FINRA’s Grace Vogel Urges Firms to Re-examine Risk Assessment Functions

FINRA’s Executive Vice President of Member Firm Regulation, Grace Vogel, addressed the New York Regulation and Compliance Conference on September 9 urging firms to seriously reexamine their processes for assessing risk. Ms. Vogel stressed that the nature of firms’ risks have changed dramatically, and warned that part of the failure of firms in recent years to foresee and mitigate the current market distress was that their risk management programs were focused on outdated models and missed the perils presented by a quickly shifting market landscape.

While all this was happening, the firm’s risk managers made faulty assumptions—which they would pay dearly for.

They believed that all mark-to-market positions would receive immediate attention when losses occurred. And they assumed that if the market took a hit they could liquidate their positions quickly, especially triple-A rated securities. The risk group thought they were correctly focusing on the noninvestment grade paper and didn’t pay enough attention to the ever growing highly rated assets that were becoming illiquid. They had not fully appreciated that 20 percent of a very large number could cause much greater losses than 80 percent of a small number.

. . .

Today we face a different world—and we need to prepare ourselves to fight a new war against risk—operating under new assumptions and using innovative tactics.

. . .

It became clear to us that, in many cases, risk management systems simply broke down. There was an over-reliance on internal models, teaching us again the painful lesson that models only work within a certain confidence interval and management needs to supplement models with robust stress testing.

Ms. Vogel also impressed upon her audience that the very nature of market risk itself has changed, and that these risks can be extraordinarily widespread and instantaneous.

But it isn’t just FINRA—every regulator is figuring out how a change in its approach can increase market stability. Because if we’ve learned one thing from this crisis, it’s that the structural risks inherent in our modern financial system no longer impact one institution or sector at a time.

Risk now reverberates throughout the entire marketplace in an instant, threatening firms and exposing investors to harm.

Vogel further observed that, though the regulatory structure of the financial markets is being reassessed, there are limits to functional regulation, and effective and robust risk assessement at each regulated firm is vitally important to restoring confidence in the markets.

We regulators can write rules, conduct examinations, and bring cases, but it’s you, in the firms, on the front lines, who carry an important share of the regulation of the industry.

You see what goes on day to day and can spot small problems before they become large ones. You’re the ones who develop specific practices and policies from our rules and guidance, to make regulation work in concert with your business, not against it.

The full text of Ms. Vogel’s address is available at: http://www.finra.org/Newsroom/Speeches/Vogel/P116960

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Push to Establish Financial Product Safety Commission

The Consumer Federation of America has announced that it, along with its allies, intends to push for the creation of an agency, similar to the Consumer Product Safety Commission, to regulate financial services products. This proposed Financial Product Safety Commission would regulate the offerings of financial and credit products, currently regulated by a complicated set of state and federal laws and agencies, like home mortgages, credit cards, and car and other consumer loans.

Chief among the proposed agency’s proponents is Elizabeth Warren, a law professor at Harvard University, recently named as head of the Congressional Oversight Panel, the five-member board overseeing the Troubled Asset Relief Program. Warren announced recently in an address before the Consumer Federation of America that she strongly supports the agency, and that she would continue to advocate for its creation. Warren has some powerful allies in Congress. Senate Majority Whip Dick Durbin (D-Ill.) introduced legislation that would create such an agency, and Senator Christopher Dodd (D-Conn), chairman of the Senate Banking Committee, will likely be receptive to the idea of a Financial Product Safety Commission, given his promise to support legislation designed to reign in what Warren and others have characterized as abusive and unfair practices of credit card companies.

What such an agency would mean to the investor protection efforts of FINRA and the Securities and Exchange Commission is uncertain. It is certain, however, that a Financial Product Safety Commission would be opposed by an array of powerful interests, including banks, credit card companies, insurance companies, and providers of mortgage products.

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SEC Deputy Chief Accountant on the Future of Mark-to-Market Accounting

In an address before the 2008 AICPA National Conference on Current SEC and PCAOB Developments on December 10, 2008, James L. Kroeker, Deputy Chief Accountant at the SEC, provided some small insight into the direction the Commission may be heading with regard to mark-to-market accounting.  Avoiding the finer points of the ongoing debate about mark-to-market accounting, Mr. Kroeker framed his comments in areas where the Commission is finding concensus among investors, companies, and other market participants affected by current market conditions.

[T]he input we have received to-date makes clear that there is room for improvement in the current accounting and reporting framework. For example, there appears to be general agreement that investors could be better served by a more stream-lined model for addressing impairments of assets that are not held for trading purposes. Most agree that the current framework for impairment can be challenging to apply, and the utility of information to investors can be improved.

As a second example, investors have clearly indicated a view that the current concept of mark-to-market accounting increases the transparency of reported financial information, and they have indicated how important this has been to them in the current environment. However, where inactive or illiquid markets exist for a given instrument, we have heard from many that additional training and tools would be helpful as preparers and auditors address front-line issues.

As a last example, and in line with one of the recommendations of the SEC’s recent Advisory Committee on Improvements to Financial Reporting, we have again heard about the importance of fostering an environment where reasonable judgments are both developed and respected.

These remarks indicate that investors, companies, and other market participants see beneficial value in the continued use of mark-to-market accounting, but perhaps with alterations or clarifications for assets not held for trading, and in instances where markets for a security are inactive or illiquid.  The key point is that investors, companies, market participants, and regulators seem to have expressed a preference for a model in which reasonable and well-founded judgements in fair valuation can still provide the most transparency and quality. 

The full text of Mr. Kroeker’s address is available at:  http://www.sec.gov/news/speech/2008/spch120808jlk.htm

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Treasury Money Funds Turn Away New Investors

Bloomberg reports that as the yields of Treasury securities continue to fall, and investors flee for the perceived safety of money funds, money market mutual funds investing mostly in U.S. Treasury securities have started to turn away new investors to protect fund yields.  Shutting out new investors protects existing investors in the fund because the fund does not have to purchase new treasuries with lower yields than those already in the fund’s portfolio.  Higher fund yields also generate higher management fees. 

This December 4, 2008 Bloomberg.com article by Miles Weiss and Christopher Condon provides some details on the larger funds that have closed to new investors, and some of the prevailing conditions driving those decisions:  http://www.bloomberg.com/apps/news?pid=email_en&refer=home&sid=aq_FV92tPkRI

 

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Rules Implementing the Credit Rating Agency Reform Act

Director of the SEC’s Division of Trading and Markets, Erik Sirri’s, opening remarks before the Commission’s December 3 open meeting provide an excellent summary of the Commission’s actions to strengthen regulation of credit rating agencies, known as “NRSRO’s.” 

The recommended rules are designed to promote the substantive goals of the Credit Rating Agency Reform Act of 2006 — to increase transparency and disclosure, to diminish or eliminate conflicts of interest, and to strengthen the oversight of NRSROs.

At the open meeting, the Commission adopted final rules, proposed in June of 2008, that increase reporting requirements for NRSROs regarding their internal assessments and processes to allow users of credit ratings to gain a better understanding of the methods employed by the NRSROs to determine and monitor credit ratings. Under these new rules, NRSROs will be required to disclose:

1. whether and, if so, how much verification performed on assets underlying or referenced by a structured finance transaction is relied on in determining credit ratings;
2. whether and, if so, how assessments of the quality of originators of structured finance transactions play a part in the determination of the credit ratings; and
3. the frequency of its surveillance efforts and how changes to its quantitative and qualitative ratings models are incorporated into the surveillance process. 

The new rules also impose expanded recordkeeping requirements on NRSROs to determine if they are following their own methods in their ratings actions, whether further disclosure was necessary, and facilitate Commission examinations.

The rules adopted on December 3 also add three new prohibited conflicts to Rule 17g-5(c):

1. The first amendment prohibits an NRSRO from issuing a credit rating with respect to an obligor or security where the NRSRO or a person associated with the NRSRO made recommendations to the obligor or the issuer, underwriter, or sponsor of the security about the corporate or legal structure, assets, liabilities, or activities of the obligor or issuer of the security. This amendment, in effect, would prohibit an NRSRO from rating its own work.
2. The second amendment prohibits a person within an NRSRO who has responsibility for participating in determining credit ratings or for developing or approving procedures or methods used for determining credit ratings from participating in any fee discussions, negotiations, or arrangements. The purpose of this amendment is to remove the persons most directly involved in making the judgments that credit ratings are based on from fee negotiations and, thereby, insulate them from a process that could make them more or less favorably disposed toward a client or class of clients.
3. The third amendment would prohibit NRSRO personnel who participated in determining or monitoring a credit rating from receiving gifts, including entertainment, from the obligor being rated, or from the issuer, underwriter, or sponsor of the securities being rated, other than items provided in the context of normal business activities such as meetings that have an aggregate value of no more than $25. The purpose of this rule is to eliminate the potential undue influence that gifts can have on those responsible for determining credit ratings.

In addition to the rules adopted, the Commission’s staff proposed additional amendments that would require NRSROs to disclose ratings history information for 100% of their current issuer-paid credit ratings in an XBRL format. The rule would apply only to issuer-paid credit ratings determined after June 25, 2007 (the effective date of the Rating Agency Act).  According to Mr. Sirri:

The purpose of this proposed amendment is to provide users of credit ratings, investors, and other market participants and observers with the maximum amount of raw data with which to compare how NRSROs initially rated an obligor or security and, subsequently, adjusted those ratings, including the timing of the adjustments. The Commission believes that requiring the disclosure of the ratings action history of each issuer-paid credit rating would create the opportunity for market participants to use the information to develop performance measurement statistics that would supplement those required to be published by the NRSROs themselves in Exhibit 1 to Form NRSRO.

The full text of Mr. Sirri’s opening remarks is available at:  http://www.sec.gov/news/speech/2008/spch120308ers.htm

The full texts of the final and proposing releases will be availalble shortly on the SEC’s website. 

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Stradley Ronon: Seven Things Directors Should Know About D&O Insurance

Stradley Ronon’s Craig R. Blackman and Heather M. Tashman have written a short piece, “Insurance and Banking Coverages: Seven Things Fund Directors and Trustees Should Know,” alerting investment company directors to key points they should consider when renewing or obtaining new D&O insurance. 

The article addresses the following seven questions directors should ask, providing a short explanation for each about why the question is important for directors and trustees to consider. 

1. Who is the insured under the insurance policy or fidelity bond?

2. Is the amount of coverage under the insurance policy or fidelity bond sufficient to protect against the risk?

3. Is there more than one insured under the insurance policy or fidelity bond?

4. What exclusions are contained in the insurance policy?

5. Does the policy exclude coverage for certain activities by endorsement?

6. Does the insurance policy provide for notice obligations in certain events such as cancellation, termination or modification? Who should receive notice?

7. Does the policy provide for interim payment of defense costs?

The full text of the article is available at:  http://www.stradley.com/newsletters.php?action=view&id=404

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No-Action Relief Allowing Participation in Global Credit Facility

The SEC staff issued a no-action letter providing relief under Section 17(d) and Rule 17d-1 of the 1940 Act allowing registered U.S. open-end investment companies and certain foreign open-end investment funds managed by affiliated advisers to enter into a joint global, unsecured, senior committed line of credit with a syndicate of global banks (a “Global Credit Facility”).  This Global Lending Facility is designed to provide the Funds with a source of cash for temporary and emergency purposes to meet unanticipated or unusually large redemption requests by shareholders.

The funds sought SEC relief out of concern that such an arrangement, whereby each of the affiliated funds participating in the Global Credit Facility –both domestic and foreign– would pay a portion of the associated fees, may violate Section 17(d) and Rule 17d-1, which generally do not permit an affiliated person of a mutual fund acting as principal to effect any transaction in which the fund is ajoint (or joint and several) participant. 

Because the Global Credit Facility would be similar, except for the participation of foreign funds, to the joint credit facilities for which the SEC staff previously has provided no-action relief,¹ the no-action letter reasons that the Foreign Funds’ participation did not change significantly the analysis under Section 17(d) and Rule 17d-1.

The SEC staff also required the following representations with respect to the foreign funds participating in the Global Credit Facility:

• In making its initial and annual best interest determinations about a U.S. Fund’s participation in the Global Credit Facility, the U.S. Fund’s board of trustees, including a majority of the independent trustees, will consider any unique issues presented by participating in the facility with the Foreign Funds.

• Regardless of whether the law of any foreign jurisdiction would impose any limits on borrowing by a Foreign Fund, at a minimum, none of the Foreign Funds would be permitted to borrow more than the amount permitted for a U.S. Fund under section 18 of the [1940] Act.

The full text of the no action letter is available at:  http://sec.gov/divisions/investment/noaction/2008/franklintempleton112108.htm#P14_1779

The full text of the letter requesting no-action releif is available at:  http://sec.gov/divisions/investment/noaction/2008/franklintempleton112008-incoming.pdf

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¹See The T. Rowe Price Funds (pub. avail. July 31, 1995) (“T. Rowe Letter”); and Alliance Capital Management L.P. (pub. avail. Apr. 25, 1997) (“Alliance Letter”, and together with the T. Rowe Letter, “No-Action Letters”).

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SEC Open Letter to CEOs of SEC-Registered Firms

On December 2, 2008, Lori Richards, director of the SEC’s Office of Compliance Inspections and Examinations, issued an open letter to leaders of SEC-registered firms, including broker-dealers, investment advisers, investment companies and transfer agents, reminding them of the critical role compliance programs play in firms’ continuing obligations under the securities laws.

Your firm’s compliance function is critical to assure that your operations comply with the law and rules for industry participation and to ensure that the interests of your customers, clients and shareholders are protected. Moreover, compliance is a vital control function that helps to protect the firm from conduct that could negatively impact the firm’s business and its reputation.

As Chairman Cox reminded CCOs in a November 13 address, and IM Director, Buddy Donohue, stressed in an address on October 12, Ms. Richards cautioned firms to avoid the temptation to cut costs by reducing compliance staff and resources.

While many firms are considering reductions and cost-cutting measures, we remind you of your firm’s legal obligation to maintain an adequate compliance program reasonably designed to achieve compliance with the law.

. . . .

Firms must be vigilant and proactive in preventing, detecting and correcting problems that could occur. Firms should pay attention to ensuring that their interactions with investors meet high standards, that sales and trading practices are appropriate, that financial, valuation and risk controls are followed, and that all disclosure obligations are met — as well as meeting all other obligations in conformity with the securities laws.

That SEC officials, from the Chairman to division heads, have stressed this point several times in recent weeks should be taken as an indication that the cuts in firms’ compliance staff and resources will be taken very seriously by the Commission’s inspection and enforcement staffs. 

The full text of Ms. Richard’s letter is available at:  http://sec.gov/about/offices/ocie/ceoletter.htm

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Third Annual Directors’ Institute, January 13-15, 2009

The Forum’s Third Annual Directors’ Institute is right around the corner.  This year’s Institute will be held in Sanibel Harbour, Florida from January 13-15, 2009.
 
This one of a kind program for fund directors only will focus on difficult issues Boards are facing during the contract renewal process, including the effect of outflows and how the financial condition of the adviser should factor into the Board’s consideration of the advisory contract.  The afternoon of January 13, participants will examine the role Boards play in fund mergers.  Andrew J. Donohue, Director of the Division of Investment Management at the US Securities and Exchange Commission, will give the keynote address that evening.
 
The host hotel is the Sanibel Harbour Resort & Spa, and the special room rate available to attendees will expire next Friday, December 12th.  To make a reservation, please call (800) 767-7777 and reference group #10B21Z.

For more information about the program, featured speakers, timing, and registration click here (pdf).

We hope to see you in Florida in January.

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Commissioner Casey: Strong Corporate Governance and Risk Management

In a recent speech before the Transatlantic Corporate Governance Dialogue Conference on Corporate Governance Standards and Financial Stability in Brussels, SEC Commissioner Kathleen Casey emphasized strong corporate governance and effective risk management as key characteristics of firms effectively weathering the current market turmoil.

We have learned once again that a strong corporate governance culture can play a key role in achieving necessary and beneficial risk taking while also minimizing potential detrimental effects to financial stability.

. . .

Specifically, four factors distinguished those firms that fared better than the rest:

• effective firm-wide risk identification and analysis;
  
• consistent application of independent and rigorous valuation practices across the firm;
  
• efficient management of capital, liquidity, and the balance sheet; and
  
• informative and responsive risk measurement and reporting.

Referencing a recent report by the Senior Supervisors Group, Commissioner Casey remarked that well governed firms managed risk better by instilling a culture of healthy skepticism throughout the organization, and are more nimble at reacting to unexpected or changing risks. 

Well-governed firms generally did a better job of sharing quantitative and qualitative information effectively across the organization, from the senior management team down through the control functions.

Perhaps as a consequence of creating an active cross-disciplinary oversight of risk factors, these firms were skeptical of rating agencies’ evaluations of complex structured financial products and relied instead on in-house expertise to execute rigorous internal valuation processes.

And unlike some competitors that were caught unprepared, they also were able to prevent the morphing of risk from forms that were readily measured and controlled into less easily governed forms, such as credit exposure to monoline insurers and liquidity risk from off-balance sheet vehicles.

Commissioner Casey also stressed the importance of strong independent leadership to effective and robust risk management and sound decision making.

Equally important was an effective risk-control function that requires an independent and strong voice within the firm in both the reporting as well as the decision-making context.

 

The full text of Commissioner Casey’s remarks is available at:  http://www.sec.gov/news/speech/2008/spch090908klc.htm#P104_10703

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