Federal Judge Implements SEC's Pro Rata Distribution Plan in Connection with Money Market Fund That Collapsed in Lehman Chaos

A federal judge has approved the SEC’s pro-rata distribution plan providing an equal payout to all shareholders of a liquidating money market fund who have not had their redemption requests fulfilled, regardless of when they submitted those redemption requests. The court determined that distributing the fund’s limited assets on the basis of unreliable NAV calculations would not be equitable. While acknowledging that pro rata distribution is not necessarily a plan that everyone would like, the court said it was the most equitable means of distributing the remaining assets of the fund in light of the unprecedented circumstances surrounding its collapse. The court found authority under Section 21(d)(5) of the Exchange Act to grant any equitable relief that may be appropriate or necessary for the benefit of investors. SEC v. Reserve Management Company, Inc., 09 Civ. 4346 (PGG), 11-25-09.

The fund collapsed and became the first money market fund open to the general public ever to “break the buck’’ as part of the extraordinary and unique circumstances surrounding the implosion of Lehman Bros. Holdings, Inc. The fund faced a tidal wave of redemption requests as a result of Lehman’s bankruptcy filing. The run on the fund coincided with a period of enormous turmoil in the credit markets that resulted in a near freeze of trading. Sitting in equity, the court crafted a remedy providing appropriate and necessary equitable relief. With regard to distribution plans in securities cases, noted the court, the Second Circuit has stated that the Commission’s judgment is entitled to deference, in light of its experience and expertise in determining how to distribute funds.

Fund investors deciding whether or not to redeem following the collapse of Lehman were unable to make informed decisions or operate on an equal playing field in light of the chaotic circumstances and the actions of fund managers and salespeople. Even for those investors who sought to redeem part or all of their investments, said the court, the order in which they redeemed is far from clear. For example, a number of claimants contended that they redeemed at an earlier time than that reflected fund records

The Commission pointed out that any attempt to unravel the factual tangle presented by the fund’s interactions with investors on September 15 and 16, 2008, would necessarily involve the complex task of recalculating and reassessing the hourly NAV figures struck on those days. In the court’s view, such an undertaking would require a difficult, time-consuming, fact-intensive and expensive inquiry in light of the discrepancies in redemption records and the fact that the NAV is based not just on the value of the fund’s assets but on the number of shares remaining in the fund at any given time. And at the end of that exercise, the issues concerning why certain investors chose not to redeem would remain. Courts confronting similar circumstances have opted for a pro rata distribution as the fairest and most equitable approach.

Rejecting claims of contractual right to redemption at a NAV of $1.00 per share, or the fund’s statutory obligation to pay redemptions at the stated NAV, the court advised claimants to remember that the court is sitting in equity and is charged with crafting an equitable remedy that takes account of the competing claims of all unpaid investors. Finally, the court rejected the argument of some investors that the fund’s acceptance of their requests to redeem changed their legal status from shareholders to creditors, dictating that they must be paid in the order they redeemed and before those who have not redeemed, who they claim are equity holders. Given that the fund is in liquidation, reasoned the court, all of its current shareholders are “creditors” seeking the return of their investments.

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Global Audit Firms Still Have Problem with PCAOB Proposed Engagement Quality Review Standard

Despite a change in the PCAOB’s proposed engagement quality review standard from know or should have known to due professional care, global audit firms still have concerns with the PCAOB’s AS 7 as it comes up for SEC approval. In comment letters to the SEC, the firms voiced concern that comments in the Board’s Release may go beyond a due professional care standard. For example, Deloitte said that the Release incorrectly equates the standard of due professional care with the legal concept of negligence.

Initially, the audit firms complained that the proposed standard of performance for engagement quality review required reviewers to consider not merely what they know, but also what they should know. The firms were united in their opposition to injecting this legal standard into a review of the audit engagement. They believed that it was an unworkable standard that would have forced audit engagement reviewers to significantly increase the scope and extent of their work in order to protect themselves from SEC or PCAOB sanctions.

The Board amended the draft to specify that the review required by the standard be performed with “due professional care,” as defined in AU section 230, Due Professional Care in the Performance of Work. While supportive of this definition, the firms were concerned that the PCAOB’s further descriptive statements in the Release on the due professional care requirement could be an unrealistic standard for concurring approval of issuance and also improperly equate due professional care with negligence.

While the Board did replace the knows or should know standard with the due professional care standard, noted Deloitte, the Release also suggested that if a review is not performed with due professional care, the reviewer may not discover significant deficiencies that the reviewer reasonably should know about. Deloitte fears that this language suggests the PCAOB may still be seeking to impose a should know standard on the EQR reviewer. Deloitte urged the SEC to clarify in the final standard that conduct that may constitute a departure from due professional care will not necessarily constitute negligent conduct for regulatory or litigation purposes. Ernst & Young, while sharing similar concerns, simply urged that any interpretations of the meaning of due professional care come from the extant standard and not from language in the Release.

For its part, KPMG is concerned that commentary in the Release seems to impose a standard higher than due professional care on the engagement quality reviewer. More specifically, the statement in the Release that “a qualified reviewer who has done so will, necessarily, have discovered any significant engagement deficiencies that could have been discovered if the review had been performed with due professional care in compliance with this standard” could be read to suggest that the reviewer is responsible for identifying all significant engagement deficiencies. KPMG does not believe that this is the PCAOB’s intent, and urged the SEC to make this clear.

In its comments to the SEC, Grant Thornton said that the Release introduces confusion into the standard. GT cautioned that the Board should not set requirements in the standards, and then, in the Release, imply that the words in the standards do not mean what they say. Thus, GT also urged the SEC to clarify that due professional care, as defined in AU sec. 230, does not guarantee that any or all significant deficiencies will be detected, but rather that the engagement quality reviewer will have reasonable, but not absolute assurance, that significant engagement deficiencies have been discovered in the review.

PricewaterhouseCoopers was a little more sanguine in its comments. While noting that some of the Board's Release commentary goes well beyond, and may be inconsistent with, due professional care under AU sec. 230, PwC fully expects the Board to apply AS 7's due professional care standard in accordance with the terms of AU sec. 230. PwC found comfort in the Board’s statement in the Release that it was not redefining due professional care in the context of the EQR standard.

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2nd Circuit Upholds Sanctions Against Connecticut Official for Fraudulent "Finder's Fees"

By N. Peter Rasmussen

A 2nd Circuit panel upheld an order by Judge Ellen Bree Burns of the District of Connecticut imposing sanctions against William A. DiBella, the former majority leader of the Connecticut State Senate, and his consulting firm, North Cove Ventures, L.L.C. The SEC charged DiBella and the firm with aiding and abetting Paul J. Silvester, the former Connecticut state treasurer, in a fraudulent investment scheme. As alleged, Silvester had invested $75 million in state pension funds with Thayer Capital Partners, a Washington, D.C.-based private equity firm, and arranged for Thayer to pay DiBella a percentage of the investment, though he did not do work to justify the payment (SEC v. DiBella).

The district court ordered DiBella to disgorge $374,500 (the amount of his ill-gotten gains from the scheme) and to pay $307,127.45 in prejudgment interest. In addition, the trial court imposed a civil penalty of $110,000.

The appellate panel rejected DiBella's argument that there were no violations for him to aid or abet because the treasurer had no fiduciary duty to disclose information concerning the investments and payments, and that the Investment Advisers Act did not apply because the case involved a state government and a state pension fund. According to the 2nd Circuit, Connecticut state law defined the treasurer as a fiduciary of the fund with duties to disclose to at least the relevant legislative committee. The Advisors Act also was applicable because Thayer, and not the state, was the alleged violator.

The SEC has also filed an application in the district court for a contempt order against DiBella for his failure to pay in the amounts entered by Judge Burns.

Commissioner Gunter Verheugen Reaffirms Corporate Social Responsibility Amidst Financial Crisis

As he nears the end of his second and presumably last term on the European Commission, Commissioner Gunter Verheugen emphasized that corporate social responsibility remains even more relevant in the financial crisis. The Commission believes that corporate social responsibility is good in good times, he noted, but an undeniable must to cope with bad times because it helps to build trust, which the Commissioner called a vital commodity in the current circumstances The biggest competitiveness gains will come to those enterprises who integrate corporate social responsibility in their core strategy and purpose. Mr. Verheugen is Commissioner for Enterprise, as well as Vice-President of the Commission.

In earlier remarks this year, the Commissioner noted that those who believe that financial markets are best when left completely alone have been recently proven wrong. Policy makers and regulators must adopt rules which effectively enable markets to operate in the interest of society. Clearly, in a market economy, business has to make profit, he acknowledged. However, a genuinely European view holds that to achieve this objective in a sustainable way, the economic activities must ultimately serve the interests of society. Enterprises do this through the wealth they generate, the jobs they provide, and the goods and services they offer, while taking care of the environment and local communities where they operate.

But the issue goes a step further, he said, it is a question of ethical behavior, of ethical standards. The financial turmoil has revealed an unexpected degree of selfishness and greed existing in our society. This must be changed, emphasized the Commissioner, not by legislation, since ethical behavior cannot be decreed by law. Instead, he said that society must put in place an environment where such behavior is not tolerated but punished.

Acting on Obama Proposal, House Legislation Would Regulate Hedge Funds and Private Equity Funds

The Obama Administration asked Congress to pass legislation requiring SEC registration of advisers to hedge funds and other private pools of capital, including private equity funds and venture capital funds, with assets under management over a certain threshold. The Administration’s proposal is broadly in line with proposals advanced by the G-20, which recommended the adoption of a confidential reporting regime pursuant to which hedge funds would be required to register and provide a regulator with information relevant to the assessment of systemic risk.

Because many hedge funds fall within certain exemptions of the Investment Company Act and the Investment Advisers Act, those hedge fund are required neither to register with the SEC nor to disclose publicly all their investment positions.

The exemption has enabled private funds to operate largely outside the framework of the financial regulatory system even as they have become increasingly interwoven with the financial markets. As a result, there is no data on the number and nature of these firms or ability to calculate the risks they pose to the broader markets and the economy. Thus, hedge funds and other private funds are not currently subject to the same set of standards and regulations as banks and mutual funds, reflecting the traditional view that their investors are more sophisticated and therefore require less protection.

Legislation passed by the House Financial Services Committee requires investment advisers to hedge funds and other private investment funds to register with the SEC if they have assets under management of at least $150 million and be subject to significant disclosure and other requirements. Current law generally does not require private fund advisers to register with any federal financial regulator. The $150 million assets under management threshold is significantly higher than the $30 million trigger proposed by the Obama Administration.

The legislation accomplishes the registration of hedge fund advisers by eliminating the Investment Adviser Act’s private adviser exemption, which exempts from registration investment advisers that have fewer than 15 clients, do not hold themselves out to the public as investment advisers, and do not act as investment advisers to registered investment companies.

The legislation creates a limited exemption for foreign private fund advisers. The legislation mandates the registration of private advisers to private pools of capital so that regulators can better understand exactly how those entities operate and whether their actions pose a threat to the financial system as a whole. In addition, new recordkeeping and disclosure requirements for private advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until this time largely escaped any meaningful regulation, without posing undue burdens on those industries. Under the legislation, advisers to hedge funds, private equity firms, single-family offices, and other private pools of capital will have to obey some basic ground rules in order to continue to play in the capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.

The legislation authorizes the SEC to require registered investment advisers to maintain records of, and submit reports about, the private funds they advise in two instances. First, as the SEC determines to be necessary or appropriate in the public interest and for the protection of investors; and second, as the SEC determines in consultation with the Federal Reserve Board, and to any other entity that the SEC identifies as having systemic risk responsibility, such as the new Financial Services Oversight Council, are necessary for the assessment of systemic risk. The records and reports of any private fund are further deemed to be the records and reports of the registered investment adviser.

The records and reports of hedge funds and other private equity funds must include information on the amount of assets under management, the use of leverage, including off-balance sheet leverage, counterparty credit risk exposures, trading and investment positions, and trading practices. As a catch all, the SEC, after consultation with the Federal Reserve Board, may require additional information that it deems necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

Similarly, the SEC is also authorized, after considering the public interest and potential to contribute to systemic risk, to set different reporting requirements for different classes of private fund advisers, based on the particular types or sizes of private funds advised by such advisers.

The information that hedge funds and private funds disclose to the SEC will be confidential, except that the Commission may not withhold information from Congress. Also, the SEC is authorized to provide the information to the Fed and the new systemic risk regulator, the Financial Services Oversight Council, which in turn must keep the information confidential in a manner consistent with the confidentiality regime established by the SEC. The legislation would require the SEC to conduct regular examinations of such funds to monitor compliance with these requirements and assess potential risk.

This information would help determine whether systemic risk is building up among hedge funds and other private pools of capital, and could be used if any of the funds or fund families are so large, highly leveraged, and interconnected that they pose a threat to overall financial stability and should therefore be under the broad oversight of the new federal systemic risk regulator.

The legislation sets forth requirements related to the maintenance of records and the periodic and special examination by the SEC of such records. Investment advisers must also make available to the SEC or its representatives any copies or extracts from such records as may be prepared without undue effort, expense, or delay as the SEC may reasonably request

The SEC is also authorized to require investment advisers to provide reports, records and other documents to the investors, prospective investors, creditors, and counterparties of the private funds they advise. The SEC cannot be compelled to disclose any report or information contained within such report filed with the SEC, but the SEC may not withhold such information from Congress.

The Investment Advisers Act is amended to remove a provision that generally bars the SEC from requiring investment advisers to disclose the identity, investments, or affairs of their clients.

The Meeks-Peters-Garrett Amendment requires hedge fund advisers covered by the asset under management threshold exemption to maintain the required records and gives the SEC the discretion to require reports in the public interest or for investor protection. The Amendment also provides that, in adopting regulations for investment advisers to mid-sized private funds, the SEC must take into account the size, governance and investment strategy of the funds in order to ascertain if they pose a systemic risk to the financial markets. Then, the SEC must provide registration and examination procedures for the investment advisers reflecting the level of systemic risk posed by the finds they advise.

The House legislation also contains a registration exemption for advisers to venture capital funds. The SEC is directed to identify and define the term venture capital fund and provide an adviser to such a fund an exemption from the registration requirements. But the Commission must require advisers to venture capital funds to maintain records and provide annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.

An important amendment offered by Committee Ranking Member Spencer Bachus is designed to protect the fiduciary obligations that investment advisers owe their clients. The legislation gives the SEC the ability to define the term "client" of an investment adviser in a broad manner. Rep. Bachus believes that clarifying this language is necessary to avoid unintended consequences. Thus, the Bachus Amendment clarifies that the SEC cannot define the term "client" to include investors in a private fund managed by an investment adviser when that private fund has also entered into an advisory contract with the same adviser. The Amendment would prevent advisers from being subjected to an irresolvable conflict of interest when they manage a pooled investment with the interest of each individual investor in mind.

An amendment offered by Rep. Bachmann would require the SEC to enter into a formal rulemaking process to provide guidance to hedge funds, private equity firms, and other private pools as they adjust to the legislation’s new registration requirements.

An amendment by Rep. Garrett would require the US Comptroller General to conduct a study and report to Congress within two years on the costs to the hedge fund industry of the legislation’s registration and reporting requirements. Another amendment offered by Rep. Kosmas would delay the effective date for one year, although advisers would have the discretion to register earlier with the SEC.

The legislation clarifies the SEC’s rulemaking authority by allowing the Commission to make rules necessary for the exercise of the powers it is granted under the Advisers Act. This rulemaking authority includes power to give different meanings to terms, including “client,” used in different sections of the Act. Additionally, the SEC and the CFTC are directed to jointly promulgate rules to establish the form and content of required reports for investment advisers registered dually under the Investment Advisers Act and the Commodity Exchange Act.

Section 205(a)(1) of the Advisers Act prohibits arrangements for contingent compensation to investment advisers based on profit-sharing arrangements with clients that encourage advisers to take undue risks with client funds. Section 205(e) gives the SEC flexibility to exempt advisory contracts with institutional clients from the ban on performance fees since these clients can appreciate the risks and are in a position to protect themselves from overreaching by the adviser. The SEC makes an exemptive determination based on a number of factors, including a client’s net worth, financial sophistication, and amount of assets under management. The legislation amends Section 205(e) to provide that, if the SEC uses a dollar amount test, such as net asset threshold, as part of determining if an exemption should be given, the Commission must adjust for the effects of inflation on the test every five years. Any adjustment that is not a multiple of $1000 must be rounded to the nearest multiple of $1000.

The Capito-Paulsen Amendment adds to the list of advisers exempted from Advisers Act registration any investment adviser who solely advises small business investment companies licensed under the Small Business Investment Act of 1958. The Amendment also provides that the SEC must exclude from the definition of venture capital fund any fund whose investment adviser solely advises small business investment companies.

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House Legislation Would Significantly Amend Securities Investor Protection Regime

The $65 billion Madoff fraud exposed faults in the Securities Investor Protection Act (SIPA), the law that returns money to the customers of insolvent fraudulent broker-dealers. Legislation moving through the House fixes these shortcomings.

Passed in 1970, SIPA authorized the formation of the Securities Investor Protection Corporation (SIPC), a private nonprofit corporation of which most broker-dealers registered with the SEC are required to be members. Whenever SIPC determines that a member firm has failed or is in danger of failing to meet its obligations to customers, and finds certain other statutory conditions satisfied, it may ask for a protective decree in federal district court. Once a court finds grounds for granting such a petition, it must appoint a trustee charged with liquidating the member firm.

Currently, under the Securities Investor Protection Act, any amount advanced in satisfaction of customer claims may not exceed $500,000 per customer. If part of the claim is for cash, the total amount advanced for cash payment must not exceed $100,000. The legislation increases the maximum cash advance amount to $250,000 and authorize SIPC, subject to the approval of the SEC, to make inflationary adjustments every 5 years to that amount starting in 2010.

Since the establishment of SIPC in 1970, Congress has generally increased the SIPC cash advance amount each time it has increased the amount of Federal Deposit Insurance Corporation coverage. Consistent with changes to FDIC coverage levels made in 2005, the legislaition would bring SIPC and FDIC coverage back in line and provide a commensurate level of protection for customers of securities brokerage firms as customers of depository institutions.

The measure updates SIPA to increase the minimum assessments paid by members of the Securities Investor Protection Corporation to the SIPC Fund. Currently, SIPA provides that the minimum assessment of a SIPC member must not exceed $150 per year, regardless of the size of the SIPC member. This limit was imposed when SIPA was first enacted in 1970 and has never been adjusted to reflect either inflation or the substantial growth of the securities industry. The measure thus strikes this current minimum assessment level and sets a new minimum assessment at 2 basis points of a SIPC member’s gross revenues.

Similarly, in the event that the SIPC Fund is or may reasonably appear to be insufficient to satisfy its statutory requirements, the SEC is authorized to make loans to the SIPC Fund by issuing notes or other obligations to Treasury. The current limit of $1 billion was imposed at the time of SIPA’s enactment and has never been adjusted to reflect either inflation or the substantial growth of the securities industry. The legislation increases the SEC’s authority to issue notes or other obligations to the lesser of $2.5 billion or the target amount of the SIPC fund specified in the SIPC by-laws.

Under current law, SIPC must designate an outside trustee for the liquidation of a failed SIPC member broker-dealer when the failed firm’s liabilities to unsecured general creditors and to subordinated lenders exceed $750,000 and where the failed firm appears to have more than 500 customers. Experience has shown that administration expenses are substantially reduced when SIPC personnel perform the liquidation functions, with equal benefit to customers as when an outside trustee is appointed. Thus, the measure permits SIPC to designate itself as trustee for the liquidation of a failed SIPC member firm regardless of the size of the firm’s liabilities to unsecured general creditors and where the failed firm appears to have less than 5,000 customers. The measure also adds insiders to the class of customers ineligible for SIPC advances.

The legislation permits SIPC to use the direct payment procedure to resolve the failure of small firms with total claims of all customers up to an aggregate of $850,000. The direct payment procedure enables SIPC to quickly and inexpensively resolve the failure of small firms without the need to use the more time-consuming and expensive procedures applicable in a judicial liquidation proceeding. Current law limits the use of the direct payment procedure to cases in which all customer claims of an affected SIPC member aggregate to less than $250,000. Congress imposed this limit when the direct payment procedure was added to SIPA in 1978, and the figure has not been adjusted since then.

SIPA currently identifies and prescribes criminal penalties up to $50,000 for several prohibited acts and for fraudulent conversion. The maximum penalty amount has remained constant since the enactment of the provisions concerning prohibited acts and fraudulent conversions, more than 3 decades ago. The legislation would increase the maximum fine under SIPA to $250,000. The measure would add false advertising and misrepresentation regarding SIPC membership or protection to the list of prohibited acts under SIPA. It would also prescribe civil liability for damages caused by such misrepresentations and criminal liability in the form of a fine up to $250,000 or imprisonment up to 5 years. Civil liability would be extended to Internet service providers who knowingly transmit such misrepresentations and provide for court jurisdiction to issue injunctions.

Under SIPA, claims of securities customers take priority over claims of general creditors. SIPC insurance, however, does not extend to futures positions, other than securities futures. The legislation would extend SIPC insurance to futures positions held in a customer portfolio margining account under a program approved by the SEC. This provision is intended to address the possibility that current law would treat a portfolio margining customer as a general creditor with respect to the proceeds from such customer’s futures positions, while the same portfolio margining customer would have priority for their securities holdings in the case of insolvency of their broker-dealer.

This uneven treatment, along with the Commodity Exchange Act requirement that futures be held in a segregated account, prevents customers from including related futures products in their portfolio margining securities accounts. These obstacles preclude those customers from taking full advantage of the efficiencies created from hedging related positions in a single account.

This provision would be fully operative when the CFTC provides exemptive relief from the CEA’s requirements regarding segregation of customer funds. However, the provision neither amends the CEA nor limits the CFTC’s discretion in granting exemptive relief.

The term customer of a debtor means any person (including any person with whom the debtor deals as principal or agent) who has a claim on account of securities received, acquired, or held by the debtor in the ordinary course of its business as a broker or dealer from or for the securities accounts of such person for safekeeping, with a view to sale, to cover consummated sales, pursuant to purchases, as collateral, security, or for purposes of effecting transfer. Customer also includes any person who has a claim arising out of sales or conversions of such securities.

The Act would also clarify that claims for cash or securities arising out of repurchase agreements and reverse repurchase agreements are ineligible for customer relief under SIPAS. It does so by excluding from the term customer persons to the extent they have a claim relating to an open repurchase or open reverse repurchase agreement. For this purpose, the term repurchase agreement means the sale of a security at a specified price with a simultaneous agreement or obligation to repurchase the security at a specified price on a specified future date.

The draft legislation directed SIPC to levy risk-based premiums on SIPC member firms, using a variety of factors such as the size of the brokerage, number of enforcement and compliance actions in recent years, and years in operation. However, the Frank-Kanjorski Amendment adopted during mark up requires only that the Comptroller General study the feasibility of a risk-based assessment regime and report to Congress in one year.

In planning and conducting the study, the Comptroller General must consult with the SEC, the FDIC, and FINRA. The study must examine modeling and other approaches to measure brokerage firm operational risk and analyze of they cam be used to manage the aggregate risk to the SIPC fund. The study must also explore if such factors as the size of the brokerage, number of enforcement and compliance actions in recent years, and years in operation can be used to assess the probability the fund will incur a loss with regard to a member firm. The study must examine the impact that risk-based assessments could have on large and small firms; and on institutional and retail brokers.

Finally, the legislation clarifies that SIPC is a budgetary entity as defined by the Federal Credit Reform Act, codifying a recent OMB determination to this effect. This provision would neither affect the status of SIPC staff as non-government employees nor subject SIPC to federal procurement law. It would, however, require an accounting of SIPC expenses and revenues in monthly Treasury statements. This clarification is needed because, for the first time, SIPC may need to borrow money from the SEC as a result of the Madoff fraud.

Barnier Named New EU Commissioner for Internal Market and Services

At a time when European financial regulation is at the threshold of significant legislative overhaul, the new Commissioner for the Internal Market and Services will be Michel Barnier of France. Currently, Mr. Barnier is a member of the European Parliament. He will be joining the second Barrasso Commission at a momentous time for EU securities and banking regulation. He will replace Commissioner Charlie McCreevy, under whose remit the most sweeping changes in financial regulation were proposed, including the regulation of hedge funds, credit rating agencies, and systemic risk. Before joining the European Parliament, Mr. Barnier was a member of the Prodi Commission, serving as Commissioner for Regional Policy.

With the G-20 emphasizing the need for a global regulatory response to the financial crisis, Mr. Barnier is aware of the challenges of globalization and the need to craft a harmonized cross-border response. In earlier remarks, he has noted that not long ago financial exchanges were nation-centric and, in all countries, capital exchanges were forbidden or restricted and the approval of the Ministry of Finance was needed before any capital could leave or enter a country. Noting that change now happens very quickly and abruptly, he recognizes the need for new paradigms and thus a need for a new governance.

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Walker Report Recommends Creation of Board Risk Committee and Links Risk to Compensation

The Walker report on corporate governance and executive compensation contains far reaching and groundbreaking recommendations that very likely will be incorporated into UK legislation. The core principles of the Walker recommendations center on risk management, disclosure, and delinking excessive risk taking from compensation, including the creation of a board risk committee with real powers and a duty to provide meaningful information about risk in the company’s annual report.

At the same time, the Walker report supports the continued use of the comply or explain doctrine for corporate governance codes, as well as endorsing the unitary board structure. The report concluded that the two-tier model of separate executive and supervisory boards, such as in Germany, did not yield better outcomes than unitary boards in the crisis period..

Recognizing that the financial crisis involved a massive failure of risk management, the report recommended the creation of an independent board risk committee with oversight of the company’s risk exposures and future risk strategy, including strategy for capital and liquidity management, and the embedding throughout the company of a supportive culture in relation to the management of risk. In preparing advice to the board on its overall risk appetite, tolerance and strategy, the risk committee should take into account the current and prospective financial environment, drawing on financial stability assessments such by central banks, and banking and securities regulators. The board risk committee should, like the audit committee, be composed of a majority of independent directors and be chaired by an independent director.

The risk assessment process used by the committee should be qualitative and also involve quantitative metrics to serve as a way of tracking risk management performance in implementation of the agreed strategy. The approach to some form of calibration of risk appetite might include one or a combination of preferred risk asset ratios; value at risk; target agency ratings, and a system of risk or exposure limits including metrics for the range of tolerance.

In addition, the report said that board-level risk governance should be supported by a chief risk officer, who would participate in the risk management and oversight process at the highest level, covering all risks across the organization, on an enterprise-wide basis, with total independence from individual business units. The CRO should report to the board risk committee, with explicit and direct access to the chair of the committee.

In exercise of the enterprise-wide role, the CRO would provide risk assessments totally independently from the executives in individual business units, and with due regard to materiality. The CRO would assess the risk of proposed new products and the pricing of risk in a particular transaction against the risk tolerance determined by the risk committee and board, and should have veto power where necessary. On a continuing basis, the CRO will ensure that risk originators in individual business units are fully aware of and aligned with the board’s appetite for risk.

The risk committee would file a separate report to be included in the company’s annual report, describing thematically the firm’s risk management strategy, including information on the key risk exposures inherent in the strategy, the associated risk appetite and tolerance and how the actual risk appetite is assessed over time, and the effectiveness of the risk management process. The report should also provide at high-level information on the scope and outcome of the stress-testing program. Also, there should be disclosure of the membership of the risk committee, the frequency of its meetings, whether external
advice was taken and, if so, its source.

Reflecting the interconnection of risk and compensation, the report recommends that the remuneration committee seek advice from the risk committee on specific risk adjustments to be applied to performance objectives set in the context of incentive packages. Any differences of view, and appropriate risk adjustments should be decided by the independent directors.

In addition, the remuneration committee’s report should confirm that the committee is satisfied with the way in which performance objectives and risk adjustments are reflected in the compensation structures and explain the principles underlying the performance objectives, risk adjustments and the related compensation structure if these differ from those put in place and disclosed in respect of executive board members

Deferral of bonuses and other incentive payments should provide the primary risk adjustment mechanism to align rewards with sustainable performance for executive board members and high end employees within the scope of the FSA Remuneration Code.

Incentives should be balanced so that at least one-half of variable remuneration offered in respect of a financial year is in the form of a long-term incentive scheme with vesting subject to a performance condition with half of the award vesting after not less than three years and of the remainder after five years. Short-term bonus awards should be paid over a three-year period with not more than one-third in the first year. Clawback should be used as the means to reclaim amounts in circumstances of misstatement and misconduct.

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UK Minister Calls for Association of Investors to Promote Sound Corporate Governance

Noting that governance is not just a corporate afterthought, but rather the means by which stable revenues and value creation are built, the UK Minister for Financial Services has called for an association of investors similar to industry trade associations to promote and lobby for sound corporate governance. In remarks at an asset management seminar, Lord Myners said that corporate governance is not a zero-sum game. Strong investor engagement leading to better corporate performance overall will increase the size of the pie and not just the share of it which goes to the best managers.

While acknowledging that some trade associations have devoted resources to governance, the Minister observed that their primary role is to further the interest of their members rather than investors. That is why a strong, well-resourced body speaking solely on behalf of investors would represent a valuable addition to the forces working for better governance. At a wider level, he continued, the investment community must take seriously the case for an organization to promote and further the debate on good corporate governance.

Governance is the key to good judgments, he said, and robust governance ensures that those judgments are in the long-term interest of the company. In turn, this requires shareholders to take an active role in holding executives to account. In part, the financial crisis was driven by poor judgments, he averred, such as a failure to question overly complex derivatives, as well as a failure to fully appreciate the interconnected nature of some transactions and markets. While regulatory responses will rightly require firms to hold more, and better quality, capital and liquidity and will deliver more coordinated international responses to crises, he said, ultimately underpinning all the problems is a failure of judgment by regulators, by boards and by senior management.

In his view, improved corporate governance is the best mechanism to foster an environment where judgment is better exercised. If delivered effectively, it requires that decisions are made on the basis of sound analysis and evidence. Good governance also ensures that the contrarian voice is heard, the voice that says maybe this isn’t such a great idea; and the voice that challenges core assumptions. Once decisions are made, good governance demands that they be documented in a transparent and complete manner.

Returning to the theme of an association of investors, the Minister emphasized that sound governance requires the full engagement of shareholders, especially institutional investors. The problem is that most shareholders do not believe that they are owners, he noted, they do not feel responsible for the functioning or the future of companies in which they hold shares. This has profound consequences. The reality of ownerless corporations disadvantages public equity as a form of ownership compared with other models, particularly private equity, and leads to pressure for more regulation to offset the vacuum in engaged oversight.

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Singapore Stesses Risk Management and Transparency in Hedge Fund Regulation

While pending legislation in the US would require hedge fund advisers to register with the SEC, and IOSCO has called for the mandatory registration of hedge funds, the Monetary Authority of Singapore is monitoring market developments and global initiatives and will fine-tune its regulatory approach as appropriate. As Singapore aligns with international standards, noted Executive Director Ng Nam Sin, the Authority will maintain a balanced approach and not ``over-swing’’ the regulatory pendulum. In remarks at a symposium on the future of the hedge fund industry, the MAS official emphasized that risk management and transparency must become the hallmarks of hedge funds. This is what investors most want to see when the look for a hedge fund to invest in, he noted, and challenging market conditions have sparked a renewed focus on risk management.

The crisis has shown that taking excessive risk without putting in place necessary risk controls is a recipe for failure, he admonished. The crisis also brought to light the need to focus on liquidity and counterparty risks, apart from market and operations risk management. As investors become more discerning, he observed, proper risk controls will no longer be an option, but rather, a critical requisite for hedge funds to institute.

In the view of the Executive Director, the crisis has also highlighted the importance of transparency with respect to the operation of hedge funds, including their investment strategies and processes. Investors have learned the hard way that they can no longer live by faith in the “black boxes” of hedge funds alone even if the past track records had been excellent. Investors need to know if the hedge funds are indeed performing according to what they have claimed in their prospectuses.

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NASDAQ Advisory Group Proposes Corporate Governance Best Practices

The NASDAQ Listing Council has proposed corporate governance best practices on a comply or explain basis. The best practices are on issues of director independence, the director election process, and shareholder interaction with directors. Widely used in European corporate governance codes, the comply or explain model requires a company to publicly discloses that it has adopted the best practice or, if it has not, explain why not. The Listing Council is an independent advisory group appointed by the NASDAQ board. A US example of comply or explain is the SEC’s requirement to disclose whether a company has a financial expert on its audit committee.

The comply or explain model offers flexibility to companies and transparency to investors and allows practices to evolve in a logical manner. In the competition for scarce investor resources, said the Council, corporations with the best practices will, over time, likely emerge as the winners. The Council envisions that any required disclosures would appear either in a company’s proxy or in its annual report filed with the SEC.

One best practice is allowing shareholders to vote annually on appointing the outside auditor. Also, the company should adopt some form of advanced resignation requirement to address the circumstance where a director fails to receive a favorable vote by a majority of the shareholders. The company should develop a process to facilitate shareholder communications with directors, with a role for independent directors to play in that process. The company should facilitate independent board leadership, with either an independent chair or an independent lead director.
An important best practice is having independent directors meet regularly in executive session, apart from management and other directors. At these meetings, the directors should discuss the tone at the top, self-evaluations by board committees, access to information, and the effectiveness of the company’s risk management strategy. Finally, the company should adopt a limit on the number of outside boards on which a director can serve.

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Audit Committees Receive Guidance on Issues Arising from Financial Crisis

As the financial crisis continues, audit committee are facing more and more challenges involving risk and uncertainties and valuing financial instruments The UK Financial Reporting Council has issued guidelines to help audit committees navigate the issues. The FRC has oversight of corporate governance. In 2003, the FRC set up an independent group to clarify the role and responsibilities of audit committees, which culminated in the Smith Guidance for Audit Committees within the overall corporate governance code.

Broadly, the audit committee should consider whether there is a need for additional disclosures about company circumstances, such as going concern issues, in preliminary announcements or other regulatory reports before the annual report is published. The committee should ensure that the annual report sets forth a fair review of the company’s business and how the business may have been changed to address the effects of the recession. Also, the committee should consider whether the board of directors needs to amend the strategic plan, including expectations of future growth and the company’s ability to sustain its business model

The audit committee must also ask if further analysis is needed of how the business has been affected by the recession. For example, if the terms of trade have been changed, the system of internal controls should be reconsidered. In particular, if sales terms and conditions have been changed, the company’s revenue recognition policy should be reviewed.

According to the FRC, the audit committee should also determine whether the company’s outside auditors have allocated sufficient additional resources to address heightened risks and, if not, negotiate to secure additional commitments. Moreover, the committee must be comfortable with the boundary between internal and external audit.

Regarding the vexing area of valuations, the FRC urged audit committees to ensure that there are procedures in place and that controls have been applied to the group’s use of models to generate cash flow and accounting valuation information, including the choice and consistent use of key assumptions. The committee must also consider if there should be changes to last year’s assumptions and whether those changes are consistent with external events.

When facing illiquid markets where securities are not traded, the committee must be satisfied that appropriate additional procedures have been taken to estimate fair values through the selection of market-based variables and the use of appropriate assumptions. Computer models used to estimate the value of assets must be tested for impairment, said the FRC, and assumptions underlying impairment tests must be consistent with how the prospects for the business have been described elsewhere in the annual report.

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House Legislation Would Require FASB to Study Securitization Standards and Orders New Regulator to Be Involved When Standards Affect Systemic Risk

Two amendments added during mark-up to the Financial Stability Improvement Act (HR 3996) could impact FASB standard-setting. The Garrett Amendment would require FASB to conduct a study of its new securitization accounting standards, while the Perlmutter-Lucas Amendment would require the new systemic risk regulator to make recommendations to the SEC on FASB standards affecting market-wide financial stability. The legislation is expected to pass the House Financial Services Committee in early December.

The amendment introduced by Rep. Scott Garrett would require FASB to conduct a study of the combined impact by each individual asset-backed security of the new credit risk retention requirements contained in the Act and also of FASB’s new securitization accounting standards, FAS 166 and 167. After the study, FASB would make statutory and regulatory recommendations for eliminating any negative impacts on the continued viability of the asset-backed securitization markets and on the availability of credit for new lending. The study would be required to be completed in 90 days and must the Board must coordinate and consult with the SEC, OCC and FDIC.

Taking effect at the end of 2009, FAS 166 and 167 will eliminate qualified special purpose entities, which are the primary securitization accounting vehicle for asset-backed securities. They will also change the criteria for the sales treatment and consolidation of financial assets and apply all of these changes retroactively.

The new securitization requirements in the legislation and the changes by FASB to the securitization accounting rules will impact both the U.S. financial sector and securitization. Federal Reserve Board Member Elizabeth Duke has noted that, if the risk retention requirements in the legislation, combined with accounting standards governing the treatment of off-balance-sheet entities, make it impossible for firms to reduce the balance sheet through securitization and if, at the same time, leverage ratios limit balance sheet growth, there could be substantially less credit available.

Thus, as policymakers and others work to create a new framework for securitization, cautioned Gov. Duke, they must avoid falling into the trap of letting either the accounting or regulatory capital drive the US to the wrong model.

Another amendment introduced by Reps. Ed Perlmutter and Frank Lucas authorizes the new systemic regulator created by HR 3996, the Financial Services Oversight Council, to make recommendations to the SEC on any adjustments to accounting standards impacting financial institutions when the Council determines that these accounting standards pose a significant risk to financial stability. This bi-partisan amendment allows regulators to make recommendations when there is no functional market for derivatives and other financial instruments.

According to Rep. Perlmutter, the amendment is intended to provide the accountability and transparency necessary for investors to assess their investments in financial institutions, while at the same time providing regulators with the flexibility they need to work with financial institutions to keep credit flowing. The amendment does not place accounting rulemaking with the Financial Services Oversight Council. The setting of accounting standards remains with FASB, subject to SEC oversight. The Council will have no authority to oversee the FASB since the legislation only allows the Council to become involved on accounting issues with systemic risks.

Only if an accounting standard poses systemic risks would the Council make recommendations, and those recommendations would be with the SEC. But the Committee strongly believes that the Council must be permitted to address systemic risks, one of which includes accounting standards.

While mark to market accounting and loan loss accounting rules did exacerbate the financial crisis, explained Rep. Perlmutter, the amendment is not about mark to market. It is about ensuring that policymakers and regulators have a way to examine systemic risks going forward, while working together to ensure that financial statements remain fairly presented for investors and other users of financial statements.

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UK Court Finds Shareholder Was Prejudiced by Inadequate Accounting for Executive Compensation

A shareholder was unfairly prejudiced within the meaning of the UK Companies Act by the failure of a company’s financial statement to adequately disclose executive compensation. Although the UK High Court of Justice found that there was no deliberate plan to conceal the truth from the shareholder, it was readily understandable that the improper accounting should cause her to lose all confidence in the competence and integrity of the board of directors. Any conscientious director should have questioned the company’s auditor about the omission of any mention of certain payments in the accounts, said the court. Moreover, the fact that the shareholder could have questioned the accounting at the annual meeting was not determinative, held the court, since transparency demands that the unvarnished truth be revealed by the financial statements, and not hidden and left to the shareholder to ask questions at a shareholders' meeting, still less to engage the services of a forensic accountant. (In re Sunrise Radio Limited, UK EWHC, 2893, Nov. 13, 2009.)

But the court rejected the claim that a general lack of transparency in the financial statements was unfairly prejudicial to the shareholder, noting that the real problem was that the company’s accounts were unconsolidated, so that the real picture of what was happening in the group could only be ascertained by looking at all the accounts of the subsidiaries. Apart from the inadequate disclosure of directors' remuneration, said the court, the accounts were properly prepared.

The company was not required to file consolidated accounts at the time, as that requirement did not apply either to small or medium sized groups. Thus, the absence of the full picture in the accounts was attributable to the legislature, reasoned the court, and not to any wrongful conduct on the part of those responsible for the accounts in question.

The court found that certain aspects of compensation were hidden among "administrative expenses". The court agreed with the conclusion of the shareholder’s accountancy expert that the directors had adopted a very careless attitude to their responsibilities. While it would be wrong to expect individual directors to be on top of the detail of the accounting requirements of successive Companies Acts and allied regulations, said the court, it is their duty to read the accounts carefully before approval them and query anything that strikes them as odd, or questionable.

Any conscientious director should have noticed the omission of any mention of certain payments in the accounts, said the court, and should have observed the contrast with the remainder of the directors' remuneration, and the disclosure in previous years of charges by related parties. It followed that a conscientious director would have queried why there was nothing about the relevant charges in the accounts, especially as the disclosed directors' remuneration was much lower in consequence.

The obvious person to raise the query with was the company’s auditor, noted the court, who was ``clearly embarrassed’’ when the deficiencies in the accounts were drawn to his attention, and did not seek to defend the accounting treatment. Had any director raised a query with the auditor at the time, emphasized the court, it is inconceivable that the accounts would have gone out in the form in which they did, with no note at all revealing the payments.

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Institutional Investors Defend an Independent PCAOB as Integral to Reform of Securities Markets

In a Supreme Court brief, a consortium of major institutional investors view the PCAOB’s authority to establish auditing, attestation, quality control, and independence standards, subject to SEC approval, as central to the oversight structure around which a reformed investment market is being built. This is in contrast to the patchwork, voluntary system the Board replaced. Essentially, the brief argues that it would be deleterious to investor confidence to return to an industry-centric peer review system of audit oversight whose strongest sanction was expulsion from the AICPA. The PCAOB, by contrast, has the discretion, subject to SEC review, to choose from a broad array of sanctions for a rule violation, ranging from censure through permanent disbarment. Thus, the consortium urged the Supreme Court to rule in the Board’s favor in an action challenging its constitutionality. The amicus brief was signed by, among others, the Council of Institutional Investors, CalPERS, and TIAA-CREF.

The case, brought by an audit firm, is before the Supreme Court on a grant of certiorari of a split panel ruling of the DC Circuit Court of Appeals that the PCAOB’s creation was constitutional. The main argument is that, under the Appointments Clause, Board Members are Officers of the Unites States subject to appointment by the President and not by the SEC, as is currently required by Sarbanes-Oxley. (Free Enterprise Fund and Beckstead & Watts v. PCAOB, Dkt. No. 08-861).

According to the brief, fundamental to the PCAOB’s mission is its power to set auditing standards. For generations, establishing auditing standards had been the province of the AICPA, which used various arms to exercise this authority. According to the brief, the total mix produced a situation that threatened the independence and objectivity of the entire process of promulgating standards and supervising the public auditing industry. Shifting the authority to promulgate auditing standards from the accountants’ own trade association to the independent PCAOB, reasoned the institutional investors, restored the fact and perception of objectivity.

Because the PCAOB starts its rulemaking from a position of independence from the regulated industry and also because that process invites participation by affected shareowners and other stakeholders, reasoned the brief, the outcome is likely to be standards that better protect investors’ interest in the accuracy of financial statements. Moreover, the confluence of rulemaking, inspection, and enforcement authority in the Board means that standards are more likely to evolve quickly and effectively to meet real-world needs.

Rejecting the contention by other amici that the PCAOB’s auditing standards are too burdensome, the institutional investors found comfort in the fact that the Board’s rules are subject to notice-and-comment review before the SEC, which receives the comments of public companies regarding burdens of compliance.

Further, drawing on the lessons from the history of voluntary self-regulation, Congress endowed the PCAOB with the necessary enforcement tools to fulfill its mission, including inspection authority, investigatory powers, and recourse to significant sanctions. All of these tools are subject to SEC oversight. And PCAOB inspections go beyond reviewing auditors for technical compliance, noted amici, delving into the broader business context of audit practices and influencing those practices.

In the view of the institutional investors, the increased regularity and rigor of inspections greatly improve the odds of detecting violations of auditing standards or auditor independence rules. Further adding to the PCAOB’s ability to detect and correct violations in a timely manner is the lifting of any restraint on inspection of audit engagements that are the subject of litigation or other ongoing controversy.

Under the previous peer review regime, reviews of such engagements were delayed until after litigation or other disputes were resolved. Under that system, said the brief, years could pass from the time a violation was committed to when it was caught and punished, if at all. The PCAOB’s new flexibility to review engagements even while a lawsuit or controversy is pending provides for more swift and certain correction of violations, contended the brief, furthering the interest of investors in removing the financial reporting process from the hands of incompetent or unethical auditors.

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Center for Audit Quality Defends PCAOB's Record in Urging Supreme Court to Leave Board Intact

With oral argument looming in a case challenging the constitutionality of the PCAOB, the Center for Audit Quality has strongly defended the Board’s achievements in accomplishing the goals of the Sarbanes-Oxley Act. In an amicus brief filed with the Supreme Court, CAQ said that the Board has improved audit quality and enhanced investor protection by conducting thorough inspections, focusing on remediation, and helping to improve the function of audit committees, backed up by the ability to impose meaningful sanctions. Oral argument in the case is set for December 7, 2009. CAQ is affiliated with the AICPA and counts as members over 700 audit firms.

The case, brought by an audit firm, is before the Supreme Court on a grant of certiorari of a split panel ruling of the DC Circuit Court of Appeals that the PCAOB’s creation was constitutional. The main argument is that, under the Appointments Clause, Board Members are Officers of the Unites States subject to appointment by the President and not by the SEC, as is currently required by Sarbanes-Oxley. The Center decided to focus its amicus brief on the need to leave the Board intact so it can continue the work of enhancing audit quality as Congress envisioned. (Free Enterprise Fund and Beckstead & Watts v. PCAOB, Dkt. No. 08-861).

The brief urged the Court to maintain the PCAOB’s oversight of auditors of company financial statements and refrain from dramatically changing the regulatory structure for the second time in less than a decade. In asking the Court to leave undisturbed the PCAOB oversight regime, CAQ emphasized that Congress structured the PCAOB to ensure that the regulation of audit firms is undertaken on an informed basis, but is not subject solely to the viewpoint of the audit profession. This structure enables the Board to reflect auditor best practices and serve the interests of the public. In addition, it is important to provide consistent and predictable regulation that can be relied upon by both auditors and investors.

Were the Court to find the PCAOB to constitutionally created, warned CAQ, the uncertainty surrounding the effect of past regulations, and the question of what form future regulation would take, would have negative consequences for investors, auditors, and the markets. At a time of financial upheaval, continued CAQ, overturning the established system of auditor regulation would exacerbate investors’ fears about the integrity of the markets and interfere with the ongoing work of regulation.

More specifically, CAQ noted that PCAOB inspections have improved audit quality by providing an independent review focused on remediating audit issues identified during the inspections, and by enhancing transparency to both audit committees and investors. Congress decided in the Sarbanes-Oxley Act that quality control criticisms identified during an inspection must remain non-public for a year after they are identified. If those criticisms are not addressed to the PCAOB’s satisfaction within the year period, they are then publicly reported. This provides registered firms additional incentive to correct problems.

The publication of inspection reports also increases transparency of the audit process to audit committees and investors by providing insight into areas where the PCAOB identified weaknesses or deficiencies through inspection. In turn, this additional information assists audit committees in their oversight of the registered firms.

Moreover, the Sarbanes-Oxley Act gave audit committees an important role in reviewing the quality of audits of financial statements. Thus, it is significant that a CAQ survey found that audit committees overwhelming believe that the quality of audits has improved under the PCAOB.

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New Mexico Proposes Rule Revisions to Align with New 2010 Securities Act

Rule amendments were proposed by the New Mexico Securities Division to align the rules with adoption of the new New Mexico Uniform Securities Act that takes effect January 1, 2010. The rule changes are likewise anticipated to become effective on January 1. Many of the proposed changes are nonsubstantive, updating rule references to reflect the correct section and subsection numbers of the new Act, lower-casing certain words like "director" and the first letter of the first word of certain subsections. A number of the substantive amendments are being made to the investment adviser rules. Please note that upon adoption a fair amount of CCH paragraph numbers will shift to correspond to different rules than they do now.

Interested persons may submit written comments about the rule proposals to Marianne Woodard, Attorney, Securities Division, New Mexico Regulation and Licensing Department, 2550 Cerrillos Rd., Toney Anaya Bldg 3rd Floor, Santa Fe, NM 87505. Alternatively, comments may be faxed to (505) 984-0617. Comments must be received by December 7, 2009.

For the text of the proposed rules please see here.

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California Amends National Security Exchange Names and Functions to Match Federal Changes

The names and functions of certain national security exchanges, stock exchanges, markets and related entities were amended by the California Department of Corporations to reflect changes made to the National Security Exchange names and functions at the federal level, effective December 10, 2009. The changes include: (1) adding the NASDAQ Global Market to the national securities exchange list and deleting references to the interdealer quotation system of the National Association of Securities Dealers, Inc.; (2) adding the New York Stock Exchange AMEX to the national securities exchange list and deleting references to the Emerging Company Marketplace; (3) adding Tier I of the NYSE Arca to the national securities exchange list and deleting references to the Pacific Stock Exchange; (4) adding Tier I of the NASDAQ OMX PHLX and deleting references to Tier I of the Philadelphia Stock Exchange; (5) adding the electronic service operated by the Pink Sheets LLC or the OTC Bulletin Board and deleting references to the National Daily Quotation Service; (6) adding the Pink Sheets LLC, the OTC Bulletin Board and the NASDAQ Stock Market LLC and deleting references to the National Quotation Bureau; (7) repealing the exemption from registration for securities listed on the Chicago Board Options Exchange; (8) repealing the exemption for securities listed on the Pacific Stock Exchange; and (9) changing references from the National Association of Securities Dealers, Inc. to the Financial Industry Regulation Authority.

For more information please see here.

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Hong Kong Securities and Futures Commission Official Looks at Regulation of Dark Pools

Noting that the SEC has made dramatic proposals to light up dark pools, Martin Wheatley, Executive Director of the Hong Kong Securities and Futures Commission said that the proposals have far-reaching implications and require careful study and thorough discussions with the industry before being adopted. While dark pool operations in Hong Kong are still relatively small, he said, the Commission has begun a study to identify the appropriate ways for alternative trading venues to develop in Hong Kong. His remarks were made at Trade Tech Asia 2009.

In an effort to increase transparency in dark pools, the SEC would require real time reporting from dark pools for their executed trades and actionable indications of interests to be displayed in the public quotation system. Dark pools in the U.S. are currently required to publicly display stock quotes if their trading volume exceeds 5 percent of the volume of a particular stock. But the new plan would reduce the threshold to 0.25 percent.

The growth of dark pools in Asia has been impeded by the fact that, unlike in the U.S. and in Europe, Asian exchanges are considered national interests and hence accorded an almost exclusive franchise to operate a stock market domestically. That said, the Executive Director believes that a case can still be made for dark pools to operate in Asia because they are not really exchanges. Dark pools can offer something exchanges cannot, that is, a wide range of order types including algorithmic trading tools. Thus, it is arguable that dark pools are not competing with exchanges, but play a complementary role in offering a different type of service or servicing a different segment of the market.

While acknowledging the benefits of anonymity and speed in dark pools, the SFC official also pointed out there are issues of best execution, price discovery, fragmentation, and transparency, The main issue being debated is that a lack of transparency in dark pool operations deprives the public of fair access to information about the best available prices to some market participants and thus results in a two-tiered market.

Since the dark pool is an institutional market, he emphasized, regulators must study the pros and cons of integrating this institutional trading venue and the trading venue offered by stock exchanges before making any policy changes. The primary focus here should be whether the two-tiered market has created difficulties for regulators to conduct market surveillance. If the presence of dark pools has affected the ability of regulators to supervise the market, he warned, regulators must work together with the industry to identify ways to address this.

The growth of dark pools also calls for a review of the best execution policy since the fragmentation of pricing data makes it difficult for investors to know where they are likely to get the best price for their orders. In some markets, there are rules requiring an exchange to route an order to another exchange or liquidity pool if there is a better price. But such order routing usually incurs costs to investors.

Price discovery is a major function of an exchange market and the efficiency with which it is carried out depends on whether orders from a diverse set of participants are properly integrated so as to achieve reasonably accurate price discovery and reasonably complete quantity discovery. Most of the dark pools determine execution prices with reference to exchange produced prices. If dark pools continue to grow and account for a significant portion of market share, reasoned the official, it will affect the price discovery function currently performed by the exchange market. The question is how can fair market prices be obtained if most transactions are executed on non-displayed markets.

Despite an IOSCO initiative to examine potential regulatory issues associated with dark pools, Mr. Wheatley does not anticipate the international harmonization of dark pool regulation. This is because dark pools have a different appeal to different jurisdictions and, thus, the corresponding regulatory regime will be quite different.

The world’s major financial exchanges have asked the G-20 to examine the erosion of price discovery and dark pools, arising from recent trends. The concerns were voiced in a letter to the Financial Stability Board, which the G-20 has designated as a key player in assuring the cross-border consistency of financial regulation legislation. The letter was signed by William Brodsky, CEO of the CBOE, in his role as Chair of the World Federation of Exchanges. It was endorsed by, among others, NASDAQ, NYSE Euronext, the London Stock Exchange, and the Tokyo Stock Exchange.

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House Legislation Would Provide for Extraterritorial Reach of Federal Securities Laws

Perhaps obviating the need for US Supreme Court review of a case involving the extraterritorial reach of the federal securities laws, House draft legislation would provide for the transnational reach of the antifraud provisions of the Securities Act, the Exchange Act, and the Investment Advisers Act. At the Court’s invitation, the Solicitor General and the SEC filed a brief in which they urged the Court not to take the case, partially because of the pending legislation. The Investor Protection Act, HR 3817, passed the Financial Services Committee this month and could be voted on by the full House in December as part of overall financial reform. There is currently no companion provision in the Senate draft legislation, the Restoring American Financial Stability Act. The case, Morrison v. National Australian Bank, Ltd., Dkt. No. 08-1191, is scheduled for a Supreme Court conference on November 24, 2009, at which time the Court will consider whether to hear it.

Section 215 of the Investor Protection Act would amend the federal securities laws to provide that US district courts have jurisdiction over violations of the antifraud provisions that involve a transnational fraud if there is conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurred outside the U.S. and involved only foreign investors, or, conduct occurring outside the U.S. that has a foreseeable substantial effect within the U.S.

In Morrison, a Second Circuit panel ruled that the US federal securities laws did not apply to foreign investors alleging fraudulent statements by a foreign issuer when the conduct in the US was merely preparatory to the fraud and the acts directly causing loss to investors occurred in a foreign country. This is the so-called foreign-cubed securities fraud action, said the appeals panel, and it is judged by the same standard of any extraterritorial application of the federal securities laws, which is whether actions in the US directly caused the loss to investors. The panel described itself as an American court, not the world’s court, which cannot expend resources resolving cases that do not affect Americans or involve fraud emanating from America. Morrison v. National Australian Bank, Ltd., CA-2, No.07-0583, Oct. 23, 2008

The rapid globalization of financial markets in recent years has cast into stark relief issues surrounding the international reach of US securities laws. Since the federal securities laws are silent on their international reach, federal courts developed tests, including the conduct test, which focuses on the nature of the conduct within the US as it relates to carrying out the alleged fraudulent scheme

A three-way split has developed among the federal Circuit Courts of Appeal as to the proper scope of jurisdiction when conduct within the US results in fraud in connection with a transaction outside the US. The predominant difference among the Circuits is the degree to which the US-based conduct must be related causally to the fraud and the resulting harm to justify the application of the federal securities laws.The Third, Eighth and Ninth Circuits have held that jurisdiction may be exercised when conduct within the US furthered the alleged fraud The Second, Fifth and Seventh Circuits have established a more restrictive test, holding that jurisdiction may be exercised only when conduct occurring within the US directly caused the alleged losses.

Finally, the District of Columbia Circuit has adopted the most stringent test, holding that jurisdiction is proper only when the fraudulent statements or misrepresentations originate in the United States, are made with scienter and in connection with the purchase or sale of securities, and directly cause the harm to those who claim to be defrauded, even if reliance and damages occur elsewhere.

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NYSE Forms Corporate Governance Commission as Legislation Looms

Against the backdrop of pending federal legislation on corporate governance, the NYSE has formed a Commission on Corporate Governance to address U.S. corporate governance reform and the overall proxy voting process for public companies. Chaired by Larry Sonsini of Wilson, Sonsini Goodrich & Rosati, the Commission will take a comprehensive look at the multitude of issues facing directors, management, stockholders, regulators and other constituencies in the on-going public debate about best practices for corporate governance. The Commission will bring together experts and representatives from corporations, stockholder advocacy groups, and regulators in an effort to forge a consensus on a variety of today’s most controversial corporate governance issues. Other members of the Commission will be former Delaware Vice Chancellor Stephen Lamb, now a Paul Weiss partner, former SEC Mike McAlevey, former Deputy Director of the SEC Division of Corporation Finance, now Chief Corporate, Securities and Finance Counsel at GE, Peter Mixon, CalPERS General Counsel, and Hye-Won Choi, Head of Corporate Governance at TIAA-CREF.

Specifically, the Commission will examine stockholder access to corporate proxy cards, including recent developments in state law and the proposed initiatives by the SEC, the overall efficacy and transparency of the proxy voting process, and the role of proxy advisory services, institutional investors and individual investors within the proxy process. More generally, the Commission will review the roles of, and relationships, accountability and communications among, directors, management, stockholders and other corporate stakeholders. Very broadly, the Commission will look corporate governance structures and corporate mechanisms impacting the governance of the corporation.

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Senate Draft Legislation Would Overrule Supreme Court Precedent and Allow Private Right of Action for Aiding and Abetting Securities Fraud

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

The Senate draft legislation, Restoring American Financial Stability Act, would enable investors to sue persons who aid and abet securities fraud. The draft amends Section 21D of the Exchange Act to provide that, in implied private civil securities fraud actions, any person that knowingly or recklessly provides substantial assistance to another person in violation of the securities antifraud rule or any other SEC rule or regulation must be deemed to be in violation to the same extent as the person to whom such assistance is provided.

This draft provision appears to overrule legislatively the US Supreme Court’s 1994 opinion in Central Bank of Denver v. First Interstate Bank that there is no implied private right of action against secondary actors who aid and abet securities fraud. Derivatively, it apparently also overrules the Court’s 2008 ruling in Stoneridge Investment Partners, Inc. v. Scientific-Atlanta, Inc., where the Court held that secondary non-speaking actors said to have participated with a company in a securities fraud scheme were not liable in a private action under Rule 10b-5

Until the Central Bank ruling, every circuit of the Federal Court of Appeals had concluded that a private right of action for securities fraud allowed recovery not only against the person who directly undertook a fraudulent act, the primary violator, but also anyone who aided and abetted the actor. A five-justice majority in Central Bank narrowed the scope of the antifraud rule by holding that its private right of action extended only to primary violators.

The Stoneridge court relied on the earlier Central Bank ruling. These aiding and abetting issues arise when secondary actors engage in conduct with the purpose and effect of creating a false appearance of material fact to further a scheme to misrepresent the company’s revenue. The argument is that the financial statement the company released to the public was a natural and expected consequence of the non-speaking actor’s deceptive acts. Had the actors not assisted the company, the theory goes, the company’s auditor would not have been fooled, and the financial statement would have been a more accurate reflection of the company’s financial condition. That causal link is sufficient to apply a presumption of reliance to the secondary actors.

Citing the Central Bank ruling, the Stoneridge court observed that, since Rule 10b-5 implied private right of action does not extend to aiders and abettors, the conduct of a secondary actor must satisfy each of the elements or preconditions for liability.

On one level, the Stoneridge opinion represented an affirmation of the ruling in Central Bank. The Stoneridge court noted that, in Central Bank, the court said that allowing the aiding and abetting action would mean that defendants could be liable without any showing that investors relied upon the aider and abettor’s statements or actions. Allowing investors to circumvent the reliance requirement would disregard the careful limits on 10b–5 recovery mandated by earlier cases.

The court also noted that the decision in Central Bank led to calls for Congress to create an express cause of action for aiding and abetting within the Exchange Act. Congress did not follow this course. Instead, in section 104 of the Private Securities Litigation Reform Act of 1995 (PSLRA), Congress directed prosecution of aiders and abettors by the SEC. The court construed this to be a conscious decision by a Congress aware of the Central Bank ruling not to legislatively expand the scope of Rule 10b-5 to private rights of action by investors. With the Restoring American Financial Stability Act, the Senate Banking Committee would change the legislative framework and allow private rights of action for aiding and abetting securities fraud.

If the provision is in the final legislation it would have broad implications for investment banks and accountants and other secondary actors. For example, relying on the Central Bank opinion, a Fifth Circuit panel said in an Enron-related case that secondary actors, such as investment banks and accountants, who act in concert with public companies in schemes to defraud investors cannot be held liable as primary violators of Rule 10b-5 unless they directly make public misrepresentations; owe the shareholders a duty to disclose; or directly manipulate the market for the company’s securities through practices such as wash sales or matched orders. This was the ruling the panel in an action alleging that investment banks engaged in transactions that allowed Enron to misstate its financial condition. (Regents of the University of California v. Credit Suisse First Boston, 06-20856, March 19, 2007).

At most, said the appeals court, the banks could have aided and abetted Enron’s deceit by making its misrepresentations more plausible but their conduct did not rise to primary liability under Rule 10b-5. And, under the Supreme Court’s Central Bank ruling, there is no private action for secondary aiding and abetting liability under Rule 10b-5. The investment banks owed no duty to Enron’s shareholders, emphasized the panel.

House and Senate Draft Legislation Would Expand PCAOB Jurisdiction

The Madoff fraud revealed that the Public Company Accounting Oversight Board lacked the power it needed to examine the auditors of non-public broker-dealers. House and Senate draft legislation would close this loophole and bring the auditors of non-public broker-dealers under the PCAOB oversight regime. The legislation would thus provide the Board with authority over the auditors of all brokers-dealers, not just the auditors of public broker-dealers, who would have 180 days to register with the PCAOB.

Additionally, like public companies, brokers-dealers would pay an accounting support fee in proportion to the broker-dealer’s net capital compared to the total net capital of all brokers and dealers that are not issuers. The Board would have investigatory, examination and enforcement authority over the auditors of all broker-dealers The PCAOB would also be authorized to refer investigations to FINRA or other defined self-regulatory organizations and share with them all information and documents received in connection with an investigation or inspection without breaching its confidential status.

Both drafts would also authorize the PCAOB to share information under a confidential regime with foreign regulatory authorities engaged in the investigation and prosecution of violations of applicable accounting and auditing laws without waiving any privileges the SEC may have with respect to such information. Both drafts define a foreign auditor oversight authority as any entity empowered by a foreign government to conduct inspections of public accounting firms or otherwise to administer or enforce laws related to the regulation of public accounting firms.

Both House and Senate draft legislation give the Board discretion to share information with foreign oversight authorities under an investor protection standard so long as they provide assurances of confidentiality to the Board. However, the Senate draft would also require the foreign authorities to describe their information systems and controls, as well as describe the laws and regulations of the foreign government that are relevant to information access.

The House draft, but not the Senate, would enhance the ability of the PCAOB to access the audit work of foreign public accounting firms when they perform audit work, conduct interim reviews, or perform other material services upon which a registered public accounting firm relies in the conduct of an audit or interim review. This statutory change is designed to resolve international conflicts that have impaired the PCAOB’s ability to fulfill its statutory obligation to inspect non-U.S. registered public accounting firms.

The Garrett Amendment to the House legislation would change the name of the PCAOB to Auditor Oversight Board. In addition, the Jenkins-Garrett Amendment would create an ombudsman within the Auditor Oversight Board to act as a liaison between the Board and registered accounting firms and issuers with regard to the issuance of audit reports. The ombudsman would also deal with any problem that registered firms or issuers may have in dealing with the Board resulting from the Board’s regulatory activities, particularly with respect to internal control over financial reporting and audit attestation under Section 404 of Sarbanes-Oxley. There are no comparable provisions in the Senate draft.

The Putnam Amendment to the House draft provides that nothing in the Sarbanes-Oxley Act provisions creating the PCAOB affects the Board’s obligations, if any, to provide access to records under the Right to Financial Privacy Act. The amendment also provides that nothing in those Sarbanes-Oxley provisions authorizes the Board to withhold information from Congress or prevents the Board from complying with a federal court order in an action commenced by the US or the Board. There is no comparable Senate provision.

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Key UK Committee Urges EU to Go Slow on Financial Stability Legislation

The UK Treasury Committee has urged the European Union to take more time on legislation establishing a systemic risk regulatory framework centered on a new European Systemic Risk Board and new European Supervisory Authorities for banking and securities, replacing CESR and other Lamfalussy Level 3 committees. The UK Committee has concerns about the size and composition of the Board and unease about the power the European Supervisory Authorities would have to override the decisions of national regulators. Similarly, there are concerns that the European Commission will have unilateral power to declare an emergency, which will further empower the Supervisory Authorities to direct national regulators.

The European Commission proposed the detailed legislative reform proposals in September of 2009. The EU Presidency is pressing for their adoption by ECOFIN at the European Council meeting on December 2. The Treasury Committee considers that to be much too fast for the adoption of a systemic risk framework that should last for many decades. There must be proper time for consideration.

The Commission proposed that the Board would carry have macro prudential oversight to look for systemic weaknesses in the financial system, while the sectoral Supervisory Authorities would co-ordinate micro prudential regulation. The Board, composed of central banks with voting rights and national regulators without such, would not have any direct power; its task will be to monitor systemic risk and issue warnings to appropriate authorities.

The fast track timetable for the legislation would be less worrying if the proposals were without controversy, said the Committee, but they are not. In fact, the Committee found cause for serious concern about the size and composition of the Board and the delegation of discretionary power to the European Supervisory Authorities to override the decisions of national regulators. There are also concerns that the Commission would have unilateral power to declare an emergency, which will empower the supervisory authorities to further direct national regulators. Significantly, the proposals do not appear to give due weight to ECOFIN’s own earlier admonition that the measures should not impinge on the fiscal responsibilities of the Member States.

The legislation, for example, would authorize the Securities Supervisory Authority to settle disagreements when there is a dispute between national regulators as to practices and, if its decision is not accepted by a national regulator, to adopt an individual decision addressed to an individual market participant. In the Committee’s view, this comes very close to giving the Supervisory Authority the power to directly regulate individual market participants. There is also fear that the Securities Authority could fundamentally undermine the proven system of takeover regulation in the UK, since it could issue guidelines undermining the flexibility given to national regulators and disrupt effective takeover regulation.

While UK Finance Services Secretary Lord Myners envisions that the Supervisory Authorities will not regulate individual firms but rather will work to achieve common regulatory standards, the committee said that the regulations as currently drafted would allow them to override the decision of a national regulator and to direct individual institutions.

Also, the legislation authorizes the Commission to declare an emergency when the financial stability of the markets is threatened. Once an emergency has been declared, a Supervisory Authority can adopt individual decisions requiring competent authorities to take the necessary action in accordance with the legislation to address any risks that may jeopardize the orderly functioning and integrity or stability of the financial markets by ensuring that financial institutions satisfy the requirements laid down in the legislation. If the competent authorities do not act, the Supervisory Authority has a reserve power to direct individual financial institutions.

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