SEC Releases Mandated Mark-to-Market Study

Yesterday, the SEC released its study on mark-to-market accounting mandated by the Emergency Economic Stabilization Act 0f 2008. The report recommends against suspending fair value accounting standards, but does recommend changes to the accounting for significant impairments and the development of additional guidance for determining fair value of investments in inactive markets, including situations where market prices are not readily available.

Among its key findings, the report finds that investors and market participants generally believe fair value accounting increases financial reporting transparency and facilitates better investment decision-making. The report also observes that fair value accounting did not appear to play a meaningful role in the bank failures that occurred in 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and in certain cases, eroding lender and investor confidence.

Rather than a crisis precipitated by fair value accounting, the crisis was a “run on the bank” at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm.  This was, in part, the result of the massive de-leveraging of balance sheets by market participants and reduced appetite for risk as margin calls increased, putting enormous pressure on asset prices and creating a “self-reinforcing downward spiral of higher haircuts, forced sales, lower prices, higher volatility, and still lower prices.

While the report does not recommend suspending existing fair value standards, it makes certain recommendations to improve their application, including:

• Development of additional guidance and other tools for determining fair value when relevant market information is not available in illiquid or inactive markets, including consideration of the need for guidance to assist companies and auditors in addressing:

• How to determine when markets become inactive and whether a transaction or group of transactions are forced or distressed
• How the impact of a change in credit risk on the value of an asset or liability should be estimated
• When should observable market information be supplemented with and/or reliance placed on unobservable information in the form of management estimates
• How to confirm that assumptions utilized are those that would be used by market participants and not just a specific entity

• Enhancement of existing disclosure and presentation requirements related to the effect of fair value in the financial statements.
• Educational efforts, including those to reinforce the need for management judgment in the determination of fair value estimates.
• Examination by the FASB of the impact of liquidity in the measurement of fair value, including whether additional application and/or disclosure guidance is warranted.
• Assessment by the FASB of whether the incorporation of credit risk in the measurement of liabilities provides useful information to investors, including whether sufficient transparency is provided currently in practice.

The report also recommends that FASB revisit its guidance on significantly impaired financial instruments, including consideration of narrowing the number of impairment models under U.S. GAAP. The report finds that under existing accounting standards, information about impairments is calculated, recognized, and reported differently based on the type of asset. The report recommends improvements in this area, including:

1. reducing the number of models utilized for determining and reporting impairments,
2. considering whether the utility of information available to investors would be improved by providing additional information about whether current declines in value are consistent with management expectations of the underlying credit quality, and
3. reconsidering current restrictions on the ability to record increases in value (when market prices recover).

The full text of the Mark-to-Market Study is available at: http://www.sec.gov/news/studies/2008/marktomarket123008.pdf

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Indexed Annuities under the SEC’s Eye

Earlier this month, the SEC adopted new final rules,based on a June 25, 2008 proposal, governing indexed annuities. This new Securities Act Rule 151A is intended to clarify the SEC’s position on the regulatory status of indexed annuities, a type of annuity that ties contract values to the performance of an index.  Rule 151A defines “indexed annuities,” and requires indexed annuities that satisfy the rule’s definition and are issued on or after January 12, 2011 to register under the Securities Act.

Section 38(a)(8) of the Securities Act exempts annuity contracts and optional annuity contracts from regulation under the Securities Act.  But, the Section 38(a)(8) exemption is not available to all contracts that are “annuity contracts” under state law (e.g., variable annuities). Whether or not indexed annuities fell within the scope of the exemption, however, had not been clarified until now.  Under the new rule 151A, indexed annuities are not “annuity contracts” and are not exempt from the Securities Act if the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract.  The rule also provides a principles-based manner in which this determination is made.  It is this principles-based method that generated the bulk of the nearly 4,800 comments to the proposal.

According to Commission Staff comments at the December 17th open meeting, Rule 151A as adopted differs from the proposed version in that: 

• It does not contain the requirement that the insurance company re-assess the status of each indexed annuity every three years. 
• In response to comments received, the scope of the rule was made narrower and clarifications were made because the rule as originally proposed might unintentionally have been interpreted to apply to traditional fixed annuities, which now remain outside the scope of Rule 151A. 

Rule 151A was proposed, and subsequently adopted, because the dramatic increase in the popularity of indexed annuities since the product was introduced in the mid 1990s, coupled with increased incidence of abusive sales practices and deceptive sales to seniors, prompted the SEC to provide clarification of their status under Section 3(a)(8).  This rule adoption has not come without controversy, however. Commissioner Paredes voted against adoption, and took the unusual step of insisting his dissenting remarks be published in the Federal Register. His dissent rests on legal grounds, in particular that Rule 151A exceeds the SEC’s regulatory authority and that courts interpreting the scope of the SEC’s power under Section 38(a)(8) does not support SEC authority extending to the regulation of indexed annuities.  His dissent also opposes the principles-based method of determining if an indexed annuity falls under the Rule 151A requirements.  Commissioner Paredes’ analysis follows that of some of the commenters opposing the rule proposal, and is sure to provide a road map for challenge to the new rule. 

The final rule release is not yet available on the SEC’s website, but the proposing release may be found at:  http://www.sec.gov/rules/proposed/2008/33-8933fr.pdf

The full text of Commissioner Paredes’ dissenting remarks is available at:  http://www.sec.gov/news/speech/2008/spch121708tap.htm

An archived webcast of the December 17, 2008 open meeting is available at:  http://www.connectlive.com/events/secopenmeetings/

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The Forum’s Ninth Annual Policy Conference, May 4th – 5th, 2009

Each year, the Forum holds a two-day Policy Conference bringing independent directors together with legislators, regulators, and other industry experts to discuss issues of critical concern to fund directors. Through a series of panel discussions and break-out sessions, the conference focuses on information that help directors understand their complex challenges and help them become better, more effective, independent directors. Every Policy Conference also includes a look at the “Future of the Fund Industry” providing insight into tomorrow’s issues. Given recent market developments, and the continually evolving regulatory and legislative responses, the future of the fund industry is certain to be foremost in everyone’s mind.  Though focused on the informational needs of fund independent directors, registration for the Policy Conference is open to all. 

The Ninth Annual Policy Conference will be held on May 4th and 5th, 2009 at the Ritz-Carlton Hotel in Washington, DC.  The program will begin on Monday, May 4th with breakfast at 8:00 am and conclude with lunch on Tuesday, May 5, 2009.

Forum members will receive an event brochure in the mail shortly.  For more details on the topics expected to be covered at the Policy Conference, as well as information on how to register and special hotel room rates at the Ritz Carlton for conference attendees, please visit the Ninth Annual Policy Conference web page at:  http://www.mfdf.com/PolicyConference.html

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Congressional Oversight Panel Issues Its First Report

The Congressional Oversight Panel (the “Panel”), chaired by Elizabeth Warren, issued the first of its series of reports on December 10, 2008. 

The report begins by laying out, in the Panel’s own words, the purpose of the Panel and the ambitious goal of its first report:

We are here to investigate, to analyze and to review the expenditure of taxpayer funds. But most importantly, we are here to ask the questions that we believe all Americans have a right to ask: who got the money, what have they done with it, how has it helped the country, and how has it helped ordinary people?   These questions, in greater detail, form the heart of this report.

This report, issued two weeks after the Oversight Panel’s first meeting, does not attempt to answer the questions Congress and the American people have about the use of the powers granted to Treasury under the Emergency Economic Stabilization Act of 2008. Rather we seek to pose those questions clearly in the context of the events that have occurred since the adoption of the Act in October. In doing so, we intend to set the agenda for our future work and to advise the Congress as to the issues that it will need to address in the next Administration.

To that end, the report then poses ten questions it sees as the heart of the Panel’s mission:

1. What is Treasury’s Strategy?
2. Is the Strategy Working to Stabilize Markets?
3. Is the Strategy Helping to Reduce Foreclosures?
4. What Have Financial Institutions Done with the Taxpayers’ Money Received So Far?
5. Is the Public Receiving a Fair Deal?
6. What is Treasury Doing to Help the American Family?
7. Is Treasury Imposing Reforms on Financial Institutions that are taking Taxpayer Money?
8. How is Treasury Deciding Which Institutions Receive the Money?
9. What is the Scope of Treasury’s Statutory Authority?
10. Is Treasury Looking Ahead?

Though the purpose of the report is merely to pose these questions, and not to answer them, it does an excellent job of summarizing the complex set of recent market events, and the Treasury’s reactions to them, making some indications of the Panel’s assessment of their effectiveness.  The discussion of the individual questions provides considerable context for each and places some much needed parameters around how the Panel intends, through regular reports, to:

• oversee the Treasury’s actions,
• assess the effect of spending to stabilize the economy,
• evaluate market transparency,
• ensure effective foreclosure mitigation efforts, and
• gurantee that Treasury’s actions are in the best interest of the American people.  

Interestingly, one of the Panel’s four members, Congressman Jeb Hensarling (R-TX), dissented from this first report, either because he feels that the Panel does not have the resources and rights necessary for effective oversight, or because he feels that there is insufficient transparency and accountability in the panel’s processes.

In order to be an effective advocate for the American taxpayer, I have to ensure that every panel member has the resources and rights necessary to conduct effective oversight.  I must also ensure that the panel adopts a serious agenda that truly brings transparency and accountability to the process.  I have raised my concerns but thus far, perhaps due to the exigency of the circumstances, they have not yet been addressed.

Until I conclude that these important issues are addressed, and that all taxpayers can be sure that their voices are represented, I cannot in good conscience approve any reports.

Hensarling Statement on First Congressional Oversight Panel Report

Hensarling makes clear in his dissent that he opposed the TARP from the beginning.  Now, serving on the body assigned to oversee the TARP, it will be interesting to see how his initial opposition to the program will figure into the Panel’s work going forward.

The full December 10, 2008 report is available at: http://cop.senate.gov/documents/cop-121008-report.pdf

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Scholar Examines the Effect of the Tax Code on US Mutual Funds

Harvard Law School professor, John C. Coates IV, has recently published a paper examining the taxation of U.S. mutual funds and, in particular, how this tax treatment may create disadvantages for U.S. mutual funds in the global market.  Coates previewed a draft of the paper, entitled “Reforming the Taxation and Regulation of Mutual Funds: A Comparative Legal and Economic Analysis,” at the October 27, 2008 roundtable of the Conference of Fund Leaders, which was sponsored by the Mutual Fund Directors Forum and the Millstein Center for Corporate Governance and Performance at Yale’s School of Management.  The Forum invited Coates to discuss the paper with the fund independent chairs and lead independent directors at the October CFL roundtable because of his analysis of and conclusions about the effect of tax treatment of U.S. mutual funds on the international competitiveness of U.S. mutual funds. 

Coates’ analysis finds that the tax treatment of U.S. mutual funds has a strongly negative effect on the global competitiveness of domestic mutual funds: 

• Mutual funds are taxed less favorably and regulated more extensively in the US than direct investments or other collective investments, including alternatives available only to wealthy investors;

• The US fund industry continues to be the world leader, but now lags domestic and foreign competitors, primarily because of US tax and securities law.

Coates’s paper also proposes certain internal structural and regulatory changes to the SEC, but his proposals for changes to the tax treatment of U.S. mutual funds clearly would require Congressional action.  His paper makes clear that these proposals would have a significant effect on the competitive position of U.S. mutual funds in the global market.

 Among the  proposals Coates analyzes are:

• eliminating taxes on capital gains;
• eliminating corporate-level taxation;

• eliminating the requirement that mutual funds distribute capital gains or long-term capital gains; and

• adding mutual funds to the list of publicly held funds that are permitted to use true pass-through tax treatment.

Professor Coates’ paper brings some long awaited academic data and analysis to support what many, if not most, in the U.S. fund industry have suspected for quite some time about the disadvantages the U.S. Tax Code places on domestic mutual funds. As U.S. funds face increasing global pressures, Coates’ data and conclusions may help clarify for policymakers and regulators the competitive issues that funds face. 

The full text of the December 1, 2008 draft of Coates’ paper is available at:  http://www.ignites.com/pdf/2008/12/ssrn-id13119451.pdf

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Interactive Data for Mutual Fund Risk/Return Summaries

On December 18, 2008, the SEC approved final rules requiring mutual funds, starting in 2011, to include data tags in their public filings supplying investors with such information as objectives and strategies, risks, performance, and costs.  The Commission believes that requiring funds to add electronic tags to the risk/return summary portion of their prospectuses, and making this tagged data available via the Internet, will allow investors to compare mutual funds easily using simple software and readers.  It should be noted that the Commission is not requiring a fund’s entire prospectus to be tagged in this way, only the fund’s risk/return summary. 

The final rule release will be available on the SEC’s website in upcoming weeks.  The June 10, 2008 proposing release is available at:  http://www.sec.gov/rules/proposed/2008/33-8929fr.pdf

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OCIE Director: Surveillance and Risk-Based Fund Overight

Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations, addressed the ICI’s Securities Law Development Conference on December 16, and shared her thoughts on how SEC oversight of mutual funds might be improved by the greater use of technology and data analysis.

Given the demographics in the mutual fund industry in recent years — the number of advisers that operate a mutual fund, the dollars managed by mutual funds, and the number of investors who rely on mutual funds as their primary investment vehicle — as well as recent portfolio losses — it is more critical now than ever that the SEC provide sound oversight. We have identified ways in which our oversight of mutual funds could be improved, and I wanted to share these ideas with you today.

Richards pointed out that the great increase in the number of advisers and funds caused OCIE switched to a risk-based approach designed to scrutinize those funds, advisers and issues that appear to present the greatest potential for having an adverse effect on investors.  Richards also stressed that establishing and maintaining an effective risk-based oversight program requires active surveillance utilizing timely and continuing access to a set of reliable information about each firm under surveillance to be able to gauge the relative compliance risk, and to monitor changes to these risk profiles over time. 

Potentially, such a surveillance system might seek to identify indications of things like mispricing, liquidity concerns, lack of diversification, and deviations from stated investment objectives. With respect to money market funds, such a system might seek to identify funds that hold securities in troubled issuers and those that may be at risk of breaking a dollar.

. . .

[C]reating a surveillance function would provide certain benefits of efficiency to mutual funds and to the SEC staff. If we were to routinely surveil key data, we would be able to better evaluate certain risks being assumed by mutual funds and could reduce the time spent doing this work during exams. In addition, with data already available, we’d be able to narrow in and focus our examinations on particular funds and particular issues.

At the present, most SEC filings by mutual funds, like Form N-SAR, are in an unstructured, text-based format, lack certain portfolio-level identifying information, and are not timely enough to provide the data needed for a robust surveillance program.  To implement an effective surveillance program for the fund industry, Richards listed general fund-level information she thinks should be filed in a meaningful and searchable format useable by OCIE’s staff:

• NAV per share;
• the shadow price for money market funds; the total net assets and shares outstanding;
• percentage of the portfolio that is fair valued; percentage of the portfolio that is illiquid;
• a description of each share class and the primary investment objective or style of the fund.

Data might also include specific information concerning each portfolio security held by the fund. Additional data from advisers might include the identity of the audit firm, the custodian of customer assets, and other data.

Given easy access to this fund specific data, Richards said that the OCIE staff could perform electronically a number of analyses now only performed during routine on-site inspections, potentially identifying, for example, indications of mispricing, valuation anomalies, liquidity concerns, deviations from investment objectives and risk-taking beyond that which was disclosed. 

Richards indicated that the kind of data she envisions could be XML-based, like the Commission’s current Interactive Data initiatives, and either may be integrated into the SEC’s EDGAR system or set up externally.  Because such a system would require Commission rulemaking, or even legislation, Ms. Richards aksed for the cooperation of the Commission and the industry in making the system she envisions possible.

I hope that the SEC staff and the fund industry will work together to further explore the ideas I have described this morning, based on our shared commitment to seek the greatest level of investor protection.

The full text of Ms. Richards’ address is avaiable at:  http://www.sec.gov/news/speech/2008/spch121608lar.htm

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Mary Schapiro to be Nominated to Head the SEC

President-Elect Obama announced that he plans to nominate Mary Schapiro, currently Chief Executive Officer of FINRA (which is the successor organization to the NASD), to be Chairman of the SEC.  Following his inauguration next month, President-Elect Obama will submit her name to the Senate, which must vote to confirm her appointment to the five-member SEC.  Following that confirmation, the President has the power to appoint her as Chairman. 

The announcement came well before the time at which other incoming administrations have turned to selecting an SEC Chairman.  In the past the agency has operated under an “Acting Chairman” well after an inauguration, with many Chairmen having being appointed in the summer following an inauguration.  Clearly, recent events have given the issue of who is to lead the SEC greater prominence.

One reason Mary Schapiro may have been President-Elect Obama’s early choice for leading the SEC is that her previous positions give her much needed experience in addressing the challenges ahead for the agency.  She previously served as a Commissioner of the SEC, being appointed in 1988 by President Reagan, reappointed by President Bush in 1989 and named Acting Chairman by President Clinton in 1993.  Schapiro then headed the Commodity Futures Trading Commission, which is responsible for regulating the US futures markets, including financial, agricultural and energy markets.  Lately, there has been considerable discussion about whether to merge many of the oversight responsibilities of the CFTC with the SEC.  Her experience at both regulatory entities may give her a unique perspective on how to successfully merge regulatory functions in a manner that will strengthen our markets and restore investors’ confidence. 

Schapiro will come in to the Chairmanship of the SEC with a long and deep understanding of the financial markets and investment advisory firms.  She was a strong and early proponent of the “summary prospectus,” arguing that lengthy disclosures impede investors’ ability to understand products, and that forcing firms to print and mail disclosures few investors want or read is a waste of resources.

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Donohue Looks Back at 2008 and Forward to 2009

In his recent speech at the ICI’s December 15, 2008 Securities Law Developments Conference, Andrew J. Donohue, Director of the SEC’s Division of Investment Management, took a look back at where the Division had been over the course of the year and discussed some of the Division’s accomplishments and lessons learned.  He also gave some hints at where the Division may spend some of its energies in the upcoming year. 

Among Donohue’s list of IM’s accomplishments were:

• The adoption of the Summary Prospectus.  Mr. Donohue stated that he was sure this new document would be a success because it is “a result of a productive collaboration among the Commission, the fund industry and fund investors.” He also characterized this rulemaking as the instance when we were finally successful in providing fund investors the key information they need in a user-friendly format, the culmination of many years of effort.
• Money Market Funds.  Donohue recounted some of the challenges faced by money market funds during the latter half of this year, and mentioned that one of the priorities of the Division in 2009 would be a review of the money market fund model and its regulatory regime.  He expressed a hope that the kind of collaboration between the SEC, industry, and investors that made the Summary Prospectus possible could be employed in crafting more effective money market fund regulation. 
• Auction Rate Preferred Securities. The Division’s Exemptive Applications Office, along with the Chief Counsel’s Office, played a leading role in the development of regulatory actions intended to better enable the closed end fund industry to address the freeze in the auction rate preferred securities market.   

• Rule 12b-1 and Recordkeeping Reform.  Mr. Donohue admitted his disappointment that the Division was not able to fulfill his plans for rule 12b-1 reform and investment adviser recordkeeping modernization. But he did promise subtantial work on both issues in 2009, in particular with regard to resolving “a fundamental concern about rule 12b-1 — namely that the rule provides for an alternative means of paying a sales load, but those 12b-1 fees are not treated, regulated or disclosed as a sales load.”

The full text of Mr. Donohue’s address is available at:    http://www.sec.gov/news/speech/2008/spch121508ajd.htm
 

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Fund Audit Committees and PCAOB No. 3

When dealing with their fund’s audit firm, directors and trustees serving on the board’s audit committee may find it useful to familiarize themselves with the PCAOB’s Auditing Standard No. 3 on audit documentation.  Knowing the general requirements for documentation imposed on auditors can help audit committee members, particularly newer directors, better communicate with their auditors and help them understand the way the auditors will memorialize the planning and performance of their work, the procedures performed, evidence obtained, and how and when they will document their conclusions. 

Among other things, PCAOB No. 3 sets out how significant findings or issues will be documented by auditors.  “Significant findings or issues” include a list of things high on an effective audit committee’s radar screens during an audit:

1. Complex or unusual transactions involving assumptions and estimates.
2. Results of auditing procedures that indicate a need for significant modification of planned auditing procedures, the existence of material misstatements, omissions in the financial statements, the existence of significant deficiencies, or material weaknesses in internal control over financial reporting.
3. Audit adjustments.
4. Disagreements among members of the engagement team or with others consulted on the engagement about final conclusions reached on significant accounting or auditing matters.
5. Circumstances that cause significant difficulty in applying auditing procedures.
6. Significant changes in the assessed level of audit risk for particular audit areas and the auditor’s response to those changes.
7. Any matters that could result in modification of the auditor’s report.

These are all matters an engaged audit committee would want to know about well before the end of the audit.  A working knowledge of Auditing Standard No. 3, particularly the Appendices, is an excellent way for audit committee members to understand what the auditors are doing, and manage communications with the auditors both before, during, and after the audit. 

The full text of Auditing Standard No. 3 is available at: http://www.pcaobus.org/Rules/Rules_of_the_Board/Auditing_Standard_3.pdf

The text of conforming amendments to Auditing Standard No. 3 is available at:  http://www.pcaobus.org/Rules/Rules_of_the_Board/Conforming_Amendments_AS5.pdf

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