Global Financial Firms Propose Recommendations in Light of Securitization Crisis

A consortium of global financial institutions have proposed a code of conduct and best practices as part of reforming the securitization process in the wake of the subprime crisis. The recommendations centered on critical issues involving risk management, compensation, asset valuation, and the rating of structured products. More broadly, the measures also aim at boosting transparency and disclosure. The report was set out under the auspices of the International Institute of Finance

Improved risk management is viewed as the most essential element of the reform effort. The first Principle of Conduct is that a pervasive culture of risk management must be embedded throughout the firm and cover all areas and activities.

In addition, the report contains extensive risk management recommendations. Firms must clarify that senior management is responsible for risk management. In addition stress testing must be integral in assessing the firm’s risk appetite. The report cautions that firms must not rely on a single risk methodology. Another principle in the code is that compensation incentives should mot induce risk taking in excess of the firm’s risk appetite. Yet another principle is that risk disclosures must provide the clearest possible picture of a firm’s overall risk profile and the evolving nature of risks as well as salient features of the risk management process. Moreover, in fulfilling disclosure mandates, firms should ensure that disclosures include the most relevant and material risks or exposures arising under current market conditions at the time the disclosure is made, including off-balance-sheet risks or exposures, especially for securitization business.

The report emphasized that financial institutions involved in the originate-to-distribute process should make sure adequate due diligence is conducted at all stages to maintain the integrity of the process. Indeed, financial institutions should apply the same credit due diligence for structured products that they plan to originate and distribute as they do for similar assets that are to be carried on the firm’s own balance sheet. Investors should demand this and factor it into their investing decisions

The report endorses fair-value accounting as an essential element of global capital markets, fostering transparency, discipline, and accountability. That said, the report recognizes that fair valuation can be problematic in illiquid or rapidly shifting markets. The report recommends that firms conduct independent and rigorous valuation of securitized products and apply expert judgment and discipline in valuing complex or illiquid instruments, making use of all available modeling techniques as well as external and internal inputs, such as consensus pricing services. A principle of conduct is that firms disclose both qualitative and quantitative information about valuations, including the methodologies employed. Firms should also have infrastructure in place to allow them to move from observable market prices to other valuation techniques when necessary given market conditions.

The report also endorses the concept of external review of credit rating agencies’ process for rating securitized products. External review is viewed as essential for the credibility and reliability of ratings. The report supports the Committee of European Securities Regulators’
(CESR) recommendation of creating an international rating agencies’ standard setting and monitoring body. The report also endorses a differentiated separate rating scale for complex securitized products.

Hedge Fund Groups File Amicus Briefs in Federal Court Appeal of 13(d) Case

Various hedge fund trade groups have filed amicus briefs in the appeal of a federal court ruling that activist hedge funds violated the Exchange Act in using equity swaps to amass a position in a target company. But, said a federal district judge (SD NY), their actions did not rise to the level of irreparable harm required to sterilize their shares. The court did, however, enjoin the hedge funds from further violations of Section 13(d) of the Act. Any additional penalties would have to come by way of an SEC action, noted the court. (CSX Corp. v. The Children’s Investment Fund Management (UK) LLP, et al, SD NY, June 11, 2008).

The court found that the hedge funds acted as a group without making the disclosure required of 5 per cent shareholders and groups by Section 13(d), a statute enacted to ensure that other shareholders are informed of such accumulations and arrangements. They then launched a proxy fight that, if successful, would result in their having substantial influence and even practical working control of the company.

The equity swaps the hedge funds employed are a type of derivative that gave them the indicia of stock ownership but not the formal legal right to vote the shares. The court did not have to decide the general question of whether holders of equity swaps are the beneficial owners of the underlying stock. Rather, the court deemed the hedge funds to be beneficial owners of the stock by reference to SEC Rule 13d-3(b), which provides that one who creates an arrangement preventing the vesting of beneficial ownership as part of a plan to avoid the disclosure that would be required if the actor bought the stock outright is deemed beneficial owner of those shares.

Importantly, the court concluded that the hedge funds created and used the equity swaps with the purpose and effect of preventing the vesting of beneficial ownership in the funds as a plan to evade the reporting requirements of Section 13(d) and conceal precisely what 13(d) was designed to force into the open. They can thus be deemed beneficial owners of the shares held by their counterparties to hedge their short exposures created by the equity swaps. For example, the court pointed to e-mails from the hedge funds discussing the need to make certain that its counterparties stayed below the 5 percent share ownership reporting threshold in order to avoid triggering disclosure obligations.

In their brief to the Second Circuit Court of Appeals, ISDA and SIFMA argued that the district court misconstrued SEC Rules 13d-3(a) and 13d-3(b) and thereby created substantial uncertainties for the equity derivatives and capital markets that require correction on appeal regardless of the outcome of this particular case. ISDA contended that the court expanded the scheme to evade language of Rule 1 3d-3(b) in a way that the SEC has never intended. Despite the SEC's clear and long-standing position that cash-settled equity swaps do not confer beneficial ownership to the long party' to an equity swap, said the brief, the court read Rule 13d-3(b) to require Section 13(d) disclosures for certain of these swaps.

The court's interpretation is unsupported by the language of the Rule and improperly extends its application beyond the scope of Section 13(d). Amici do not claim that an equity swap can never be employed as part of a scheme to evade under Rule 1 3d-3(b). But they do claim that the use of swaps, without more, cannot by itself constitute such an evasion. There must be some additional act of deception that conceals the true ownership of the relevant equity security.

In its amicus brief, the Managed Funds Association said that the court’s opinion contains a number of broad statements, principally in dicta, about the applicability of rules to transactions involving total return swaps that are contrary to widespread current industry and SEC understanding of the law. While taking no position on the outcome of the appeal, MFA asked only that the Court of Appeals reaffirm the principles identified in the brief and reject any contrary implications suggested by the district court’s opinion.

US Treasury Will Move on Blueprint Affecting Hedge Funds

Against the backdrop of the President Working Group on Financial Markets best practices for hedge fund managers, a senior Treasury official said there is also a need to move on a longer-term, strategic basis based on the Blueprint for Financial Regulatory Reform. Acting Under Secretary for Domestic Finance Anthony Ryan told a group of asset managers in Boston that the current U.S. regulatory structure is not optimally positioned to address the modern financial system with its diversity of market participants, complex financial instruments, convergence of financial intermediaries and trading platforms, and global integration. The official also said that, along with improvement to risk management at financial institutions, investors must practice their own form of risk management when confronted with complex securitized products.

The official urged hedge fund managers to play a special role as reform efforts advance. Referencing the PWG principles and guidelines regarding private pools, he said that, while private pools of capital bring many advantages to the capital markets, they also pose challenges, including systemic risk and investor protection. It will take a combination of strong market discipline and regulatory policies to address these risks.

The PWG has also formed two private-sector committees to develop best practices for asset managers and investors. Their draft practices were released for public comment in April, and the groups will release their final reports this summer. The draft calls on hedge funds to adopt comprehensive best practices in all aspects of their business, including the critical areas of disclosure, valuation of assets, risk management, and conflicts of interest. The report recommended innovative and far-reaching practices that exceed existing industry standards, and calls for increased accountability for hedge fund managers.

A draft Fiduciary's Guide for investors provides recommendations to individuals charged with evaluating the appropriateness of hedge funds as a component of an investment portfolio. The guide provides recommendations to those charged with executing and administering a hedge fund program once a hedge fund has been added to the investment portfolio. The senior official emphasized that these best practices offer a guide for responsible investment in hedge funds and, as such, it is critical that they be implemented.

But this is not enough. On a long-term basis, he noted, Treasury’s blueprint for reform provides a framework for market stability centered on a regulator with broad powers focusing on the overall financial system. The market stability regulator would have the ability to evaluate the capital, liquidity, and margin practices across the entire financial system and their potential impact on overall financial stability.

To do this effectively, the market stability regulator would have the ability to collect information from commercial and investment banks, and hedge funds. Rather than focusing on the health of a particular organization, the market stability regulator would focus on whether a firm's practices threaten overall financial stability. The regulator would have broad powers and the necessary corrective authorities to deal with eficiencies that pose threats to financial stability.

UK Will Reform Taxation of Asset Managers

The UK Treasury has proposed a sweeping reform of the taxation of asset managers in an effort to enhance competitiveness. The proposals would introduce a direct tax exemption regime for UK authorized investment funds, remove tax as a barrier to qualified investor schemes by replacing the substantial holding rule; and adapt the tax rules for investment trust companies to deliver tax efficient investment into interest bearing assets. A key goal of the initiative is to position the UK as a location in which to launch authorized investment funds for sophisticated and institutional investors.

Investors in qualified investment schemes are either institutional or sophisticated individual investors who can be expected to understand the risks involved in a wide range of investments. The substantial holding rule imposes a tax charge on certain investors if their units represent rights to 10 per cent or more of the net asset value qualified investment scheme. The mechanical nature of the rule has acted as a barrier to the development of these investment vehicles. Thus, the substantial holding rule will be replaced with a more flexible test aimed at removing tax as a barrier to these investment schemes and reducing compliance obligations for investors in them.

More specifically, the substantial holding test would be replaced with a genuine diversity of ownership rule designed to ensure that the tax advantages are only available where the investment is widely held. Under the proposed genuine diversity of ownership rule, qualified investor schemes must make investment units widely available and specify the intended categories of investor. Also, they must not limit investors to a limited number of specific persons or specific groups of connected persons. Further, they must widely market the investment to reach the intended categories of investors.

UK Rejects Fannie Mae-Freddie Mac Model for Mortgage-Backed Securities Market

A UK Treasury report rejects the Fannie Mae-Freddie Mac model for secondary markets in mortgage-backed securities. The Crosby Report also said that, because of a number of factors, the volume of mortgage-backed securities is not likely to return to the levels that existed before the crisis erupted. The process of securitization will be reformed, not abandoned, said the report. Reform must create transparent and fair markets for securitized assets so that lenders, issuers and investors can all fully understand the risks attached to the financial transactions. Ultimately, the UK Treasury envisions a gold standard for the asset-backed securities industry for the global marketplace that would promote cross-border investor confidence and thereby extend the appeal of mortgage-backed securities.

While commenters urged a temporary government guarantee for high quality mortgage-backed securities, the report noted that this would transfer credit risk from investors to the Government in a way that could distort incentives and create a moral hazard. Guarantee models come in a variety of guises, observed the report, often reflecting the specific country or historical contexts. In some existing structures, the government guarantee is implicit rather than explicit; though the recent experience of Fannie Mae and Freddie Mac illustrates that markets will tend to regard the former as equivalent to the latter. The report emphasized that an implicit government guarantee on mortgage-backed securities would not be an appropriate model for the UK to adopt.

On the broader issue of securitization reform, the report praised transparency proposals recently set forth by a group of European trade associations. Consistent with a recent Financial Stability Forum report, the trade groups stressed improved transparency and disclosure by issuers and the publication of periodic reports on European securitization markets. They also urged the development of global standardized reporting of transactions in conjunction with the American Securitization Forum, including standardized definitions and valuation principles.

The report favorably singled out the American Securitization Forum’s project on securitization transparency and reporting. The project is focused on developing specific market standards and practices, including templates for disclosure in securitization and model warranties to provide assurances to investors regarding the allocation of risk.

White Paper on Act Reforming Regulation of Fannie Mae and Freddie Mac Is Available

Acting on a broad consensus that government sponsored enterprises need a strong well-funded and independent federal regulator, Congress has overhauled the regulatory oversight of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The Housing and Economic Recovery Act (HR 3221) creates an independent and unified regulator of the GSEs with broad powers analogous to federal banking regulators, and with a free hand to set appropriate capital standards, and a clear and credible process sanctioned by Congress for placing a GSE in receivership. The Act also holds the GSEs to SEC reporting requirements comparable to other large, complex public companies. My white paper on the reform provisions is now available.

Housing Bill Gives SEC Role in Oversight of Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac are now SEC reporting companies and also subject to Exchange Act proxy and insider reporting rules as part of the overhauled of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The Housing and Economic Recovery Act (HR 3221) also requires the Federal Home Loan Banks to register their securities under the Exchange Act, but Congress gave them a number of exemptions from the 1934Act. The SEC Chair is also a member of a four-person oversight board that will oversee the new independent federal regulator for the GSEs, the Federal Housing Finance Agency (FHFA), which will have broad regulatory powers over the operations, activities, corporate governance, safety and soundness, and mission of the GSEs. The Federal Housing Finance Agency would be headed by a Director, appointed by the President and confirmed by the Senate for a 5-year term.

In addition to the SEC Chair, the oversight board is composed of the Director, the Treasury Secretary, and the HUD Secretary. Any member of the board may require a special meeting of the board. Otherwise, the board will meet quarterly. The board must testify annually before Congress on a number of matters involving the GSEs, including their safety and soundness and any material deficiencies in their operation. The testimony must also include an evaluation of the performance of the regulated entities in carrying out their respective missions, as well as a discussion of their overall operational status.

The Act adds a new Section 38 to the Securities Exchange Act to require the registration of the securities of the GSEs. For Fannie Mae and Freddie Mac, the statute provides no class of their equity securities will be exempt from the registration provisions of the Exchange Act, and also provides that there will be no exemption from the internal controls, proxy, and insider reporting provisions of the 1934 Act.

As of July 18, 2008, Freddie Mac and Fannie Mae have voluntarily registered their common stock under the Exchange Act and are now subject to the Act's periodic and current reporting requirements.

Section 16(a) is the insider reporting statute of the Exchange Act, which requires corporate officers and directors and 10 percent shareholders to file public reports in connection with trading in the equity securities of their companies. Section 16(a) is a disclosure statute based on a legislative belief that prompt publicity is a potent weapon in the battle to curb the abuse of inside information. Section 16(a) is also designed to give investors information about purchases and sales by insiders that might indicate the insider’s private opinion about the company.

SEC rules under Section 16(a) and federal court rulings deem officers with significant policymaking duties as subject to Section 16 reporting. Such as: CEO, President, CFO, Controller, any VP in charge of a principal business unit or division or function, such as sales or finance.

Federal Home Loan Banks

The Federal Home Loan Banks are directed by Section 38 to register a class of their common stock under the Exchange Act within 120 days of enactment and thereafter maintain such registration.

Section 38 also imposes some Sarbanes-Oxley governance requirements on the Federal Home Loan Banks by requiring them to comply with the audit committee independence mandates of Section 301 of Sarbanes-Oxley and the SEC rules adopted under it. Specifically, the federal home loan banks must have independent audit committees whose members cannot accept consulting fees or become affiliated persons of the banks.

The Act amends Section 105(b) of the Sarbanes-Oxley Act by adding the Federal Housing Finance Agency to the list of those federal agencies with which the PCAOB may share information without loss of confidentiality.
The Act specifically exempts federal home loan banks from a number of provisions of the federal securities laws. The banks are exempt from the proxy rules, for example. They are also exempt from the broker-dealer registration and transfer agent provisions of Sections 15 and 17A of the Exchange Act. They are exempt from the entire Trust Indenture Act.

The members of the Federal Home Loan Bank System are exempt from compliance with the beneficial ownership reporting and insider reporting provisions of the Exchange Act and related SEC regulations with respect to their ownership of or transactions in the capital stock of the federal home loan banks.

The Act also exempts the Federal Home Loan Banks from periodic reporting requirements under the securities laws pertaining to the disclosure of related party transactions that occur in the ordinary course of the business of the banks with members and the unregistered sales of equity securities. Also, SEC tender offer rules will not apply in connection with transactions in the capital stock of the federal home loan banks.

The Act directs the SEC to adopt regulations in the public interest regarding the exemptions. In issuing regulations, the SEC is ordered to consider the distinctive characteristics of the federal home loan banks when evaluating the accounting treatment with respect to the payment to the Resolution Funding Corporation and the role of the combined financial statements of the banks. In its rulemaking, the Commission must also consider the accounting classification of redeemable capital stock and the accounting treatment related to the joint and several nature of the obligations of the banks.

Congress Overhauls Regulatory Regime for Fannie Mae and Freddie Mac; SEC Has Role

Acting on a broad consensus that government sponsored enterprises need a strong well-funded and independent federal regulator, Congress has overhauled the regulatory oversight of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The Housing and Economic Recovery Act (HR 3221) creates an independent and unified regulator of the GSEs with broad powers analogous to federal banking regulators, and with a free hand to set appropriate capital standards, and a clear and credible process sanctioned by Congress for placing a GSE in receivership. The Act also holds the GSEs to SEC reporting requirements comparable to other large, complex public companies. The Senate passed the bill today and cleared it for the President, who is expected to quickly sign it.

Overview of Reform Legislation

The new federal regulator for the GSEs will have enhanced authority to raise capital standards, set strict prudential standards, including internal controls, and enforce these new standards and promptly take corrective action. The new regulator will oversee, and can directly restrict, executive compensation at Fannie Mae and Freddie Mac.

The Act establishes the Federal Housing Finance Agency (FHFA), an independent agency, to oversee Fannie Mae, Freddie Mac and the Federal Home Loan Banks. FHFA is empowered with broad regulatory powers over the operations, activities, corporate governance, safety and soundness, and mission of the GSEs. The measure provides new and more flexible authority to establish minimum and risk-based capital requirements.

The Act also increases Treasury’s authority under existing lines of credit to Freddie Mac, Fannie Mae, and the Federal Home Loan Banks for the next 18 months, giving Treasury standby authority to buy stock or debt in those companies. To use the authority, the Secretary must make an emergency determination that use of the authority is necessary to stabilize markets, prevent disruptions in mortgage availability, and protect the taxpayer.

The authority also provides enhanced oversight of the enterprises while the standby facility is in place, with the Federal Reserve consulting with the new regulator on the safety and soundness of and risks posed by the GSEs.

As part of the enhanced oversight, the new regulator must specifically approve, disapprove or modify executive compensation at all of the GSEs. A regulated entity may be required to withhold compensation from an executive officer during a review of the reasonableness and comparability of compensation, and may take into consideration any wrongdoing by the officer

New authority is also provided to establish critical capital levels and capital classifications, and specify supervisory actions to be taken regarding undercapitalized, significantly undercapitalized, and critically undercapitalized regulated entities. There will be an expanded conservatorship and receivership authority similar to that of federal bank regulators.

FHFA is given clear enforcement authority, including cease and desist, removal, subpoena and civil money penalty authority

The Act also includes provisions transferring supervisory and regulatory authority to oversee the Federal Home Loan Bank System to the FHFA, and requires the FHFA, in regulating the these banks to recognize the distinctions between the enterprises and the banks. The Act also clarifies the ability of the Federal Home Loan Banks to voluntarily merge, and provides clear regulatory authority regarding the liquidation or reorganization of a bank.

Federal Housing Finance Agency

The Federal Housing Finance Agency would be headed by a Director, appointed by the President and confirmed by the Senate for a 5-year term. The Director can be removed for cause by the President.

The Director must have a demonstrated understanding of financial management or oversight, and have a demonstrated understanding of capital markets, including the mortgage-backed securities markets and housing finance. There is a three-year look back provision under which a person who has served as an executive officer or director of any regulated entity or entity-affiliated party at any time during the preceding 3-year period cannot serve as the FHFA Director. The Director must also be a US citizen.

On a transitional basis, the Act names the current regulator of the GSEs, the Director of the Office of Federal Housing Enterprise Oversight, as the Director of the new agency until a Director is appointed by the President and confirmed by the Senate.

The Act creates an oversight board to advise the Director on strategy and policy with regard to carrying out his or her statutory duties. The board may not exercise any executive authority and the Director may not delegate to the board any of his or her powers or duties

The measure mandates a board of four members composed of the Director, the Treasury Secretary, the HUD Secretary and the SEC Chair. Any member of the board may require a special meeting of the board. Otherwise, the board will meet quarterly. The board must testify annually before Congress on a number of matters involving the GSEs, including their safety and soundness and any material deficiencies in their operation. The testimony must also include an evaluation of the performance of the regulated entities in carrying out their respective missions, as well as a discussion of their overall operational status.

With regard to Fannie Mae and Freddie Mac, the Act establishes an independent regulator and make the GSEs function more like private corporations. The new regulator will review and set portfolio limits, establish minimum capital requirements, and review new programs and products. More broadly, the Act authorizes the new regulator to supervise the GSE portfolios for safety and soundness. Any new financial products developed by the GSEs must be approved by the Director, after a finding that the product is in the public interest and consistent with the safety and soundness of the GSE.

FHFA would issue and enforce prudential management and operations standards for the regulated entities, including credit, interest rate, and market risks, internal controls, liquidity, and investments. The agency may also require a regulated entity to withhold compensation from an executive officer during a review of the reasonableness and comparability of compensation, and may take into consideration any wrongdoing by the officer.

The Act also empowers FHFA to adjust minimum and risk based capital levels. The agency may increase the minimum capital level through regulation or, if there is a serious safety and soundness concern, temporarily through an order. The agency may also establish capital or reserve requirements with respect to particular programs or activities as the agency considers appropriate. The measure also authorizes the regulator to adjust the portfolio holdings of the GSEs. This could be done for either the purpose of increasing safety and soundness of the enterprise or fulfilling the housing mission.

The Act requires the GSEs to register at least one class of capital stock with the SEC under Exchange Act reporting requirements. Also, the GSEs will be subject to SEC proxy and insider reporting provisions. Thus, their directors and policymaking officers will have to comply with the reporting requirements of Section 16(a).

House Passes Broad Overhaul of Regulation of Fannie Mae and Freddie Mac; SEC Has Role

Acting on a broad consensus that government sponsored enterprises need a strong well-funded and independent federal regulator, the massive housing bill (HR 3221) overhauls the regulatory oversight of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The Act would create a new, independent regulator of the GSEs with broad powers analogous to current banking regulators. The measure has passed the House and is heading for Senate passage.

The housing GSEs are uncommon institutions with a unique set of duties and stakeholders. They are chartered by Congress, limited in scope, and are subject to congressional mandates, yet they are publicly traded companies with all the earnings pressure the markets can apply. They are also among the largest US financial institutions, and are among the largest issuers of debt in the world.

The new regulator for the GSEs will have enhanced authority to raise capital standards, set strict prudential standards, including internal controls, audits, and to enforce these new standards and promptly take corrective action. The new regulator will oversee, and can directly restrict, executive compensation at Fannie Mae and Freddie Mac.

The Act establishes the Federal Housing Finance Agency (FHFA), an independent agency, to oversee Fannie Mae, Freddie Mac and the Federal Home Loan Banks. FHFA is empowered with broad regulatory powers over the operations, activities, corporate governance, safety and soundness, and mission of the GSEs. The measure provides new and more flexible authority to establish minimum and risk-based capital requirements.

FHFA is given clear enforcement authority, including cease and desist, removal, subpoena and civil money penalty authority.

The Federal Housing Finance Agency would be headed by a Director, appointed by the President and confirmed by the Senate for a 5-year term.

The Act creates an oversight board to advise the Director on strategy and policy with regard to carrying out his or her statutory duties. The measure mandates a board of four members composed of the Director, the Treasury Secretary, the HUD Secretary and the SEC Chair. Any member of the board may require a special meeting of the board. Otherwise, the board will meet quarterly. The board must testify annually before Congress on a number of matters involving the GSEs, including their safety and soundness and any material deficiencies in their operation.

The Act requires the GSEs to register at least one class of capital stock with the SEC under Exchange Act reporting requirements. Also, the GSEs will be subject to SEC proxy and insider reporting provisions. Thus, their directors and policymaking officers will have to comply with the reporting requirements of Section 16(a).

IRS Revenue Ruling 2008-31 Says Property Derivatives Contract on US Real Property Index Not Interest in Real Property Under Tax Code

According to the IRS, a property derivatives contract is not considered real property for purposes of the federal tax code. Revenue Ruling 2008-31 declares that a foreign company’s interest in a notional principal contract the return on which is calculated by reference to an index referencing data from a broad range of United States real estate is not a real property interest under section 897(c)(1) of the Internal Revenue Code.

Because of the broad-based nature of the real property index, reasoned the IRS, an investor cannot, as a practical matter, own or lease a material percentage of the real estate, the values of which are reflected by the index. The foreign company entered into the derivatives contract with an unrelated counterparty, a domestic company. The foreign company profits if the Index appreciates to the extent the underlying United States real property in the particular geographic region appreciates in value over certain levels.

Conversely, a loss is suffered if the Index depreciates or fails to appreciate more than at a specified rate. During the term of the derivatives contract, the counterparty does not, directly or indirectly, own or lease a material percentage of the real property, the values of which are reflected by the Index.

Section 897(a) provides that gain or loss from the disposition of a US real estate property interest of a foreign company or individual must be taken into account as effectively connected income under section 871(b)(1) or section 882(a)(1), respectively, as if the taxpayer were engaged in a trade or business within the United States during the taxable year and as if such gain or loss were effectively connected with such trade or business.

IRS regulations adopted under Section 897 provide that an interest in real
property includes any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.
Because of the broad-based nature of the index, the derivatives contract does not represent a direct or indirect right to share in the appreciation in the value … of the real property within the meaning of the regulations. Thus, the IRS concluded that the foreign company’s interest in the derivatives contract calculated by reference to the index is not a US real property interest under section 897(c)(1).

European Commission Will Propose Regulation of Credit Rating Agencies in October

In October, the European Commission will propose a registration and external oversight regime for credit rating agencies under which regulators will supervise the policies and procedures followed by the rating agencies. In remarks in Dublin, Commissioner for the Internal Market Charlie McCreevy also announced that the Commission will soon propose revisions to the Capital Markets Directive designed to enhance risk management. Separately, the commissioner rejected calls to temporarily disregard fair value accounting because he feared that precipitate action now could add to the confusion and create even greater distrust in companies' accounts. What is needed in the short-term, he emphasized, is additional guidance on the valuation of complex and illiquid financial instruments.

Noting that the IOSCO voluntary code of conduct for credit rating agencies has not worked, and that steps taken by the rating agencies themselves are insufficient, the commissioner concluded that an EU-wide regulatory regime must be implemented. Reforms to the corporate and internal governance of rating agencies will form a part of the new regime. He also emphasized that the Commission will try to strengthen competition by encouraging entry into the ratings market by new players. The European Securities Markets Expert Group has stressed the importance not just of governance of rating agencies, but also the importance of having an appropriate corporate culture as well.

He also said that the proposed regime for credit rating agencies will ensure that regulators with responsibility for oversight will have at their disposal sufficient resources and expertise to keep up with financial innovation and to challenge the rating agencies in the right areas, on the right issues, at the right time.

At their July meeting EU Finance Ministers (ECOFIN) said that the central role ratings play in structured finance makes it imperative to address the concerns that have been raised in the context of the financial turmoil concerning the transparency of the
rating processes, risk of conflicts of interest related to the remuneration models of the rating agencies, accountability and the quality of ratings.

On a broader topic, the commissioner emphasized the cross-border nature of the current market crisis and the need to enhance the cross-border regulation of financial groups. In this regard, the proposed changes in the Capital Markets Directive will require colleges of regulators for all cross-border banking groups. The objectives of the changes are twofold. First, the Commission wants more exchange of information, cooperation, and agreement on reporting and capital requirements to significantly enhance regulatory efficiency. Second, any signs of stress will be detected more easily and earlier in a college environment, thereby permitting joint contingency plans and crisis assessments.

In addition, the commissioner said that a new Memorandum of Understanding between national central banks, regulators, and finance ministers has been agreed upon. The MOU reflects the commitment of all EU authorities to deepen cooperation in concrete ways and facilitate coordinated actions in cross-border crisis situations that may affect a financial group, infrastructure or market.

The revision to the Directive will also address elements of the prudential treatment of securitization and credit risk transfer, as well as the large exposures regime and hybrid capital instruments. It will also take into account the work under way by the Basel Committee on Banking Supervision on banks' liquidity risk management which is due to be issued in the autumn of 2008.

According to the commissioner, the first objective of the ECOFIN Roadmap to resolve the malfunctions of the financial markets revealed by the sub-prime crisis is the urgent need for qualitative improvements in transparency for investors, markets and regulators. After being strongly pushed to come up with a convincing proposal on exposures to structured products and off-balance sheet vehicles, the industry is now starting to publish its quarterly reports on primary markets. Data on price and spread changes will be updated by the industry on a monthly basis. New data reports on holdings of securitized products should enhance the insight of regulators and policy makers into the exposures of financial institutions.

The banking industry has started a consultation on its guidelines for best practices on disclosures of securitization activities and risk exposures. While the G7 has endorsed the Financial Stability Forum’s recommendation to apply full disclosure to the mid-2008 financial statements, these guidelines will not be effective until the year-end disclosures. For this reason, the Commission asked the industry to clearly spell-out how it will comply with the G7 request. In a letter to the Commission, the industry committed to encourage the implementation of the FSF recommendations and to monitor the process to ensure consistency in the longer term.

SEC-CFTC Task Force Finds Speculation Did Not Contribute to Higher Energy Prices

Against the backdrop of bills moving through Congress to curb speculation on energy derivatives, a task force of federal financial regulators, including the SEC, the Fed and the CFTC, has reported that preliminary analysis does not support the proposition that speculative activity has systematically driven changes in oil prices. If a group of market participants has systematically driven prices, they reasoned, detailed daily position data should show that that group’s position changes preceded price changes.

But the task force’s preliminary analysis suggests that changes in futures market participation by speculators have not systematically preceded price changes. On the contrary, most speculative traders typically alter their positions following price changes, suggesting that they are responding to new information.

More specifically, the regulators found that there is no statistically significant evidence that the position changes of any category or sub-category of traders systematically affect prices. This is to be expected in well-functioning markets. On the contrary, there is evidence that non-commercial entities alter their position following price changes.

The task force’s preliminary analysis also suggests that changes in the positions of swap dealers and non-commercial traders most often followed price changes. This result does not support the hypothesis that the activity of these groups is driving prices higher. The task force found that the activity of market participants often described as speculators has not resulted in systematic changes in price over the last five and a half years. On the contrary, most speculative traders typically alter their positions following price changes, suggesting that they are responding to new information, just as one would expect in an efficiently operating market. In particular, the positions of hedge funds appear to have moved inversely with the preceding price changes, suggesting instead that their positions might have provided a buffer against volatility-inducing shocks.

Since this is an interim report, the task force intends to examine these findings further as it continues its work. Data from the CFTC’s Special Calls on the activities of commodity swap dealers and commodity index traders is expected to become available for review during this time.

Further, the financial agencies pointed out that the distinction between hedging and speculation in futures markets is less clear than it may appear. Traditionally, those with a commercial interest in or an exposure to a physical commodity have been called hedgers, while those without such an exposure have been called speculators. In practice, however, hedgers may be “taking a view” on the price of a commodity, and even those who are not participating in the futures market despite having an exposure to the commodity could be considered speculators.

Hong Kong Markets Largely Unaffected by Securitization Turmoil

The Hong Kong securities markets have been relatively unaffected by the market turmoil in asset-backed securities, said Securities and Futures Commission Executive Director Keith Lui, since the markets have less exposure to sub-prime credit and structured credit products than the US markets. In remarks at the German Development Institute in Berlin, he also noted that, while Hong Kong has a very active derivative warrants market, the warrants are listed and traded on the stock exchange and have attracted significant retail interest. Moreover, products offered to the general public or retail investors require the prior authorization of the Securities and Futures Commission. More sophisticated financial instruments in Hong Kong are available only to professional investors and high net worth private banking clients.

That is not to say that the Commission is not learning from the sub prime crisis. Mr. Liu said that that the crisis has reaffirmed the importance of transparency and disclosure, and the need to ensuring that there are no regulatory gaps. The regulatory regime has to be robust and yet flexible enough to respond to changes in the financial landscape. There are also valuable lessons to be learned on the need for information sharing, coordination and cooperation among national and international regulators and central banks, and equipping these agencies with the appropriate tools and authority to restore confidence and maintain stability in the face of a looming crisis. In this regard, he praised the work of the Financial Stability Forum.

More broadly, the official noted that financial markets go through recurring cycles of liberalization to facilitate financial innovation, followed by increased liquidity and rising leverage induced by irrational optimism, and finally liquidation as asset prices collapse, which often leads to limitation that re-regulates market and intermediary activities. The cycle then repeats once markets rebound. In his view, the role of the regulator is to strike a judicious balance between market development and innovation on one hand, and the protection of investors and the maintenance of market stability on the other.

FASB Urged to Go Slow on Revising Standards for Off Balance Sheet Vehicles

Securities industry groups have asked FASB to be less hasty in its revisions to accounting standards for off balance sheet vehicles lest the Board’s actions have unintended deleterious consequences for financial institutions. In a letter to the Board, the Securities Industry and Financial Markets Association and the American Securitization Forum said that the abrupt consolidation of securitization special purpose entities (variable interest entities) would swell the balance sheets of the affected financial institutions and impair financial ratios and regulatory capital tests. Further, without time to consider the appropriate regulatory and rating agency response to such changes in accounting, the institutions would face capital constraints.

FASB Statement of Accounting Standards No. 140 provides standards for accounting for securitizations and other transfers of financial assets and collateral. FASB Interpretation No. 46R addresses consolidation by business enterprises of variable interest entities.

The trade group also raised the specter of impairing the ongoing convergence of US GAAP and IFRS if the Board proceeds with undue haste. Policy changes without international convergence will prolong the drain on the Board’s and constituents’ time, noted the letter, as further changes to derecognition and consolidation policies will result from the convergence process.

While recognizing that the Board must act in response to the recent credit crisis, the groups said that a year-end 2008 deadline poses too many risks. The letter suggested a more measured and realistic deadline of January 1, 2010, which would permit full deliberation of policy alternatives and time for possible field testing of the proposal so that the Board and constituents can fully gauge its outcome. Concomitantly, there would be a public comment period commensurate with the importance of the changes.

That said, the groups recognize that FASB has reached tentative decisions in its fast-tracked deliberations on Statement 140 and Interpretation 46(R) that would bring sweeping changes to securitization accounting. Financial institutions, including possibly the GSEs, that currently do not consolidate the issuing entities used in securitizations may be required to consolidate some or all of those entities. The affected transactions may include many garden variety transactions, such as retail auto loan securitizations, many of which were not a contributing factor to the current credit crisis.

The groups also emphasized that too much consolidation of variable interest entities can be just as confusing to users of financial statements as too little. More nuanced approaches should be considered, said the letter, in particular approaches that enable users of financial statements to differentiate between assets that are truly controlled by the consolidated reporting entity versus those that have been isolated from that entity and its creditors and appropriately recognize differences among the prevailing structures used for various asset classes. For several years, the American Securitization Forum has advocated linked presentations as a concept with great potential as part of the final resolution of the issues surrounding securitization accounting. The groups strongly advocate full deliberation of a linked presentation as part of the current round of accounting policy changes.

NASAA Requests Comments on IA Model Rules

The Investment Adviser Regulatory Policy and Review Project Group of the North American Securities Administrators Association (NASAA) is soliciting public comments on two sets of model rules it created for investment advisers and investment adviser representatives. The first set of model rules coordinate generally with the investment adviser and investment adviser representative provisions of the Model Uniform Securities Act of 2002, created to act as a helpful template for those states having adopted or planning to adopt the 2002 Act. The second set are model rules to coordinate specifically with the investment adviser/investment adviser representative exam requirements of both the 2002 Act and the Uniform Securities Act of 1956.

The comment period will be open for 21 days, from Friday, July 18 to Friday, August 8, 2008. Comments should be sent to Kenneth Hojnacki, Wisconsin Dept. of Financial Institutions, Division of Securities, P.O. Box 1768, Madison, Wisconsin 53701-1768; kenneth.hojnacki@dfi.state.wi.us.

As IFRS Goes Global, IASB Members Must Be More Globally Diverse and Funding Must Be Broad-Based

As international financial reporting standards continue to gain ground as global accounting standards, the oversight committee of the IASB continues to reform its due process and funding mechanisms and drives to become more geographically diverse. The International Accounting Standards Committee is also anxious to complete the remaining active items on the IASB’s convergence project with FASB. The oversight body noted that no new items will be added to the convergence agenda described in the IASB-FASB Memorandum of Understanding

As the effort to obtain broad-based funding for the IASB continues, the oversight committee said that most countries have established funding systems that comprise levies on listed companies, such as the UK, or are national payments through national authorities, exchanges and business associations. Some countries, including Germany and the United States, still operate voluntary funding regimes but have greatly expanded the sources of funding.

As IFRS become the recognized international standard, it is imperative to create a sustainable long-term financing system with a diversification of sources. The financial commitments must be open-ended and not contingent on any particular action that would infringe on the independence of the IASB in setting international accounting standards.

With international accounting standards looming, the oversight committee is committed to a globally diverse IASB. To that end, the IASB would be expanded to 16 members with new diversity guidelines. The vision is to pre allocate four board memberships for Europe, four for North America and four for Asia, Oceania and then have four left, which are flexible. IASC Chair Gerrit Zalm noted that Africa and South America wish to be represented, and that the board would have some flexibility left to honor that wish.

The oversight committee will also establish a Monitoring Group to end the practice of self-appointment and create a formal link to public authorities. Among other things, the Monitoring Group will review procedures for appointing IASB members, ensure adequate financing for the Board, and review the IASB’s compliance with its operating procedures. The group will be composed of the SEC chair, a European Commissioner, the chair of the Japanese Financial Services Agency, the IMF Managing Director, the chairs of the IOSCO technical and emerging markets committees, and the president of the World Bank

At an IASB roundtable held as part of the reform process, Kenneth Sullivan of the IMF noted that governance becomes increasingly important as IFRS evolves into a world class set of accounting standards. As countries have adopted IFRS they have surrendered sovereignty of some form to a private body, he pointed out, and this means that there must be a transparent governance body. He said that the IASB governing body should be the equivalent of a company’s audit committee. Thus, there should be strict lines between the operational activities of internal controls, preparing accounts, governance and the monitoring of that process.

Target Company Passes Revlon Test But Fails to Dislcose Interests of Financial Adviser

A target company fulfilled its Revlon duties to its shareholders, ruled the Delaware Chancery Court, but stumbled on its disclosure duties by failing to inform stockholders about a company financial adviser’s separate incentives to support the merger. Since shareholders must have full disclosure in order to make an informed decision, Vice Chancellor Noble enjoined the vote on the merger pending curative disclosure. (David P. Simonett Roleover IRA v. Margolis, Del. Chan. Ct, June 27, 2008).

Under the Revlon doctrine, a target company in play must maximize shareholder value within a range of reasonableness. In finding that the directors satisfied Revlon, the court noted that the company attempted to elicit the interest of nineteen potential acquirers, including strategic and financial entities. In addition, the auction process spanned several months and featured multiple rounds of bidding with five potential suitors invited to the table. Moreover, the board was actively engaged, said the court, holding at least fifteen meetings to discuss the process and being regularly informed by its investment advisor and outside legal counsel. In declining to second-guess the board’s auction, the court emphasized that the process was fair, comprehensive, sophisticated, and open.

The disclosure process did not fare as well. When the directors of a Delaware corporation seek shareholder action, explained the court, they are bound by their fiduciary duties of due care and loyalty to disclose fully and fairly all material information within their control.

The target company failed to adequately quantify facets of the interest that one of its financial advisers had in the transaction. The adviser was a global investment bank who allegedly had financial interests beyond its fee in the merger that were not fully disclosed

Initially, the court noted that the financial advisor’s opinion of the fairness of a proposed transaction is one of the most important process-based underpinnings of a board’s recommendation of the transaction to its stockholders and, in turn, for the stockholders’ decision on the transaction. Thus, the vice chancellor emphasized that it is imperative for the stockholders to be able to understand what factors might influence the financial advisor’s analytical efforts.

In this instance, if the merger occurs, the investment bank will receive, not only a substantial fee, but also benefits as the holder of various company obligations. It appears that its debt holdings will be cashed out and a complex hedge/warrant arrangement unwound. Turning debt into cash, perhaps at something of a premium, confers a significant benefit. The peculiar benefits of the merger to the adviser, beyond its expected fee, must be disclosed to stockholders.

The company is asking its stockholders to have faith in the financial adviser and to rely upon its expertise, said the court. While the adviser may be deserving of that confidence, observed the court, the stockholders have every right to expect the company to share with them any extraneous, substantial reasons the adviser may have for seeing that the transaction is consummated.

In this instance, the company failed to achieve that objective, the court found, and the denial of the stockholders’ right to full and complete disclosure as to the peculiar interests of the financial advisor in the merger was irreparable harm. Thus, the court enjoined the shareholder vote pending curative disclosure to the stockholders regarding the potential benefits of the transaction to the adviser.

Hong Kong Records First Conviction for Insider Trading

A finance manager of a listed company became the first person convicted of insider trading under the Hong Kong 2003 Securities and Futures Ordinance. The finance manager engaged in insider trading in a company’s stock while employed with a wholly-owned subsidiary of the company. A magistrate imposed a six-month suspended sentence and a fine of $200,000 Hong Kong dollars.

Declaring that protecting investors from dishonest insiders is a cornerstone obligation for market regulators, Securities and Futures Commission Director of Enforcement Mark Steward said that the Commission will continue to attack insider trading wherever it is detected. Four more cases arising from Commission investigations are presently before the Market Misconduct Tribunal, he noted, and in three other cases before the High Court the SFC has obtained interim orders freezing approximately $100 million in suspected insider profits.

In this case, the SFC alleged that the finance manager sold her shares in the company while aware of non-public information that one of the company’s major debtors had filed for Chapter 11 bankruptcy protection in the United States. The insider thereby avoided a loss of $63,333. The insider was aware that the debtor’s inability to pay its debt to the company would affect the company’s financial position and share price. Subsequently, the company did announce a decline in profit, partially attributed to the bad debt provision resulting from its debtor’s bankruptcy. The calculation of avoided loss was based on the difference between the actual disposal price and the two-day re-rated share price of the company immediately after the release of the financial results.

In a separate unrelated event, the Commission announced that a former managing director at a global investment bank was arrested and charged with nine counts of insider trading in connection with the shares of a listed company prior to the announcement of an acquisition deal. It was alleged that the managing director obtained the inside information about the company’s proposed acquisition while he was part of the bank’s team advising the company on the transaction.

Senate Version of Bill Reforming Fannie Mae and Freddie Mac Drops Sarbanes-Oxley Corporate Governance Provisions; Adds SEC Chair to Oversight Board

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

Acting on a broad consensus that government sponsored enterprises need a strong well-funded federal regulator, the massive housing bill (HR 3221) would overhaul the regulatory oversight of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The Senate and House have passed different versions of HR 3221. Both bills would create a new, independent regulator of the GSEs with broad powers analogous to current banking regulators. The Federal Housing Finance Agency would be headed by a Director, appointed by the President and confirmed by the Senate for a 5-year term. The House bill also imposes many of the corporate governance provisions of the Sarbanes-Oxley Act on the GSEs, including certification of financial statements, codes of ethics, loan prohibitions, and independent audit committees.

The House bill, but not the Senate bill, requires the SEC, in consultation with the Fed, to study the impact of fair value accounting standards on financial institutions and report its findings and recommendations to Congress within 90 days of the bill’s enactment. Specifically, the SEC must examine the impact of fair value accounting with respect to residential mortgages that are at risk of foreclosure and mortgage-backed securities involving such mortgages, as well as the effects of fair value accounting on a financial institution's balance sheet and capacity to provide refinancing to residential mortgagors that are at risk of foreclosure. Further, the SEC must examine the feasibility of modifying fair value accounting standards during periods of market fluctuation in order to maintain the ability of the financial institution to continue to carry mortgages on residential property at risk of foreclosure and assure the availability of credit to refinance at-risk residential mortgages.

Both bills create an oversight board to advise the Director on strategy and policy with regard to carrying out his or her statutory duties. The Senate bill mandates a board of four members composed of the Director, the Treasury Secretary, the HUD Secretary and the SEC Chair. Any member of the board may require a special meeting of the board. Otherwise, the board will meet quarterly. The board must testify annually before Congress on a number of matters involving the GSEs, including their safety and soundness and any material deficiencies in their operation.
HR 3221 has passed the House and Senate, and has been returned to the House for additional consideration. It also faces a veto threat from the Bush Administration.

The housing GSEs are uncommon institutions with a unique set of duties and stakeholders. They are chartered by Congress, limited in scope, and are subject to congressional mandates, yet they are publicly traded companies with all the earnings pressure the markets can apply. They are also among the largest US financial institutions, and are among the largest issuers of debt in the world.

The measure has two major components. First, it significantly increases the strength of the regulator of the two major federal housing government-sponsored enterprises, Fannie Mae and Freddie Mac. Second, it deals with the Federal Home Loan System, which was seen as less in need of drastic change.

With regard to Fannie Mae and Freddie Mac, both bills establish an independent regulator and makes the GSEs function more like private corporations. The new regulator will review and set portfolio limits, establish minimum capital requirements, and review new programs and products. More broadly, the bills authorize the new regulator to supervise the GSE portfolios for safety and soundness. Any new financial products developed by the GSEs must be approved by the Director, after a finding that the product is in the public interest and consistent with the safety and soundness of the GSE.

FHFA would issue and enforce prudential management and operations standards for the regulated entities, including credit, interest rate, and market risks, internal controls, liquidity, and investments. The agency may also require a regulated entity to withhold compensation from an executive officer during a review of the reasonableness and comparability of compensation, and may take into consideration any wrongdoing by the officer.

The bills also empower FHFA to adjust minimum and risk based capital levels. The agency may increase the minimum capital level through regulation or, if there is a serious safety and soundness concern, temporarily through an order. The agency may also establish capital or reserve requirements with respect to particular programs or activities as the agency considers appropriate. The measure also authorizes the regulator to adjust the portfolio holdings of the GSEs. This could be done for either the purpose of increasing safety and soundness of the enterprise or fulfilling the housing mission.

The bills require the GSEs to register at least one class of capital stock with the SEC under Exchange Act reporting requirements. Also, the GSEs will be subject to SEC proxy and insider reporting provisions. Thus, their directors and policymaking officers will have to comply with the reporting requirements of Section 16(a).

Importantly, the House bill requires the enterprises to comply with a number of significant provisions of the Sarbanes-Oxley Act. Fannie Mae and Freddie Mac must have independent audit committees as required by Section 301 of Sarbanes-Oxley. The audit committee will be responsible for hiring, firing and compensating the outside auditor. Audit committee members must be given funds to engage independent counsel and other advisers as they determine necessary to carry out their duties. In addition, audit committees must set up a system to receive and address complaints regarding accounting, internal control and auditing issues. The bill also requires the rotation of audit partners involved in the audit of the enterprise after five years, which is similar to the mandate in Section 203 of Sarbanes-Oxley.

The bill also requires Fannie Mae and Freddie Mac to establish a code of ethics with the standards enunciated in Section 406 of Sarbanes-Oxley. Thus, the code of ethics must contain standards designed to promote honest and ethical conduct, including the ethical handling of conflicts of interest between personal and professional relationships. The code must also promote full and accurate disclosure in the periodic financial reports filed by the enterprises.

Justice Douglas Presages Enron and Doing the Minimum

If we look back, sometimes we can see that there is nothing really new under the securities regulation sun. In 1936, Commissioner William O. Douglas, later US Supreme Court Justice, said, in a speech at the Yale Club, that when disclosure of truth becomes an art and when avoidance of disclosure becomes a game, the essence and spirit of the new legislation will have become subverted although the formalities may have been fully satisfied. That does sound like the Enron situation. Comm. Douglas also said that the conventions of accountants tend to become fixed and ritualistic. They are likely to degenerate into shibboleths. Instead of being descriptive tags, accounting terms too often become vague and indefinite words of art, not pungent with meaning, not vital with significance. Instead of accurately reflecting the true state of the financial condition and of the accounting practices of the company, they too often result in devitalizing the facts by forcing them into a mould which only traditional and conventional practices can justify. The Justice instructs us that the true function of the public accountant is to subject to an impartial mind the accounting practices and policies of issuers.

Delaware Supreme Court Answers Certified SEC Shareholder Proposal Questions

In the first test of a new process allowing the SEC to certify questions to the Delaware Supreme Court, the Court said that, while a shareholder proxy proposal requiring the company to reimburse the reasonable expenses incurred by stockholders running a slate of director nominees is a proper subject for action by shareholders under Delaware law, the proposal’s adoption would cause the company to violate Delaware law. Justice Jacobs wrote the opinion for the full Delaware Supreme Court.

A change in the Delaware Constitution allows the SEC to certify questions to the Court. The provision is effected by Rule 41 of the Court’s rules. As required by the rule, the Court found that there were important and urgent reasons for an immediate determination of the questions the SEC certified. The Court cited Rule 41(b), which suggests that unsettled questions relating to a state statute should be certified.

The company asserted that it could exclude the shareholder proposal from its 2008 proxy materials in reliance on two bases provided by the SEC proxy rules. The first ground for exclusion is that the proposal is an improper subject for shareholder action under Delaware law. (Rule 14-8(i)(1), which allows exclusion if the proposal is not a proper subject for shareholder action under laws of the state of the company’s organization). The second basis for exclusion is that, if adopted, the proposal would cause the company to violate Delaware law. (Rule 14a-8(i)(2), which allows exclusion if the proposal’s implementation would cause the company to violate any state law to which it is subject).

On the first question, the Court ruled that, even though infelicitously couched as a substantive-sounding mandate to expend corporate funds, the proposal had the intent of regulating the process for electing directors and was thus a proper subject for shareholder action. The court noted that the process for electing directors is a subject in which shareholders of Delaware corporations have a legitimate and protected interest.

Further, the shareholders of a Delaware company have the right to participate in selecting the contestants for election to the board. They are entitled to facilitate the exercise of that right by proposing a bylaw encouraging candidates other than board-sponsored nominees to stand for election. The bylaw would accomplish that by committing the company to reimburse the election expenses of shareholders whose candidates are successfully elected. That the implementation of that proposal would require the expenditure of corporate funds will not, in and of itself, make such a bylaw an improper subject matter for shareholder action.

But since the directors would breach their fiduciary duties if they complied with the bylaw, continued the court, it would violate the prohibition against contractual arrangements that commit the directors to a course of action that would preclude them from fully discharging their fiduciary duties to the company and its shareholders. This binding bylaw imposed involuntarily on the directors in the specific area of election expense reimbursement is one that would also prevent the directors from exercising their full managerial power in circumstances where their fiduciary duties would otherwise require them to deny reimbursement to a dissident slate.

That such circumstances could arise is not far fetched. Under Delaware law, a board may expend corporate funds to reimburse proxy expenses when the controversy is concerned with a question of policy. But in a situation where the proxy contest is motivated by personal or petty concerns, or to promote interests that do not further or are adverse to, those of the company, the board’s fiduciary duty could compel that reimbursement be denied altogether. Such a circumstance could arise, for example, if a shareholder group affiliated with a competitor of the company were to cause the election of a minority slate of candidates committed to using their director positions to obtain, and then communicate, valuable proprietary strategic or product information to the competitor.

Senate Report Finds Banks Used Offshore Securities Accounts as Tax Havens to Evade US Tax Law

A bipartisan Senate investigation has revealed that tax haven banks are assisting U.S. taxpayers in evading federal taxes by urging U.S. clients to open securities accounts in their offshore jurisdictions, assisting them in structuring those accounts to avoid disclosure to U.S. authorities, and providing financial services in ways that do not alert U.S. authorities to the existence of the foreign accounts. One large global Swiss bank is currently under investigation by the SEC, IRS, and Department of Justice. The report, by the Subcommittee on Investigations, is entitled Tax Haven Banks and US Tax Compliance.

The Senate staff found that, although the Swiss bank had extensive banking and securities operations in the United States that could accommodate its U.S. clients, it directed its bankers to target U.S. clients to open more bank accounts in Switzerland. Swiss bankers were encouraged to travel to the US and recruit new US clients The Swiss bankers also marketed securities and banking products and services while in the United States, and accepted orders for securities transactions from clients in the United States, without an appropriate license and in apparent violation of U.S. law and banking policy.

U.S. securities laws prohibit persons from advertising securities products or services or
executing securities transactions within the United States unless registered with the SEC. In addition, securities products offered to U.S. persons must comply with U.S. securities laws, which generally means that they must be registered with the SEC, a condition that may not be met by non-U.S. securities, mutual funds, and other investment products. State securities laws may have similar prohibitions.

Moreover, U.S. tax laws may require foreign financial institutions to report sales of non-U.S. securities on 1099 Forms if the sales are effected in the United States, such as through a broker physically in the United States or telephone calls or emails originating in the United States. In addition, although the Swiss bank is itself licensed to operate as a bank and broker-dealer in the United States, its banking and securities licenses do not extend to its non-U.S. offices or affiliates providing services to U.S. residents.

In provisions known as “deemed sales” rules, federal tax laws and the standard QI agreement require sales of non-U.S. securities to be reported by foreign financial institutions on 1099 Forms sent to the IRS, if those sales were effected in the United States, such as arranged by a broker physically in the United States or through telephone calls or emails originating in the United States. To avoid violating U.S. law, exceeding its SEC and banking licenses, or triggering 1099 reporting requirements for deemed sales, the bank maintained written policies restricting the marketing and client-related activities that may be undertaken in the United States by bank employees from outside of the country.

But the facts suggested that the bank was not enforcing its own policies. This lack of enforcement, in turn, raised concerns that Swiss bankers with U.S. clients may have been routinely violating bank policy and U.S. law.

More broadly, the Senate staff found that bank secrecy laws and practices are serving as a cloak, not only for client misconduct, but also for misconduct by banks colluding with clients to evade taxes, dodge creditors, and defy court orders. In addition, the bank employed practices that could facilitate, and have resulted in, tax evasion by their U.S. clients, including assisting clients to open accounts in the names of offshore entities; advising clients on complex offshore structures to hide ownership of assets; using client code names; and disguising asset transfers into and from accounts.

Also, the report found that the bank assisted its U.S. clients in structuring their foreign accounts to avoid QI reporting to the IRS, including by allowing U.S. clients who sold their U.S. securities to continue to hold undisclosed accounts and by opening accounts in the name of non-U.S. entities beneficially owned by U.S. clients. While these banking practices did not technically violate the QI agreements, the result is that the bank helped keep accounts secret from the IRS and thereby facilitated tax evasion by its U.S. clients.

SEC Issues Emergency Order to Stop Naked Short Selling

In an effort to end naked short selling contributing to the disruption in the securities markets, the SEC issued an emergency order requiring all persons to borrow or arrange to borrow the securities identified in certain issuers prior to effecting an order for a short sale of those securities. In order to allow market participants time to adjust their operations to implement the enhanced requirements, the order takes effect at 12:01 a.m. EDT on Monday, July 21, 2008.

In testimony before the Senate Banking Committee, SEC Chair Christopher Cox said that the emergency order is designed to enhance protections against naked short selling in the securities of primary dealers, Fannie Mae, and Freddie Mac. The emergency order will provide that all short sales in the securities of primary dealers, Fannie, and Freddie are subject to a pre-borrow requirement. In addition to this emergency order, said the chair, the SEC will undertake a rulemaking to address these same issues across the entire market.

The Commission acted because there now exists a substantial threat of sudden and excessive fluctuations of securities prices generally and disruption in the functioning of the securities markets that could threaten fair and orderly markets. The emergency powers granted to the SEC by Section 12(k)(2) of the Exchange Act were invoked.

Noting that false rumors can lead to a loss of confidence in the markets, the SEC said that such loss of confidence can also lead to panic selling, which, in turn, may be further exacerbated by naked short selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process. If significant financial institutions are involved, reasoned the Commission, this chain of events can threaten market disruption.

The SEC pointed to the events preceding the sale of The Bear Stearns Companies Inc. as amply illustrative of the market impact of rumors. During the week of March 10, 2008, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. As Bear Stearns’ stock price fell, its counterparties became concerned, and a crisis of confidence occurred late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms. In light of the potentially systemic consequences of a failure of Bear Stearns, the Federal Reserve took emergency action.

Earlier this year in a significant move, the UK Financial Services Authority adopted rules requiring the disclosure of significant short positions in stocks admitted to trading on markets which are undertaking rights issues. For this purpose, the authority defined a significant short position as 0.25% of the issued shares achieved via short selling or by any instruments giving rise to an equivalent economic interest. The obligation will be to disclose positions exceeding this threshold to the market by means of a Regulatory Information Service by 3.30pm the following business day. The new rules took effect on June 20, 2008.

The FSA still views short selling as a legitimate technique which assists liquidity and is not in itself abusive. But it is also the case that the rights issue process provides greater scope for what might amount to market abuse, particularly in current conditions. The FSA believes that improving transparency of significant short selling in such shares would be a good means of preventing the potential for abuse. In these circumstances, non-disclosure of significant short positions gives the market a false and misleading impression of supply and demand in the securities concerned.

SEC Advisory Committee on Improvements to Financial Reporting (Pozen Committee) Issues Final Report

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

The SEC Advisory Committee on Improvements to Financial Reporting (Pozen Committee) has issued its draft final report recommending major changes to regulation and standard-setting involving financial statements and the independent audit of them. Formed by the SEC in July 2007 with a mandate to examine how to increase the usefulness of financial reports to investors and reduce their complexity to investors, preparers and auditors, the committee is chaired by Robert Pozen.

From the outset, the committee focused its recommendations on areas where the SEC, FASB, and the PCAOB could act in a reasonable time. The committee avoided recommendations that would require legislation. The overarching principle guiding the committee’s recommendations is that the primary purpose of financial statements must be to help investors make well-informed decisions.

The committee also limited its scope on international matters. While broadly supporting the move towards international accounting standards, the committee did not focus on the ongoing convergence of US GAAP and IFRS. The committee believes that the principles underlying its recommendations are relevant no matter how convergence ends up.

The main themes of the recommendations are increasing the usefulness of information in SEC reports and enhancing the standard setting process.

A number of recommendations deal with reforming the FASB standard-setting process. For example, the committee urges the SEC to recommend that FASB develop a framework to integrate existing disclosure requirements into a cohesive whole to ensure meaningful communication and logical presentation of disclosures, based on consistent objectives and principles. This would eliminate redundancies and provide a single source of disclosure guidance across all financial reporting standards.

FASB should also disclose the principal assumptions that may impact a company’s business, as well as provide a qualitative discussion of the key risks and uncertainties that could significantly change these amounts over time. This would encompass transactions recognized and measured in the financial statements, as well as events and uncertainties that are not recorded, such as litigation and regulatory developments.

The committee also urges the SEC to issue a statement of policy articulating how it evaluates the reasonableness of accounting judgments and include factors that it considers in making the evaluation. The statement of policy should also address the choice and application of accounting principles. Similarly, the PCAOB should develop guidance on how the Board, including its inspections and enforcement divisions, would evaluate the reasonableness of judgments made based on PCAOB auditing standards. The PCAOB’s statement of policy should acknowledge that the Board would look to the SEC’s statement of policy to the extent the PCAOB would be evaluating the appropriateness of accounting judgments as part of an auditor’s compliance with PCAOB auditing standards.

The Pozen Committee seeks the creation of a formal Financial Reporting Forum to include the SEC, FASB and the PCAOB, as well as representatives from the preparer, auditor, and investor communities, to make recommendations for responding to immediate needs and longer-term priorities in the financial reporting system. This may require the FASB to re-evaluate the roles and composition of other advisory groups or agenda committees. One or more key decision-makers from the SEC, the FASB, and the PCAOB should sit on the FRF, which would allow coordination of how and by whom guidance should be issued, thereby reducing the impetus for the SEC to issue interpretive implementation guidance.

On that point, the committee asks the SEC to stop issuing broad interpretive implementation guidance that would change U.S. GAAP. Instead such matters should be referred to FASB through the Financial Reporting Forum. Also, the SEC staff should re-emphasize that its comment letter and pre-clearance processes are registrant-specific and that other registrants should respond to those comments by changing their accounting only after concluding it is appropriate to do so.

With regard to the materiality standard, the SEC or FASB should supplement existing guidance to reinforce the concept that those who evaluate the materiality of an error should make the decision based upon the perspective of a reasonable investor. Materiality should be judged based on how an error affects the total mix of information available to a reasonable investor. Just as qualitative factors may lead to a conclusion that a small error is material, qualitative factors also may lead to a conclusion that a large error is not material. In this recommendation, the term “large” refers to any error that is more than insignificant. The committee understands that this is a broad definition and that the larger an error is the more likely that it will be deemed material regardless of any qualitative factors.

The committee endorses the US Supreme Court’s definition of materiality in that a fact is material if a reasonable investor in making an investment decision would consider it as having significantly altered the total mix of information available. See Basic, Inc. v. Levinson and TSC Industries, Inc. v. Northway, Inc., When looking at how an error impacts the total mix of information, reasoned the committee, one must consider all of the qualitative factors that would impact the evaluation of the error. This is why bright lines or purely quantitative methods are not appropriate in determining the materiality of an error to annual financial statements.

The committee believes that the current materiality guidance in SAB Topic 1M is appropriate in making most materiality judgments, but warned against making one-directional materiality judgments under which, for example, a quantitative error would be considered material without regard to qualitative factors. Such a one-directional judgment would be inconsistent with the Supreme Court’s materiality standard, which requires an assessment of the total mix of information available to the investor.

The determination of how to correct a material error should be based on the needs of investors making current investment decisions. For example, a material error that is not important to a current investment decision would not require the restatement of the financial statements in which the error occurred, but would need to be promptly corrected and prominently disclosed in the current period.

Regarding restatements, the committee is concerned about the impact of the lack of information for investors during the dark period between the initial notification to the SEC and the time when the restated financials are filed with the SEC. This silence creates significant uncertainty regarding the size and nature of the effects on the company of the issues leading to the restatement, which often results in decreases in the company’s stock price. The current disclosure surrounding a restatement is often not adequate to allow investors to evaluate the company’s operations and the likelihood that such errors could occur in the future. Thus, the committee urges the SEC to issue guidance on the disclosure if financial information during the period in which the restatement is being prepared. Companies should be encouraged to provide any reasonably reliable financial information affecting the restatement.

DOJ Will Revise McNulty Memo as Specter Readies Legislation on Attorney-Client Privilege

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

In an effort to counter impending legislation, the Department of Justice announced that it would revise the McNulty Memorandum to enhance protection of the attorney client protections in federal prosecutions for securities and other white collar crimes. In a letter to senior members of the Senate Judiciary Committee, the DOJ said that in the coming weeks it will revise the McNulty Memo to provide the corporate community more comfort in the areas of attorney-client privilege and joint defense agreements. DOJ also said that in the 18-month existence of the McNulty Memo it has not approved one request from prosecutors to obtain from companies core attorney-client communications or non-factual attorney work product.

Against the backdrop of the bi-partisan Attorney-Client Privilege Protection Act, sponsored by Judiciary Committee Ranking Member Arlen Specter, DOJ asked for time to implement the changes to McNulty and review their operation after a ``reasonable amount of time’’ before legislation is pursued in this area. The House passed a companion bill (HR 3013) to the Specter bill last year.

Specifically, DOJ said it would make five substantive changes to the principles in the next few weeks. First, cooperation with an investigation will be measured by the extent to which a company discloses relevant facts about the misconduct and not by any waiver of its privileges. Second, federal prosecutors will not demand the disclosure of McNulty Category II information as a condition for cooperation credit. Category II information is non-factual attorney work product and core attorney-client privileged communications. But DOJ emphasized that attorney-client communications made in furtherance of a crime or fraud, or that relate to an advice-of-counsel defense, are excluded from the privilege by well-settled case law.

Third, federal prosecutors will not consider whether the company has advanced attorney fees to its employees in evaluating its cooperation. Fourth, federal prosecutors will not consider whether the company has entered into a joint defense agreement when evaluating corporate cooperation. The government may, however, request that a company refrain from disclosing to others sensitive information about the investigation that the government provides in confidence to the company, and may consider if the company has abided by this request. Fifth, federal prosecutors will not consider if the company has retained or sanctioned employees in evaluating cooperation. But, how and whether a company disciplines culpable employees may bear on the quality of its remedial measures or its compliance program.

In a response letter to DOJ, Senator Specter said that, given the lengthy delays and the potential prejudice involved in these matters, it is too much to ask for the legislative process to await a written revision of McNulty and then await a review of the implementation of a new memorandum for a ‘reasonable amount of time’ which could be very long.

While acknowledging that the revised memorandum will be more explicit, the senator described the revisions being readied as ``unsatisfactorily vague.’’ For example, while cooperation will be measured by the disclosure of facts and evidence and not the waiver of privilege, such facts and evidence may have been obtained from an individual who expected that the confidentiality of his or her disclosures of facts and evidence would be protected under the attorney-client privilege. Here, the senator cited the example of the employees in the case, In re Grand Jury Subpoena: Under Seal, 415 F.3d 333 (4th Cir. 2005), who were confused about confidentiality because the company’s counsel told them, “We can represent you as long as no conflict appears.”

Further, in his view, a reference excluding non-factual attorney work product still leaves a large undefined area where factual and non-factual attorney work product may overlap.
On the question of federal prosecutors not considering whether the corporation has entered into a joint defense agreement, Sen. Spector wants to know what relevance that factor has ever had and how often DOJ opposed such joint defense agreements in the past. Similarly, as to federal prosecutors not considering sanctions against employees, the senator wants to know what relevance that ever had and what the DOJ has done on that matter in past cases.

Issued in late, 2006, the McNulty Memo provides standards to guide federal prosecutors when they request disclosure of privileged information. The policy clarifies that attorney-client communications should only be sought in rare cases. Before prosecutors request protected legal advice, mental impressions and conclusions and legal determinations by counsel, they must take the requests to their U.S. Attorney, who must seek approval directly from the deputy attorney general. In order to support their request, prosecutors must meet a "legitimate needs" test for the information, including the likelihood that the privileged information will benefit the government's investigation and whether the information sought can be obtained in a timely and complete fashion by using alternative means that do not require waiver.

IRS Revenue Ruling Says Fund of Funds' Management Fees Are Not Deductible as Business Expenses

In a revenue ruling of import to hedge funds, the IRS said that the management fee of a fund of funds is not an ordinary and necessary expense and cannot be treated as a business expense and deducted under IRC Section 162. The IRS reasoned that the activities of a fund of funds consists solely of acquiring and disposing of interests in other funds, and that such activities do not constitute a trade or business within the meaning of § 162. See Revenue Ruling 2008-39. Rather, the management fee of a fund of funds should be treated as an investment expense under IRC Section 212.

According to the IRS, the question of whether the management fee of a fund of funds may be deducted as a business expense under § 162 or an investment expense under § 212 had to be resolved solely by reference to the activities of the fund of funds, and not the activities of the underlying funds in which it invests.

The management fee of an underlying fund is an ordinary and necessary
business expense within the meaning of § 162 in carrying on that fund’s trade or business. But the management fee of the fund of funds is without regard to the activities of its portfolio funds and is an ordinary and necessary expense in carrying on its investment activities. The management fee of the fund of funds is not paid or incurred by the fund on behalf of any underlying fund in connection with that fund’s trade or business.

Thus, the IRS concluded that, because the fund of funds itself is not engaged in a trade or business within the meaning of § 162 and because the management fee is not paid or incurred on behalf of any underlying funds in which it invests in connection with their trade or business, the management fee is not deductible under § 162. Rather, the fund of funds annual management fees are ordinary and necessary expenses described in § 212 paid or incurred in connection with its investment activities. Accordingly, the investor’s share of the fund of funds’ management fee is deductible under § 212.

Further, pursuant to § 703(a)(2)(E) of the IRC, the fund of funds does not take into account its management fees in computing its taxable income Instead, § 1.702-1(8)(a)(i) requires that the fund of funds separately state its management fees and that investors take into account separately their distributive share of the fund of funds management fees.

Because the management fee of each underlying fund is an ordinary and necessary expense paid or incurred in carrying on the trade or business of those funds, the management fee is deductible under § 162. As a result, each fund takes its management fee into account in computing its taxable income or loss described in § 702(a)(8), and the fund of funds takes into account its distributive share of the taxable income or loss of each fund in computing its own taxable income or loss described in § 702(a)(8). The investor takes into account its distributive share of the fund of funds taxable income or loss in computing the investor’s tax liability.