municipal securities as defined in the Securities Exchange Act. In a letter to the SEC and banking agencies, the MSRB said the broad exemption is needed to avoid a bifurcation of the municipal securities market that will, in the Board’s view, achieve no meaningful additional benefit to the safety and soundness of the banking system.

The MSRB said that it is essential that the governmental obligations exemption be expanded, because the exemptions from the proprietary trading prohibition for underwriting activities, trading on behalf of customers, and market making activities are structured in such a way that they are not useful in the municipal securities market. Unless changed, the proposed regulations will serve as an impediment to a free and open market in municipal securities to the detriment of investors and issuers of municipal securities.

The letter points out that the narrowness of the government obligations exemption is not mandated by Dodd-Frank and that banking and securities law definitions of political subdivision that pre-date Dodd-Frank, and that gave expansive meaning to the term political subdivision to effectively parallel the definition of municipal securities under the Exchange Act, might well have been considered by Congress in drafting this provision of Dodd-Frank.

The MSRB urged the regulators to use the Exchange Act definition of municipal security, which the Board said was the most comprehensive definition. The covered banking entities that underwrite and trade in the municipal securities market must all apply the Exchange Act definition as a regular part of their activities, noted the MSRB, adding that the use of he Exchange Act definition will promote consistency of regulation of brokerage firms and covered banking entities, which promotes fair and efficient markets.

Given the extremely divergent ways in which the 50 states organize and empower their
subdivisions, municipalities, and authorities, noted the MSRB, the distinction drawn by the Volcker proposed regulations between those municipal securities that would be treated as governmental obligations and those that would not ultimately results in an adherence to form over function. In the view of the MSRB, there is no principled basis for maintaining such a distinction that is consistent with the purposes of the overall Volcker regulations or of the governmental obligations exemption.

Two issues of securities with identical terms and provisions, and with identical risk profiles, and which otherwise would exhibit the identical trading behavior, would be treated in completely different ways under the Volcker Proposal because the too narrowly tailored provisions of the governmental obligations exemption would treat one issue as a governmental obligation and the other one as a covered financial position. Given that the various existing federal statutes that use different terminology to describe municipal securities nonetheless have consistently been interpreted and applied to cover effectively the same universe of securities as set forth in the definition of municipal securities under the Exchange Act, reasoned the MSRB, there is no reason to believe that Congress intended to carve out a subset of such securities in a manner that did not promote any discernible or effective public policy.

There are some substantial differences between the corporate debt market and the municipal securities market that limit the usefulness of the underwriting activities exemption in the municipal securities market. For example, many state laws require competitive underwritings for certain types of issuers or bond types, rather than the negotiated underwritings that are the norm in the corporate debt markets. In addition, while the corporate debt market is characterized by a relatively small number of issuers and debt issues of significant size, noted the MSRB, the municipal securities market is characterized by a much larger number of issuers and much smaller issue sizes.

The trading on behalf of customers exemption would effectively require covered banking entities either to act in a fiduciary capacity for a customer or as a riskless principal. Those limits would make the exemption largely ineffectual in the municipal securities market. Most municipal securities transactions are executed by broker-dealers in a principal capacity, which does not give rise to a fiduciary duty under current law. But note that the Dodd-Frank Act directed the SEC to conduct a study on creating a single fiduciary standard for dealer and investment advisor transactions for or on behalf of retail customers and empowered the SEC to engage in rulemaking to create such a standard. If the SEC were to create such a single fiduciary standard, reasoned the MSRB, the Volcker Rule might then view such retail sales as meeting the exception for trading on behalf of a customer.

The general prohibition against proprietary trading does not apply to market-making activities. But the definition of market maker is unlikely to be of much use in the municipal securities market since dealers in municipal securities do not regularly or typically post bid-ask prices for a significant number of municipal securities.

SEC and CFTC Issue Joint Report on Global Swap Regulation as Mandated by the Dodd-Frank Act

2012-02-02T11:53:00.002-06:00

As mandated by Section 719(c) of the Dodd-Frank Act, the SEC and CFTC issued a joint report describing the regulatory framework for OTC derivatives in the Americas, European Union, and Asia, and analyzing the similarities and differences across jurisdictions. Essentially, the report provides a snapshot of current efforts to regulate OTC derivatives in the Americas, Europe, and Asia and, as such, is a timely complement to ongoing efforts at the CFTC and the SEC to monitor similarities and, more importantly, differences among regulatory proposals. Regulatory developments will continue for the foreseeable future, and the Commissions will continue to address issues arising from regulatory divergence.

Broadly, the report recommends that the CFTC and SEC staffs should continue to monitor developments at the national level across jurisdictions and should communicate with fellow regulators involved in efforts to regulate OTC derivatives. The CFTC and SEC staffs should also continue to participate in international fora and actively contribute to initiatives that are designed to develop and establish global standards for OTC derivatives regulation.

Similarly, the CFTC and SEC staffs should continue to engage in bilateral dialogues with regulatory staff in the European Union, Japan, Hong Kong, Singapore, and Canada and should consider dialogues with additional jurisdictions, as appropriate. In the view of the Commissions, these recommendations provide a roadmap for successful consultation and coordination with non-U.S. authorities to promote effective and consistent international standards in the regulation of OTC derivatives.

Regulation of OTC derivatives has just begun, noted the report, and efforts to regulate them involve global financial stability, which is linked to consistent and comprehensive OTC derivatives regulatory reform. While the G-20 leaders have agreed to the OTC derivatives commitments, said the report, it is still too early to determine precisely where there is alignment internationally and where there may be gaps or inconsistencies. In the interim, the CFTC and SEC are working with other domestic and foreign regulators to analyze requirements and coordinate regulatory proposals to the greatest extent possible. The Commissions will continue to monitor global reforms and are committed to working closely with their international counterparts in this effort.

Section 752(a) of Dodd-Frank requires the CFTC and the SEC to consult and coordinate with foreign regulators on the establishment of consistent international standards for regulating swaps and swaps entities to promote effective and consistent global regulation. The Commissions have been, and will continue to be, actively involved in several international initiatives and in various international fora that are focused on the regulation of OTC derivatives. Consistent with Dodd-Frank’s mandate, the Commissions have directed staff to participate in international work streams that are developing standards for OTC derivatives regulation, as well as in fora for additional consultation and coordination.

The report noted that the European Union has started the process of creating an EU-wide regulatory framework for OTC derivatives with the European Market Infrastructure Regulation (EMIR) and amendments to the Markets in Financial Instruments Directive (MiFID). The CFTC and SEC staffs has been engaged in a regulatory dialogue with the European Commission and the European Securities and Markets Authority (ESMA) concerning differences between Title VII of Dodd-Frank and EMIR and MiFID.

EMIR is designed to increase transparency in the OTC derivatives market and reduce counterparty credit and operational risks. To this end, EMIR requires reporting of derivatives transactions to trade repositories and the clearing of eligible OTC derivatives through central counterparties. EMIR also contains measures to reduce counterparty credit risk and operational risk for bilaterally transacted OTC derivatives.

Under EMIR, as proposed, all OTC derivatives that have been declared subject to the clearing obligation would be required to be cleared through authorized or recognized central counterparties after EMIR is approved. ESMA will have primary responsibility for implementation. EMIR would require central counterparties to comply with detailed prudential, business conduct, and organizational requirements

The report noted that the Hong Kong Monetary Authority and Securities and Futures Commission proposed an OTC regulatory regime in October 2011, with an eye to adopting final regulations by the end of 2012. The Hong Kong Authorities have proposed that only a recognized clearing house or an authorized automated trading services provider should be eligible to be designated as a central counterparty. They are considering whether to require clearing by local central counterparties of products that are considered systemically important to the Hong Kong financial market.

The SFC intends to adopt international standards consistent with IOSCO for the regulation of central counterparties before recognizing an entity as a recognized clearing house or authorized automated trading services provider for OTC derivatives. These international standards include standards relating to governance structures, financial resources, membership criteria, risk management policies and procedures, margining requirements, and default procedures.

Dissent

CFTC Commissioner Scott O’Malia issued a dissent to the joint report. In the commissioner’s view, although there is coordination on general policy considerations, significant questions remain regarding the extraterritorial application of specific rulemakings currently underway at the SEC and CFTC.

According to the commissioner, the application of entity definitions proposed by the CFTC would subject U.S. entities to mandatory clearing and capital requirements even if they operate outside the U.S., while foreign competitors may not be so constrained.

In addition, a number of jurisdictions object to a DFA provision indemnifying swap data repositories and the CFTC, and have demanded that if change is not made, they will not cooperate with U.S. swaps data collection efforts. Staff has noted that a statutory change may be necessary to ensure that the U.S. is able to fully cooperate with international regulators to share critical information regarding global risk exposure and trade data.

My colleague Lene Powell contributed to this post.

President Would Sign Legislation Banning Insider Trading by Members of Congress

2012-02-02T09:31:00.002-06:00

The Obama Administration strongly supports Senate passage of S. 2038, which clarifies that Members of Congress and staff may not engage in insider trading. In a Statement of Policy, the Administration said the legislation would help limit the corrosive influence of money in politics and ensure that the Congress is playing by the same set of rules as everyone else, an important component of the President’s Blueprint for an America Built to Last.

The Stop Trading on Congressional Knowledge (STOCK) Act, HR 2038, clarifies that Members and employees of Congress are subject to the prohibitions arising under Section 10(b) of the Securities Exchange Act and Rule 10b-5, including the prohibition on insider trading. In particular, it makes clear that Members and employees of Congress owe a duty arising from their position of trust and confidence not to use nonpublic information obtained by virtue of their position for personal benefit. It also requires reporting of various transactions, including purchases and sales of stock, within 30 days. The full Senate voted to proceed to debate on the bill by a 93-2 vote on January 30.

In addition, S. 2038 requires the Comptroller General in consultation with the Congressional Research Service to prepare a report for submission to the Congress on the role of political intelligence in the financial markets. This report would address, among other things, the effects of the sale of political intelligence on the financial markets, related legal and ethical considerations, and the merits of imposing disclosure requirements on those who engage in political intelligence activities.

The Statement of Policy notes that the President said in his State of the Union message that it is critical that the Congress take steps to restore the American people’s trust in Washington. Members of Congress should not be able to trade stocks based on nonpublic information gleaned on Capitol Hill. The Administration believes this bipartisan legislation is an important first step to prevent Members of Congress from profiting from their positions and calls for swift passage.

Senior UK Minister Concerned with Proprietary Trading Restrictions of Volcker Rule, Asks for Dialogue with US Regulators

2012-02-01T18:30:00.000-06:00

A senior UK Minister is concerned that the proposed regulations implementing the Dodd-Frank Volcker Rule provisions would impact adversely impact the liquidity of global funding markets and particularly non-US sovereign debt markets. In a letter to Fed Chair Ben Bernanke, Chancellor of the Exchequer George Osborne said that the proposed regulations would make it more difficult and costlier to provide market making services in non-US sovereign markets. Any consequent withdrawal of market-making services by banks would reduce liquidity in sovereign markets, he noted, which in turn would engender greater volatility and make it more difficult, riskier and costlier for countries such as the UK to issue and distribute their debt.

The Chancellor also said there may be a risk that the proprietary trading restrictions will continue to have implications for firms foreign to the US which use US exchanges or other market infrastructure to carry out their business. Unless exemptions are sufficiently broad, he cautioned, the risk is that the Dodd-Frank Volcker provisions could disincentivize transactions with US counterparties, which could reduce market liquidity and lead to investors experiencing higher costs, delays, and potentially greater price volatility. Over the medium term, this may encourage a migration of market making to outside the regulated banking sector.

The Minister asked for US financial regulators to engage in a dialogue with UK officials in an effort to fully understand the underlying financial stability objectives of the extra-territorial aspects of the Volcker rule and to ensure that we learn from each other in taking forward these important reforms. I hope that a dialogue about these measures would be mutually beneficial and help support greater policy consistency between the US and UK.

In this context, Chancellor Osborne noted that the UK government has formally accepted the recommendations of the Vickers Commission to ring-fence retail banks from investment banks. Thus, the US and the UK are both implementing structural reforms to create a safe and sustainable global banking system. The Vickers proposals reflect the importance that the stability of the financial services industry within the UK economy, reasoned the Chancellor, while recognizing the international character of the financial sector and the desire to avoid measures that would have extra-territorial effect.

The UK government will draft legislation implementing the Vickers Commission recommendations to ring-fence retail traditional banking activities from investment banking activities. While proprietary trading and investments in hedge funds would not be prohibited, these activities would be outside the ring-fence and thus isolated from retail banking where implicit government guarantees appear strongest. In addition, the ring-fenced bank would be legally and operationally independent from the rest of its corporate group. According to the Vickers Commission, effective ring-fencing also requires measures for independent governance to enforce the arm’s length relationship, with the board of the ring-fenced retail subsidiary having a majority of independent directors.

FASB Oversight Body Finds FIN 48 Working as Intended, With Some Concern about Revealing Sensitive Information to IRS

2012-02-01T11:30:00.003-06:00

FIN 48, a FASB accounting standards interpretation intended to increase relevance and comparability in financial reporting information about income tax uncertainties, generally achieves that purpose, although some stakeholders believe the standard could be improved. The broad consensus is that, on balance, the benefits of FIN 48’s improved consistency and reporting of income tax uncertainty information outweigh its costs. These were the conclusions of the first formal post-implementation review of an accounting standard set by FASB under a new review process established by the Financial Accounting Foundation, FASB’s oversight body. FIN 48 is Codified in Accounting Standards Codification Topic 740, Income Taxes.

FASB Chair Leslie F. Seidman said that post-implementation review is an important feedback loop in the standard-setting process. Chairman Seidman believes that the report on FIN 48 affirms the overall effectiveness of the reporting requirements and the FASB’s processes, while identifying suggestions for improvement. FASB will consider the reported findings and provide a written response in the coming weeks.

The review found that more information about income tax uncertainties is reported using FIN 48 than using prior accounting guidance. Investors are using that information in some manner in their investment decision process. Investors use the information in different ways, from predicting income tax cash flows to assessing how aggressive managements are in their income tax strategies. Preparers might not disclose sensitive income tax uncertainty information if they perceive it to be detrimental to tax settlements.

It was further found that uncertain income tax positions are recognized and measured more consistently using FIN 48 guidance than using prior accounting guidance. However, consistently applying FIN 48 may not increase the comparability of information about income tax uncertainties across companies and other reporting entities. The principal reasons comparability may not be increased are managements’ judgments and the complexity of the tax code. Management has to assess each tax position separately on its technical merits, assuming taxing authorities’ full knowledge of the positions. Different judgments may result in different reported outcomes, even for similar uncertain income tax positions.

The review also concluded that reported information about income tax uncertainties is more relevant since FIN 48 was issued. However, such information may not be predictive or confirmatory of future cash flows because FIN 48 employs a benefit-recognition approach, not a best-estimate approach for liabilities to be settled.

Investors and other financial statement users believe FIN 48 generally provides useful information. Public companies have increased the amount of information provided about income tax uncertainties. Preparers said, however, that they are concerned that the judgments involved in accounting for income tax uncertainties result in information that is not comparable, and may not represent amounts expected to be paid. Further while preparers generally understand FIN 48’s provisions and are able to apply them, they said that difficulties arise in making judgments about outcomes applied to complex, and often vague, tax code and practices.

Preparers and practitioners said that they changed some operating practices to implement FIN 48. The most common changes were employing additional tax specialists, engaging tax advisors, and changing the level of coordination between tax and other functions. Relatively few preparers said that they changed their tax strategies for FIN 48 reasons.

The FASB issued FIN 48 in 2006 to reduce diversity in practice in recognizing, measuring, and reporting uncertainties relating to income tax positions. Generally, an income tax position is a deduction or credit taken or expected to be taken in an income tax return that is recognized, measured, and reported in an entity’s financial statements. A tax position also includes a decision not to file an income tax return, or to classify transactions or entities as tax exempt. Taxing authorities may challenge income tax positions, thus creating uncertainties about the taxes ultimately to be paid.

FIN 48 was partially a reaction to SEC concerns about earnings management and financial press reports that companies could manage earnings by determining the amount and timing of income tax reserves. The IRS was concerned about aggressive and abusive income tax positions.

In addition, one of the most common material weaknesses reported in the first round of Sarbanes-Oxley Section 404 filings related to income taxes. The PCAOB introduced new audit documentation requirements that went into effect shortly before the initial adoption of FIN 48. Those requirements, along with the requirements of FIN 48, resulted in much more information and detail in income tax accrual work papers.

The review found that preparers did not experience unexpected changes in taxing authority behavior in selecting entities for audit or in settlement negotiations. Preparers are concerned, however, that IRS Schedule UTP, Uncertain Tax Position Statement, introduced in 2010 and directly related to FIN 48, could lead to adverse audit and settlement consequences. The report concluded that it is too soon to determine the economic consequences of IRS Schedule UTP, if any.

Feedback gathered by the review team also indicated that most preparers did not incur significant FIN 48 implementation and continuing compliance costs. However, some preparers, particularly those from smaller organizations said they incurred significant costs such as additional audit fees, external legal and accounting expertise, and documenting existing tax positions

Preparers said that they did not experience any significant capital market effects or effects on entity valuations attributable to FIN 48’s implementation and disclosures. Users said that they did not perceive any significant capital market effects, or effects on entities’ valuations, attributable to FIN 48.

Preparers and practitioners think that the FIN 48 disclosures reveal sensitive information to taxing authorities, particularly when an entity has limited uncertain income tax positions. They also question the reliability of certain disclosures of sensitive information, such as significant changes that could occur in the next 12 months. They reason that a requirement to disclose sensitive information leads to ambiguous disclosures.

Investment Management FAQ Explains Dodd-Frank Mid-Sized Investment Adviser Provisions

2012-02-01T11:16:00.003-06:00

Pursuant to the Dodd-Frank Act, a mid-sized adviser with between $25 million and $100million assets under management must, after July 21, 2011, must register with the SEC if it is not required to be registered as an adviser with the state securities authority in the state where it maintains its principal office and place of business or is not subject to examination as an adviser by the state where it maintains its principal office and place of business.

The Division of Investment Management (FAQ) has advised that a mid-sized adviser registered with the SEC as of July 21, 2011 must remain registered with the Commission until January 1, 2012 (unless an exemption from Commission registration is available). Each adviser registered with the Commission on January 1, 2012 must file an amendment to its Form ADV no later than March 30, 2012, which for most advisers will be their annual updating amendment. A mid-sized adviser that is no longer eligible for SEC registration will need to be registered with the state securities authorities by June 28, 2012, and must withdraw its Commission registration by filing Form ADV-W, indicating it is filing a partial withdrawal, no later than that date.

A mid-sized adviser with its principal office and place of business in New York or Wyoming is not subject to examination by the state securities authority within the meaning of the Dodd-Frank Act and would have to register with the SEC. A mid-sized adviser with its principal office and place of business in any other state is subject to examination. (Division of Investment Management FAQ)

Senate Legislation Would Close Tax Loophole that Subsidizes Short-Term Speculation in Derivatives

2012-01-31T18:19:00.001-06:00

Senate legislation would end a tax loophole that allows traders in complex derivatives to buy and sell these instruments in days or even seconds, yet claim a large portion of the resulting income as a long-term capital gain. Introduced by Senator Carl Levin (D-Mich) the Closing the Derivatives Blended Rate Loophole Act, S 2033, would end a tax subsidy that allows people who make short-term investments in certain derivatives to treat much of their earnings as long-term capital gains.

Generally speaking, taxpayers are allowed to claim the lower capital gains tax rate on earnings only if those earnings come from the sale of assets that they have held for more than a year. In this way, the federal tax code encourages the long-term investment that helps the economy grow.

But under Section 1256 of the Internal Revenue Code, traders in covered derivatives can claim 60 percent of their income as long-term capital gains, no matter how briefly they hold the asset. This blended tax rate applies if the trader holds the asset for 11 months or 11 hours. According to Sen. Levin, the derivatives blended tax rate is an example of how the complexities of the tax code can grant breaks for the few at the expense of the many

He noted that in December of 2011 the American Bar Association Tax Section called for ending the loophole, telling lawmakers in a letter that, whatever the merits of extending preferential rates to derivative financial instruments generally, there is no policy basis for providing those preferential rates to taxpayers who have not made long-term investments.

House Members Ask SEC to Delay Registration of Private Equity Fund Advisers

2012-01-31T12:29:00.003-06:00

In a bi-partisan letter to the SEC, seventeen House Members, including Capital Markets Subcommittee Chair Scott Garrett (R-NJ), asked the Commission to delay the March 30, 2012 implementation of regulations requiring the registration of investment advisers to private equity funds and to exclude advisers of private equity funds that are not highly leveraged at the fund level from the registration. The Members believe that applying these new requirements to private equity is detrimental to capital formation and job creation and does little to protect consumers and address potential systemic risk. Given the lack of systemic risk associated with private equity funds and the sophistication of the investors in private equity funds, the substantial costs of registration outweigh any potential benefits.

In the view of the Members, the SEC’s registration requirements do not sufficiently consider the nature of private equity funds and the significant differences between private equity and other types of investment pools. Private equity firms employ long-term investment strategies by locking in capital for multiple years. Private equity investors are typically highly sophisticated qualified purchasers who have committed capital for a fixed term and cannot withdraw from that commitment.

Further, the Members emphasized that, given the lack of systemic risk associated with private equity funds and the sophistication of fund investors, the substantial cost of requiring registration of the fund advisers outweighs the potential benefits. Private equity funds will have to expend substantial resources for the establishment and ongoing operations of a compliance program, with many of these costs funneling down into the fund’s portfolio companies, creating burdens for those company managers.

In addition, the Members believe that requiring registration by private equity fund advisers not only misdirects resources at private equity firms but also at the SEC. As a result of private equity fund adviser registration, the SEC will have hundreds of new firms to oversee and inspect, thereby diverting regulatory resources from the core duty of protecting retail investors and other new oversight priorities that can contribute in a meaningful way to financial stability.

The legislation directs the SEC to define the term private equity fund and also directs the SEC to adopt rules requiring private equity fund advisers to maintain records and provide the SEC with reports the Commission deems necessary after considering fund size, governance, risk and investment strategy. The legislation was introduced by Rep. Robert Hurt (R-VA); is co-sponsored by House Financial Services Committee Chair Spencer Bachus (R-ALA) and Capital Markets Subcommittee Chair Scott Garrett (R-NJ).

The Dodd-Frank Act requires most advisers to private investment funds to register with the SEC, including advisers to private equity funds. Rep. Hurt said that the legislation is designed to give private equity firms the same exemption that venture capital firms enjoy under Dodd-Frank.

Committee members are concerned with the private equity registration requirement. They do not see private equity firms as a source of systemic risk. Rep. Gary Peters (D-MI) said that private equity firms are not generally liquid and not highly leveraged, and thus do not pose a systemic risk. It makes no sense to treat private equity firms the same as large hedge funds, he posited. Rep. Hurt fears that the over-regulation of private equity firms could lead to less job creation. He believes that the registration requirement imposes an undue burden on private equity firms.

Senate Set to Pass Legislation to Curb Use of Insider Information by Members of Congress and Staff

2012-01-30T19:50:00.002-06:00

The Senate is set to pass legislation barring members of Congress from profiting on inside information they obtain as part of the job and that is not readily available to the public. The dispute over the applicability of insider trading laws to Congress centers largely on the issue of whether Congress owes a legally enforceable fiduciary duty to the source from which they receive material, non-public information. The Stop Trading on Congressional Knowledge (STOCK) Act, S 2038, makes it explicit that Members and staff owe such a duty under the securities laws. The full Senate voted to proceed to debate on the bill by a 93-2 vote on January 30.

Specifically, the legislation provides that, for purposes of insider trading prohibitions under the Securities Exchange Act, the prohibition against Members of Congress and employees of Congress using inside information for personal benefit states a duty of trust and confidence. HR 2038 authorizes the SEC to issue regulations implementing the legislation and otherwise ensuring that Members and staff are subject to insider trading prohibitions. Nothing in the Act diminishes an existing legal obligation of Members and staff and makes clear that the STOCK Act does not limit or otherwise alter existing securities laws.

A public perception has developed that Congress is not covered by insider trading laws, and worse, has exempted itself from them, said Senator Joseph Lieberman (I-Conn.), the sponsor of the legislation. This is not true, he noted, but the legislation eliminates ambiguities in current insider trading rules that might make it harder to prosecute a member of Congress than a member of the public for using inside information for personal benefit.

HR 2308 also makes conforming changes to the Commodity Exchange Act to ensure that the insider trading prohibitions under that Act apply to Members of Congress and staff.

Within12 months of enactment, the STOCK Act directs the GAO to submit a report to Congress assessing the role of political intelligence in the financial markets and the extent to which investors are using access to Congressional insiders and other federal employees to inform their investment decisions. This report is intended to shed light on the practice and better inform any future Congressional action in this area.

The report must discuss what is known about the prevalence of the sale of political intelligence and the extent to which investors rely on such information; as well as what is known about the effect that the sale of political intelligence may have on the financial markets. The report must also examine the extent to which information which is being sold would be considered non-public information and the legal and ethical issues that may be raised by the sale of political intelligence. Importantly, any benefits from imposing disclosure requirements on those who engage in political intelligence activities must be discussed, as well as any legal and practical issues that may be raised by the imposition of disclosure requirements on those who engage in political intelligence activities.

For these purposes, the Act defines political intelligence to mean information that is derived by a seller from direct communications with executive branch and legislative branch officials; and provided in exchange for financial compensation to a client who intends, and who is known by the seller to intend, to use the information to inform investment decisions.

IASB Chair Says US Will Come on Board with IFRS, Details Remaining Convergence Projects

2012-01-30T19:10:00.001-06:00

Noting that wherever he goes in the world the one question asked more than any other is will the US come on board with IFRSs, IASB Chair Hans Hoogervorst emphasized that the US will ultimately come on board. While conceding that he has no privileged insight regarding the SEC’s internal decision making, the Chair said at an Ernst & Young IFRS seminar in Moscow that the SEC Chief Accountant recently said that the SEC will make a decision on IFRS in the coming months.

This is not an easy decision to make, acknowledged the IASB Chair, since the US has already developed a sophisticated set of financial reporting standards over many decades. Transitional concerns have to be carefully considered. That is why Chairman Hoogervorst has consistently supported the general approach for the endorsement of IFRSs described by the SEC staff’s work plan. He also noted that the US is committed to supporting global accounting standards under SEC policy and US Government policy. A set of global accounting standards is also the policy of the G20, of which the US is a key player.

There are many practical challenges facing the SEC in making the decision, noted the IASB Chair, and they are real. However, both the IASB and FASB have made it clear that a continued program of convergence by another name is not an acceptable way forward. With regard to the ongoing convergence plan, the IASB head noted that the only projects left to complete are on revenue recognition, lease accounting and financial instruments.

Revenue is the top line number and is important to every business. It is all the more important to get this standard right. Because the topic is so important, the Boards have taken a very careful and conservative approach in developing the revenue recognition standard. A second exposure draft has been published and the consultation period runs a full 120 days until March 2012. The new standard will replace US requirements that are generally considered to be too detailed and international requirements that are not detailed enough.

Lease accounting is a difficult area, said the IASB Chair, but one where improvements are needed. For many companies, lease obligations represent their greatest area of off balance sheet financing. These transactions must be accounted for in a way that is transparent to investors. It seems odd that investors must guess what a company’s liabilities from leasing are, he noted, even though management has this information at its fingertips. These obligations can be substantial, he added. The boards are finalizing the revised proposals and expect to publish a further exposure draft for public comment shortly.

The final project is financial instruments. This project was always going to be difficult, he said, adding that it took more than ten years to develop IAS 39, the existing financial instruments standard. Doing it midway through the worst financial crisis in 80 years has made it even harder. Also, the IASB and FASB have been pulled in different directions, which has made achieving convergence very challenging.

Some difficult choices remain to be made, the Chair averred, beginning with classification and measurement. The Board set out to replace IAS 39 with an entirely new standard. The first part of this work was completed in less than a year, with the issuance of IFRS 9, which the IASB Chair described as a very good standard. Also, the complexity associated with IAS 39 has been reduced.

Meanwhile, FASB has been refining its own approach on classification and measurement. FASB responded to feedback on its exposure draft and moved from a full fair value approach to a mixed measurement model. There are still differences in the Boards’ positions, said the IASB chief, but they are ``not a million miles apart.’’

On impairment, after exploring a number of alternative approaches, the IASB and FASB are finally on the same page with a workable model. The Boards recently agreed on an approach that divides expected loan losses into three categories, he said, referred to by staff as “The Good, The Bad and The Ugly.” He is hopeful that the Boards are now in a position to move quickly to the exposure draft stage. He expects the Boards to finalize this phase of the project before the end of the year.

On hedging, the IASB has come up with a general model that has been very well received and will soon publish on its website a staff draft of the model. This will give FASB additional time to take a closer look at the IASB proposal. The IASB is convinced that its hedging model gives investors a more reliable view on the economic reality of modern business practices. By redressing accounting mismatches it gives investors a much better view of the way in which companies hedge their economic risks. This work will also establish the underlying principles for macro hedging, noted the IASB Chair, which will be subject to a separate exposure draft.

US Sentencing Commission Proposes Enhanced Guidelines in Securities and Mortgage Fraud Cases Pursuant to Dodd-Frank Sec. 1079A Directives

2012-01-30T11:52:00.002-06:00

The United States Sentencing Commission has implemented the directives of Section 1079A of the Dodd-Frank Act regarding cases involving securities fraud and cases involving mortgage fraud and financial institution fraud. Section 1079A requires the Commission to review and, if appropriate, amend the guidelines applicable to these offenses and consider whether the guidelines appropriately account for the potential and actual harm to the public and the financial markets from them.

In the course of its Section 1079A review, the Commission became aware that some insider trading defendants engage in serious offense conduct but nonetheless, because of market forces or other factors, do not necessarily realize high gains. The concern has been raised that in such cases the guidelines may not adequately account for the seriousness of the conduct and the actual and potential harm to individuals and markets, because the guidelines use gain alone as the measure of harm.

Thus, with regard to securities fraud, the Commission proposes a specific offense characteristic that applies if the offense involved sophisticated insider trading, which would be defined as an especially complex or intricate offense conduct pertaining to the execution or concealment of the offense. The Commission proposes a non-exhaustive list of factors that federal courts must consider in determining whether the offense involves sophisticated insider trading, including the number and dollar value of the transactions; the number of securities involved; the duration of the offense; whether corporate shells or offshore financial accounts were used to hide transactions; and whether internal monitoring or auditing systems or compliance and ethics program standards or procedures were subverted in an effort to prevent the detection of the offense.

The Commission also proposes an enhancement if, at the time of the offense, the insider-defendant was an officer or a director of a public company; a registered broker or dealer, or a person associated with a broker or dealer; or an investment adviser, or a person associated with an investment adviser; or an officer or a director of a futures commission merchant or an introducing broker; a commodities trading advisor; or a commodity
pool operator.

The Commission also asked for comment on whether it should provide further guidance regarding the causation standard to be applied in calculating loss in cases involving securities fraud. For example, should the Commission provide a loss causation standard similar to the civil loss causation standard articulated by the Supreme Court in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), where the Court held that civil securities fraud plaintiffs must prove that their economic loss was proximately caused by the defendant’s misrepresentation or other fraudulent conduct as opposed to other independent market factors.

With regard to mortgage fraud, the Commission proposes two changes to the calculation of loss in mortgage fraud cases. First, the Commission would specify that in the case of a fraud involving a mortgage loan in which the collateral was disposed of at a foreclosure sale, courts should use the amount recovered from the foreclosure sale. Second, in the case of a fraud involving a mortgage loan, reasonably foreseeable pecuniary harm would include the reasonably foreseeable administrative costs to the lending institution associated with foreclosing on the mortgaged property, provided that it exercised due diligence in the initiation, processing, and monitoring of the loan and the disposal of the collateral.

With regard to financial institution fraud generally, the Commission proposes to broadens the applicability of the guidelines, which provide an enhancement if the offense involved specific types of financial harm, such as jeopardizing a financial institution. Currently, courts are directed to consider whether the financial institution suffered one or more listed harms, such as becoming insolvent, as a result of the offense. The Commission proposes to direct federal courts to consider whether one of the listed harms was likely to result from the offense but did not result from the offense because of federal government
intervention.

House Ag Committee Approves Legislation Exempting Inter-Affiliate Swaps from Dodd-Frank Derivatives Requirements

2012-01-29T14:44:00.005-06:00

Legislation exempting inter-affiliate swaps from margin and other requirements under the derivatives provisions of the Dodd-Frank Act was approved by voice vote by the House Agriculture Committee. Sponsored by Rep. Steve Stivers (R-OH) and Rep. Marcia Fudge (D-OH), HR 2779, would exempt swaps and security-based swaps entered into by a party that is controlling, controlled by, or under common control with its counterparty. The exempted transactions would be reported to an appropriate swap data repository, or, if there is no such repository that would accept them, to the CFTC in the case of exempted swaps, or the SEC in the case of exempted security-based swaps. Rep. Stivers said that the legislation is designed to ensure that Congress does not penalize companies over the way they choose to do business. The House Financial Services Committee earlier approved HR 2779 in a bi-partisan 53-0 vote.

Inter-affiliate swaps are swaps and security-based swaps executed between entities under common corporate ownership. H.R. 2779 exempts inter-affiliate swap and security-based swap trades that are designed to mitigate risks associated with market-facing trades, where a corporation executes a derivatives transaction with an investment bank or other entity, which may be either a swap dealer or security-based swap dealer.

Currently, companies use inter-affiliate swaps to combine positions and centrally hedge risk. This is accomplished by executing most or all of its external swaps or security-based swaps through a single or limited number of affiliates. Despite the significant differences between inter-affiliate swaps and swaps between unrelated parties, the Dodd-Frank Act treats these swaps the same, which increases the cost of hedging risk for end-users. House Report No. 122-344.

Rep. Stivers noted that inter-affiliate swaps are a type of accounting transaction used to assign risk of swap to the proper entity within the corporate family. The federal government should not be influencing that type of decision by essentially picking winners and losers within a corporate family, said the Representative, who assured the subcommittee that the legislation does not change corporation law. Rep. Stivers also noted that the measure applies only to swaps, not to all derivatives.

An amendment offered by Rep. Stivers and Rep. Gwen Moore (D-WI) designed to prevent entities from using the inter-affiliate swap exemption to evade Dodd-Frank derivatives regulation was agreed to by voice vote. Primarily, the amendment would ensure that financial services companies cannot use the exemption to evade other provisions of Dodd-Frank. Rep. Moore noted that the intent of the amendment is to prevent evasion of clearing and margin requirements. The amendment allows the SEC to adopt regulations to include in the definition of security-based swap any agreement or transaction structured as an affiliate transaction to evade the requirements of Dodd-Frank.

Under H.R. 2779, inter-affiliate swap trades must still be reported to a swap data repository and to the appropriate regulators. While the bill does not exempt security-based swap trades from all of Title VII’s requirements, the bill does exempt such transactions from the margin, capital, clearing and execution, and real-time reporting requirements of Title VII. The bill would also prohibit affiliate transactions from being used as a factor in defining a security based swap dealer or major security-based swap participant.

During the Ag Committee markup of HR 2779, Chairman Frank Lucas (R-OK) expressed strong support for the legislation, noting that HR 2779 ensures that companies can maintain successful business models centralizing risk management expertise in a single or limited number of affiliates. He observed that regulating inter-affiliate swaps would not provide additional risk reduction but would raise costs for many companies.

Rep. Fudge said that an exemption for inter-affiliate swaps from margin and other requirements of Dodd-Frank Act would allow for centralized hedging whereby a company using inter-affiliate swaps can combine its positions, executing most if not all of its market facing swaps through a single affiliate. These transactions do not pose or increase systemic risk and would not lead to abuse, she averred, because Section 721(c) of Dodd-Frank gives regulators explicit anti-evasion authority and HR 2779 preserves the power to regulate security-based swap transactions under Sections 23A and 23B of the Federal Reserve Act. More broadly, said Rep. Fudge, the legislation balances business needs while protecting investors from abuses.

In earlier testimony supporting HR 2779, ISDA noted that the legislation addresses an issue of significant concern to major swaps market participants. Inter-affiliate swaps are transactions between two legally separate subsidiaries, explained ISDA, and are commonly used by financial institution dealers in connection with their roles as market intermediaries and by end-users to hedge capital and manage balance sheet risks. End-users use inter-affiliate swaps transactions to hedge their capital, manage risks inherent in a particular balance sheet asset/liability mix and manage other related risks arising from their general operations.

Audit Committee Chairs of Global Companies Inform PCAOB that Mandatory Auditor Rotation Would Undermine the Committee

2012-01-29T13:21:00.002-06:00

Comment letters on the PCAOB’s concept release on auditor independence and audit firm rotation reveal a growing consensus among the audit committee chairs of complex global corporations that mandatory audit firm rotation would undermine the audit committee as overseer of the company’s relationship with its outside auditor in the post-Sarbanes-Oxley era. Peter V. Ueberroth, audit committee chair of Coca-Cola, Inc. noted that, since the passage of the Sarbanes-Oxley Act in 2002, independent audit committees have had the primary responsibility for engaging, overseeing, and terminating the outside auditor. In passing Sarbanes-Oxley, he noted, Congress clearly recognized that the audit committee brings a unique and informed perspective to consideration of which firm is best positioned to serve as a company’s outside auditor.

The audit committee chair at the Louisiana-Pacific Corporation said that, in the Sarbanes-Oxley Act, Congress explicitly rejected mandated audit firm rotation. Instead, the Act strengthened the role of audit committees, which enhanced the communication between the independent auditors and the audit committee, increased the discussion around independence and provided more transparency to the services provided by the audit firms.

Mr. Ueberroth, a former chair of the United States Olympic Committee board of directors, also posited that imposing a mandatory rotation requirement would inevitably interfere with the audit committee’s responsibility for assessing the effectiveness of the auditor and choosing whether to retain the auditor based on this assessment. That key responsibility would be subordinate to a mandate to choose a new firm, he said, even when that firm, in the judgment of the audit committee, may not be as qualified as the current auditor to serve the company. Further, requiring a company to rotate audit firms would presents serious risks related to the effective functioning of the audit process and, consequently, could lead to a deterioration in audit quality, particularly in the years leading up to, and after, a rotation. Mandatory audit firm rotation also would create a host of practical difficulties for Coca-Cola and similar companies with complex global business operations.

The chair of the Exxon Mobil audit committee, Michael Boskin, former Chair of the Council of Economic Advisers under President George H. W. Bush, emphasized that mandatory auditor rotation could have a detrimental effect on the quality of the independent audit function and would diminish the important role of the board audit committee, a primary function of which is to promote the independence of the audit function. The chair explained that the audit committee accomplishes this through exercising direct responsibility for appointing, compensating, retaining and overseeing the work performed by the independent auditor. Mandating rotation of the audit firm would diminish the audit committee’s responsibility to appoint and retain the independent auditor.

Mr. Boskin also noted that an auditor can achieve a profound understanding of a complex, multinational company only through active engagement over an extended period of time. Attaining this deeper understanding of the company, its philosophy, policies, standards, and systems is critical to audit effectiveness, he remarked, and takes many years to achieve. Mandatory rotation undermines the process for developing this holistic view of a company, he said, and would make audits less effective and more vulnerable to error.

The audit committee chair at AT&T observed that mandatory audit firm rotation would be ineffective in increasing audit quality and protecting investors. It would also diminish the audit committee’s oversight role. The audit committee is best positioned to select the company’s outside auditor, emphasized the chair, and industry expertise combined with institutional knowledge gained over time significantly enhances the quality of the audit.

Echoing the comments of other audit committee chairs, the Union Pacific Corp. audit committee chair noted that mandatory audit firm rotation may lead to increased audit costs as a newly engaged audit firm may require additional staff and time to ensure a comprehensive audit.

The chair of the audit committee at New York Life Insurance Co. said that mandatory audit firm rotation would result in no meaningful improvement in auditor independence, objectivity and professional skepticism and would come with significant cost and risk. The chair stressed the importance of the continued autonomy of the audit committee to choose the right auditor, based on the audit firm's experience and industry knowledge, instead of being forced to choose an auditor due to a mandated requirement. Any
requirement to adopt mandatory rotation would take away discretion from the audit committee to do what is in the best interest of the company. The audit committee is in the best position to evaluate whether the company’s outside auditors are independent, objective and are exercising an appropriate level of professional skepticism.

The chair of the audit committee at Imperial Oil said that mandatory rotation of the audit firm effectively supersedes the board audit committee's important responsibility to appoint and retain the independent auditor. Further, since there are only a limited number of audit firms large enough to audit companies like Imperial Oil, mandatory rotation, based on arbitrary points in time could limit the availability of qualified firms, placing the audit committee in an unacceptable position.

House Ag Committee Approves Legislation Clarifying Dodd-Frank Swap Execution Facility Provisions

2012-01-28T14:30:00.001-06:00

The House Agriculture Committee approved by a voice vote bi-partisan legislation providing certainty and direction with regard to the Dodd-Frank definition of swap execution facility. Sponsored by Rep. Scott Garrett (R-NJ), Chair of the Capital Markets Subcommittee, the Swap Execution Facility Clarification Act, HR 2586, is designed to implement congressional intent reflected in the heavily negotiated language of the swap execution facility definition in Dodd-Frank. H.R. 2586 directs regulators to provide market participants with the flexibility they need to obtain price discovery in the market and in the method of execution they use.

The Act would clarify that a swap execution facility cannot be required to have a minimum number of participants, receive or respond to quote requests, or display quotes for a certain period of time. Further, the SEC and CFTC would not be permitted to limit the means of contract execution or require trading systems to interact with each other.

In addition to allowing voice execution on a swap execution facility for any trade, HR 2586 prohibits ‘the 15 second rule,’ restrictions on the request for quote (RFQ) model and a sweep the book requirement. Chairman Garrett believes that the specific nature of this direction is necessary to promote the conditions for a competitive regulated swaps market to thrive in the U.S.

An amendment to HR 2586 offered by Ag Committee Ranking Member Collin Peterson (D-MN) was approved by voice vote. The Peterson Amendment is designed to send a signal to not gut CFTC powers on swap market transparency. In this spirit, the amendment preserves CFTC authority to promote greater transparency. Rep. Peterson noted that swap execution facilities must be open transparent marker places where competition governs. The Peterson Amendment was strongly support by Ag Committee Chair Frank Lucas (R-OK), who described it as a targeted amendment that will give swap execution facilities the flexibility to evolve naturally without hindering liquidity or choice for market participants. ‘

Chairman Garrett praised the Ag Committee’s approval of HR 2586, noting that regulating the execution of swap transactions as mandated by the Dodd-Frank Act is the most significant market structure undertaking since 1934. If Congress and the regulators don’t get it right, he warned, there is a risk of putting the U.S. at a competitive disadvantage with foreign counterparts. While for some the goal is to have swaps trade with continuous pricing like the equity and futures markets, he said, because many swaps are illiquid products with sporadic pricing, that goal simply isn’t practicable at this time. H.R. 2586 is specifically designed to promote the transparent evolution of swaps trading on swap execution facilities and help to ensure that a vibrant swap market develops in the U.S. Importantly, it also protects the confidential trading strategies of asset managers, pension funds, insurance companies, farm credit banks and the ability of commercial end-users to access the swap market to fund long-term projects necessary to create jobs.

During the markup of HR 2586 in the Financial Services A technical amendment offered by Chairman Garrett, and suggested by the SEC, would strike ``trading system or platform’’ from the bill and insert ``method of trading system functionality.’’ According to Chairman Garrett, this is term of art that keeps the congressional intent of allowing different methods of trading while obviating the need for new definitions in the legislation.

FinCEN to Work with SEC in Developing Regulations Requiring Investment Advisers to Set Up AML Programs and Report Suspicious Activities

2012-01-28T11:56:00.002-06:00

The Financial Crimes Enforcement Network is working on a regulatory proposal that would require investment advisers to establish anti-money laundering programs and report suspicious activity. In remarks at a recent American Bankers/American Bar Association seminar, FinCEN Director James Fries, Jr. said that FinCEN looks forward to working with the SEC as well as the States in developing the proposed regulations. FinCEN is a bureau within the Treasury Department charged with administering and enforcing compliance with the Bank Secrecy Act and associated regulations.

Although investment advisers are not expressly included within the definition of financial institution under the Bank Secrecy Act, the Act authorizes the Treasury Secretary to include additional types of entities within the definition of financial institution if it is determined that they engage in an activity similar to, related to, or a substitute for an activity of an enumerated entity. FinCEN regulations currently apply to broker-dealers and mutual funds.

On May 5, 2003, FinCEN published a notice of proposed rulemaking in the Federal Register proposing that investment advisers, because of the types of activities they engage in and the services they provide, should be defined as financial institutions for the purpose of requiring them to establish anti-money laundering programs. Many investment advisers provide investment advice to clients who have granted the adviser the power to manage the assets in their accounts, frequently on a discretionary basis, reasoned FinCEN, and thus engage in activities that are similar to, related to, or a substitute for financial services that are provided by other Bank Secrecy Act financial institutions.

Further, advisers managing clients’ assets work so closely with other financial institution, such as by directing broker-dealers to purchase or sell client securities or by directing banks to transfer client funds, that the advisers’ activities are related to those of the other financial institutions. Advisory services can also be a substitute for products offered by investment companies or insurance companies, for example, when clients seek to have advisers manage their assets through other forms of pooled investment vehicles.

Given the amount of time that had elapsed since the initial publication without further regulatory action, on November 4, 2008, FinCEN withdrew the proposed regulations and said that it would not proceed with regulations for investment advisers without publishing new proposals and allowing for industry comments. Since then, there have been significant changes in the regulatory framework for investment advisers with the passage of the Dodd-Frank Act and SEC rules implementing Dodd-Frank. Based on passage of Dodd-Frank and other changes, FinCEN revisited the topic of investment advisers.

According to the Investment Advisers Association, the number of investment advisers registered with the SEC totaled 11,539 in 2011, and the total assets under management reported by all investment advisers increased 13.7% to $43.8 trillion in 2011, from $38.6 trillion in 2010. According to the SEC, there are more than 275,000 state-registered investment adviser representatives and more than 15,000 state-registered investment advisers. Approximately 5% of SEC-registered investment advisers are also registered as broker-dealers, and 22% have a related person that is a broker-dealer. Additionally, approximately 88% of investment adviser representatives are also registered representatives of broker-dealers.

NY Senator Says SEC and CFTC Should Uniformly Enforce the Volcker Rule

2012-01-27T16:16:00.000-06:00

The SEC, CFTC and banking agencies must achieve a uniform approach to enforcement of the Volcker Rule so as not to favor certain entities with an advantage and not to create opportunities for regulatory avoidance, emphasized Senator Kirstin Gillibrand (D-NY). In a letter to the regulators, the Senator also questioned how granular the enforcement level would be and said that the market making so crucial to the financial markets must continue under the Volcker regulations.

The proposed regulations implementing the Volcker provisions in Section 619 of Dodd-Frank call for enforcement at the smallest unit of organization. The Senator queried if this meant individual traders or trading desks. In her view, granular enforcement at that level would create a substantially different standard than one focused on a larger picture. In addition, such a standard may require added build time to develop the reporting mechanisms to enable such a standard to function. At the very least, the Senator urged the regulators to clarify the unit of enforcement needed to assess the level at which the standards proposed will be applied.

Further, the Senator pointed out that Congress sought to balance the need of financial institutions to hold assets in order to maintain market liquidity with the Volcker Rule restrictions. The ability of firms to make markets is critical to the competitiveness of the US financial industry and to the maintenance of deep and liquid financial markets that undergird the economic system. The Senator emphasized that the final regulations should strike this important balance in order to ensure the competitiveness and safety of financial institutions.

Securities Industry and Corporate Secretaries Ask SEC to Use Negotiated Rulemaking in Adopting Dodd-Frank Pay Ratio Regulations

2012-01-27T10:14:00.007-06:00

The securities industry and the Society of Corporate Secretaries and Governance Professionals have urged the SEC to employ a negotiated rulemaking process when adopting pay ratio regulations under Dodd-Frank that will allow a representative group of stakeholders on a rulemaking advisory committee to join with the Commission in developing a balanced rule that achieves the legislative intent of Section 953(b).

In a letter to the SEC, SIFMA and the Society also asked the Commission to hold a roundtable discussion of experts and stakeholders to better understand the potential issues and unintended consequences of implementing the pay ratio disclosure requirements. The letter was also signed by, among others, the Financial Services Roundtable and the US Chamber of Commerce.

The groups also urged the SEC to submit the proposed regulations to the Office of Information and Regulatory Affairs (OIRA) review process. OIRA is located within the Office of Management and Budget and was created by Congress with the enactment of the Paperwork Reduction Act of 1980 to review federal regulations. In the view of the trade groups, a thorough OIRA review will allow for increased scrutiny to better understand the cost and benefits of the pay ratio rules and aid the SEC in choosing the least burdensome means of implementing Section 953(b). This will ensure that the best and most practical approaches can be included in a proposed regulation that will balance the perceived benefit of this disclosure against the implementation costs.

Moreover, the groups urged the SEC to follow the requirements outlined in Executive Orders 13563 and 13579 to identify alternative approaches and choose the least burdensome means of implementation.

Section 953(b) requires disclosure of the median of the annual total compensation of all employees of an issuer, except the CEO, as calculated in accordance with Item 402(c)(2) of Regulation S-K, the annual total compensation of the CEO, and the ratio of the median annual compensation of all employees to the CEO’s compensation. Recently, the House Financial Services Committee reported out a bi-partisan bill that would repeal Section 953(b). The Burdensome Data Collection Relief Act, HR 1062, is currently awaiting action by the full House of Representatives.

The corporate disclosure regime is designed to provide information that is useful to investors when making investment decisions, noted the groups. While pay ratio disclosure may be of general interest to some investors, they conceded, it is unclear how this disclosure will be material for the reasonable investor when making investment decisions. The ratio will inevitably vary widely among industries or businesses without any relevance to the financial performance of a company. Thus, additional consideration of any possible benefit to be provided by this disclosure must be considered in the rulemaking process and weighed against the costs.

According to the groups, there are significant hurdles and burdens faced by the business community in attempting to comply with Section 953(b). There is a widespread misperception that this information is readily available at the touch of a button, noted the letter, but this could not be further from the truth. Companies may have tens of thousands of employees stretched out over dozens of countries, especially the largest companies with operations around the world. Obtaining the data will be difficult and time-consuming as the definition of compensation among countries will vary widely, and companies will face difficulties attempting to rationalize compensation with currency fluctuations.

The requested SEC roundtable could gather information from the people that will handle the practical compliance with this rule. The groups asked that this roundtable discussion, if it occurs, be designated part of the rulemaking record.

Given the lack of discussion about the practical implications of Section 953(b) prior to its enactment, continued the groups, it is of utmost importance during difficult economic times that implementing regulations are carefully and thoughtfully proposed. Further, the SEC should use caution during the rulemaking process to ensure that the economic consequences do not outweigh the objectives of the rule.

Noting that Section 953(b) does not include a deadline for promulgating regulations, the trade associations urged the SEC to resist rushing into proposing regulations, given the substantial cost and implementation burdens that are likely to be imposed on companies. While acknowledging that Section 953(b) is more prescriptive than many Dodd-Frank requirements, the groups said that the SEC has been afforded the time to thoroughly analyze the economic impacts that different alternatives will have on the U.S. economy at large. Thus, the SEC should consider how to provide the most flexibility for the least cost and minimize the disadvantages of unnecessary regulatory expenditures.

Finally, the groups urged the SEC to submit the proposed regulations to the Office of Information and Regulatory Affairs (OIRA) review process. In the view of the trade groups, a thorough OIRA review will allow for increased scrutiny to better understand the cost and benefits of the pay ratio rules and aid the SEC in choosing the least burdensome means of implementing Section 953(b). This will ensure that the best and most practical approaches can be included in a proposed regulation that will balance the perceived benefit of this disclosure against the implementation costs.

Senator Hagan Urges SEC and Other Regulators to Adhere to Legislative Intent in Crafting Dodd-Frank Volcker Regulations

2012-01-26T19:57:00.003-06:00

The proposed regulations implementing the Volcker Rule provisions of the Dodd-Frank Act may unintentionally narrow the scope of permitted activities, such as market making, that Congress preserved and could siphon liquidity from capital markets and harm US capital formation, said Senator Kay Hagan (D-NC). In a letter to the SEC and CFTC, the Senator noted that, in crafting Section 619(d), Congress acknowledged that market-making, underwriting, and asset management are critical to capital formation and essential to preserving robust liquidity in U.S. capital markets. The Volcker Rule prohibitions were never intended to restrict or prohibit legitimate structures, she continued, including foreign funds, joint ventures, venture capital funds, loan funds, securitization vehicles, and structured notes, that are not usually thought of as private equity or hedge funds and do not relate to trading the firm's own capital.

Senator Hagan is also concerned that the proposed regulations could inadequately clarify the treatment of certain investments made by insurers. Section 619(d)(I)(F) of Dodd-Frank includes trading in an insurance company's general account as a permitted activity and, by its terms, exempts permitted activities from the proprietary trading ban. While the proposed regulations do provide an exemption from the proprietary trading restrictions for the general account of an insurer, she noted, the section that provides this exemption does not address covered funds.

Further, the covered funds section does not expressly extend the exemption that permits proprietary trading activities on behalf of the general account to allowing the general account to hold an ownership interest in a covered fund. The Senator urged the regulators to conform the rule to Section 619's directive to accommodate the business of insurance and include investments in covered funds within the exemption for insurers.
In Section 619(d)(I)(B) of Dodd-Frank, Congress explicitly permitted market making.

While acknowledging the difficulty in distinguishing market making from prohibited activities, the Senator emphasized the importance of ensuring that regulatory limits on proprietary trading do not unnecessarily prevent firms from engaging in the accepted and legitimate activities necessary to preserve orderly markets and service clients.

Restrictions that impede the ability of firms to make markets could reduce liquidity and trigger unintended consequences, said the Senator. Moreover, the complex monitoring regime proposed by the regulators has the potential to reduce liquidity in secondary markets by causing dealers to limit the size of the positions that they purchase for fear of tripping prohibitions. A reduction in liquidity could limit the ability of mutual funds, pension funds, and other institutions to adequately serve investors, including many US retail customers. Senator Hagan urged regulators to carefully evaluate the impact of the proposal on the ability of firms to make markets and to avoid regulations that could reduce market liquidity, discourage investment, limit credit availability, and increase the cost of capital for companies.

Corporate Secretaries Oppose PCAOB Suggestions of AD&A and Auditor Assurance Outside Financial Statements

2012-01-26T18:22:00.001-06:00

The possible revisions to standards on the reports of outside auditors on company financial statements suggested by a PCAOB concept release would fundamentally change the role of the auditor from an independent analyst to an original source of information for investors, said the Society of Corporate Secretaries and Governance Professionals. In a comment letter to the PCAOB, the Society said that the net effect of many of the suggestions in the concept release would make the auditor a guarantor of the accuracy and completeness of the financial statements and, indeed, of the company’s historical results of operations and financial condition.

While the PCAOB would retain the outside auditor’s pass/fail opinion on a company’s financial statements, the Society believes that the pass/fail approach would be vitiated by the alternatives set out in the release. Depending on the nature and extent of the auditor’s comments in the proposed Auditor’s Discussion and Analysis (AD&A), and in any required assurance on disclosures outside the financial statements, the audit would yield the equivalent of high pass, medium pass, low pass, and similar grades, which would add complexity and uncertainty for investors that does not exist with the current pass/fail system.

The Society strongly disagrees with requiring an AD&A because it would be counterproductive to the PCAOB’s goal of providing greater transparency to investors and would substitute the auditor’s judgment for management’s judgment, which could ultimately undermine the auditor’s independence and management’s responsibility for the financial statements and related disclosures. Management is ultimately responsible for the preparation of the financial statements and related disclosures and is in the best position to understand its business and discuss its financial results. If an auditor were required to provide its own analysis of critical audit risks and close calls, reasoned the Society, the auditor would essentially be taking ownership of the financial statements.

Moreover, providing more detailed disclosure by the auditor of the matters considered and underlying considerations with regard to an issuer’s financial statements would not meet the PCAOB’s stated objectives of increasing transparency and making financial statements more relevant to users, noted the Society, rather it would likely increase confusion and the length of disclosure documents without a corresponding benefit. In addition, the nature and process of review and approval of the AD&A would greatly increase the difficulty of meeting tight time frames for filings under the securities laws, particularly filings of large, accelerated filers whose financial statements are generally complex.

According to the Society, even if the AD&A does not become boilerplate, which is a fear, the lack of consistency and comparability among different issuers’ AD&As would cause confusion. In the Society’s view, to add a discussion on difficult and contentious issues, particularly including close calls on the application of complex accounting standards, would create an unproductive situation where there are two potentially competing views on accounting matters.

The Society also disfavors the proposed assurance on items outside of the financial statements. While auditors are familiar with the figures and disclosure upon which the MD&A, earning releases, and non-GAAP measures are based, the cost of requiring an auditor opinion on MD&A or these other disclosures would provide relatively little benefit compared to the cost. Auditors already routinely comment on these matters and issuers routinely take such comments into account, noted the Society, and their responsibilities include consideration of whether such information is materially inconsistent with the financial statements.

Thus, the scope and nature of these other disclosures is unlikely to materially change as a result of requiring a more formal assurance on the part of auditors, reasoned the Society, but would only increase the cost. The illustration of a possible attestation in the release appears to suggest that such an attestation would have to contain a legal opinion that the MD&A satisfies SEC regulations, as well as assurance or comfort regarding the amounts and numbers contained therein. The Society cautioned that these requirements would be well beyond the scope of auditors’ duties and would require an auditor to develop expertise in areas not currently associated with auditing responsibility.

House Ag Committee Approves Legislation Clarifying End-User Exemption from Dodd-Frank Derivatives Margin Requirements

2012-01-26T13:43:00.003-06:00

The House Agriculture Committee has approved bi-partisan legislation clarifying that commercial end users would not be subject to margin requirements for uncleared swaps under derivatives provisions of the Dodd-Frank Act. The Business Risk Mitigation and Price Stabilization Act, HR 2682, sponsored by Rep. Michael Grimm (R-NY) and Gary Peters (D-MI), passed the committee by voice vote with strong support from Chairman Frank Lucas (R-OK) and Ranking Member Colin Peterson (D-MN). The legislation has already been approved by the Financial Services Committee on a voice vote.

The Dodd-Frank Act does not require regulators to impose margin requirements on end users and the legislative history clarifies that Congress did not intend to impose margin requirements on non-financial end users. Nonetheless, the legislation was driven by end user uncertainty about whether they will be subject to margin requirements.

At the markup of the bill, Chairman Lucas said that, while the CFTC has followed congressional intent, the banking regulators have proposed to require margin in the form of cash or highly liquid securities from non-financial end users, thereby ignoring congressional intent. Thus, he viewed this legislation as critical to reaffirming congressional intent to expressly and clearly provide an end-user exemption. In this regard, Chairman Lucas noted a letter sent by Senators Chris Dodd (D-CT) and Blanche Lincoln (D-AK) to House oversight chairs stating that the Dodd-Frank Act does not authorize federal regulators to impose margin on end users that use swaps to hedge or mitigate commercial risk.

Rep. Grimm said that HR 2682 clarifies the intent of Congress to provide an explicit exemption on the posting of margin by end users. He emphasized that the legislation ensures that federal regulators will not impose margin requirements on true ends users that use swaps to manage their business risks, like to lock in the cost of raw materials.

True end-users are companies that use derivatives to manage an actual business risk, he noted, generally to hedge against fluctuating prices, currency rates, or interest rates, and not to speculate. Forcing true end-users to post margin can have several negative consequences, he noted, such as the costs of hedging could be become so high that they stop hedging, resulting in a detrimental rise in prices for consumers. Also, capital would be restricted that would otherwise be used for job creation or reinvestment to make US companies more competitive in the global economy. Further, the high costs of hedging could drive business overseas to foreign derivatives markets and could also increase regulatory arbitrage.

UK Financial Conduct Authority Product Intervention Powers Explained by Martin Wheatley

2012-01-25T18:20:00.002-06:00

The product intervention powers of the new UK Financial Conduct Authority will be exercised around a strong governance framework in a flexible and proportionate manner assured Martin Wheatley, designated CEO of the FCA. In remarks to the British Bankers Association, he said that the power to ban a financial product will not be used either lightly or indiscriminately and pledged that regulatory intervention will not prevent innovation and product development. In addition, the FCA will set out principles for when it will use these types of powers. While the intervention powers will be a useful regulatory tool for protecting investors, he noted, it will not be the first tool the FCA reaches for and it will not be the norm. He does not envision FCA staff walking around offices ``with clipboards waiting to jump in and stop’’ the next good financial product idea.

The UK is in the process of fundamentally reforming its domestic financial regulatory regime. The Financial Services Authority is being abolished in its current form. The new Financial Conduct Authority will oversee the conduct of financial services firms, the operation of markets and the protection of consumers, with new powers to ban the sale of toxic products. Martin Wheatley is currently the Managing Director of the FSA Consumer and Markets Business Unit; and is slated to be the first CEO of the FCA. He was formerly CEO of the Hong Kong Securities and Futures Commission.

With regard to product intervention, the official set out some scenarios where intervention could be used. The FCA could intervene to ban inherently flawed products, such as products that offer such poor value or have such disadvantageous features that most consumers are unlikely to benefit from them. Also, intervention could be proper when there is widespread promotion or selling to customers for whom the product is unsuitable. Another example could be products where there is a strong incentive for a mis-sale, such as instances where profitability is so great that the product is just being sold to everyone, regardless of whether it is appropriate for them, and the usual regulatory measures will not put a stop to it.

Mr. Wheatley also detailed a number of forms of product intervention that the FCA could employ. For example, the FCA could intervene to ban the sale of a particular type of product to all customers, or to certain categories of customer. Moreover, intervention could be used to mandate the inclusion or exclusion of specific product features. Or sales could only be allowed in certain specified situations, such as only selling the product if it includes or excludes specified features, and if sales are limited to particular categories of customer, or through particular distribution channels.

On a separate point, the official urged people to follow the FSA guidance for creating structured financial products that was published last year. The guidance sets out four steps the FSA expects people designing and selling such products to go through. First, identify the target audience and design a product that meets their needs so it is clear who you are aiming it at, and that your high risk, high return investment is not meant for ``the 80 year old widow who visits your branch looking for a way to save without losing her money. ‘’

Second, test the products to ensure that they can deliver fair outcomes. This can involve looking to see how the product would fare under different scenarios. Third, have in place a robust approval process before the products go on sale. This means that the sales process gets the product in the hands of the right people. Fourth, monitor the product to see who is buying it and how it is performing. This is not just about selling it and moving on, said the official, but taking an interest in how it is actually working in practice.

NASAA Proposes Model Crowdfunding Exemption

2012-01-25T14:44:00.005-06:00

The Small Business Capital Formation Committee of the North American Securities Administrators Association (NASAA) has released for internal comment a proposed new NASAA Model Crowdfunding Exemption. The proposed model rule would create a transactional exemption at the state level for the sale of securities through an Internet-based offering to numerous small investors, a procedure known as "crowdfunding."

As discussed in the Request for Member Comments, the key elements of the proposed exemption include the following:

- Issuers are limited to an aggregate offering amount of $500,000 over a 12-month period.

- Individual investments are limited to $1,000 per year, per offering, with a multi-investment limit of eight percent or less of annual income.

- Issuers must make a one-stop filing in the state of the issuer’s principal place of business, using proposed new Form CF.

- Issuers must disclose certain information, including their business plans and proposed use of proceeds, on a website accessible to all state securities regulators.

- Cautionary language has been developed to provide investors with important information about the general investment risks of crowdfunding.

- Issuers must escrow investor proceeds until they reach the target offering amount.

- Individuals and companies with prior disciplinary history will be disqualified from using the exemption.

- Offerings must be conducted through an intermediary that is registered as a broker- dealer, but the intermediary is exempted from certain rules applicable to traditional broker-dealers.

The proposed exemption will not become viable at the state level unless a corresponding exemption is created under federal law. The Committee noted that the proposed model rule contains a lower aggregate offering limit than the current proposals that have been introduced in Congress in H.R. 2930, S. 1791, and S. 1970, but the Committee believes that the model rule otherwise represents a compromise between the competing federal proposals.

In the Committee's view, the most important aspect of the proposed rule may be the requirement that intermediaries register as broker-dealers, presumably because intermediaries would thus fall within the current definition of a "broker-dealer" by accepting transaction-based compensation. The rule, however, sets up a framework for exempting the intermediary from some of the rules that apply to traditional broker-dealers, provided the intermediary’s activities are limited to crowdfunding. In particular, the proposed rule exempts the intermediary from the normal rules related to SRO membership, short sales, penny stocks, suitability, and prospectus delivery requirements. The Committee observed that this approach is similar in some respects to the treatment of security futures dealers in Section 15(b)(11) of the Securities Exchange Act of 1934.

NASAA members will have until February 7, 2012 to comment on the proposed exemption.

US Hedge Fund Industry Comments on EU Derivatives Regulation, Supports Sound Central Counterparty Governance

2012-01-25T14:10:00.002-06:00

The US hedge fund industry strongly supports the European Union Regulation promoting central clearing designed to increase transparency of the derivatives market and reduce counterparty and operational risk in trading. In a comment letter on the proposed Regulation, the Managed Funds Association broadly posited that balanced central counterparty governance is critical to promoting competition in the derivatives market and that clients have an interest in sound governance requirements that foster fair and objective risk-based access, broad product offerings and competitive pricing.

In that spirit, the MFA said that EMIR (European Market Infrastructure Regulation) should affirmatively mandate the inclusion of non-dealer, client representatives on central clearing counterparty boards and risk committees. As a significant proportion of the trading volume in the OTC derivatives market, clients are important stakeholders. Thus, the MFA reasoned that they should have their views reflected in the critical decisions of these bodies and should be entitled to attend and vote at meetings, not merely consulted.

The MFA feared that, without such a mandate, narrow interests will dominate and central counterparties may not adequately take into account the views of all market participants. In addition, in order to completely effect fair representation and balanced governance of central counterparties, no single group of market participants should constitute a controlling majority of any boards or risk committees.

The MFA also suggested that the Regulation allow central counterparty employees to have representation on risk committees. Such employees are motivated to expand the scope of central counterparty products and services, offer optimal capital, margin and cost management and maintain risk management procedures, which prevent losses to the central counterparty, clearing members and the market. Moreover, such employees provide further counterbalance to the potential conflicts of interest of other constituencies represented on risk committees.

The MFA also supports portability measures facilitating a client’s ability to transfer freely all or part of its portfolio and related margin between clearing members. Clients should be able to negotiate transfers of their positions to another clearing member at any time, whether prior to or following the default of their current clearing member.

The Regulation should clarify that ceding clearing members must effect such transfers as promptly as technologically feasible and without imposing fees or other conditions that could act as a barrier or deterrent to portability and competition in the provision of clearing services. If a central counterparty transfers only part of a portfolio, the untransferred portion must be appropriately margined, in accordance with the margining methodology agreed to by the clearing member and client, or absent express agreement, as previously applicable to the client’s portfolio.

It is also important for the Regulation to permit netting arrangements allowing parties to net initial and variation margin amounts across a broad range of exposures and assets, including across cleared and uncleared exposures, as well as across related legal entities. Such netting will reduce aggregate counterparty credit risk, lower trading costs, allow for efficient use of capital, provide better transparency as to counterparty risk and reduce complexity and settlement risk. Without permitting robust netting arrangements, liquidity will drain from the derivatives market as participants seek other execution strategies to prevent over-collateralization.

The European Securities and Markets Authority (ESMA) will draft technical standards specifying the minimum margin standards, including the percentage of margin that central counterparties must collect as well as the related time horizons. The MFA urged ESMA to be mindful of the increased costs that margin regulation may impose on clients both in terms of the margin amount and of the increased administrative costs associated with collecting margin and verifying calculations.

Praising real time clearing, the MFA urged that the Regulation require immediate acceptance or rejection of a trade upon submission for clearing by both central counterparties and clearing members. Providing open access to real-time clearing of trades will promote market efficiency by enabling participants to reduce their counterparty credit risk without delay, said the hedge fund group, and by ensuring unrestricted access to the broadest range of executing counterparties, more liquidity and competitive pricing.

Real-time clearing will also enhance market transparency and protect the anonymity of a client’s executing counterparties and will avoid the imposition of additional credit limits, fragmentation of liquidity, delays in acceptance of trades and/or the imposition of barriers to access to clearing such as inappropriate execution documentation.

The MFA has consistently advocated for the protection of client collateral in cleared and bilateral trades based on its belief that segregation protects investor positions and margin from clearing member insolvency. The EU Parliament Text of the Regulation provides greater protections for clients than the EU Council Text as there is a positive segregation requirement with an opt-out in the Parliament Text as opposed to a requirement to offer an opt-in. Specifically, the Parliament Text requires that a clearing member must distinguish in separate accounts with the central counterparty the positions of the clearing members from those of its clients. The MFA strongly supports providing clients with a robust level of protection for both their positions and assets that also promotes efficient portability.

The hedge fund group supports the recognition of third country central counterparties. The three criteria for the recognition of third country central counterparties set out in the Commission’s proposal remain in the Council and Parliament texts but with certain amendments. In particular, the Council Text reflects the MFA’s suggestion that coordination with non-European regulators on the approval procedures would ensure that the equivalency test applied is reasonable and not unduly restrictive towards the regulatory frameworks of third countries.

In addition, both the Council Text and the Parliament Text contain a reciprocity requirement, which provides that ESMA may only recognize a central counterparty established in a third country when ESMA deems the legal framework of that third country to provide for an effective equivalent recognition of central counterparties authorized in the EU.

In the MFA’s view, this restriction would be difficult to implement in practice, does not significantly increase the protections available to EU entities, and is likely to have the effect of unduly restricting the ability of EU entities to access third country central counterparties. As a result, the MFA recommends eliminating this reciprocity requirement.

Cordray Outlines to House Panel His Vision for a CFPB with Full Enforcement Authority

2012-01-24T12:53:00.001-06:00

Director Richard Cordray’s vision is that the new Consumer Financial Protection Bureau will make consumer financial markets operate fairly in order to protect consumers, support honest businesses, and play a crucial role in helping to safeguard the overall economy. In testimony before a House oversight panel chaired by Rep. Patrick McHenry (R-NC), he said that the Bureau will benefit consumers by clarifying the prices and risks of consumer financial products and services.

When consumers know the true costs, benefits, and risks of competing products, he reasoned, they will be better able to make informed decisions. It will also help people avoid being ambushed by costly surprises buried in the fine print, he continued, so that they can have proper confidence that the terms of the deal stated today are the terms they will actually be living with down the road. The Bureau will benefit honest businesses by leveling the playing field and ensuring that financial institutions play by the same set of rules.

He also noted that Bureau has launched the first federal nonbank supervision program, one of the central new authorities provided by the Dodd-Frank Act. There are thousands of nonbank providers of financial products and services that make up a significant portion of the consumer financial marketplace, including mortgage lenders, mortgage servicers, mortgage brokers, payday lenders, consumer reporting agencies, debt collectors, and money services corporations.

The Director said that the nonbank supervision program will include conducting individual examinations and may also include requiring reports from businesses to determine what areas need greater focus. The Bureau will determine what degree of supervision to perform based on an analysis of the risks posed to consumers, including factors such as the nonbank’s volume of business, types of products or services, and the extent of state oversight for consumer financial protection.

Now that the CFPB has a Director, the Bureau has full authority to investigate and bring enforcement actions to ensure that financial providers are held accountable if they violate the law, and that the rules of the road governing banks and nonbanks are applied evenhandedly to all participants. In this area, observed Director Cordray, the Bureau is also cooperating closely with other law enforcement agencies to avoid any duplication of work and to coordinate limited resources. The Bureau has many tools to address problems in the financial markets, he said, including supervision, rulemaking, and enforcement. The Director emphasized that filing lawsuits or administrative actions will be necessary at times to ensure that the law is followed and respected, and that harm to consumers from unlawful conduct is remedied.

Massachusetts Provides Guidance on Social Media Use by Investment Advisers

2012-01-24T11:02:00.011-06:00

Investment advisers that discuss business with existing or prospective clients on any of the 21st Century Internet platforms for socializing, e.g., facebook, twitter or LinkedIn, must be aware that their communications may be subject to state regulation, according to the Massachusetts Securities Division. Investment advisers do not violate Massachusetts' investment adviser rules per se by using the new social media but must be particularly mindful of the State's advertising, recordkeeping and supervisory requirements because of the risk for harming a large number of investors by virtue of the media's ability to reach an immensely wide audience.

An adviser's web page on facebook, twitter or LinkedIn, for example, would likely be "advertising" if it can be accessed by the general public. Moreover, a web page is "advertising" in Massachusetts if the page is created or maintained in the adviser's name, or contains business-related content about the firm, or solicits advisory services. Even a sole-proprietor adviser's web page is "advertising" if the adviser discusses services in the name of the adviser's representative. And the long-standing restrictions against using testimonials or making misleading statements apply to an adviser's web pages on social media. Similarly, the prohibition against advertising an adviser's past specific profitable recommendations applies to posting those recommendations on a web page unless the adviser posts a list of all the adviser's recommendations made within the last one-year period. Now, new restrictions on the use of social media hold advisers responsible for web page content even if the advisers did not create the content, if the advisers were somehow "entangled" or involved in its creation or preparation by another person, or if the advisers explicitly or implicitly "adopted" or approved or endorsed the content after it's creation by another person.

As for recordkeeping, SEC Rule 204-2 requires advisers to retain their advertisements, and Massachusetts, in addition, requires advisers to maintain a correspondence file or log. Regarding supervision, the long-standing requirement that advisers create and enforce written procedures for supervising their investment adviser representatives applies to supervising their representatives' use of social media and, moreover, instructs state investment advisers to consider recently released SEC guidelines for federally-registered investment advisers on the proper use of social media by their representatives.

Securities and Derivatives Groups Must First Challenge CFTC Position Limits Regulations in District Court Says DC Circuit

2012-01-23T14:09:00.000-06:00

A three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit dismissed a challenge by securities and derivatives industry associations to rules establishing derivatives position limits adopted by the Commodity Futures Trading Commission. Citing circuit precedent, the court stated that the “normal default rule” is that “persons seeking review of agency action go first to district court rather than to a court of appeals.”

According to Judges Rogers, Garland and Brown, “Initial review occurs at the appellate level only when a direct-review statute specifically gives the court of appeals subject-matter jurisdiction to directly review agency action …There is no express congressional authorization of direct appellate review applicable to the petition for review in this case.”

SIFMA and ISDA filed a petition for review of the CFTC’s position limits regulations in the DC Circuit. Simultaneously, noting that there may be a question as to the proper forum for the challenge due to lack of direct precedent, the associations also filed a complaint in the District Court for the District of Columbia.

In Letter to House Leader, SEC Chair Details Work of Economists on Potential Regulations on Broker-Adviser Fiduciary Standard

2012-01-22T14:40:00.004-06:00

There are currently three economists working within the Division of Risk, Strategy and Financial Innovation on the topic of retail financial advice and the differences between the broker and investment adviser regulatory regimes, said SEC Chair Mary Schapiro in a Jan. 10, 2012 letter to Rep. Scott Garrett, Chair of the House Capital Markets Subcommittee. The letter was in response to Chairman Garrett’s recent questions on the progress of SEC economists in gathering and analyzing data necessary for a meaningful consideration of potential standard of conduct regulations for brokers and investment advisers providing retail investment advice.

In the letter, Chairman Schapiro also said that the SEC staff is drafting a public request for information to obtain specific data on the provision of investment advice and regulatory alternatives. She noted that, in addition to the work of the SEC economists, it is especially important to ask the public for additional data and empirical analysis.

Although SEC employees do not track their time by specific projects, the SEC Chair assured Chairman Garrett that the Risk Fin economists spend a significant amount of their time on the issues of the standard for brokers and advisers providing retail investment advice. Specifically, they have reviewed and catalogued the publicly available data, including academic articles, reports and surveys and opinion pieces discussing the market for retail financial advice. The search encompasses information describing differences between regulatory regimes based on fiduciary and suitability standards, the economics of the financial advice industry, the quality of financial services, conflicts of interest, consumer disclosure, and retail investment behavior.

In December of 2011, Risk Fin communicated a summary of the available literature to the SEC and the Risk Fin economists discussed the evidence and its relevance to potential regulation. Risk Fin economists are also conducting an ongoing dialogue with financial economists at other agencies and from academia. The SEC believes that this interaction will give Commission economists a useful and different perspective on how to conduct an economic analysis in this area.

According to Chairman Schapiro, the Risk Fin economists have also proactively reached out to industry groups and finance and law academics to ascertain the availability of data important to any future economic analysis and also to obtain additional points of view. Similarly, Risk Fin economists are working with other SEC staff to develop focus group and survey questions to obtain additional information and insights through investor testing.

In moving forward with regulatory action, the SEC will follow its usual practice of including its economic analysis for review and public comment as part of any proposal. This process has the important benefit of providing a mechanism for refining the economic analysis by seeking feedback on specific issues and making requests for private data, she said, especially in this area where the data needed to conduct an analysis may not be publicly available.

Based on its review of the broker-dealer and investment adviser industries pursuant to a study mandated by Section 913 of the Dodd-Frank Act, in 2011 the SEC staff recommended the adoption of a uniform federal fiduciary standard for brokers and advisers that would be no less stringent than the standard currently applied to investment advisers under Advisers Act Sections 206(1) and (2). The new standard would apply uniformly to both brokers and investment advisers when providing personalized investment advice about securities to retail customers

In her letter to Chairman Garrett, Chairman Schapiro noted that two Risk Fin economists were members of the interdivisional drafting team responsible for publishing the study. These economists continue to regularly meet with staff from the Division of Investment Management and the Division of Trading and Markets to collectively discuss the topic and meet with outside interest groups. Investment Management and Trading and Markets staff also contribute to the economic analysis by providing industry insights and legal analysis.

In a letter sent to Chairman Schapiro on March 17, 2011, Chairman Garrett said that, while Section 913 of Dodd-Frank Act gives the SEC the discretion to adopt a uniform fiduciary standard for brokers and investment advisers, the statute does not mandate the adoption of such a standard, and in no way suggests a congressional intent that the SEC move forward on such a rulemaking without a sufficient basis. The letter was also signed by 13 members of the Financial Services Committee.

The Garrett letter also notes that the SEC has not identified and defined clear problems that would justify a rulemaking and does not have a solid basis on which to move forward. The SEC should conduct a thorough cost benefit analysis that considers customer preferences while evaluating the specific impact that any market changes would have for investors, as well as assessing the broader practical impact that such changes might have throughout the entire financial marketplace. For example, if the SEC’s activities should involve a relationship with the Department of Labor’s incipient changes to the existing definition of fiduciary under ERISA, advised Chairman Garrett, this should factor into the SEC’s analysis and subsequent activities in order to minimize disruption to the provision of financial services to investors.

Mainland Has Potential for Significant Derivatives Market Says Hong Kong Securities Regulator

2012-01-22T14:25:00.001-06:00

While the current focus of Mainland China’s financial sector is the stock and bond markets, noted a Securities and Futures Commission senior official, there is an even greater potential for derivative products. In recent remarks, SFC Executive Director Alexa Lam urged the creation of a cooperative venture by Shanghai and Hong Kong in the derivatives markets, especially in derivatives involving precious metals and base metals, where Europe is neither the most important producer nor one of the biggest users. Expressing optimism for the future development of the global derivatives markets, she urged full use of Shanghai's large customer base and Hong Kong’s international standards of technology and regulation as a key to good cooperation and development. The official noted that, as of June 2011, the global outstanding notional amount of derivatives was over 700 trillion U.S. dollars.

The Deputy Chief Executive also noted that derivatives are risk management tools. Derivatives allow financial institutions, entities, businesses, investors and consumers to conduct risk management Since risk is continuous, she reasoned, as long as companies continue to operate there will be risk management needs. This dynamic will fuel global demand for derivatives products. But she also cautioned that the financial crisis revealed the risk of derivatives, including leverage and price volatility. At the same time, regulatory reform is underway, including importantly central clearing and central settlement for standardized derivatives. Not only does the settlement system itself need to have a sound risk management system, she emphasized, regulators must be able to conduct strict supervision.

UK Finance Minister Cautions that Transparency and Position Limit Reforms Must Be Calibrated for Derivatives Markets

2012-01-21T11:54:00.001-06:00

Transparency and market position reform of the derivatives markets must proceed deliberately based on rigorous impact assessments to fully understand the costs and benefits, said UK Finance Minister Mark Hoban in remarks to the London Stock Exchange. While greater transparency has clearly had a positive effect in equity markets, he noted, the same measures may not be directly transferrable to the derivatives markets.

Derivative markets are considerably less liquid than equity markets, he said, and extreme care is needed to ensure that transparency requirements are carefully designed to work for each asset class. For example, while the component bonds that make up Markit’s iBoxx bond indices are some of the most actively traded bonds in Europe, a review of over 9000 of these bonds revealed that only 52 percent actually traded at least once in a six month sample period in 2010.

The European Commission must also undertake a rigorous analysis when it comes to updating MiFID to reflect changes in the commodities market. He urged the Commission not to succumb to knee jerk reactions which may only serve to increase costs for EU citizens.

The Minister emphasized that it is vital to remember that the commodities derivatives market serves a critical economic function in allowing end users to mitigate commercial risk. That is why the Minister is skeptical about blanket position limits across all markets, while acknowledging that they have a role to play in defined circumstances. In his view, active position management by exchanges and authorities will be much more effective in tackling market abuse, and will also provide a more rigorous approach. He said that it is incorrect to think that blanket limits will enable governments to control prices, as some would seem to suggest.

More broadly, he urged the Commission to resist pressure to use the ongoing MiFID reforms to raise barriers against third countries seeking to trade with the EU. Across EU dossiers there has been an increasing and worrying tendency to try to implement strict equivalence or reciprocity provisions through EU legislation. The Minister cautioned that this approach could effectively close EU financial markets to third country firms.

For instance, it seems that no third country would meet the standards as set out under the current MiFID proposal. From the moment that it is passed and until equivalence decisions are taken, it would close the EU market entirely to any new third country firm. Barriers would also be placed in the way of outward investment flows, for example restricting access to emerging markets. At a time when it is vital to attract more investment both within and without the EU, it is an approach that undermines growth.

Federal Magistrate Says Negative Dodd-Frank Say on Pay Vote Did Not Overcome Business Judgment Presumption

2012-01-20T10:41:00.001-06:00

A federal magistrate (DC Ore) ruled that a shareholder derivative action alleging that board members breached their fiduciary duty of loyalty with regard to executive compensation failed to show the futility of pre-suit demand on the board because, despite a negative shareholder say on pay vote, the challenged action was protected by the business judgment rule. The shareholder advisory vote on executive compensation, mandated by the Dodd-Frank Act, resulted in 62 per cent of the shareholders rejecting the pay package. (Plumbers Local No. 137 Pension Fund, et al. v. Davis, et al, DC Ore, Civ. No. 03: 11-633-AC, Jan. 11, 2012)

The shareholders’ allegations did not dispel the presumption that the board’s compensation decisions could be attributed to a rational purpose. Specifically, the allegation that the board violated the company’s pay for performance policy was not sufficient to overcome the business judgment presumption. The fact that the board’s compensation decision does not square with the shareholder’s interpretation of the pay for performance policy is not the equivalent of an allegation that the board intentionally misled shareholders that it would follow the policy when it actually had no intention of doing so.

Compensation determinations are typically within the business judgment of the board and the allegations here were not sufficient to overcome the presumption that the board exercised business judgment. The board’s actions did not directly defy or violate any company by-law, any shareholder agreement, or any legally mandated disclosure or reporting requirement, noted the magistrate. The shareholders rely on a pay for performance policy that does not establish a binding standard for compensation.

Citing Delaware precedent, the magistrate noted that futility of demand can be shown in one of two ways. First, demand is futile when the directors are not independent or disinterested. Second, demand is futile when there is a reasonable doubt that the challenged transaction was not the product of a valid exercise of business judgment. The shareholders failed to satisfy either test.

In this situation, only one director, the CEO, stood to personally benefit from the compensation decision. Thus, a majority of the board was not interested in the decision. The magistrate rejected the contention that the interest needed to excuse demand existed because the board members face a substantial likelihood of liability.

The court similarly rejected the contention that the board lacked independence because it was subject to the outsized influence of the CEO, the only director with a personal interest in the compensation package. To accept that contention, reasoned the magistrate, would effectively erase the demand requirement and negate its purpose.

Securities and Banking Industries Respond to DOL Request for Data in Drafting Reproposed Fiduciary Definition

2012-01-19T13:34:00.002-06:00

Securities and banking trade groups have responded to a Department of Labor request for assistance in developing an expanded regulatory impact analysis of a proposed change to the DOL’s long-standing definition of fiduciary. In a letter to DOL, SIFMA and the American Bankers Association expressed the hope that this expanded analysis will help provide appropriate direction to the Department as it develops the re-proposed regulation defining an ERISA fiduciary. The trade groups believe that DOL, plan participants, plan sponsors and plan service providers will all benefit from a comprehensive and supportable regulatory impact analysis.

While the trade groups do not have the particular information requested, they do have access to providers who may be able to assist. The trade groups asked for a meeting with DOL to discuss clarifying and perhaps refining the requested information. Through an expanded dialogue on these issues, they noted, the securities and banking industry can fully understand the information and data needs of DOL and, in turn can then reach out to their respective members to determine what information the industry is able to provide.

In September of 2011, DOL said it would re-propose its rule on the definition of a fiduciary consistent with the President's January 2011 Executive Order on regulation. Thus, the re-proposal is designed to inform judgments, ensure an open exchange of views and protect consumers while avoiding unjustified costs and burdens. Consistent with the Executive Order, the extended rulemaking process also will ensure that the public receives a full opportunity to review the agency's updated economic analysis and revisions of the rule. DOL pledged to continue to coordinate closely with the SEC and CFTC to ensure that this effort is harmonized with other ongoing rulemakings.

Specifically, DOL will clarify that fiduciary advice is limited to individualized advice directed to specific parties, and respond to concerns about the application of the regulation to routine appraisals. DOL will also clarify the limits of the rule's application to arm's length commercial transactions, such as swap transactions.

The reproposed regulation will also contain exemptions addressing concerns about the impact of the new regulation on the current fee practices of brokers and advisers, and clarify the continued applicability of exemptions that have long been in existence that allow brokers to receive commissions in connection with mutual funds, stocks and insurance products. The DOL said it would craft new or amended exemptions that can best preserve beneficial fee practices, while at the same time protecting plan participants and individual retirement account owners from abusive practices and conflicted advice.

Last year, the securities industry asked DOL to coordinate with the SEC on redefining the term “fiduciary” under the Employee Retirement Income Security Act (ERISA), effectively changing 35 years of established regulatory certainty. In testimony before the House Education & Workforce Committee, SIFMA executive vice president for public policy and advocacy Ken Bentsen said that the proposed original regulation had far broader impact than the problems it sought to address. It would reverse 35 years of case law, enforcement policy and the understanding of plans and plan service providers as well as the manner in which products and services are provided to plans, plan participants and IRA account holders, without any legislative direction.

SIFMA asserted that the proposed rule was in conflict with Section 913 of the Dodd-Frank Act, which authorizes the SEC to establish a uniform fiduciary standard of care for brokers and advisors providing personalized investment advice. While current exemptions to the prohibited transaction rules of ERISA permit fiduciaries to select themselves or an affiliate to effect agency trades for a commission, there is no exemption that permits a fiduciary to sell a fixed income security or any other asset on a principal basis to a fiduciary account.

Lack of exemptive relief in this area is contrary to what Congress explicitly stated in authorizing the SEC to promulgate a uniform fiduciary standard of care for brokers and advisers providing personalized investment advice under Section 913 of Dodd-Frank. In SIFMA’s view, the result of that conflicting prohibition is that the broker would not be able to execute a customer’s order from his or her own inventory, but rather must purchase the order from another dealer, adding on a mark-up charged by the selling dealer.

SEC Issues Small Entity Compliance Guide for Reporting on Form PF

2012-01-18T11:23:00.002-06:00

The SEC has published a small entity compliance guide on reporting by investment advisers to private funds, certain commodity pool operators and commodity trading advisers. The SEC and the CFTC jointly adopted new reporting requirements on October 31, 2011 and new Form PF for filing the information with the SEC. The reporting requirements affect SEC-registered investment advisers with at least $150 million in private fund assets under management. The information that is collected by the SEC will be shared with the Financial Stability Oversight Council.

Private fund advisers that are also registered with the CFTC as commodity pool operators or commodity trading advisers will satisfy the CFTC's reporting obligations by filing Form PF. These advisers also may consolidate their reporting on Form PF with respect to private funds and non-private fund commodity pools.

The data that is reported to the SEC on Form PF will not be made publicly available in a manner that would identify a particular adviser or fund, but it may be used in an enforcement action.

The SEC-registered advisers that must report on Form PF are divided into two groups, with one for large and one for small advisers. Large private fund advisers are those with at least $1.5 billion in assets under management attributable to hedge funds; liquidity fund advisers with at least $1 billion in combined assets under management attributable to liquidity funds and registered money market funds; and advisers with at least $2 billion in assets under management attributable to private equity funds. All others will be considered smaller private fund advisers.

An investment adviser generally is a small business for purposes of the Investment Advisers Act and the Regulatory Flexibility Act if it has assets under management with a total value of less than $25 million; did not have total assets of $5 million or more on the last day of its most recent fiscal year; and does not control, is not controlled by, and is not under common control with another investment adviser that has assets under management of $25 million or more, or any person (other than a natural person) that had total assets of $5 million or more on the last day of its most recent fiscal year. Investment advisers that are defined as small businesses have no obligation to report on Form PF.

Advisers that have at least $150 million in private fund assets under management and do not exceed a large adviser threshold must file Form PF once a year within 120 days of the end of the fiscal year. These advisers will report only basic information about their size, leverage, investor types, concentration, liquidity and fund performance. Smaller advisers that manage hedge funds must report hedge fund-specific information about strategy, counterparty credit risk and the use of trading and clearing mechanisms.

Large private fund advisers have to provide more detailed information more frequently. Large hedge fund advisers must file Form PF to update information within 60 days of the end of each fiscal quarter. They must provide aggregated information with respect to their exposures by asset class, geographical concentration and turnover by asset class. For each managed hedge fund with a net asset value of at least $500 million, the advisers must report information about each fund's exposures, leverage, risk profile and liquidity.

Large liquidity fund advisers must file Form PF to update information about the funds they manage within 15 days of the end of each fiscal quarter. The information must include the types of assets in each of the liquidity fund's portfolios, risk profile information and the extent to which the fund has a policy of complying with Investment Company Act Rule 2a-7.

Large private equity fund advisers will file Form PF annually within 120 days of the end of the fiscal year. These funds must respond to questions about the extent of the leverage incurred by their funds' portfolio companies, the use of bridge financing and investments in financial institutions.

The guide outlines the two-stage phase-in period for the Form PF filing requirements. Most private fund advisers will begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, that ends on or after December 15, 2012.

Advisers with at least $5 billion in assets under management attributable to hedge funds; liquidity fund advisers with at least $5 billion in combined assets under management attributable to liquidity funds and registered money market funds; and advisers with at least $5 billion in assets under management attributable to private equity funds must begin filing Form PF after the end of their first fiscal year or fiscal quarter that ends on or after June 15, 2012.

This post was contributed by my colleague Jacquelyn Lumb.

UK Legislation Would Provide Mandatory Vote on Executive Compensation and Otherwise Unlock Shareholder Power

2012-01-17T16:26:00.001-06:00

The UK government is readying a legislative package that would increase the transparency of financial statements and give shareholders a mandatory vote on executive compensation. The legislation will introduce binding shareholder votes on executive pay as part of a package of measures to moderate boardroom behavior and will overhaul the way shareholders can access information.

In recent remarks, Deputy Prime Minister Nick Clegg said that the legislation is designed to give company shareholders the proper tools to behave like owners of the business rather than absentee landlords. The government does not want unhappy shareholders to sell their shares and move on, but rather to stay and throw their weight around so that the company improves.

One reason investors are passive, reasoned the official, is because they cannot see the reasons to act. Shareholders should be able to use annual reports as a kind of report card so they can see how well their money is being spent. But, he noted, many annual reports are impenetrable texts that obscure the financial statements rather than illuminate them.

Hundreds and hundreds of pages of facts, figures, charts and graphs are provided, but nowhere is there a clear single figure showing who gets paid what or a simple summary of where the money goes, such as how much is spent on directors, how much on dividends, or how mush is re-invested in the business. This type of information is absolutely essential for any investor trying to calculate value for money, posited the Minister, and not enough companies make it transparent.

The legislation will require companies to present financial information so that investors don’t need an accountancy degree to decipher them, he noted. For example, shareholders would only need to look at one number, not a dozen, to see how senior executives are being compensated. Companies must implement a clear policy for departing CEOs so that, if they deviate from that policy, and if a hefty payment is made for failure, that decision is illuminated. Also, the way the money is spent will need to be crystal clear. So if a company is spending too much on boardroom pay compared to the amount being reinvested in the business, noted the official, they will have to explain why and show investors where their money is going.

Key Senators Suggest Enhancements to SEC Proposed Regulations on Securitization Conflicts of Interest

2012-01-16T17:22:00.002-06:00

The Senate authors of the securitization conflict of interest provisions of the Dodd-Frank Act codified in Section 621 have suggested enhancements to the proposed SEC regulations implementing those provisions. In a letter to the SEC, Senators Carl Levin (D-MI) and Jeff Merkley (D-Ore) said that securitization transactions rife with conflicts of interest demonstrate not only the importance of investor safeguards, but also the need to strengthen aspects of the proposed regulations.

The proposed regulations would apply to an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of such entity, of an asset-backed security. While recognizing that such parties typically have substantial roles in the assembly, packaging and sale of asset-backed securities, the Senators noted that this language simply repeats the statutory terms without adding needed clarification to ensure that key asset-backed securities participants are prohibited from engaging in conflicts of interest damaging to the securitization markets.

The Senators said that the regulations should define the terms used to describe who is a covered person, and those persons should, in the aggregate, cover any party that has made a material contribution to the economic structure or composition of an asset-backed security, its management, or the sale of interests in the product to investors. The SEC should clarify that the test for whether a person is covered by the conflict of interest regulations will depend not just on the person's job title, but the party's economic involvement in the securitization transaction.

For example, collateral managers typically have significant influence in the structure, composition, and management of an asset-backed security, observed the Senators, adding that they are typically the main driver behind the selection and purchase price of the securitized assets. According to the Senators, to leave collateral managers out of a regulation intended to limit conflicts of interest in securitizations would make no sense in the context of industry norms and unduly restrict regulatory scope and impact.

The proposal suggests adopting the narrow definition of "sponsor" used in Regulation AB as a type of catchall phrase to encompass a variety of securitization participants. In the view of the Senators, adopting the Regulation AB definition of sponsor risks using a term that is both under-inclusive and confusing in the context of Section 621. A better approach, suggested the Senators, would be to define sponsor broadly for purposes of Section 621 to include any person (including a collateral manager, servicer, or custodian) who, for a fee or other remuneration or benefit, participates in the design, composition, assembly, sale, or management of the asset-backed security.

Similarly, in order to restore confidence in U.S. securitization markets, the proposed regulations must apply broadly to the wide variety of asset-back securities products that exist today as well as those that will be designed in the future. The proposal follows the statutory mandate that it cover asset-backed securities as that term is defined by Section 3(a)(77) of the Securities Exchange Act, as well as synthetic asset backed securities. In using the newly-created definition under Section 3(a), said the Senators, Congress explicitly rejected the more narrow definition used in Regulation AB.

Because the Section 3(a)(77) definition is so new, noted the Senators, its contours are still somewhat fluid. The success of the proposed regulations will thus partially rely on the Commission's interpretation of Section 3(a)(77). Since that definition explicitly applies to securities, including collateralized debt obligations, they observed, it already encompasses both registered and unregistered asset-backed securities products, which is important given that the collateralized debt obligations at the center of the financial crisis were unregistered securities.

The proposed regulations also encompass synthetic asset-backed securities products, a term that currently has no statutory definition. The proposal does not offer its own definition of synthetic asset-backed securities, instead noting that the term is commonly understood by market participants. While conceding that may be true, the Senators said that the regulations should not rely exclusively on the understandings of market participants, as those may vary and shift over time.

Instead, the Senators urged the SEC to provide a regulatory definition broad enough to cover any synthetic product that creates an economic exposure equivalent to one or more asset-backed securities. The lawmakers suggested that a possible definition in line with Section 3(a)(77) would be a fixed-income or other security that references any type of financial asset, including a loan, a lease, a mortgage, a secured or unsecured receivable, or index, and allows the holder of the security to receive payments that depend primarily on the value or performance of the referenced assets. The rule should also explicitly cover so-called hybrid products containing a mix of cash and synthetic assets.

In order to ensure that financial innovation does not render the definition under-inclusive, the SEC should add a catchall provision to its definition of covered products to ensure that the regulations will apply to any financial product that is the economic equivalent of a cash, synthetic, or hybrid asset-backed security. Without that added provision, cautioned the Senators, the regulations would not be able to restrain conflicts of interest affecting products important to the asset-backed securities markets.

Section 621 prohibits securitization participants from designing and selling asset-backed securities and then profiting from transactions in which the participants' interests materially conflict with the interests of persons being sold the securities. The proposal appropriately limits the scope of covered conflicts of interest to those arising out of transactions related to the asset-backed securities, said the Senators, and not unrelated activities.

Similarly, the proposed regulations wisely avoid a precise definition of material conflict of interest, which is a concept backed by years of administrative determinations and case law, and in which federal securities regulators already have significant expertise. Capturing that experience in a concise regulatory definition is neither feasible nor wise, reasoned the Senators, since the concept needs to remain flexible and adaptable to ensure its effectiveness.

In place of a precise definition, the proposal offers interpretive guidance to determine when a material conflict of interest exists. The guidance appears to prohibit securitization participants from engaging in a transaction through which they would have the potential to benefit if the related asset-backed securities perform poorly and there is a substantial likelihood that a reasonable investor would consider that fact important.

The Senators allowed that this approach seems to best capture the intent of Section 621. The guidance would also determine that a material conflict of interest exists when securitization participants benefit from allowing a third party to structure an asset-backed security in a way that permits a third party to benefit from a short transaction and there is a substantial likelihood that a reasonable investor would consider that fact important. Put simply, a securitization participant could not get paid for enabling a third party to engage in a conflicts-ridden transaction that the securitization participant itself could not.

The Senators urged the SEC to enhance the test by replacing ``structure an asset-backed security’’ with ``influence the structure of an asset-backed security.’’ They reasoned that it is more typical for third parties to "influence" rather than "structure" an asset-backed security.

Both conflict of interests tests would incorporate the well-established judicially-inspired standard of a substantial likelihood that a reasonable investor would consider the conflict important to his or her investment decision. In other words, the conflict must be big enough for a reasonable investor to want to know about it before investing. While this standard is backed by a significant body of court interpretations, noted the Senators, the incredibly complex nature of asset-backed securities and the sheer number of roles that may be performed by various securitization participants may make its application difficult.

Thus, the Senators urged the SEC to make it explicit that the reasonable investor standard should be applied broadly to evaluate, not only obvious conflicts of interest arising from asset selection issues, but also hidden conflicts of interest that may arise from inappropriate fees, ministerial arrangements, or other actions taken by securitization participants. In addition, the regulations should clarify that application of the reasonable investor standard must assume that investors have all of the relevant facts to perform a fair evaluation of the securitization, including facts that may have actually been concealed from them at the time of the transaction.

Treasury Official Assures Congressmen Concerned about FATCA’s Impact on Capital Markets

2012-01-16T17:07:00.005-06:00

A senior US Treasury official has assured four Members of the House of Representatives that their concerns about the impact of FATCA on the U.S. capital markets will be kept in mind during the drafting of FATCA regulations. In a letter to Rep. Blaine Leutkemeyer (R-MO), Emily S. McMahon, Acting Assistant Secretary (Tax Policy), said that Treasury and the IRS are working assiduously to provide further guidance that will help to implement FATCA in an efficient, effective and commercially reasonable manner. This guidance will reflect careful consideration of the comments that they are receiving from the financial industry. The four concerned Members are Rep. Luetkemeyer,Rep. Ron Paul (R-TX), Rep. John Campbell (R-CA), and Rep. Donald Manzullo (R-Il).

Passed as part of the Hiring Incentives to Restore Employment Act (HIRE), FATCA creates a new reporting and taxing regime for foreign financial institutions with U.S. accountholders. FATCA adds a new Chapter 4 to the Internal Revenue Code, essentially requiring foreign financial institutions to identify their customers who are U.S. persons or U.S.-owned foreign entities and then report to the IRS on all payments to, or activity in the accounts of, those persons. The Act broadly defines foreign financial institution to comprise not only foreign banks but also any foreign entity engaged primarily in the business of investing or trading in securities, partnership interests, commodities or any derivative interests therein.

According to the Joint Committee on Taxation, investment vehicles such as hedge funds and private equity funds will fall within this definition. Firms meeting the definition must enter into agreements with the IRS and report information annually in order to avoid a new U.S. withholding tax.

In their letter to Treasury, the Members said that FATCA's damage to the markets could appear in many forms. The most immediate impact, as foreign investors abandon US markets before 2013, could be rapidly deteriorating stock and bond prices. Any sharp drop in stock and bond prices, in turn, could impair consumer confidence, they noted, and the combined effect of these results could decimate any fragile economic recovery. The long-term impacts of FATCA could include reluctance by foreign firms to enter U.S. markets or conduct business domestically and the relocation of U.S. firms offshore.

In its response letter, Treasury shared the Members’ commitment to maintaining strong U.S. capital markets and said it has been closely consulting with U.S. and foreign financial institutions in developing guidance to implement FATCA. In addition, Treasury and the IRS issued a Notice on July 14, 2011, providing for phased implementation of the obligations imposed by FATCA over a transition period lasting through 2015, in order to provide financial institutions sufficient time to adapt their procedures and information technology systems.

New IASB Oversight Chair, a Former Securities Regulator, Is Fully Committed to Global Adoption of IFRS

2012-01-16T17:05:00.001-06:00

The new Chair of the IFRS Foundation, the overseer of the International Accounting Standards Board, is strongly committed to the adoption of IFRS as the set of global accounting standards. Michel Prada said that IFRSs have become the internationally accepted standards for high quality financial reporting. They are recognized by most major economies, starting with the EU in 2005, and have contributed hugely to the transparency and comparability of financial information for listed companies.

The ongoing financial crisis should not slow down the collective effort towards global accounting standards, he emphasized, but rather the recent market turmoil shows how important it is to deliver sound, transparent and consistent information to market participants in order for them to make informed decisions. Uncertainty and ambiguity are fundamentally detrimental to efficient markets and to sound risk management, he noted, which can trigger irrational and herd-like behaviors.

Chairman Prada is fully committed to the collective effort of promoting the goal of the global adoption of IFRSs as issued by the IASB, including the process of convergence, which he described as a tool for dealing with transition towards full adoption rather than being an end point in itself. This is of the essence when considering the relationship between the IASB and the US-based FASB, he noted. While appreciating the challenges faced by the largest economy in the world when considering the possibility of fully endorsing the global standards in a strategic domain, he said that significant progress has already been achieved in that direction and work continues.

A former securities regulator, Mr. Prada was Chairman of the Autorité des Marchés Financiers, the French markets and securities regulator, where he was an outspoken advocate for investor protection and global standards. He also served as Chairman of the Executive and Technical Committees of IOSCO and was a founding member of the Financial Stability Forum (now the Financial Stability Board). More recently, Mr Prada was a member of the Financial Crisis Advisory Group, formed to advise the IASB and FASB on their response to the financial crisis. And most recently he served as Chairman of the International Valuation Standards Council, which has established excellent working relations with the IASB in the field of valuation of all sorts of assets.

Abraham, Martin and John

2012-01-16T09:37:00.002-06:00

I thought I saw him walkin' up over the hill,
With Abraham, Martin and John (Dion)

Abraham Lincoln made the pledge a reality and one hundred years later Dr. Martin Luther King, Jr. redeemed it. That took far too long. How foolish the doctrine of Interposition seems today, how misguided was Massive Resistance and, as to the Southern Manifesto, I will leave that to history and, as John F. Kennedy said, move on to New Frontiers.

We hear a lot of talk today about job creation. Dr. King was one of the greatest job creators in US history. We must never forget that a great legacy of Dr. King is the new Toyota plant in Mississippi, the new VW plant in Tennessee, the new Siemens plant in North Carolina, and the new Hyundai plant in Alabama, because no international company would have ever built gleaming new facilities in a segregated South. So, in addition to everything else, thank you Dr. King for all the jobs you helped create in the New South.

Fed Gov. Duke Calls for Guidance on Accounting for Troubled Debt Restructurings and Sets Goal for Loan Loss Accounting

2012-01-15T14:29:00.001-06:00

Federal Reserve Board Governor Elizabeth Duke favors the issuance of guidance clarifying the regulatory and accounting treatment of troubled debt restructuring, non-performing assets, and classified loans which, while they have different definitions, time frames, and regulatory consequences, often seem to be used interchangeably. In remarks before the California Bankers Association, the Fed official also sees a need to clarify expectations, improve transparency, and heighten consistency around accounting for loan losses.

With regard to troubled debt restructuring, Gov. Duke noted that some bankers are reluctant to offer modifications that would help struggling borrowers and enhance the potential for ultimate repayment because they are concerned that the loan would be classified as a TDR and remain classified even after performance under the modified terms is demonstrated.

She also noted that a factor contributing to uncertainty is the intersection of Generally Accepted Accounting Principles (GAAP) and regulatory requirements. In her view, nowhere is this more evident than in the accounting for the allowance for loan and lease losses. The current accounting standard requires provisions only to cover losses that have already been incurred.

The central banker observed that conflicting views of the range of likely losses sometimes leads to a perception that the regulatory evaluation of the adequacy of accounting for loan loss levels involves something of a black box. To further complicate things, the accounting standard generally requires estimation, using statistical analysis, of a bank's unique past loss patterns, but most community banks have neither the rich data nor the capability to perform such analysis.

Gov. Duke said that the Federal Reserve staff is currently investigating whether there is any way to use available supervisory data to publish loss rate ranges that could be used as a starting point for any bank to calculate allowance amounts in a way that is simple to understand and not inconsistent with GAAP. Even if development of such a tool does not turn out to be feasible, she continued, the staff is still working to amend its approach to clarify expectations, improve transparency, and heighten consistency.

Hedge Fund Industry Asks CFTC to Approve ICE Petition on Portfolio Margining and Calculating Margins for Cleared Swaps

2012-01-15T12:46:00.004-06:00

The ICE portfolio margining program will benefit customers and the U.S. credit default market by facilitating systemic risk reduction, providing capital efficiencies, and encouraging greater clearing and facilitating the transition to clearing and should thus be approved by the CFTC, said the hedge fund industry. In a letter to the Commission, the Managed Funds Association also noted that approval of the ICE petition will improve buy-side access to clearing and remove economic barriers to customer clearing, promote competitive equality, and improve risk management. Without the exemptive relief requested in the ICE petitions, the MFA believes that none of these benefits will be realized.

The ICE petition is also supported by the Futures Industry Association. In a letter to the CFTC, the FIA said that a commingled portfolio margining account will allow ICE Clear Credit to offer the greatest benefit to the market and market participants by providing its broker dealer and futures commission merchant clearing members and their customers with greater operational efficiencies and a more comprehensive offering of products that can be cleared.

In particular, continued the FIA, because many market participants hedge index credit default swap positions with a single-name credit default swap, in the absence of portfolio margining, a trader will have to post full margin for both assets, which will require a significant capital outlay that will discourage participation in the US swap market and potentially add to systemic risk during times of stress. Portfolio margining will provide participants in the credit default swap market with the incentive and capital efficiency necessary to make the central clearing of credit default swaps, as contemplated in the Dodd-Frank Act, economically feasible.

Similarly, the MFA strongly believes that by granting the requested exemptive relief in the ICE petitions, the CFTC will provide customers in the credit default swap market with the economic incentives and capital efficiencies necessary to promote clearing of a broader scope of swap contracts. The requested exemptive relief would thus facilitate the achievement of the systemic risk reduction goal of the Dodd-Frank Act. Customers will be able to expend less capital on margin by virtue of the ability to net customers’ offsetting positions in security-based credit default swaps and index credit default swaps in cleared swaps customer accounts under ICE Clear Credit’s margin methodology.

Moreover, without portfolio margin treatment, many customers may determine that clearing their security-based and index credit default swaps will be prohibitively expensive. This would have a limiting effect on both the volume of voluntary clearing prior to the clearing mandate becoming effective, said the MFA, and the breadth of credit default swap clearing after the clearing mandate becomes effective. In the association’s view, these results would be inconsistent with a key Dodd-Frank Act goal to promote greater central clearing of swaps to reduce systemic risk.

Without the exemptive relief requested in the ICE Petitions, noted the MFA, ICE Clear Credit and its broker-dealers and futures commission merchants would be required to maintain separate accounts subject to the different margin rules of the CFTC and SEC to hold customer collateral relating to index and security-based credit default swaps. Separate accounts would make clearing significantly more expensive for customers because they would be required to fully margin both accounts.

For example, a customer that sells single-name credit default swaps to offset the risk of a correlated index credit default swap will, without the ability to net margin under a portfolio margining program, have to post full margin for both assets. The resulting inability of broker-dealers and futures commission merchants clearing such transactions on behalf of customers to net the margin of correlated index and security-based credit default swaps held in separate accounts would eliminate the economic efficiencies that can be gained from portfolio margining and that are inherent in a wide range of hedging strategies.

The MFA believes that these inefficiencies will act as an economic disincentive, not only to customers’ efficient portfolio risk management, but also to moving the US credit default swap marketplace to central clearing. Further, such a significant disincentive would severely undermine a fundamental objective of the Dodd-Frank Act to reduce systemic risk through promotion of greater clearing of swaps and the reduction of systemic risk. In addition, the Dodd-Frank Act encourages portfolio netting for systemic risk management reasons, charging the CFTC and the SEC with issuing exemptive orders under Section 713(a) in support of portfolio margining.

The FIA noted that Section 713 amends the Securities Exchange Act to provide that cash and securities, including security-based swaps, that are carried in a segregated account in accordance with an approved portfolio margining program will be subject to the commodity broker liquidation provisions of Subchapter IV of Chapter 7 of title 11 of the Bankruptcy Code. With this amendment, said the FIA, a major impediment to implementation of portfolio margining has been removed.

US Hedge Fund Industry Asks EU Securities Regulator to Provide Guidance on Short Selling Regulation

2012-01-14T16:36:00.001-06:00

The European Securities and Markets Authority (ESMA) was urged by the US hedge fund industry to provide clarifying guidance on aspects of the recently approved EU Regulation restricting transactions in short sales and credit default swaps. The Regulation, (2010) 0482, is intended to harmonize the rules on short selling and credit default swaps and thereby ensure that the EU internal financial market functions correctly. ESMA is the pan-European securities regulator.

In a letter to ESMA, the Managed Funds Association asked ESMA to provide examples, for purposes of the restriction on uncovered sovereign credit default swaps, in which the value of a particular portfolio of assets is correlated to the value of the particular sovereign debt, and adopt clear requirements for investors and other market participants to locate shares prior to engaging in a short sale. In addition, the MFA requested that the Regulation include convertible bonds in the calculation of a net short position. The letter was signed by Richard H. Baker, MFA CEO, and former Chair of the House Capital Markets Subcommittee.

Article 3(3) of the Regulation requires that any position held by a person indirectly, including through an index or basket of securities, must be included in the calculation of short and long positions. The association noted that Article 3(3) refers to the position holder having regard to publicly available information as to the composition of the index or basket. The MFA urged ESMA to clarify that publicly available information means information that can be obtained without payment so that position holders do not have to pay significant fees to index owners for data licenses.

Otherwise, said the MFA, it would be extremely expensive for market participants to include broad-based indices in their calculations. Typically, trades on indices are used for hedging purposes rather than to take a directional view on a particular name on the index, so market participants do not currently track the detailed information in relation to underlying stock in an index.

The MFA is especially concerned about the practical effect of requiring disaggregation of all positions in indices. Unlike existing short selling disclosure rules that apply mainly to financial institutions, the disclosure obligation under the Regulation applies to all companies admitted to trading in the EU. This means, said the MFA, that the reporting burden will be significantly greater than is currently the case under the existing regime.

This is particularly problematic in relation to broad-based indices. In this regard, the MFA believes that Article 3(3) should be interpreted such that a position in an index should be considered only if an individual stock represents more than a certain percentage, such as 20 percent, of the index, or the position holder through its holding in the index holds more than 1 percent of the relevant stock. This approach is used, for example, by the UK Financial Services Authority in its existing rules on the disclosure by holders of long positions. The FSA rule includes an anti-avoidance provision so that a person could not utilize this approach in order to avoid having to make the relevant notification.

The MFA also believes that a person calculating a net short position should be permitted to net long positions held by means of convertible bonds against short positions in the same issuer. Excluding convertible bond positions, reasoned the MFA, would mean excluding what is legitimately a long position from the calculation and giving an inaccurate result. The MFA noted that the definition of “issued share capital” in the Regulation refers to the total of ordinary and any preference shares issued by the company, but does not include convertible debt securities.

Thus, the definition does not exclude convertible bonds from the calculation of long positions under Article 3(2) of the Regulation, reasoned the MFA, it simply states which of the issuer’s securities should be aggregated to determine the denominator of the calculation of a person’s net short position. Thus, the association urged ESMA and the European Commission to clarify that investors should include long positions through convertible bonds in the calculation.

The MFA also posited that, when calculating long and short positions for purposes of the disclosure obligation, investment managers should be permitted (but not required) to aggregate the positions of funds managed by them where appropriate, such as for funds which adopt similar investment strategies. Noting that the broad definition of “sovereign goes beyond a reference simply to each EU Member State, the MFA sought the clarity of a specific list of entities which are considered to be sovereign issuers for purposes of the Regulation; with such a list to be published on the ESMA website. Importantly, the MFA urges that financial instruments be accounted for on a delta-adjusted basis rather than a notional basis, which more accurately reflects the relevant person’s economic exposure to the underlying shares and is consistent with existing short selling rules.

Uncovered Positions in Credit Default Swaps

The main issue raised by Article 4 of the Regulation is whether for purposes of the restriction on uncovered sovereign credit default swaps in Article 14 the value of a particular portfolio of assets or financial obligations is correlated to the value of the particular sovereign debt so that one could show that the credit default swap was entered into to hedge an exposure. The MFA encouraged ESMA to take a broad view of correlation, recognizing that correlation can be present in a wide range of circumstances.

The MFA also asked the EU regulators not to impose a strict requirement for the sovereign credit default swap protection buyer to hold the exposure it is hedging for the life of the swap. This is important, explained the MFA, because under English law and New York law, which together govern the majority of credit default swaps, a requirement that a credit default swap protection buyer always hold the reference obligation could result in that swap contract being characterized as a contract of insurance.

This would result in the protection seller being required to have a license to write insurance, noted the MFA, adding that protection sellers in most cases do not have such licenses. The MFA urged ESMA to clarify that the reference to “insurable interest” principle should be taken as merely indicative of the policy behind the rule in Article 14 of the Regulation, rather than an expression of what the rule requires.

Consistent with the insurance recharacterization issue, the MFA asked that there be no strict requirement for a sovereign credit default swap to be unwound upon the protection buyer no longer holding the reference asset, provided that the protection buyer entered into the swap contract in good faith with the intent of holding the asset for a reasonable period of time and hence was hedging an exposure. In addition, a protection buyer under a sovereign credit default swap should have the flexibility to reallocate the hedge to another asset by redesignating what the relevant swap covers for purposes of Article 4 of the Regulation.

In Comments to PCAOB, Large Audit Firms Oppose Mandatory Audit Firm Rotation

2012-01-13T12:13:00.001-06:00

In letters to the PCAOB, large audit firms said that the costs of mandatory audit firm rotation outweighs the benefits and that implementation of an audit firm rotation regime could undermine the critical role of audit committees and detract from sound corporate governance. The firms were commenting on a concept release issued by the PCAOB on auditor independence and audit firm rotation.

In its comment letter, KPMG said mandatory audit firm rotation could present risks to audit quality as well as significant costs and practical problems for auditors and public companies. There is some evidence that mandatory audit firm rotation could decrease audit quality and that fraudulent financial reporting is more likely to occur in the early years of the audit-client relationship.

In addition, KPMG believes that it would be arbitrary under applicable legal standards for the Board to move forward with a proposal that would dramatically change the fundamental principle that the audit committee is in the best position to decide which is the best external audit firm to audit the company’s financial statements without more empirical evidence that the perceived problem can be solved by the proposed solution. Moreover, mandatory audit firm rotation likely would place significant burdens and costs on auditors and public companies. For example, mandatory audit firm rotation would present audit firms with significant uncertainty regarding audit capacity needs and where best to locate talent with particular skill sets, and also inhibit longer-term investment in the development of specialized industry sectors.

Mandatory audit firm rotation also presents many practical implementation problems that could significantly increase costs to public companies and their shareholders, noted KPMG, costs which have not been fully quantified in any study. Most obvious is that companies would suffer increased costs as new auditors are appointed and seek to understand fully the work of the company and the prior auditor. Also troubling from the perspective of a public company is that mandatory audit firm rotation would undermine the audit committee’s ability to always select the best auditor for the job and determine whether changing auditors is in the best interests of the company and its shareholders.

Mandatory rotation divorces decisions about auditor appointment from the circumstances of the individual company and does not allow for situations in which it may be important not to change the auditor, such as when there are major changes underway at a company like a merger or acquisition or implementation of new financial reporting software.

Similarly, Ernst & Young said that mandatory audit firm rotation is neither a necessary nor a constructive means to promote auditor skepticism. E&Y was aware of no evidence suggesting that mandatory firm rotation will improve audit quality. Moreover, there are many identifiable and known downsides to such a policy with little to no certain benefit. A mandatory audit firm rotation model would not only give rise to substantial costs and disruptions, posited E&Y, it would also impair audit quality, undermine sound corporate governance, and detract from the ability to maintain a robust accounting profession.

In the view of PricewaterhouseCoopers, mandatory audit firm rotation does not pass a cost-benefit test. The most significant cost relates to diminished audit quality and less reliable financial reporting. Mandatory audit firm rotation may not be the most efficient way to enhance auditor independence and audit quality considering the additional financial costs and the loss of institutional knowledge of a public company’s previous auditor of record. The potential benefits of mandatory audit firm rotation are harder to predict and quantify.

Mandatory audit firm rotation also would involve considerable disruption, said PwC, which could further impact audit quality and the financial reporting process. In the initial years of an auditor's tenure, there is a significant effort from all parties in the financial reporting process to assist the audit team in understanding the business and internal control over financial reporting. PwC also believes that mandatory audit firm rotation would diminish audit committee effectiveness by preventing the audit committee from making the judgment to retain its existing firm in some circumstances and require it to choose a firm which it does not believe would be in the best interest of its company’s shareholders.

There will no doubt be many circumstances in which the audit committee determines that retaining the existing audit firm beyond the statutory period would be the best alternative for achieving the highest quality audit. In turn, mandatory audit firm rotation also presents significant corporate governance implications since a principle of sound governance is that the audit committee is in the best position to determine whether auditor rotation is appropriate. Since the passage of the Sarbanes-Oxley Act, audit committees on the whole have embraced their responsibility as independent stewards of the auditor relationship and function effectively in discharging those responsibilities.

While Deloitte & Touche said that mandatory audit firm rotation is not as effective as would be making improvements in the existing system, the firm allowed that a limited form of mandatory rotation, what Deloitte called remedial rotation, should be considered. For example, the PCAOB might recommend to the audit committee an auditor change as a result of serious adverse inspection findings that the Board believes cannot be resolved otherwise. In appropriate circumstances, the PCAOB or the SEC also could seek agreement from an audit firm to resign from an engagement, or a company to change auditors, as a condition for resolving an enforcement investigation. These measures would allow for change in specific auditor-company relationships, reasoned Deloitte, without mandating audit firm rotation for the entire system.

In its comment letter, BDO noted under mandatory audit firm rotation the audit learning curve would be significantly steeper because an entire audit firm is being replaced, rather than just the lead partner and engagement quality reviewer. Thus, the institutional knowledge a firm gains during its tenure is lost, reasoned BDO, and the successor firm would need to devote substantial time in building an appropriate level of knowledge.

While acknowledging that companies do change auditors in the normal course of business, BDO pointed out that these voluntary changes are effectively managed. In contrast, the exponential increase in the rate of audit firm changes under a mandatory rotation regime would place excessive burdens on management, the audit committee, and the new audit firm in implementing a smooth transition, with the potential negative effect on audit quality.

Securities Industry Urges Clarification of Proposed FINRA Whistleblower Rules

2012-01-13T06:04:00.002-06:00

The securities industry has asked that FINRA rule proposals addressing disputes arising under a whistleblower statute be changed by replacing ``dispute” with “claim” in every instance in new section (b) of Rule 13201 and new item (3) of Rule 2263. In a letter to the SEC, which must ultimately approve the rule change, the Securities Industry and Financial Markets Association said that as a practical and definitional matter there can be no “dispute” until the parties join issue in an ongoing legal proceeding by disagreeing about the facts or the law. But a “claim” is the mere assertion of a right, in this case under a statute. To the extent that the proposal simply aligns FINRA’s rules with Dodd-Frank Act Section 922, and other federal statutes that do not require parties to arbitrate whistleblower claims, SIFMA supports the proposed changes.

According to SIFMA, using the term “dispute” creates a risk that a party could raise a whistleblower retaliation defense or otherwise assert some counterclaim under a whistleblower statute in an effort to improperly remove the entire case from arbitration. The proposal should clarify that it applies only to a bona fide whistleblower claim, that such a claim may be severed and removed from securities arbitration, and by doing so, the proposal is not intended to allow parties to avoid arbitrating other claims in the case that are properly subject to securities arbitration. SIFMA believes that replacing “dispute” with “claim” would help provide necessary clarity and certainty on this point.

SIFMA also urged that the word “federal” be inserted before “whistleblower statute” in new section (b) of Rule 13201 and new item (3) of Rule 2263 to clarify that the rule’s application is limited to federal whistleblower claims which are not subject to arbitration. As currently drafted, the proposed rule would seemingly apply to all whistleblower statutes, both federal and state (if any) that carve-out whistleblower claims from arbitration. The Federal Arbitration Act, however, generally preempts state statutes that invalidate arbitration agreements and thus would preempt state statutes that remove whistleblower claims from arbitration. As a result, the proposal could be read to expand upon U.S. Supreme Court jurisprudence and current law, and frustrate federal preemption under the FAA. The proposal should be amended to clarify that such is not the purpose or intent.

Hedge Fund and Securities Industries Urge SEC and CFTC to Allow Hedge Funds and Commodity Pools to Qualify as Eligible Contract Participants

2012-01-12T15:09:00.003-06:00

The hedge fund and securities industries are concerned that the proposed definition of eligible contract participant under the Dodd-Frank Act will cause substantial disruptions to financial markets. In a joint letter to the SEC and CFTC, the Managed Fund Association and SIFMA urged the Commissions to adopt changes to the definition allowing private funds and other commodity pools to qualify as eligible contract participants, provided that the funds and pools were not formed for the purpose of evading the definition.

The associations believe that private funds and commodity pools should be able to rely on Section 1a(18)(A)(v)(I) of the Commodity Exchange Act without the need to look through to determine whether every direct or indirect investor/participant is an eligible contract participant. Thus,they urge the Commissions to clarify that a hedge fund or traditional commodity pool will continue to qualify as an eligible contract participant by relying on Section 1a(18)(A)(v)(I), which, as amended by Section 721(a)(9) of Dodd-Frank permits a hedge fund having assets exceeding $10,000,000 to qualify as an eligible contract participant.

The scope of the eligible contract participant definition is critically important because Sections 723(a)(2) and 763(e) of Dodd-Frank make it unlawful for a non-eligible contract participant to enter into a swap or security-based swap other than on a designated contract market or a regulated exchange. Also, many financial counterparties have arrangements in place with hedge funds and traditional commodity pools that are dependent upon their status as eligible contract participants.

The foreign exchange market is the world’s largest financial market, noted the Commissions, with a deep and liquid marketplace that provides an important adjunct to all of the other financial markets. Institutional investors regularly participate in the market to reduce risks by hedging currency exposures; to convert returns from international investments into domestic currencies; and to make cross-border investments. Private funds, including funds that constitute commodity pools, are significant participants in this market and provide a considerable amount of liquidity to the market.

The associations said that the adoption of the proposed definition without appropriate changes could lead to the disruption of the currency markets and increase the potential for greater systemic risk without accomplishing the regulatory goal of enhancing the protection of retail investors. Many of the funds that would become non-eligible contract participants with respect to foreign exchange trading under the proposed definition are sophisticated investors and significant liquidity providers to the U.S. foreign exchange market.

If the Commissions’ proposed definition were to be adopted, noted the trade groups, it would have the potential of categorizing a significant proportion of traditional institutional accounts managed by sophisticated money managers as retail, which would adversely impact the liquidity these market participants bring to the foreign exchange market through their active participation. In fact, investment funds and commodity pools may be precluded from trading certain currencies at all, warned the associations, since not all currencies have corresponding exchange-traded futures contracts or are represented on retail foreign exchange platforms.

According to the associations, there is no indication that requiring customers that are clearly institutional in nature to trade in the retail markets will add any protection for retail customers. Further, the proposed definition is not consistent with the underlying rationale behind the sophisticated investor framework established through law and regulation by the SEC and CFTC and limits the ability of entities managed by sophisticated money managers that are subject to registration and examination by regulators to qualify as eligible contract participants.

The proposed definition is also likely to preclude institutional accounts from effectively or efficiently diversifying or hedging their portfolio against foreign exchange risk and increase costs for individual investors who are ultimately likely to bear the burden of greater costs. Moreover, if institutional accounts and their counterparties were forced to trade in the retail foreign exchange market, the associations are concerned that many of the firms would have difficulty doing so from an operational perspective.

As a result, it will become very difficult for affected firms to operate within the U.S. In addition, requiring these entities to transact as non-eligible contract participants for foreign exchange will mean that the entities would need to trade with a separate retail-focused dealer and not with the swap dealer that will be the counterparty to the entities on all other transactions. In the view of the associations, bifurcating trading entities will create systemic risk by eliminating the benefits of close-out netting.

SEC Approves PCAOB’s 2012 Budget, Engages in Q&A with PCAOB Chair Doty

2012-01-12T15:07:00.002-06:00

The SEC unanimously approved the PCAOB’s 2012 budget of $227.7 million. Board Chair James Doty appeared at the open meeting to answer the commissioners’ questions. SEC Chief Accountant James Kroeker said that information technology and its governance continue to pose challenges to the Board. The Board was instructed to report to the SEC on its progress on those initiatives. The Board also must continue to report to the SEC on the timing of the issuance of its inspections and on developments in gaining access to certain foreign jurisdictions to conduct inspections.

Most of the Board’s budget is covered by the accounting support fee which is assessed on issuers and broker-dealers. The budget represents an increase of 11% over the 2011 budget which is primarily attributable to the Board’s inspection program. The Board will increase staff to perform inspections of the audits of SEC-registered broker-dealers and to increase the number of international inspections in 2012.

In opening remarks, SEC Chair Mary Schapiro referred to the unprecedented change that was brought about by the PCAOB’s oversight of the audit profession. The former system of peer reviews, where one auditor reviewed the work of another, has been replaced by the PCAOB’s inspection reports. Chairman Schapiro said it is striking to compare an old peer review with a PCAOB inspection report.

Chairman Doty believes the 2012 budget will place the Board in a strong position to fulfill its investor protection mandate. One of the main drivers of the budget are personnel costs, which account for 75% of the budget, 58% of which is for inspection personnel. IT costs make up 10% of the budget, rent and facility make up 8%, and travel 7%. The travel expenses are mainly inspection-related trips, including foreign travel.

Commissioner Elisse Walter asked Doty to address the Board’s enforcement efforts. He said that inspections and enforcement go hand-in-hand. Chairman Doty would like to see inspections and mediation work, with enforcement as a last resort. He added that it would also help if Congress agrees to lift the prohibition on making public the Board’s filed enforcement actions. Litigation proceedings can stretch out for years, he said, and the lack of transparency creates a tremendous roadblock to settling actions.

Commissioner Walter also asked about whether the Board plans to accelerate the issuance of its inspection reports. The PCAOB Chair said that he is optimistic about that and would like to see final reports issued within six months after the inspectors leave the field.

Commissioner Luis Aguilar addressed the serious challenges the Board faces in gaining access to foreign accounting firms to perform inspections. In his opinion, firms should not be able to participate in an issuer’s audit if they are beyond the Board’s oversight. Chairman Doty reported progress in a number of jurisdictions. The Board is working through all of the data protection issues in Europe, he said. The agreement with Japan was a big step forward, in his view. However, Doty said the 36 Chinese firms that are registered have not made information available to the Board. In Comm. Aguilar’s view, the situation cannot continue ad infinitum.

Commissioner Troy Paredes also asked about the timing of the inspection reports and how to close the gap to achieve the goal of issuance six months after inspectors leave the field. Chairman Doty said the Board had developed a backlog, which has substantially been cleared. He also pointed out that it is a retrospective process, looking back at a year of completed audits. With firms’ cooperation, he sees no reason why the Board should not be able to get the reports out within that time frame.

The Chair also noted that the inspection reports are not a report card on a firm. The purpose of the report is to direct the firm and the public to the questions they should be asking. He added that the staff’s audit practice alerts should be read by everyone, including audit committees and management, as should the Board’s 4010 reports.

Commissioner Paredes asked about the Board’s use of cooperation credit in enforcement proceedings. The PCAOB chief said that the Board applies credit, but it is not always evident. The Board has less to offer when a firm cooperates, but when it does, Doty said the Board fully acknowledges that cooperation.

When Comm. Paredes asked about the expectations for the Board’s Office of Research and Analysis, Mr. Doty said that ORA produces over 500 reports a year. It is the data management function of the Board. The Chair expects ORA to show enhancements each year in its ability to deliver refined information to help the Board make accurate decisions about rulemaking, enforcement and investigatory steps, adding that he wants to see increasing relevance in the data ORA produces.

Responding to a question about the role of economic analysis in the Board’s standard setting activities, Chairman Doty acknowledged the increased interest in economic analysis in connection with the SEC’s rulemaking and said the Board pays attention to those instructions.

Commissioner Paredes also asked how the Board determines whether it is efficiently using its resources. Mr. Doty said that firms have admitted that audit quality has improved through the inspection process. The Board can see improvements with the triennially inspected firms. Conduct is changing, in his view, and audit practices are improving, as is conduct in the boardroom.

Chairman Schapiro addressed the problem with access to foreign firms and said both the SEC and the PCAOB have a real sense of urgency on the matter. It is very easy to register and to deregister, said the PCAOB Chair, who added that the Board pushes back when a firm seeks to register in a jurisdiction where the Board has no access. The Board has denied registration, he said. Some registered firms have gone dark and the PCAOB head acknowledged that the Board has been slow to pull the plug on their deregistration.

Finally, responding to a query from Chairman Schapiro if the Board has the necessary depth of expertise in connection with international financial reporting standards, Mr. Doty said the Board has IFRS experts and expects to hire more.

This post was contributed by my colleague, Jacquelyn Lumb

Indiana Issues Private Equity/Venture Capital Fund Administrative Order In Connection with IA Registration

2012-01-12T13:51:00.004-06:00

An administrative order by the Indiana Securities Division extends a 2008 policy statement on private equity/venture capital funds and investment adviser registration by providing a post-Dodd-Frank Act IA registration exemption for the funds following that Act's elimination of the Section 203(b)(3) de minimis exemption for investment advisers.

Effective January 9, 2012 and until the Division can adopt a rule for these funds, no enforcement action will be taken against any person that fails to register in the State as either an investment adviser or investment adviser representative, provided: (1) the person maintains a place of business in Indiana; (2) has had not more than five client residents of Indiana during the preceding 12 months; (3) does not hold itself out generally to the public as an investment adviser; and (4) advises a qualified fund as defined under SEC Rule 203(m)-1, if neither the fund's adviser nor any of the adviser's affiliates are subject to federal Regulation A "bad boy" disqualification provisions.

NOTE that fund advisers described in (4) above who advise at least one qualifying private fund excluded from the "investment company" definition in Section 3(c)(1) of the Investment Company Act of 1940 that are not venture capital funds must meet additional requirements.

Hedge Fund Industry Petitions SEC to End Regulation D Ban on General Solicitation

2012-01-11T13:37:00.001-06:00

In a public rulemaking petition, the Managed Funds Association asked the SEC to amend Rule 502(c) of Regulation D to eliminate the prohibition on offers or sales securities by general solicitation or general advertising with respect to private funds. The petition is part of the broader effort by executive and regulatory policy makers and the SEC to modernize the securities laws in response to technological innovations and the evolving manner in which investors, issuers and other market participants interact. The framework for issuers to raise capital through private offerings under Regulation D dates back almost thirty years, noted the MFA, during which time the securities markets, issuers, and investors have undergone extensive change. The MFA posited that private funds and regulatory oversight of the industry, in particular, would be unrecognizable to the original drafters of Regulation D

In the petition, the MFA said that eliminating the prohibition would reduce the legal uncertainty resulting from the current regulation of private fund offerings conducted in reliance on Regulation D and increase transparency of the hedge fund industry in a manner consistent with the Dodd-Frank Act and recent regulatory initiatives. The change would also facilitate capital formation and reduce administrative costs by allowing investors to more easily obtain information about private funds, while at the same time maintaining strong investor protections and ensuring that only sophisticated investors are able to purchase interests in private funds.

Moreover, the requested amendment would reduce regulatory oversight costs and allow the SEC staff to reallocate resources to other aspects of investor protection, including products offered and sold to retail investors. The MFA emphasized that the petition is not proposing that anyone other than sophisticated investors be permitted to invest in hedge funds; and further emphasized that the activities of hedge fund managers in connection with an offering or sale of securities would continue to be subject to the broad anti-fraud provisions of the securities laws.

The MFA noted that the terms “general solicitation” and “general advertising” are not defined in Regulation D or elsewhere in the federal securities laws, and therefore have an uncertain and potentially broad application. The SEC has indicated that an issuer seeking to comply with these limitations should determine whether a particular manner of securities offering constitutes a general solicitation or general advertising based on relevant facts and circumstances.

As a result of this framework, Rule 502(c) subjects hedge funds to a sweeping prohibition on a range of activities and communications, noted the MFA, and as a practical matter fund managers only engage in activities which the SEC staff has identified as permissible. Guidance issued by the staff, however, such as no-action letters, is dependent on the specific facts and circumstances of the entity making a request, and therefore generally offers only narrow, limited relief upon which other issuers may rely.

Despite the best of intentions by the SEC staff to provide clear, workable guidance, by its nature this approach leads to uncertainty for hedge fund managers in assessing whether the facts associated with a range of communications, including discussions with potential investors, participation at industry events, and making public statements, would comply with the terms of previous guidance issued to another entity in a distinct set of circumstances. According to the MFA, this uncertainty is exacerbated by the potentially severe consequences to a hedge fund that would threaten its survival if it engages in conduct that is deemed to violate Regulation D.

For example, the SEC staff has indicated that an important factor in assessing if an offering is in compliance with Regulation D is whether an issuer, or a selling agent or other person acting on its behalf, has a pre-existing substantive relationship with an offeree so that the issuer or agent could form a reasonable belief that it meets the investor eligibility requirements. This condition is particularly difficult for hedge fund managers to interpret and apply to their businesses, said the MFA, because they generally conduct continuous offerings of securities. As a result, managers must carefully analyze whether they, or a selling agent acting on behalf of a fund, have established a substantive relationship with an offeree prior to, or in the course of, an offering.

The hedge fund industry group also noted that eliminating the ban would allow the SEC staff to reallocate resources to other important aspects of investor protection, including oversight of products that are offered and sold to retail investors. The current framework requires the SEC staff to determine whether activity constitutes a general solicitation or general advertising on a case-by-case basis. This approach requires the staff to expend scarce resources to evaluate an issuer’s conduct in connection with a broad range of activity.

In addition, eliminating the ban would reduce the cost of capital for private funds and lead to greater efficiency in private offerings, said the MFA, which in turn would facilitate the allocation of capital and investment by private funds throughout the financial markets. Private fund managers face significant costs in seeking to comply with the ban due to its broad application, the limited scope of existing guidance, and the severe consequences of an inadvertent violation. Managers expend considerable time and resources when making any sort of communications or participating in industry events, and often take a conservative approach and refrain from such activity. These effects impose administrative burdens for managers and unnecessarily limit communications with potential investors, increasing the cost of obtaining capital for private funds.

In the First Session of the 112th Congress, the House passed by an overwhelming 413-11 vote the Access to Capital for Job Creators Act, H.R. 2940, to instruct the SEC to amend Regulation D to eliminate the ban on general solicitation and advertising. There is a companion bill in the Senate.

In Letter to SEC, Securities Professionals Concerned that Volcker Rule Proposals Will Hurt Liquidity

2012-01-11T11:12:00.004-06:00

Proposed regulations implementing the Volcker Rule provisions of the Dodd-Frank Act could impose comprehensive restrictions on market making and curtail liquidity, in the view of the National Association of Securities Professionals. In a letter to the SEC, the association urged regulators to redraft the proposed regulations to clarify that basic market making functions of covered institutions are not impacted by the Volcker Rule. The congressional intent of the Volcker Rule was to restrict proprietary trading, said the association, not to impose comprehensive restrictions on market making.

The original intent of Section 619 of Dodd-Frank is to prohibit U.S. banks with insured deposits from engaging in proprietary trading and limit bank holding companies from participating in hedge fund and private equity businesses. The first objective has largely been achieved, maintained the association, since most of the covered institutions have shut down or spun off their proprietary trading operations. But the expansive and granular regulatory framework put forward by the proposals implementing Section 619 runs the risk of restricting large institutions from fulfilling their beneficial market making functions. Broker-dealers are obligated to act as an agent for buyers and sellers by executing their orders in the market, noted the securities professionals, or act as a principal by supplying liquidity directly to clients. This role is particularly vital to US interests on a routine basis and even more so in times of crisis when natural buyers may be hard to find.

The securities professionals believe that liquidity is critically important to the health and vitality of the US financial system. Liquid markets promote efficient capital allocation. Wen liquidity dries up, there is less access to credit and the cost of capital goes up, hindering business growth and job creation. If implemented in an overly intrusive manner, contended the association, Section619 has the potential to curtail liquidity. Covered institutions, fearful that their actions will be second guessed by regulators, could become hesitant to fulfill their market making role.

One particular concern is how the proposed regulations covers the natural process of maintaining inventory in anticipation of client demand. As in any business, broker dealers manage inventory in anticipation of client demand. Section 619's metrics and granularity run the risk of inserting regulators into the process of building inventory. Inventory management -including managing inventory for profitable return -is not proprietary trading as it was thought of in the debate around the Volcker rule. The association urged the SEC redraft the regulations to ensure that such normal course market making functions are not subject to regulatory second-guessing.

Texas Proposes Administrative Procedure Rule Amendments

2012-01-10T11:24:00.000-06:00

Amendments to the rules of practice in contested cases were proposed by the Texas Securities Board to more closely align the rules with the Texas Securities Act, the Administrative Procedures Act and the rules of the State Office of Administrative Hearings. Provisions would cover administrative hearing notices and costs; burden or proof; subpoenas and depositions; default; informal dispositions, decisions and orders by the Securities Commissioner; motions for rehearing; records; and ex parte communications. Other proposed changes would correct a cross-reference in a shelf registration rule and update a citation to the Texas Development Corporation Act.

Federal Magistrate Grants SEC Request for Show Cause Order in Case Involving China-Based Accounting Firm

2012-01-10T09:22:00.003-06:00

At the request of the SEC, a federal magistrate approved the issuance of a show cause order in an action brought by the Commission against a China-based accounting firm registered with the PCAOB. The court found, largely for the reasons offered by the SEC, that service of the application on the firm was not a prerequisite to the issuance of the proposed order directing the accounting firm to show cause why the court should not enter an order requiring the firm to produce documents responsive to an SEC subpoena. The SEC asserted that on May 27, 2011, it served an administrative subpoena on the accounting firm in connection with an investigation styled In the Matter of Longtop Financial Technologies Limited, SEC File HO-11698. The firm is a Chinese member firm of Deloitte Touche Tohmatsu Limited, a UK private company.

In her ruling, the magistrate cited a federal district court ruling granting the SEC’s application for an order to show cause noting that the Exchange Act permits worldwide service of process in cases involving the enforcement of subpoenas. SEC v. Lines Overseas Management, Ltd., D.D.C. No. Civ. A. 04-302, January 7, 2005. The SEC’s application for an order directing compliance with its subpoena will be a subject of a hearing, and, accordingly, remains pending. (SEC v. Deloitte Touche Tohmatsu CPA, Ltd., D.D.C, Miscellaneous Action No. 11-0512 GK/DAR, Jan. 4, 2012.)

The SEC filed the subpoena enforcement action against Deloitte Touche Tohmatsu CPA Ltd. for failing to produce documents related to the SEC’s investigation into possible fraud by the Shanghai-based public accounting firm’s longtime client Longtop Financial Technologies Limited. According to the SEC’s application and supporting papers filed in U.S. District Court for the District of Columbia, the SEC issued a subpoena on May 27, 2011, and D&T Shanghai was required to produce documents by July 8, 2011. The SEC said that, although the accounting firm is in possession of vast amounts of documents responsive to the subpoena, it has not produced any documents to the Commission to date. As a result, the Commission said that it has been unable to gain access to information that is critical to an investigation that has been authorized for the protection of public investors.

According to the court papers, D&T Shanghai was Longtop’s auditor since at least 2007, and the firm consented that its audit reports for Longtop could be filed annually with the SEC while knowing that they would be relied upon by U.S. investors. On May 22, the firm resigned as Longtop’s auditor after discovering numerous improprieties during an audit for the year ended March 31, 2011. In its resignation letter, which was included in a Form 6-K furnished by the company on May 23, D&T Shanghai identified numerous indicia of financial fraud at Longtop and indicated that the firm’s prior year audit reports for the company could no longer be relied upon by investors.

As part of the Longtop investigation, the SEC staff issued and served the subpoena on D&T Shanghai seeking production of documents related to the incomplete audit of the company for the year ended March 31 as well as prior year audits that the firm completed. According to the court papers, these documents may reveal information about the firm’s discovery of false financial records at the company, how any fraud schemes at the company were able to continue undetected, and basic information necessary to ferret out whether there was a fraud, who was behind it, how significant it was, and how it was conducted.

The SEC’s court papers note that the company is a foreign private issuer whose American depositary shares (ADSs) traded on the NYSE from the date of its initial public offering in October 2007 until May 17, 2011, when the NYSE halted trading prior to delisting Longtop’s securities in August 2011.

ESMA Guides on Inside Information, Dividends and Derivatives under Market Abuse Directive

2012-01-09T19:35:00.002-06:00

Concerned about recent incomplete disclosure of the full details of dividend payment announcements that may have caused undue effects on equity derivatives, the European Securities and Markets Authority (ESMA) reminded issuers that they should consider any relevant information related to dividend payments and policies as inside information should this information be likely to have a significant effect on the prices of either the issuer’s shares or related derivatives or both. Using a Q&A vehicle, ESMA noted that the definition of inside information in Article 1 of the Market Abuse Directive expressly includes information relating to an issuer of financial instruments that would be likely to have a significant effect on the prices of related derivative financial instruments.

ESMA is aware of the influence that information on expected dividends has on the price of futures and other derivatives. The Authority also acknowledges the effect that changes in dividend policies and payment patterns have on the price formation of equity derivatives, including futures. Like any inside information, noted ESMA, this information should be disclosed as soon as possible, according to Article 6 of the Market Abuse Directive, and in a manner which enables fast access and complete and timely assessment of the information by the public.

The provisions affect various aspects of dividend policies and payments that might have a significant effect on the prices of derivative instruments, such as ex-date, provisional and final amounts, nature of the payment, special dividend, any changes on previously announced information, and changes in dividend payment patterns. For instance, a decision to change the ex-dividend date compared to the preceding year’s date should be disclosed in a timely manner so that the information is incorporated into the pricing models used on the derivative markets.

The disclosure of this type of information should be done promptly, said ESMA, even when the proposals for any change on dividend policy, including dates and nature of the dividend, are still subject to further consideration or approval by the general shareholders meeting. Investor relations units should take special care when replying to questions posed by investors or firms so as to ensure that only the information that was previously disclosed by the issuer under the Market Abuse Directive obligations is provided in those answers and that selective or unintended disclosures regarding the issuers' dividend policy are avoided.

ESMA therefore urges issuers, especially those whose shares are included in reference indices and are the underlying in listed derivatives contracts, to pay special attention to this issue in order to ensure an effective and harmonized application of the Directive.

In Letters to PCAOB, EU, Australian and Japanese Accounting Groups Oppose Mandatory Audit Firm Rotation

2012-01-09T18:37:00.002-06:00

Comment letters to the PCAOB reveal a strong consensus among global accounting associations that mandatory audit firm rotation could reduce audit quality without increasing auditor independence or enhancing professional skepticism. The comments were in response to a PCAOB concept release on auditor independence and auditor rotation.

Mandatory audit firm rotation would not be conducive to enhancing either auditor independence or professional skepticism, said the European Federation of Accountants, and could even have a potential adverse impact on audit quality. In its letter to the PCAOB, the Federation noted that mandatory audit firm rotation would contradict the objective of reinforcing audit committees since it would take away one of the key roles of audit committees to decide when and whether a new audit firm should be appointed. Similarly, in its letter, the Japanese Institute of Certified Public Accountants said that mandatory audit firm rotation would adversely impact audit quality and financial reporting.

The Institute of Chartered Accountants in England and Wales believes that mandatory audit firm rotation would be a counter productive step that would remove authority from the audit committee and hence negatively impact sound corporate governance, while not concomitantly improving audit quality. In fact, continued the Institute, studies have concluded that discarding the audit firm’s cumulative understanding every few years will inevitably lead to a higher risk of audit failure in the early stages of a new appointment. In its letter to the Board, CPA Australia opposed mandatory audit firm rotation due to a lack of clear evidence of audit quality improvement that would result from such a measure. CPA Australia would support a pilot program to try to obtain such evidence.

The Federation observed that the European Commission is also considering mandatory audit firm rotation as well as other measures. The European debate focuses mainly on market related issues when discussing mandatory audit firm rotation, noted the Federation, while the PCAOB approaches the debate from the angle of independence, professional skepticism and audit quality. Due to the evident extraterritorial consequences of such requirements, emphasized the Federation, it is essential to carefully consider the practical feasibility of the measures if introduced in only one jurisdiction for companies with global activities and their auditors.
Thus, the Federation urged the PCAOB to coordinate any initiatives with its international counterparts in order to achieve a coherent, practical and sustainable solution.

Mandatory audit firm rotation is not the most practical or cost-effective way to respond to concerns regarding independence, said the Federation, citing the alternative of greater involvement of audit committees and making the auditor appointment process more independent of management. This could be combined with tendering procedures under the responsibility of the audit committee and through more transparency by the company regarding the selection and appointment process. Further, guidance could be given to audit committees on how they make proper use of their duty to monitor auditor independence.

The Federation also posited that there is no direct link between mandatory audit firm rotation and professional skepticism. International auditing standards professional skepticism requirements, which are similar to requirements in the current US standards, highlight that the auditor should not solely rely on the honesty and integrity of management and those charged with governance, but must obtain evidence and evaluate the persuasiveness of this evidence. Moreover, while recognizing that earlier decisions can always be challenged, engagement quality control review is an integral part of the audit of listed companies.

Thus, the Federation suggested that it may be more relevant to consider further improvements to the auditing standards on professional skepticism with the aim of enhancing the application of this principle, rather than seeking enhancements of professional skepticism through other policy measures, such as requiring audit firms to rotate on a regular basis.

The Institute of Chartered Accountants emphasized that mandatory rotation of audit firms will not address the concerns the PCAOB has about professional skepticism. In fact, the Institute cautioned that auditors are only in a position to fully apply skepticism when they have developed sufficient knowledge of the client and industry, which mandatory audit firm rotation could undermine. As an alternative, the Institute suggested enhancing auditor documentation of the approach to skepticism and increasing audit committee involvement.

The Federation also pointed out that, since Korea introduced mandatory audit firm rotation in 2006, a Korea University study concluded that audit hours and fees increased while audit quality remained unchanged or decreased slightly. In addition, a recent European Parliament report on the European Commission’s Green Paper on Audit Policy endorsed the concept of internal key audit partner rotation instead of external audit firm rotation.

The Japanese CPA Institute said that mandatory audit firm rotation would make it difficult for audit firm personnel to gain specialized knowledge and experience in specific industries or areas. Mandatory audit firm rotation may also result in low-balling of audit fees, while increasing audit cost.

In its comment letter, the German Institute of Public Auditors cautioned that mandatory audit firm rotation could increase market concentration because audit firm changes would be mainly restricted to larger firms, since audit committees perceive that medium firms lack the resources and expertise. Thus, rather than facilitating access of the medium-sized firms to more audit clients, said the Institute, it would make it easier for large audit firms to encroach on smaller firm audit clients. The German Institute also believes that mandatory audit firm rotation would intensify a price spiral that could threaten audit quality. More broadly, it would lead to permanent movement in the audit market that, in the view of the Institute, would ultimately detract from the value of auditing and lead to an audit being seen as a mere commodity to be valued by price alone, which would also undermine audit quality.

FRC Will Propose Changes to UK Corporate Governance Code on Auditor Selection and Audit Committee Reports

2012-01-09T12:42:00.002-06:00

Noting that reporting by audit committees is often unenlightening, the UK Financial Reporting Council said that it would propose changes to the UK Corporate Governance Code and the related guidance on audit committees to stimulate more informative reporting and to extend the remit of the audit committee. The FRC also intends to propose that the independent outside audit of a company’s financial statements should be put out to tender at least every ten years. It is also possible that the FRC will consult on changes to the going concern provision in the Code, depending on the outcome of the current inquiry being led by Lord Sharman.

The FRC believes that how the audit committee actually discharges its duties is rarely covered and that very few audit committees report the key decisions taken or judgments made by the committee. The FRC also believes the current state of affairs threatens to undermine confidence in audit committees at a time when there is considerable skepticism about the effectiveness of the outside audit and the audit committee.

The proposed amendments to the Corporate Governance Code would extend the reports that the audit committee gives to the board and which subsequently appear in the annual report. The FRC will also consult on proposals to require clearer reporting on how the external auditor is selected. Recommendations on what companies should disclose about the selection process were incorporated into the FRC’s Guidance on Audit Committees in 2008 but, disappointingly, these have been followed by only one-third of companies.

The FRC Guidance on Audit Committees (formerly known as the Smith Guidance) is intended to assist company boards when implementing the sections of the Corporate Governance Code dealing with audit committees and to assist directors serving on audit committees in carrying out their role. The Guidance states that the audit committee section of the annual report should explain to shareholders how it reached its recommendation to the board on the appointment, reappointment or removal of the external auditors. This explanation should normally include supporting information on tendering frequency, the tenure of the incumbent auditor, and any contractual obligations that acted to restrict the audit committee’s choice of external auditors.

The initial recommendation of the Sharman Panel was that the FRC should move away from a model where disclosures about going concern risks are only highlighted when there are significant doubts about the company’s survival to one which integrates going concern reporting within a broader disclosure model in which the directors always report how they arrived at the going concern statement, as part of their discussion of strategy and principal risks in the company’s narrative report, with the audit committee report confirming that a robust process has been undertaken. The audit committee report should also provide an explanation of the material risks to going concern considered and addressed; and identify any that they have not been able to resolve.

The Panel believes that the auditor should comment in the audit report on the going concern section of the narrative report and of the audit committee’s published report, if these fail to provide the required information, and otherwise state that it has nothing to add. The final recommendations of the Sharman inquiry are expected in February of 2012. Lord Sharman was the Liberal Democrat Spokesperson for Trade and Industry/Business and Regulatory Reform from 2001 to 2010. Before that, he held numerous senior UK and international positions with KPMG

Corporation Finance Division Guides on Financial Statement Disclosure around European Sovereign Debt Exposure

2012-01-09T09:43:00.002-06:00

Noting current uncertainties in connection with European sovereign debt exposures, and the lack of transparent, comparable information, the SEC Division of Corporation Finance issued guidance out of concern about the adequacy of financial statement disclosures for investors. Under the circumstances, the staff believes that principles-based item requirements may call for more detailed disclosure on this topic. In determining which countries are covered by the guidance, companies should focus on those experiencing significant economic, fiscal and/or political strains such that the likelihood of default would be higher than would be anticipated when such factors do not exist.

The staff expects that the countries covered by this analysis would vary and thus the disclosures should be sufficiently flexible to capture those risks as they change over time. Corp Fin encourages companies to disclose the basis used for identifying the countries included in this disclosure.

The staff said that disclosures should be provided separately by country, segregated between sovereign and non-sovereign exposures, and by financial statement category, to arrive at gross funded exposure. Companies should also consider separately providing disclosure of the gross unfunded commitments made. The staff suggests that companies provide information regarding hedges in order to present an amount of net funded exposure. In deciding what disclosure is relevant and appropriate for the particular facts of each company, the staff urges companies to consider a number of factors, including gross funded exposure, unfunded exposure, and total gross exposure, as well as the effects of credit default protection to arrive at net exposure and other risk management disclosures.

With regard to gross funded exposure, companies should consider the basis for the countries selected for disclosure and the basis for determining the domicile of the exposure, as well as the separate categories of exposure to sovereign and non-sovereign counterparties. Companies should also consider categories of financial instruments, including loans and leases, held-to-maturity securities, available-for-sale securities, trading securities, and derivatives to arrive at a gross funded exposure. For held-to-maturity securities, the amortized cost basis and the fair value should be considered. Similarly, for available-for-sale securities, the fair value, and if material, the amortized cost basis should be considered.

For trading securities, only the fair value need be considered. For derivative assets, the fair value should be considered, except that amount could be offset by the amount of cash collateral applied if separate footnote disclosure quantifying the amount of the offset is provided.

Regarding unfunded exposure, the company should consider the amount of unfunded commitments by type of counterparty and by country, and the key terms and any potential limitations of the counterparty being able to draw down on the facilities.

According to the SEC staff, the effect of gross funded exposure and total unfunded exposure should be subtotaled to arrive at total gross exposure as of the balance sheet date, separated between type of counterparty and by country. Appropriate footnote disclosure may be provided highlighting additional key details, such as maturity information for the exposures.

The effects of credit default protection purchased separately by counterparty and country should also be disclosed, along with the fair value and notional value of the purchased credit protection. In addition, the nature of payout or trigger events under the purchased credit protection contracts should be disclosed, noted the staff, and the types of counterparties that the credit protection was purchased from and an indication of the counterparty’s credit quality. The company should also reveal whether credit protection purchased has a shorter maturity date than the bonds or other exposure against which the protection was purchased. If so, there should be clarifying disclosure about this fact and the risks presented by the mismatch of maturity.

The other risk management disclosures include how management is monitoring and mitigating exposures to the selected countries, including any stress testing performed and the effects of indirect exposure in the analysis of risk. Disclosure should explain how the companies identify their indirect exposures, examples of the identified indirect exposures, along with the level of the indirect exposures.
It is also incumbent on management to disclose current developments, such as rating downgrades, financial relief plans for impacted countries and widening credit spreads of the identified countries, and how those developments, or changes to them, could impact the company’s financial condition, results of operations, liquidity or capital resources.

ESMA Planning Guidance on Hedge Fund Regulation and Proposed Regulations on ETFs in 2012

2012-01-08T14:35:00.002-06:00

Having proposed regulations under the Alternative Investment Fund Managers (AIFM) Directive last year, the European Securities and Markets Authority plans to issue guidance on the regulation of hedge fund and private equity fund managers under the Directive in 2012, according to ESMA Chair Steven Maijoor. In remarks at the EFAMA investment management forum, the Chair also said that ESMA plans to propose regulations under the UCITS Directive that are specific to exchange traded funds, such provisions ensuring an adequate level of protection of retail investors dealing on the secondary market. EFAMA is the European Fund and Asset Management Association.

The AIFM Directive introduced an entirely new regulatory landscape for managers of hedge funds and other alternative investments. By the end of 2011, ESMA delivered to the European Commission proposed implementing regulations on the AIFM Directive. The proposals were the result of two separate consultation papers and two open hearings that led to the receipt of a considerable amount of responses from a wide range of stakeholders, including valuable input from EFAMA. Despite a very tight time constraint and the significant amount of topics covered by the mandate, ESMA delivered its advice by the mid-November deadline set by the Commission.

Chairman Maijoor believes that it is generally recognized that ESMA’s proposals represent a reasonable balance between the need to introduce an adequate level of investor protection within the alternative investments framework and the constraints of the Level 1 Directive, on one hand, and the concerns expressed by the industry, on the other. He noted that ESMA introduced very important clarifications on some of the core elements of the AIFMD which are linked to investor protection, such as the transparency requirements, the duties of the depositary and its liability regime, and the rules applying to the delegation to third country managers and depositaries. The Commission will now analyze the proposals ESMA made to assist them in developing the AIFMD Level 2 measures.

But ESMA’s work on the AIFMD is not done, emphasized the Chair. Indeed, ESMA has already determined areas in which it will complement the proposals through the development of further guidelines, for example on the advanced method of calculation of leverage, and is willing to lead the negotiation of the co-operation agreements with the non-EU competent authorities which are foreseen by the AIFMD provisions on third countries. Further, ESMA is progressing with its work on the regulatory technical standards on the types of AIFM, which should be adopted in parallel with the Level 2 implementing measures, and will start working shortly on the other measures foreseen by the Directive, such as the guidelines on sound remuneration policies.

Separately, ESMA is also developing guidelines on exchange traded funds and structured UCITS designed to ensure a better regulatory framework for investors. The rationale here is the well-known issue of the retailization of complex products. Taking that into account, ESMA is determined to introduce new rules which will reduce risk and deliver more transparency for retail investors exposed to such products. The regulations will be specific to exchange traded funds, such as a requirement for such funds to use an identifier, as well as new provisions ensuring an adequate level of protection of retail investors dealing on the secondary market.

The Chair is aware of concerns that the guidelines would create an ETF-specific regime focusing on this category of product only and not imposing equivalent requirements on other UCITS that are exposed to indices or that carry out investment activity using techniques which are very similar, if not identical, to the ones used by ETFs. But he assured that ESMA intends to identify clearly those provisions which are relevant to all UCITS funds, with only some rules being specific to ETFs and reflecting their characteristics, for example, issues relating to the secondary market trading.

For issues arising from securities lending activities, for instance, ESMA will cover all kinds of UCITS, including exchange traded funds, engaging in such activity. In particular, ESMA aims to deliver more transparency for investors by requiring funds to disclose in their prospectuses the fact that they make use of securities lending, and setting out some specific rules on the disclosure of collateral and its quality.

Finally, the Chair emphasized that the packaged retail investment products (PRIPs) initiative remains a central piece of work in terms of investor protection. The range of products to be covered is quite broad and potentially includes collective investment undertakings, structured products and derivatives, and he knows there are MiFID II proposals to extend selling standards to structured deposits.

A goal of the PRIPs initiative is to apply consistent rules to similar investment product. It is essential for investor protection to ensure that similar, competing retail investment products are subject to the same requirements. The Commission clearly defined that approach in the consultation it launched last year where it proposed to apply consistent standards across the market by setting the Key Investor Information Document (KIID) as a benchmark for all PRIPs as far as the disclosure requirements are concerned, and the MiFID rules as a benchmark for all PRIPs as regards selling practices.

ESMA fully supports the creation of a level regulatory playing field for all retail investment products in terms of disclosure and selling practices. For selling practices in particular, ESMA is aware of the fact that a horizontal legislative approach may raise some issues in relation to the areas of competence of securities and insurance regulators in those EU Member States where they are not integrated and that the Commission has already presented a proposal for the review of the MiFID rules.

German and UK Governments Oppose Regulatory Monitoring of Explanations under Comply or Explain Corporate Governance Codes

2012-01-07T13:10:00.003-06:00

The UK and the Federal Republic of Germany both oppose requiring regulators to monitor company explanations as to why a provision of the corporate governance code was not complied with. In letters to the European Commission, the governments said that review of the efficacy of a company’s reason for not complying with a code provision was best left to the markets and the shareholders. The governments were responding to an EC Green Paper on reforming corporate governance. Both Germany and the UK have comply or explain corporate governance codes requiring an explanation when a company does not comply with a code provision.

While compliance with the Corporate Governance Code is monitored by investors and private sector organizations that scrutinize compliance with the Code, noted the UK, ultimately it is the shareholders’ responsibility to determine whether an explanation offers sufficient information to make an informed investment decision.

It is important that shareholders continue to make these decisions, said the UK letter, and it is not for government or regulators to interfere in these relationships. For this reason monitoring bodies should not take on the role of checking the quality of explanations, emphasized the UK, and comply or explain statements should not become regulated information under the terms of the Transparency Directive.

While sharing the Commission’s concern about the informative quality of explanations, the UK believes that the best way to allay these concerns is through guidance rather than regulatory oversight. If guidance could be given to those writing and receiving the explanations, reasoned the UK, it is possible that the quality of explanations may improve significantly and shareholders themselves may become more adept at questioning an explanation. In this spirit, the UK Financial Reporting Council will shortly develop a consensus about what constitutes a proper explanation under a comply and explain code.

In its letter to the Commission, the Federal Republic was highly skeptical of requiring regulators or other authorities to monitor the comply or explain responses of German companies under the corporate governance code, which is a job best left to the markets.

German public companies are required to declare annually whether or not they have complied with the recommendations of the German Corporate Governance Code. Since the Accounting Law Modernization Act went into effect, companies are required not only to disclose divergences from the code recommendations, but also give a reason for these divergences.

The idea of a corporate governance code with a comply or explain arrangement is based on the concept that non-mandatory statutory arrangements are developed by industry itself, reasoned the Federal Republic, and compliance or non-compliance with them is subject to the oversight of the capital markets. The German corporate governance code works with a comply or explain mechanism, said the government, because the capital markets evaluate the statements, and where appropriate, draws its conclusions from them. If the statements are not convincing or are incomplete or are not authoritative, the capital markets will draw conclusions from this.

In addition, a state monitoring authority would entail a major organizational effort. Monitoring would have to be very careful and be carried out with a uniform standard. Even more, said the Federal Republic, an undesirable standardization of comply or explain statements could result from regulatory monitoring since the monitoring agency would make it known what responses were acceptable in what form, and companies would employ these in a formulaic manner.

EU Court of Justice Rules that Unrealized Capital Gains Can Be Taxed When Company Transfers to Another Member State

2012-01-07T12:48:00.001-06:00

EU law does not in principle preclude the charging of tax on unrealized capital gains relating to the assets of a company when it transfers its place of management to another Member State, ruled the Court of Justice of the European Union. However, the immediate recovery of the tax at the time when the company transfers its place of management, without the company being given the possibility of deferred payment of the tax, is not compatible with EU law. National Grid Indus BV v. Inspecteur van de Belastingdienst Rijnmond/kantoor Rotterdam, C 371/10, 29 November 2011.

The case involved a company incorporated under Netherlands law that transferred its place of management from the Netherlands to the UK. After the transfer, it was deemed to be resident in the UK by virtue of a Convention on the avoidance of double taxation concluded between the Netherlands and the UK. Consequently, the company ceased to obtain profits taxable in the Netherlands so that, under Netherlands legislation, a final settlement of unrealized capital gains existing at the time of the transfer of the place of management was drawn up by the Netherlands tax authorities, who demanded immediate payment of the tax. The company contested that decision, claiming that it was contrary to the principle of freedom of establishment.

The Court of Justice first confirmed that the company could rely on freedom of establishment in order to challenge the decision of the Netherlands tax authorities. The Court then found that a company incorporated under Netherlands law wishing to transfer its place of effective business outside the Netherlands suffers a disadvantage in terms of cash flow compared to a similar company keeping its place of management in the Netherlands.

Under the national legislation, the transfer of a Netherlands company's place of management to another Member State entails the immediate taxation of the unrealized capital gains relating to the assets transferred, whereas such capital gains are not taxed when a Netherlands company transfers its place of management within the Netherlands. That difference of treatment is liable to deter a company incorporated under Netherlands law from transferring its place of management to another Member State, reasoned the Court, and constitutes a restriction that is in principle prohibited by the Treaty provisions on freedom of establishment.

However, the Court also noted that preserving the allocation of powers of taxation between EU Member States is a legitimate objective. Also, in the absence of any harmonizing measures of the European Union, Member States retain the power to define, by treaty or unilaterally, the criteria for allocating their taxing powers. In that context, the transfer of the place of effective management of a company of one Member State to another does not mean that the Member State of origin has to abandon its right to tax a capital gain that arose within the ambit of its powers of taxation before the transfer. The legislation at issue is therefore appropriate for ensuring the preservation of the allocation of powers of taxation between the Member States concerned. The Court pointed out that the Treaty offers no guarantee to a company that transferring its place of effective management to another Member State will be neutral as regards taxation.

However, in order to assess the proportionality of such legislation, the Court drew a distinction between the establishment of the amount of tax and the recovery of the tax. The Court found that the Member State of origin complies with the principle of proportionality if, for the purpose of safeguarding the exercise of its powers of taxation, it determines definitively, without taking account of decreases or increases in value which may occur subsequently, the tax due on the unrealized capital gains that have arisen in its territory at the time when its power of taxation in respect of the company in question ceases to exist. But the Court did rule that legislation prescribing the immediate recovery of tax on unrealized capital gains relating to assets of a company transferring its place of effective management to another Member State at the very time of that transfer is disproportionate.

House Oversight Chair Asks DOJ for Information About Cordray Recess Appointment

2012-01-06T20:24:00.000-06:00

In a letter to Attorney General Eric Holder, House Financial Services Chair Spencer Bachus (R-ALA) asked for information about the recess appointment of Richard Cordray to be Director of the Consumer Financial Protection Bureau, which the Chair described as a matter of significant public interest and importance. Chairman Bachus noted that, by launching its non-bank regulatory program, the CFPB apparently views the appointment as sufficient to activate rulemaking and other authorities pursuant to Section 1066 of Dodd-Frank, even though that provision on its face conditions the exercise of these authorities on Senate confirmation of a Director.

In order to assist the Committee in reviewing this matter, Chairman Bachus asked for a response to three questions by January 20, 2012. First, he asks if the White House sought DOJ’s advice on any aspect of the appointment and, if so, copies of any documents reflecting such advice. Second, given that the Senate has been meeting in pro forma session once every third day, and no adjournment resolution has been passed by either house of Congress, the Chairman would like DOJ’s view on whether the Senate was in recess at the time of Mr. Cordray’s appointment such that the President could lawfully exercise his recess appointment authority.

Third, Chairman Bachus asks if it is DOJ’s view that the Bureau Director position was a vacancy that happened such that the President was authorized to constitutionally fill it. If so, the Oversight chair asks how DOJ would reconcile that view with the Vacancies Reform Act (P.L. No. 105-277), which purports to codify aspects of the exercise of the recess appointment power and does not appear to provide that a newly-created office like CFBP Director is vacant.

Texas Adopts IA Custody Rule and Amendments to Written Exam Rules

2012-01-06T15:42:00.003-06:00

A safekeeping rule for investment advisers with custody of their clients’ funds or securities was adopted by the Texas Securities Board, together with amendments to the written examination rules for dealer principals, agents, investment advisers and investment adviser representatives. The "solicitor" definition was clarified. NOTE: A rule on advisory performance based fees remains proposed.

Corporate Secretaries Society Concerned About DOL Interim Rules for Handling Whistleblower Retaliation Claims

2012-01-05T19:15:00.002-06:00

Some aspects of the Department of Labor’s interim final rules for handling whistleblower retaliation claims under Section 806 of the Sarbanes-Oxley Act are unauthorized by statute, imbalanced, and unduly prejudicial to employers’ reasonable interests, in the view of the Society of Corporate Secretaries and Governance Professionals. In a letter to the DOL, the Society maintained that the interim final rules lack any standards governing the issuance of preliminary reinstatement orders, that OSHA lacks the authority to enforce preliminary reinstatement orders in federal court, and that the oral complaint provision will have unintended negative consequences. And all this comes against the backdrop of recent decisions where the Administrative Review Board (ARB) has taken an exceedingly broad approach to interpreting Section 806. While the Society embraces the need to ensure that good faith whistleblowers are protected against retaliation, the final rules must protect employers' interests on par with those of employee whistleblowers.

The interim final rules lack standards governing the issuance of preliminary reinstatement orders, noted the Society, which is particularly troublesome in light of OSHA’s presumption in favor of reinstatement and that staying a preliminary reinstatement order would be available only based on exceptional circumstances. Since reinstatement orders may carry potentially significant, harmful consequences for the employer, reasoned the Society, the rules should contain safeguards ensuring that such a remedy is warranted and appropriate under the circumstances rather than presuming that reinstatement is proper.

The lack of clear and reasonable standards gives OSHA unfettered discretion to issue reinstatement orders without regard to business, human resources or legal concerns, said the Society, which is inconsistent with constitutional requirements. The Society suggests that OSHA include in the final rules factors that which have been considered by courts to determine when reinstatement is appropriate, such as whether hostility exists between the employee and the company such that reinstatement would adversely impact productivity or information flow, whether the employee poses risks in terms of violence, misappropriation, or otherwise compromising the value of the company’s reputation or property, and whether the employee’s position no longer exists.

The Society also urged that the rules be modified to provide meaningful standards governing when an ALJ should stay a preliminary order of reinstatement. The current language stating that such a stay must be granted only based on exceptional circumstances is substantive, said the Society, not procedural, and would unduly constrain the ALJ’s otherwise vested discretion and authority and leave them in the dark as to when a stay is warranted.

In the interim final rules, continued the Society, OSHA’s position that any preliminary reinstatement orders that it issues are enforceable by federal courts is directly at odds with express statutory language and federal court decisions. OSHA rebuffs this solid line of decisions, noted the Society, and takes a position that would allow an employee to be taken in and out of the work force at each stage of appeal. For example, an ALJ could decide against reinstatement, the ARB could then order reinstatement and the federal Circuit Court of Appeals could then reverse the reinstatement order; and the employee would move in and out of the company with each decision. The rules do not provide any standards that would resolve this real and unacceptable risk.

The Society is also concerned that provisions in the interim final rules would enable OSHA investigators to take in oral complaints and then create a written complaint based on the complainant’s statements. This could have unintended negative consequences, warned the Society, and urged OSHA not to enact it. The prior rule requires complaints to be in writing. OSHA does not provide examples of how the prior requirement prejudiced whistleblowers or otherwise was unworkable, noted the Society. Further, the new rule is unnecessary because most Sarbanes-Oxley complaints are filed by sophisticated professionals.

Moreover, the new rules shift the OSHA investigator’s role from neutral fact-finder to advocate. The investigator in this circumstance now creates the complaint, said the Society, rather than just reviewing and investigating it and can be expected to make efforts to ensure that it sets forth a defensible prima facie case. This is problematic because the rules lack any standards governing the investigator’s creation of a written complaint to ensure that the investigator will act in an entirely neutral capacity, avoid asking leading questions in the course of preparing the complaint, and avoid expanding the scope of the complaint to fill in gaps to avoid dismissal.

Section 806 of Sarbanes-Oxley provides whistleblowers with broad protection against retaliation, and its safeguards recently became even more robust as a result of the enactment of the Dodd-Frank Act and a range of decisions recently issued by the Administrative Review Board. Dodd-Frank amended Section 806 to cover private subsidiaries of publicly traded companies and to guarantee a jury trial in SOX whistleblower cases pursued in federal district court.

In addition, the ARB issued a ruling that significantly expanded the scope of protected activity under Section 806. In Sylvester v. Parexel International LLC, ARB No. 07-123 (May 25, 2011), the ARB ruled that a complainant need not demonstrate a fraud on shareholders to sustain a whistleblower claim under Section 806 and repudiated what the Society called the widely accepted standard requiring complaints to definitively and specifically relate to one of the categories of fraud in Section 806. In the Society’s view, the existence of these expanded whistleblower protections underscores the need to ensure that employers are provided adequate due process in the context of the DOL’s administration of Section 806 complaints.

Japanese Securities and Banking Regulators Fear that Volcker Rule Proposed Regulations Would Hurt Government Bond Trading

2012-01-05T16:17:00.001-06:00

The proposed regulations implementing Dodd-Frank’s Volcker Rule provisions would have an adverse impact on the trading of Japanese government bonds, in the view of the Financial Services Agency and the Bank of Japan. In a letter to the SEC, the Japan’s financial regulators said that the Volcker proposals would raise the operational and transactional costs of trading in Japanese government bonds and could lead to the exit from Tokyo of Japanese subsidiaries of US banks.

In addition, some Japanese banks might be forced to cease or dramatically reduce their US operations. In turn, these reactions could further adversely affect liquidity and pricing of the government bonds. Even more, sovereign bond markets worldwide might be affected at this critical juncture. Thus, the FSA and Bank of Japan urged the SEC and the banking agencies to expand the range of exempted securities to include Japanese government bonds.

The Japanese regulators posit that the extraterritorial application of the Volcker Rule restrictions on proprietary trading and relationships with hedge funds and private equity funds to foreign entities owned by foreign financial groups could adversely affect the liquidity of the financial markets globally. It could also have a negative impact on US financial stability, which the Dodd-Frank Act aims to achieve as a primary objective. As long as the groups are subject to appropriate group-wide supervision by foreign supervisors, noted the letter, such foreign entities should be exempted from the requirements.

According to the proposed restrictions, US banking groups and foreign banking groups with a branch or a subsidiary in the US would be subject to restrictions on their current positions of government bonds, except US treasuries. While market making and other less-risky trading are exempted, noted Japan’s financial regulators, the restrictions would impose a significant burden and higher costs on foreign banks, including major Japanese firms, and make sovereign bond trading less attractive and profitable.

It is also possible that the smooth functioning of the Bank of Japan's money market operations would be adversely affected by the proposed restrictions. This might, in turn, exert extremely negative pressures on sovereign bond markets worldwide through reduced liquidity and a rise in volatility, which would be particularly worrisome under current financial market condition.

Short-term foreign exchange swaps would also be subject to the proposed restrictions. In many jurisdictions, short-term foreign exchange swaps are used uniquely for the purpose of US-dollar funding by major foreign banking entities, observed the regulators, including the Japanese Banking Groups, rather than as tools for proprietary trading. If foreign exchange swaps are restricted by the new Volcker regulations, cautioned Japan’s financial regulators, branches and subsidiaries of US banks would not be able to provide USD liquidity to foreign counterparts through short-term swaps.

This could squeeze USD funding significantly outside the US and accelerate the deleveraging of European banks by liquidating foreign assets. In addition, it does not seem consistent to restrict short-term swaps while FX spot trading and long-term swaps, through which more risks could be assumed, are exempted. Therefore, the FSA and central bank strongly request that short-term foreign exchange swaps be exempted from the Volcker restrictions.

Non-US asset management funds would also be subject to the restrictions, said the regulators, except those which do not have US investors or those which would need to register under the Investment Company Act. In practice, it would be almost impossible for an investor to judge whether a fund is exempted or not, and the proposed restrictions could create an uncertain investment climate for non-US funds, resulting in significantly reduced investments in those funds and reduced investment opportunities for US investors. The FSA and central bank said it would be more appropriate to dialogue with foreign regulators to find a clear objective definition of the funds in question.

Finally, and more broadly, Japan’s regulators urged the SEC and the banking agencies to take due account of the cross-border impact of financial regulations and the need to collaborate with affected countries. When it comes to the extraterritorial application of financial regulations, emphasized the FSA and Bank of Japan, the home authorities bear the primary regulatory responsibilities.

Considering the potentially serious negative impact on the Japanese markets and associated significant rise in the cost of related transactions for Japanese banks, the regulators urged the SEC and banking agencies to refrain from extraterritorial application of the Volcker restrictions, or to amend the definition of “control” and “affiliate” in the final regulations so as not to include foreign joint ventures and foreign subsidiaries which are controlled by foreign banking groups.

Director Cordray Outlines Vision for CFPB and Begins Regulation of Non-Bank Financial Entities

2012-01-05T11:32:00.001-06:00

In his first remarks as Director of the Consumer Financial Protection Bureau, Richard Cordray outlined a vision for the Bureau of transparency, effective enforcement and exercising the full powers of the Bureau over banks and non-bank financial entities. In remarks at The Brookings Institution, the Director announced that the Bureau will immediately launch a program for supervising non-bank financial entities, such as payday lenders, mortgage servicers, mortgage originators, private student lenders, and other firms that often compete with banks but have until now escaped meaningful federal oversight. This launch fulfills the twin promises of the Dodd-Frank Act that the Bureau will have a singular focus on protecting consumers in the financial marketplace, and ensuring that large banks and non-bank financial firms are held to the same standards.

The non-bank markets are large and significant, the Director emphasized, and provide valuable services to customers who lack access to other forms of credit. For example, he noted that nearly 20 million US households use payday lenders and pay roughly $7.4 billion in fees every year. Also, many subprime loans during the housing bubble were made by nonbank mortgage brokers. The Bureau is pledged to establish clear standards of conduct so that all financial providers play by the rules.

He also noted that a primary objective of the Bureau is to bring clarity to the financial markets. Since people have a hard time understanding the terms of a financial deal when they have to pore over reams of fine print, he said, so the Bureau launched its Know Before You Owe campaign to provide consumers with easy-to-understand disclosures clarifying the prices and risks of financial products right up front. The Director posited that two basic premises of a well-functioning market are that buyers and sellers understand the terms of the deal, and that buyers are able to compare possible alternatives. Honest businesses want to compete in such a market, he reasoned, and they are satisfied to win market share based on fair competition and excellent customer service, not through deception or fraud.

Another key objective of the CFPB is ensuring that financial institutions are playing by the rules. The Bureau inherited the responsibility of supervising the largest banks in the country to make sure they are following the law. In practical terms, that means that the Bureau has examiners on the ground with broad authority to review loan documents, ask tough questions, and make a financial institution fix problems that come to light. The Director believes that financial institutions can speak to their customers more simply and more clearly, adding that straightforward transparency promotes responsible decision-making by consumers.

The Bureau will also clarify that there are real consequences to breaking the law. Informants and whistleblowers have been given direct access to the CFPB. The Bureau took over a number of investigations from other agencies in July, he noted, and are pursuing some investigations jointly with them. The CFPB has also started its own investigations. While some investigations may be resolved through cooperative efforts to correct problems, he said, others may require enforcement actions to stop illegal behavior.

House Oversight Panel Invites CFPB Director Cordray to Testify as Legislation Blocking His Appointment is Readied

2012-01-05T09:44:00.004-06:00

A House panel has invited the recess-appointed CFPB Director Richard Cordray to testify January 24 on policy concerns about the structure of the Bureau and how the concerns of the oversight panel can be reconciled. In a letter to Mr. Cordray, Rep. Patrick McHenry (R-NC), Chair of the Oversight Subcommittee on TARP and Financial Services, noted that the CFPB Director has enormous authority to invalidate any consumer financial product in the United States and broadly regulate financial products and services with minimal oversight. The letter emphasizes that the Subcommittee is deeply interested on how the Director will implement and enforce the unparalleled powers of his new office.

In a separate statement, Chairman McHenry said that this unprecedented appointment runs counter to the constitutional requirements for a recess appointment and President Obama’s own campaign pledge to run the most transparent administration in history. He posited that the enormous authority put in the hands of a single director for the CFPB must be accompanied by appropriate congressional oversight and transparency.

Meanwhile, Rep. Jeff Landry (R- LA) said that he would introduce legislation to prevent Mr. Cordray's appointment from going forward until a court rejects his appointment on its unconstitutionality. The Constitution is clear, said Rep. Landry, the President can appoint officials with the Advice and Consent of the Senate. Since the Senate has advised the President against making Cordray’s nomination and has not given its consent on his appointment and with the House meeting to keep Congress in session, reasoned Rep. Landry, the appointment of Mr. Cordray can only be considered an abuse of the recess appointment process.

Separately, Financial Services Committee Chairman Spencer Bachus (R-ALA), said that the President’s unprecedented attempt to circumvent the Constitution and ignore the law indicates that he has abandoned any effort to work in a bipartisan manner to strengthen accountability and oversight of the CFPB. In the Chairman’s view, the recess appointment of Director Cordray has delegitimized the CFPB and has opened the agency up to legitimate legal challenges that will cripple it for years.

Applying Spanish Law and Citing Internal Affairs Doctrine, Delaware Supreme Court Affirms Dismissal of Derivative Action

2012-01-05T06:18:00.003-06:00

The Delaware Supreme Court has upheld the Chancery Court’s application of Spanish law to dismiss a derivative action by a Spanish minority shareholder on behalf of a Spanish parent company with a Delaware subsidiary that aided in effectuating the challenged acquisition of another company. The parent’s majority shareholder, a Spanish entity, also held a majority interest in the acquired company. Invoking the internal affairs doctrine, the Supreme Court said it would violate the principle of comity for a Delaware court to disrupt the internal affairs of a Spanish corporation by displacing Spanish derivative standing rules with those of Delaware. Sagarra Inversiones, S.L. v. Cementos :Portland Valderrivas, et al.,Uniland Acquisition Corp., Nominal Defendant, C.A. No. 6179-VCN, Aug. 5, 2011.

The internal affairs doctrine recognizes that only one state should have the authority to regulate a company’s internal affairs and that is the state of incorporation. In a double derivative action of this type involving a wholly-owned subsidiary, a shareholder must plead demand futility at the parent level. Thus, where the parent is not a Delaware corporation, under the internal affairs doctrine, the law of the state of incorporation determines the showing that a plaintiff must make to show it has standing to bring a multiple derivative action. Because the minority shareholder only owns shares in the parent corporation organized under the laws of Spain, the Chancery Court properly considered whether it had standing to bring a derivative claim under Spanish law.

In an en banc opinion, the Delaware Supreme Court rejected the notion that the presuit demand requirement in derivative actions is not within the embrace of the internal affairs doctrine. The Court held that the presuit demand requirement is quintessentially an internal affair that falls within the scope of the internal affairs doctrine. Noting that the internal affairs doctrine is a dominant and overarching choice of law principle, the Supreme Court said that an important rationale for the doctrine is to prevent companies from being subjected to inconsistent legal standards, and thus the authority to regulate a corporation’s internal affairs should not rest with multiple jurisdictions. The term internal affairs encompasses matters pertaining to relationships among or between the corporation and its officers, directors, and shareholders The doctrine requires that the law of the sovereign nation of incorporation must govern those relationships.

The presuit demand requirement serves a core function of substantive corporation law, said the Court, in that it allocates as between directors and shareholders the authority to sue on behalf of the corporation. The entire question of demand futility is inextricably bound to issues of business judgment and the standards of that doctrine's applicability. The decision to bring a lawsuit or to refrain from litigating a claim on behalf of a corporation is a decision concerning company management.

In the Court’s view, those contours of the demand requirement fall firmly within the gravitational pull of the internal affairs doctrine, and thus are determined by the law of the jurisdiction of incorporation of the entity on whose board a presuit
demand is required. In this case, the law of Spain governs the presuit demand requirements that the shareholder must satisfy to sue derivatively.

The Court also rejected the claim that public policy should displace the internal affairs doctrine. It would violate the principle of comity, said the Supreme Court, and serve no legitimate Delaware interest, for a Delaware court to disrupt the internal affairs of a Spanish corporation by displacing Spanish derivative standing rules with those of Delaware.

Public policy cannot operate as a protean ethic that trumps, on an ad hoc basis, settled choice of law rules that govern the right of a stockholder to enforce, derivatively, claims that belong to the corporation in which it owns shares. When the shareholder took ownership of its shares, reasoned the Court, it did so with presumed knowledge that its ownership interest was subject to the legal rights conferred, and the restrictions imposed, by the Spanish legal regime.

Hawaii Investment Company and Advisory Fees Remain Reduced in 2012

2012-01-04T16:46:00.003-06:00

The 2012 reduced fees for investment adviser, investment adviser representative and investment company security filings will remain at the 2011 reduced fee amounts throughout 2012. Broker-dealer and agent fees were removed from the reduced fee schedule for 2012, having returned to their pre-reduced amounts of $200 and $50, respectively, for initial and renewal registration. Please email Henry Tanji, Securities Compliance Specialist, at htanji@dcca.hawaii.gov with any questions.

President Intends to Use Recess Appointment to Name Cordray CFPB Director

2012-01-04T13:14:00.002-06:00

The President is set to use a recess appointment to name Richard Cordray as the first Director of the Consumer Financial Protection Bureau. A Statement on the White House blog sets out the legal and factual background of the appointment.

The Statement notes that the Constitution gives the President the authority to make temporary recess appointments to fill vacant positions when the Senate is in recess, a power all recent Presidents have exercised. The Senate has effectively been in recess for weeks, it says, and is expected to remain in recess for weeks. The Statement posits that in an ``overt attempt to prevent the President from exercising his authority during this period, Republican Senators insisted on using a gimmick’’ called pro forma sessions, which are sessions during which no Senate business is conducted and instead one or two Senators simply gavel in and out of session in a matter of seconds. The Statement asserts that ``gimmicks do not override the President’s constitutional authority to make appointments to keep the government running.’’ In fact, continues the Statement, the lawyers who advised President Bush on recess appointments wrote that the Senate cannot use sham “pro forma” sessions to prevent the President from exercising a constitutional power.

Reacting to the recess appointment, Senator Richard Shelby (R-ALA), Ranking Member on the Banking Committee, said that the President did an end run around Congress, the elected representatives of the American people, in order to avoid accountability to them. Senator Shelby said that he has led the fight for accountability at the consumer bureau. Joined by 44 Republican Senators, Senator Shelby sent a letter last year to the President urging amendments to the Dodd-Frank Act to change the Bureau’s governance, replacing the single Director with a Board to oversee the Bureau. On December 8, 2011, Senator Shelby said on the Senate floor that in order to make the Bureau more accountable, the Bureau should be led by a Board of Directors rather than a single Director.

On the one-year anniversary of the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the House of Representatives passed legislation restructuring the Consumer Financial Protection Bureau created by the Act. The Consumer Financial Protection Safety and Soundness Improvement Act, HR 1315, would establish a bi-partisan, five-member Commission consisting of a Chair and four additional members to carry out all of the duties that would otherwise fall to the Director of the CFPB. Commission members would be appointed by the President, confirmed by the Senate, and would serve five-year terms.

Massachusetts Private Fund Adviser Exemption Up for Public Hearing January 5, 2012

2012-01-04T11:41:00.006-06:00

A public hearing on a new private fund adviser exemption, as well as an amended institutional investor definition and revised custody requirements for investment advisers will be held at the Massachusetts Securities Division on Thursday, January 5 at One Ashburton Place, Room 1701 in Boston Massachusetts 02108. Public comments will be received through Friday, January 6. Please email your comments to securitiesregs-comments@sec.state.ma.us.

The proposed amendments for the public hearing are as follows:

Registration exemption for private fund advisers. As proposed, private fund advisers would be exempt from investment adviser registration in Massachusetts, provided the advisers are not subject to "bad boy" disqualifications under Rule 262 of federal Regulation A, and electronically file through the IARD the SEC-filed reports and amendments required by SEC Rule §204-4, together with a $300 fee, at which time the electronic submission would be considered "filed."

Private fund advisers to certain 3(c)(1) funds. Private fund advisers advising at least one 3(c)(1) fund that is not a venture capital fund would, in addition to meeting the above requirements: (1) advise only those 3(c)(1) funds (other than venture capital funds) whose outstanding securities (other than short-term paper) are beneficially owned solely by persons who, after deducting the value of the primary residence from the person’s net worth, would each meet the “qualified client” definition in SEC rule 205-3 at the time the securities are purchased from the issuer; (2) disclose in writing to each “non-venture capital 3(c)(1) fund beneficial owner,” at the time of purchase, either the services the advisers will provide, and duties the advisers will owe, the beneficial owners, or disclose to the beneficial owners that services will not be provided, or duties owed, to them, and disclose all other material information affecting the beneficial owners’ rights or responsibilities; and (3) obtain audited financial statements annually of each non-venture capital 3(c)(1) fund and deliver a copy of the financial statements to each beneficial owner.

Grandfathering for private fund advisers with non-qualified client. Private fund advisers to one or more non-venture capital 3(c)(1) funds beneficially owned by persons who are not “qualified clients” as defined above could still qualify for the private fund adviser exemption if: (1) the subject fund(s) existed before March 30, 2012 and cease(s) to accept beneficial owners who are not qualified clients as of that date; and (2) the private fund advisers to the subject fund(s) were in compliance, as of March 30, 2012, with the “no transacting business in Massachusetts unless registered” requirement of §201(c) under the Massachusetts Securities Act, disclose in writing to the fund(s)’ beneficial owners the “services/duties provided (or not provided) to them as mentioned above, and deliver the audited financial statements mentioned above.

Notes pertinent to all private fund advisers. (1) Investment adviser representatives would be exempt from registration if registration would be required solely because of their being employed by or associated with an "exempt private fund adviser." (2) The exemption would not apply to federal covered investment advisers, i.e., private fund advisers registered with the SEC; they would need to comply with state notice filing requirements. (3) A "private fund,""private fund adviser, " "3(c)(1) fund," "value of primary residence," and "venture capital fund" would be defined.

Institutional buyer definition. Currently, institutional buyers may be: (1) an organization described in Section 501(c)(3) of the Internal Revenue Code having a securities portfolio of more than $25 million; (2) an investing entity whose only investors are financial institutions and institutional buyers as described in Massachusetts Securities Act §401(m) and Massachusetts Securities Rule 12.205(1)(a)6.a.; or (3) an investing entity made up exclusively of accredited investors as defined in Rule 501(a) of federal Regulation D under the Securities Act of 1933 who each invested a minimum of $50,000. As proposed, the definition in (3) above would additionally require the subject fund to have existed before March 30, 2012 and to have ceased to accept new beneficial owners as of that date.

Custody of, and discretionary authority over, client funds or securities. As proposed, investment advisers registered or required to register in Massachusetts that have custody of their clients’ funds or securities would need to comply with the safekeeping requirements of SEC Rule 206(4)-2 under the Investment Advisers Act of 1940. Massachusetts would adopt the "custody" definition in SEC Rule 206(4)-2 of the 1940 Act. An investment advisers would not be exempt from the independent verification requirement in subsection (b)(3) of SEC Rule 206(4)-2 unless the adviser: (1) has written consent from the client to deduct advisory fees from the qualified custodian-held account; and (2) sends the qualified custodian and client an invoice or statement of the fee amount to be deducted from the client’s account each time a fee is directly deducted.

Investment advisers registered or required to register in Massachusetts that have discretionary authority over their clients’ funds or securities would maintain a minimum $10,000 bond from a Massachusetts-qualified bonding company.

Pamela Gibbs Named Director of SEC Office of Minority and Women Inclusion

2012-01-03T18:26:00.001-06:00

Pamela A. Gibbs has been named the first Director of the SEC’s Office of Minority and Women Inclusion, which was mandated by the Dodd-Frank Act so that the federal financial regulators would each establish an office devoted to workforce diversity, the use of minority and women-owned service providers, and the assessment of the diversity policies and practices of the businesses each regulates.

Director Gibbs comes to the SEC from the CFTC, where she has served since October 2009 as the Director of its Office of Diversity and Inclusion. In that role, Ms. Gibbs was the principal advisor to the CFTC Chair on equal employment and diversity matters, and oversaw outreach and recruitment of minority and women’s groups. She also worked with the agency’s Office of General Counsel and Office of Human Resources to ensure fairness and consistency in the agency’s personnel policies and practices.

Prior to her service with the CFTC, Ms. Gibbs spent 18 years at the U.S. Department of Labor, where she started in 1991 as a trial attorney in the Civil Rights Division. She later was Acting Deputy Director for Program Operation in the Office of Federal Contract Compliance Programs, and was Director of the Equal Employment Opportunity Unit in the Employment Standards Administration from April 2006 to October 2009.

German and UK Governments Oppose Regulatory Monitoring of Explanations under Comply or Explain Corporate Governance Codes

2012-01-03T17:46:00.002-06:00

The UK and the Federal Republic of Germany both oppose requiring regulators to monitor company explanations as to why a provision of the corporate governance code was not complied with. In letters to the European Commission, the governments said that review of the efficacy of a company’s reason for not complying with a code provision was best left to the markets and the shareholders. The governments were responding to an EC Green Paper on reforming corporate governance. Both Germany and the UK have comply or explain corporate governance codes that require an explanation when a company does not comply with a code provision.

While compliance with the Corporate Governance Code is monitored by investors and private sector organizations that scrutinize compliance with the Code, noted the UK, ultimately it is the shareholders’ responsibility to determine whether an explanation offers sufficient information to make an informed investment decision.

It is important that shareholders continue to make these decisions, said the UK letter, and it is not for government or regulators to interfere in these relationships. For this reason monitoring bodies should not take on the role of checking the quality of explanations, emphasized the UK, and comply or explain statements should not become regulated information under the terms of the Transparency Directive.

While sharing the Commission’s concern about the informative quality of explanations, the UK believes that the best way to allay these concerns is through guidance rather than regulatory oversight. If guidance could be given to those writing and receiving the explanations, reasoned the UK, it is possible that the quality of explanations may improve significantly and shareholders themselves may become more adept at questioning an explanation. In this spirit, the UK Financial Reporting Council will shortly develop a consensus about what constitutes a proper explanation.

In its letter to the Commission, the Federal Republic was highly skeptical of requiring regulators or other authorities to monitor the comply or explain responses of German companies under the corporate governance code, which is a job best left to the markets.

German public companies are required to declare annually whether or not they have complied with the recommendations of the German Corporate Governance Code. Since the Accounting Law Modernization Act went into effect, companies are required not only to disclose divergences from the code recommendations, but also give a reason for these divergences.

The idea of a corporate governance code with a comply or explain arrangement is based on the concept that non-mandatory statutory arrangements are developed by industry itself, reasoned the Federal Republic, and compliance or non-compliance with them is subject to the oversight of the capital market. The German corporate governance code works with a comply or explain mechanism, said the government, because the capital market evaluates the statements, and where appropriate draws its conclusions from them. If the statements are not convincing or are incomplete or are not authoritative, the capital market will draw its conclusions from this.

In addition, a state monitoring authority would entail a major organizational effort. Monitoring would have to be very careful and be carried out with a uniform standard. Even worse, said the Federal Republic, an undesirable standardization of comply or explain statements could result from regulatory monitoring since the monitoring agency would make it known what responses were acceptable in what form, and companies would employ these in a formulaic manner.

California Proposes Private Fund Adviser Exemption

2012-01-03T15:40:00.004-06:00

An exemption from investment adviser registration was proposed for private fund advisers by the California Department of Corporations. The exemption, if adopted, would replace the currently effective de minimis exemption that has been extended by emergency for 90 days from January 18, 2012 and anticipated to become inoperative on June 28, 2012. The proposed exemption would require private fund advisers to meet certain conditions, including the advisers not being subject to specified "bad boy" disqualification provisions, submitting SEC-filed reports required by Rule 204-4 of the Investment Advisers Act of 1940, and paying the $125 adviser registration fee to make the exemption effective for one year. Additional requirements would apply to private fund advisers to 3(c)(1) funds.

While no public hearing is currently scheduled, interested persons may submit written comments about the proposed rule until 5:00 p.m. on February 20, 2012. Comments may be mailed to the Department of Corporations, Attn: Karen Fong, Office of Legislation and Policy, 1515 K Street, Suite 200, Sacramento, CA 95814, or emailed to regulations@corp.ca.gov, or faxed to (916)-322-5875.

In Letter to CFPB, Key Senator Says Proposed Regulations on Foreign Remittance Transfers Challenge Community Banks

2012-01-03T13:11:00.000-06:00

Senator Jeff Merkley (D-Ore) is concerned that the Consumer Financial Protection Bureau’s proposed regulations implementing the foreign remittance transfer provisions of the Dodd-Frank Act present challenges for community banks and credit unions. In a letter to Raj Date, CFPB Acting Director, Senator Merkley, a key member of the Banking Committee, said that compliance with in-advance disclosure requirements may be challenging for foreign remittance transfers involving open networks where transactions are conducted through a series of independent correspondent entities. Community banks and credit unions will need time to develop the systems needed to provide the full disclosure that Section 1703 promises.

Authored by Senator Daniel Akaka (D-Haw), Section 1703 provides certainty to consumers making foreign remittance transfers by requiring full disclosure of exchange rates and transaction fees prior to the transaction.

Senator Merkley is also concerned that the draft regulations contain a permanent exemption for countries where exchange rates are not legally knowable. In his view, this could be a troubling loophole that, if needed at all, should only be used in the narrowest of circumstances with additional safeguards.

The Senator also urged the CFPB to clarify the distinctions between consumer transactions covered by the implementing regulations and business transactions. The intent of Section 1073 is to protect retail consumers from undisclosed fees and problems concerning error resolution, said the Senator, adding that the statute was not intended to cover commercial or business transactions. Thus, final regulations should exclude commercial transactions, he said, in order to avoid any confusion under the definition of consumer in the statute, including both incorporated and unincorporated businesses

Finally, the Senator urged the CFPB to consider if requiring the open network institution to provide consumers with a clear and understandable summary or average of recent comparable transactions to the same destination country would be helpful. In his view, this would assist the consumer in making an informed decision, and also assist the marketplace in transitioning to the new system.

Federal Judge Asks SEC to Provide Factual Predicate in Settling Enforcement Action Involving Disgorgement of Bonuses

2012-01-03T10:58:00.002-06:00

A federal judge has asked the SEC to provide a written factual predicate for why the agency believes the court should find that proposed final judgments in an enforcement action alleging that a company prepared materially inaccurate financial statements and lacked adequate financial controls are fair, reasonable, adequate, and in the public interest. (SEC v. Koss Corporation, No. 2:11-cv-00991, ED Wis). Citing Judge Rakoff’s opinion in SEC v. Citigroup Global Mkt. (SD N.Y. Nov. 28, 2011), Judge Randa specifically requested that the SEC provide, by January 24, 2012, a written factual predicate addressing the adequacy of the proposed final judgment provision regarding disgorgement by the company’s CEO.

The company and its CEO consented to the entry of an injunctive order without admitting or denying the SEC’s allegations. As part of the settlement, the CEO agreed to reimburse the company incentive-based compensation pursuant to Section 304 of the Sarbanes-Oxley Act, which requires CEOs and CFOs to disgorge bonuses and other incentive-based compensation in cases of accounting restatements resulting from material non-compliance with SEC financial reporting requirements.

In a letter to the SEC, Judge Randa noted that the Commission has alleged that the CEO, who was also the company’s CFO, failed to oversee the accounting and financial functions of the company. The SEC relies upon the separate consent documents of the company and the CEO, and has filed proposed final judgments as to each defendant. The letter requests that the SEC address concerns raised by the proposed final judgments and provide a written factual predicate for why it believes the court should find that the proposed final judgments are fair, reasonable, adequate, and in the public interest.

The consent document states that the CEO will be required to reimburse the Company for $242,419 in cash and 160,000 of options, and that bonus reimbursement, together with his previous voluntary reimbursement of bonus amounting to $208,895 represents the CEO’s entire fiscal year 2008, 2009, and 2010, incentive bonuses. Without any factual predicate for how those disgorgement terms were determined and what more, if anything, could have been subject to disgorgement, said Judge Randa, the court cannot assess their fairness and the extent to which they serve the purpose of disgorgement, which is to deprive the violator of unjust enrichment and thereby further the deterrence objectives of the securities laws.

Moreover, the court is concerned that the proposed judgments are not final judgments because they do not expressly state the disposition of the claims against the parties; e.g., dismissal without prejudice, while including a provision for the retention of jurisdiction over the enforcement of the terms of the settlement agreement. With respect to the retention of the Court’s jurisdiction,