Jim Hamilton’s World of Securities Regulation

In Letter to SEC Former Fed Chair Volcker Defends Proposed Regulations Implementing Dodd-Frank Volcker Rule

2012-02-13T16:07:00.005-06:00

In a letter to the SEC and banking agencies implementing the Volcker Rule provisions of the Dodd-Frank Act, former Fed Chair Paul Volcker emphasized that a basic public policy of Dodd-Frank is that proprietary trading of financial instruments, which is essentially speculative in nature, engaged in primarily for the benefit of limited groups of highly paid employees and of stockholders does not justify the taxpayer subsidy implicit in routine access to Federal Reserve credit or deposit insurance. Proprietary trading activity, hedge funds, and equity holdings should stand on their own feet in the market place, he said, not protected by access to bank capital, to the official safety nets, and to any presumption of public assistance as failure threatens. Mr. Volcker also dismissed the argument that US banks complying with the regulations would suffer in their competitive position vis-à-vis international banks as ``superficial at best’’.

He also discussed what the former Fed Chair called the ``thorny issue’’ of guidance with respect to defining the character of market making for customers. Clearly, he posited, we know what it does not mean. Holding substantial securities in a trading book for an extended period obviously assumes the character of a proprietary position, he noted, particularly if not specifically hedged. Various arbitrage strategies, esoteric derivatives, and structured products will need particular attention, the central banker stressed, and to the extent that firms continue to engage in complex activities at the demand of customers, regulators may need complex tools to monitor them.

There may well be occasions when a customer oriented purchase and subsequent sale extending over days cannot be more quickly executed or hedged. But substantial holdings of that character should be relatively rare, he observed, and limited to less liquid markets. Flagrant, intentional violation of the general restrictions should be evident from review of well designed metrics and ad hoc examinations, he emphasized, and should also be identified by a bank’s internal controls.

Mr. Volcker’s understanding is that only a very few very large banking organizations engage in continuous market making on any significant scale. It is those institutions that will require the attention of the regulators. He also understands that the lawful restrictions extend to all banking organizations, including community and regional banks normally inactive. The management of those institutions must understand the nature of the restrictions.

However, consistent with effectively administering the law, oversight and reporting of those institutions may be less intrusive than that appropriate for active trading operations. For small banks, infrequent transactions with customers who may not have easy access to fluid public markets may at times lead to rather longer holding periods, subject to the review of the customer relationship and relevant record keeping. More generally, when or if there is demonstrably clear understanding and enforcement by management of the principles, detailed rules may be less necessary and oversight less intensive.

On the question of proprietary trading, the former Chair noted that it entails substantial risks. Securities are bought, held and sold in the expectation of profits from changes in market prices. The financial crisis has seen spectacular trading losses in large commercial and investment banks here and abroad operating on an international scale, with various loss estimates for major international commercial and investment banks ranging to hundreds of billions of dollars. Internal controls are difficult to implement in active and highly complex markets, he said, and in critical instances they proved woefully inadequate. Consequently, the stability of important banks was jeopardized, contributing to a financial crisis of historic dimension.

The need to restrict proprietary trading is not only a matter of the immediate market risks involved, in the central banker’s view, it is also the seemingly inevitable implication for the culture of the commercial banking institutions involved, manifested in the huge incentives to take risk inherent in the compensation practices for the traders. The result is to undermine the financial services industry as a service industry. Complicating the situation further are the unavoidable conflicts of interest inherent in proprietary trading, he added, particularly if embedded in market-making with the clear implication of fiduciary responsibilities toward customers. Institutional investors should be able to have confidence that their dealers are providing them the financial services they desire, for a transparent price, and are not operating at a conflict with their goals.

Mr. Volcker also assured that the restrictions on proprietary trading by commercial banks legislated by the Dodd-Frank Act are not likely to have an effect on liquidity inconsistent with the public interest. The trading in stocks is still dominated by organized exchanges, and it is not the main focus of commercial bank trading activity. Trading in fixed-income securities and derivatives has become an important part of the activity of a few commercial banks over the past decade.

Consequently, strong restrictions on proprietary trading and on sponsorship of hedge and equity funds under the new law present those institutions with a choice to either give up their proprietary trading activity or their banking license. The apparent reluctance to do the latter, he reasoned, only reinforces the perceived value of access to the Federal safety net and the substantial implicit subsidy to borrowing costs.

Proprietary trading activity, hedge funds, and equity holdings should stand on their own feet in the market place, he said, not protected by access to bank capital, to the official safety nets, and to any presumption of public assistance as failure threatens. Today, thousands of hedge funds operating with relatively little leverage and dependent on the equity capital of partners, represent much more limited risk to the financial system in the event of failure.

Regarding competition, Mr. Volcker rejected the argument that United States banking organizations will suffer in their competitive position vis-à-vis international banks as ``superficial at best’’. Competition in banking, here as elsewhere, is desirable for the benefits it brings in institutional efficiency and better, more economical service to customers, he reasoned, and any contribution of proprietary trading to customer service and competition is not at all obvious.

Restrictions on proprietary trading offer customers a conflict of interest free platform, he pointed out, with bankers focused exclusively on their customer’s needs and with all of the bank’s capital committed in support of those customer activities. Both underwriting and market making could continue alongside non-bank financial institutions. Consequently, he concluded that U.S. banks will remain able to compete effectively for the full range of a customer’s financial needs, and stand strongly against institutions preoccupied with purely proprietary interests.

Deposit and payment facilities, the providing of credit, and asset management are the substance of commercial bank customer services. Does anyone really think that institutions with highly leveraged proprietary trading will lure this business from solidly capitalized, U.S. banks focused on serving customers, asked the former Fed Chair.

Corp Fin Issues C&DI on Advisory Vote Description

2012-02-13T14:28:00.002-06:00

The SEC’s Division of Corporation Finance today issued a new C&DI providing guidance on how to describe the shareholder advisory vote on the proxy card and voting instruction form. Exchange Act Rule 14a-21 mandates that shareholders be given an advisory vote to approve compensation of named executive officers, as disclosed under Item 402 of Regulation S-K. According to C&DI 169.07 (added February 13, 2012), the following descriptions are acceptable:

1. To approve the company’s executive compensation
2. Advisory approval of the company’s executive compensation
3. Advisory resolution to approve executive compensation
4. Advisory vote to approve named executive officer compensation

However, the description “To hold an advisory vote on executive compensation” is unacceptable. This is so, reasoned the C&DI, because shareholders may be confused about whether they are voting in an advisory capacity to approve executive compensation or whether they are voting to hold an advisory vote.

Second Circuit Panel Rules that Hedge Fund Was Not a Customer of Broker and FINRA Member for Purposes of Arbitration

2012-02-13T14:25:00.001-06:00

A Second Circuit panel has enjoined a hedge fund from proceeding with its FINRA arbitration against a registered broker-dealer and FINRA member with respect to a credit default swap agreement because the hedge fund was not a customer of the broker-dealer within the meaning of the FINRA Code. The panel found that the hedge fund had acknowledged in the agreement that the credit default swap was an arm's length transaction and that the firm had not provided the hedge fund with any agency, brokerage, advisory or fiduciary services with respect to the swap agreement. The hedge fund was alleging that the broker-dealer fraudulently induced the fund to enter into the swap agreement and had breached the FINRA Conduct Rules and its own fiduciary duties. Wachovia Bank, Wachovia Capital Markets LLC v. VCG Special Opportunities Master Fund, Ltd., CA-2, No. 10-1648-cv, Oct. 28, 2011)

The FINRA Code definition of customer states only that a customer must not include a broker or dealer, noted the appeals panel, and an online FINRA glossary, to which no reference is made in the FINRA Rules, describes a customer as a person or entity not acting in the capacity of an associated person or member that transacts business with any member firm and/or associated person. (FINRA Glossary of Arbitration Terms)

When the parties to relevant agreements and transactions have expressly disclaimed any sort of advisory, brokerage, or other fiduciary relationship, reasoned the panel, there is no need to grapple with the precise boundaries of the FINRA meaning of customer. In this action, there was no claim that the hedge fund had a brokerage agreement with the broker-dealer. Moreover, there was no factual issue as to whether the broker-dealer provided advice, recommendations, or other services to the hedge fund. On this record, the appeals court concluded that no rational fact finder could infer that the hedge fund was a customer of the broker-dealer for purpose of the FINRA arbitration.

Hedge Fund Industry Assn. Chair Discusses Hedge Fund Directive and MiFID II at EU Forum

2012-02-13T12:30:00.002-06:00

Speaking on behalf of the members of the global alternative investment community at the 10th Annual Financial Services Conference in Brussels, Managed Funds Association Chair William Goodell discussed the industry's views on a number of relevant public policy initiatives and participated in a panel discussion with Verena Ross, Executive Director of the newly formed European Securities and Markets Authority, and Markus Ferber, a Member of the European Parliament who will play a lead role in drafting the legislation and conducting the negotiations for the amended Markets in Financial Instruments Directive (MiFID II).

Regarding MiFID II, Mr. Goodell noted that the alternative investment community shared the goal of European policy makers in promoting enhanced transparency, investor protection and market structure reforms that would enable investors to more effectively seek out industry participants, and capital markets, as a source of safe, stable returns and reliable risk management.

The institutions and individuals that invest in hedge funds support a regulatory framework that will reduce systemic risk, provide enhanced transparency, strengthen investor safeguards, and bolster legal certainty for investors, said the MFA Chair, who added that the MFA will work constructively with policy makers around the globe to accomplish these shared policy objectives in an intelligent, thoughtful manner.

The MFA has encouraged regulators to be consistent in the implementation of reforms so as to avoid fragmentation and the risk of regulatory arbitrage. The MFA supports the proposal in MiFID II that provides for non-discriminatory access to central counter parties and trading venues, and encourages greater coordination with the access provisions included in the European Market Infrastructure Regulation to prohibit discriminatory practices and dismantle barriers that may prevent competition.

While noting that the hedge fund industry has consistently supported the reduction of systemic risk, the MFA Chair expressed concern that the Alternative Investment Fund Manager Directive’s reporting requirements go beyond the systemic risk template created by IOSCO and differ from reporting requirements in the UK and the U.S. Such a lack of international coordination will limit the comparability of the different reports, he said, making global systemic risk monitoring more difficult for regulators and creating unnecessary, significant burdens for global managers. In a post financial crisis world, where policy makers and regulators are concerned about reducing systemic and trading risk, he reasoned, it is critical to implement measures that can be useful for regulators across the globe as they seek to assess potential systemic risk.

Obama Administration's Proposed Budget Calls for Financial Crisis Responsibility Fee on Large Financial Institutions

2012-02-13T06:31:00.006-06:00

The Obama Administration’s proposed budget reissues the call for a Financial Crisis Responsibility Fee on the largest financial institutions to fully compensate taxpayers for the extraordinary support they provided to the financial sector through the Troubled Asset Relief Program (TARP) and other Government actions. The assistance given to the largest financial firms represented an extraordinary step that no one wanted to take, said the Administration, but one that was necessary in order to stem a deeper financial crisis and set the economy on a path to recovery.

The cost associated with the excessive risk-taking by the largest financial institutions continues to ripple through the economy. Furthermore, although many of the largest financial firms have repaid the Treasury for their TARP assistance, they continue to implicitly benefit from the TARP funds that bolstered their balance sheets during a period of great economic upheaval.

The fee will be restricted to financial firms with assets over $50 billion and will be imposed until all TARP costs have been recouped. The Administration’s Financial Crisis Responsibility Fee aligns with the congressional intent of the TARP legislation that requires the President to propose a way for the financial sector to pay back taxpayers so that not one penny of the Government’s TARP-related debt is passed on to the next generation. It would extend be¬yond 2021 as necessary to achieve these ends. The structure of this fee would be consistent with principles agreed to by the G-20 Leaders and similar to fees proposed by other countries.

The financial crisis responsibility fee would be based on liabilities of U.S.-based bank holding companies, broker-dealers, and companies that control broker-dealers and insured depository institutions. A driving rationale for the financial crisis responsibility fee is that it would provide a deterrent against excessive, and potentially risky, leverage and assets for the largest firms.

The fee would only apply to firms with worldwide consolidated assets of $50 billion or more. Firms with worldwide consolidated assets of less than $50 billion would not be subject to the fee for the period when their assets are below the threshold. United States subsidiaries of foreign firms that fall into these categories and that have assets of $50 billion or more also would be subject to the fee.

Former Chair of India’s Securities Regulator and former Big Four Global CEO Named to IASB Oversight Foundation

2012-02-12T15:01:00.000-06:00

The former Chair of the Securities and Exchange Board of India, C. B. Bhave, and the former Global CEO of Deloitte Touche Tohmatsu Limited, James Quiqley, have been named trustees of the IFRS Foundation, which is responsible for the oversight of the International Accounting Standards Board. Before chairing the SEBI, Mr Bhave served as Chair and Managing Director of the National Securities Depository, during which time he led the reform of the Indian Tax Information Network and created India’s first share depository. In addition to his Deloitte responsibilities, Mr Quigley is co-Chair of the TransAtlantic Business Dialogue and serves as a Board member and adviser to several organizations. He is a former Trustee of the Financial Accounting Foundation, the FASB’s oversight body, and a former Board member of the Center for Audit Quality, He has also served on SEC and AICPA financial reporting advisory committees.

German Corporate Governance Code Commission Proposes Enhancements to Supervisory Board and Audit Committee Independence

2012-02-12T14:29:00.001-06:00

The Government Commission on the German Corporate Governance Code has proposed amendments to the Code to enhance the independence of supervisory board members and audit committees. The supervisory board should include an appropriate number of independent members in order to encourage the independent provision of advice to and the supervision of the management board. The Commission also proposes that the chair of the supervisory board should not also be the chair of the audit committee.

The audit committee chair should be independent and not be a former member of the company's management board whose appointment ended less than two years ago. The Commission also proposes to modify the definition of independence to include relations with third parties over and above business or personal relations with the company or its management board. The modified recommendation will have no effect on the special situation arising from the Act on Co-Determination of Employees in the Supervisory Board or the One Third Employee Representation Act. Further, the supervisory board is in the future to specify concrete objectives for the number of its independent members in connection with its composition.

In addition, the Commission proposes the revision of the compensation structure of the supervisory board members so that where performance-based remuneration is also awarded in addition to a basic salary, the former must primarily be related to long-term company performance. Moreover, the Code recommendation on the matters on which the chair of the supervisory board should regularly consult with the management board would be broadened to include planning, the risk situation and compliance. As a result, this catalogue would be identical to the information duties of the management board towards the supervisory board.

The aim of the Corporate Governance Code is to make Germany’s corporate governance rules transparent for both national and international investors, thus strengthening confidence in the management of German corporations. Germany embraces a dual system of corporate governance involving an executive board and a supervisory board. The executive board is responsible for managing the enterprise, while the supervisory board appoints, supervises and advises the members of the executive board and is directly involved in decisions of fundamental importance to the enterprise.

UK Accounting Standards Board Proposes Changes to Financial Reporting Standards

2012-02-12T14:12:00.000-06:00

The UK Accounting Standards Board has proposed significant changes to financial reporting standards in the UK and the Republic of Ireland. The ASB proposed to replace all existing financial reporting standards with IFRS for small and medium-sized enterprises and introduce a reduced disclosure framework for the financial reporting of certain qualifying entities. The ASB will not proceed with the three-tier system it had previously proposed.

The proposed framework permits certain entities (mainly subsidiaries) to apply the measurement and recognition requirements of EU-adopted IFRS with reduced disclosures. The drafts are open for comment until 30 April 2012. Subject to the feedback received, the ASB expects to issue the final standards by the end of 2012.

The overall objective of the proposed revision is to enable users of financial statements to receive high quality and understandable financial reporting proportionate to the size and complexity of the entity and the users’ information needs. The proposed financial reporting standards are cost-effective to apply and are consistent with global accounting standards through the application of an IFRS-based solution. They also reflect up-to-date thinking and developments in the way businesses operate and the transactions they undertake. They balance consistent principles for accounting by all UK and Republic of Ireland entities with pragmatic solutions and are based on size, complexity, public interest and users’ information needs.

As part of the proposals, development costs may be capitalized and carried forward in certain circumstances; merger accounting is permitted for business combinations under common control, hedge accounting is permitted for net investments in a foreign operation, and investment entities are permitted to account for joint ventures at fair value. In addition, all entities will be required to recognize derivatives on balance sheet at fair value.

Committee on Capital Markets Urges Rigorous Cost-Benefit Analysis for Any Mandatory Auditor Rotation Regulations

2012-02-12T13:42:00.002-06:00

A robust cost-benefit analysis is critical if the PCAOB decides to take further action on mandatory audit firm rotation, said the Committee on Capital Markets Regulation. Citing the DC Circuit’s 2011 decision vacating the SEC proxy access rule, the Committee cautioned that a rule regarding mandatory audit firm rotation could be subject to a similar successful judicial challenge if it does not exhibit adequate cost-benefit analysis. Thus, in a letter to the Board, the Committee urged the PCAOB and SEC together to continue to collect and analyze information relating to the costs and benefits of mandatory audit firm rotation. It would be ill-advised, emphasized the Committee, to implement mandatory audit firm rotation, with its enormous known costs, without strong empirical evidence that the proposal will achieve the PCAOB’s goal of enhancing auditor independence, objectivity, and skepticism.

In this regard, the Committee noted that the PCAOB has presented no empirical evidence to suggest that mandatory audit firm rotation would improve auditor independence and skepticism. The PCAOB acknowledges that professional skepticism is a state of mind and may be difficult to identify as the cause of an audit failure, and that audit failures can also reflect a lack of technical competence or experience. Perhaps more importantly, continued the Committee, a preliminary analysis of the PCAOB’s inspection data appears to show no correlation between auditor tenure and number of comments in PCAOB inspection reports. Academic research suggests similar conclusions.

Formed in 2005, the Committee has been dedicated to improving the regulation of U.S. capital markets. In May 2009, the Committee released a comprehensive report entitled The Global Financial Crisis: A Plan for Regulatory Reform, which contains fifty-seven recommendations for making the U.S. financial regulatory structure more integrated, more effective, and more protective of investors in the wake of the financial crisis. Since then, the Committee has continued to make recommendations for regulatory reform of major areas of the U.S. financial system. The Committee is co-chaired by Glenn Hubbard, former Chair of the President’s Council of Economic Advisers, and John Thornton, former President and Co-Chief Operating Officer of the Goldman Sachs Group. Former SEC Commissioner Roel Campos is a Committee member.

In the Committee’s view, mandatory audit firm rotation would impose significant costs both on audit firms and on companies. Transitioning to a new audit firm will result in the loss of institutional knowledge, including both an audit firm’s substantive knowledge of a company as well as its practical knowledge of, for example, a company’s accounting and recordkeeping systems. These costs take several forms: there would be financial costs as the auditors must educate themselves about their new client and its operations, as well as costs incurred by companies who will be required to expend significant time and resources researching, assessing, and selecting new auditors and then bringing them up to date on the company’s business. There could also be potential costs related to audit failures, which a 2003 report by the General Accounting Office indicated are more likely in the early years of an audit.

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.