Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The Federal Energy Regulatory Commission’s (FERC) August 5, 2013, $28 million show cause order against BP America Inc. and other BP affiliates highlights the interrelationship between the Commodity Futures Trading Commission (CFTC) and FERC in enforcement matters.

On the surface, the case appears to be what has become a “garden variety” FERC market manipulation case. FERC alleges that BP sold physical gas at a loss to benefit its financial position. As part of its investigation, FERC found a “smoking gun,”—a tape of a phone conversation between a junior member of the physical trading desk and the trader responsible for trading the physical gas—outlining the alleged manipulation. FERC then found facts confirming, in its mind, a manipulative scheme. After BP was unable to provide contemporaneous documentation or after-the-fact explanations to justify the trading, FERC proposed a $28 million civil penalty against BP (but, unlike its recent Barclays case, not against the traders involved, even though the traders apparently initiated the alleged scheme, without the knowledge or involvement of upper BP management).

A closer examination, however, reveals an interrelationship between FERC and the CFTC in enforcement matters. BP self-reported this trading, but not to FERC. BP self-reported to the CFTC, apparently as part of a procedure implemented after a 2007 settlement with the CFTC involving alleged manipulation in propane markets. BP America Inc., et. al., Enforcement Staff Report and Recommendation, Docket No. IN13-15 at fns 2, 209-211 (Enforcement Report). The CFTC then notified FERC Enforcement. Similarly, the CFTC originally received the “smoking gun” tape and forwarded it to FERC. See fn. 180. In addition, the CFTC actively participated in BP’s internal investigation (and by extension the FERC investigation) by requiring “BP to submit an outline of the questions that it [BP] intended to ask the [BP] traders” in its (BP’s) investigatory interviews. Id. at fn. 188. (FERC made additional suggestions.) Finally, throughout the Enforcement Report are depositions of BP personnel that were done by the CFTC, including key witnesses in the case. See e.g., fn. 4, CFTC deposition of Clayton Luskie, the junior member of the BP trading desk at the center of the controversy and fn. 13, CFTC deposition of Graydn Comfort, the trader responsible for trading the physical gas.

FERC, in turn, increased the penalty because of the previous enforcement action by the CFTC, specifically because “BP has a prior history within five years of an adjudication of similar misconduct by another enforcement agency [the CFTC].” Id. at p. 73. Further, FERC said that BP had “violated an order directed specifically at BP, i.e., the 2007 CFTC order from the propane investigation permanently prohibiting BP from “violating the Commodity Exchange Act or manipulating the price of any commodity in interstate commerce.” Id.

BP’s response is due in early October. Check back on this blog for further updates.

 

The PCAOB has issued two new proposed auditing standards addressing the auditor’s opinion and information included in annual reports.  To me the proposals seem to provide redundant information, are highly problematic, address matters that have better alternative solutions and don’t make sense.

Take the auditor’s report for example.  The PCAOB proposes that the auditor communicate “critical audit matters.” “Critical audit matters” include those matters addressed during the audit that, among other things, involved the most difficult, subjective, or complex auditor judgments.

In 2003 the SEC issued interpretive guidance on MD&As.  It stated in part:

“When preparing disclosure under the current requirements, companies should consider whether they have made accounting estimates or assumptions where:

  • the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and
  • the impact of the estimates and assumptions on financial condition or operating performance is material.

If so, companies should provide disclosure about those critical accounting estimates or assumptions in their MD&A.

Such disclosure should supplement, not duplicate, the description of accounting policies that are already disclosed in the notes to the financial statements. The disclosure should provide greater insight into the quality and variability of information regarding financial condition and operating performance.”

It’s hard for me, at least, to imagine how this portion of the PCAOB proposal differs significantly from current MD&A requirements.

“Critical accounting matters” also include those matters that posed the most difficulty to the auditor in obtaining sufficient appropriate evidence; or posed the most difficulty to the auditor in forming the opinion on the financial statements.  If there is a critical accounting matter, the auditor’s report would:

  • Identify the critical audit matter;
  • Describe the considerations that led the auditor to determine that the matter is a critical audit matter; and
  • Refer to the relevant financial statement accounts and disclosures that relate to the critical audit matter, when applicable.

So how would this work in practice?  A discussion to the effect that “The Company has a lot of Level 3 assets and we spent a lot of time trying to understand the valuations and after numerous discussions with management we found the Company’s practices acceptable”?  If the support isn’t adequate, it would be addressed I imagine through reporting a material weakness in internal control or an adverse opinion.  If the support is adequate, the discussion can only be a hook for litigation that is sure to follow or needless tension between auditors and management and audit committees.

The PCAOB proposes the audit report will include “A statement containing the year the auditor began serving consecutively as the company’s auditor.”  Yes, investors need some information to judge the relation of the auditor with the issuer.  And that information is already included in the proxy statement.  If this information is so important, it should go with the already required disclosures to prevent sprinkling it throughout the documents.

And then we get to the second proposal, which is referred to as the “proposed other information standard.”   The proposed standard would establish requirements regarding the auditor’s responsibilities with respect to “other information.”  “Other information” is information, other than the audited financial statements and the related auditor’s report, included in a company’s annual report that is filed with the SEC under the Exchange Act and contains that company’s audited financial statements and the related auditor’s report. For example, other information in an annual report filed by a company on Form 10-K would include, among other items, selected financial data, MD&A, exhibits, and certain information incorporated by reference.

What do current standards require?  Under existing PCAOB standards, the auditor has a responsibility to “read and consider” other information in certain documents that also contain the audited financial statements and the related auditor’s report; however, there is no related reporting requirement to describe the auditor’s responsibility with respect to other information.  Under the existing other information standard, the auditor considers whether the other information is materially inconsistent with information in the financial statements. If the auditor concludes there is a material inconsistency between the other information and the financial statements, the existing standard provides the auditor with certain procedures to respond to the material inconsistency. Additionally, the existing standard provides that, if while reading the other information for a material inconsistency, the auditor becomes aware of a material misstatement of fact in the other information, the auditor would discuss this with management and perform other procedures based on the auditor’s judgment.

Comparing the new standard to the old standard, it’s hard to find material, tangible improvements:

New Standard Old Standard
Apply the auditor’s responsibility for other information specifically to a company’s annual reports filed with the SEC under the Exchange Act that contain that company’s audited financial statements and the related auditor’s report. Nothing new here.  If the old standard didn’t apply to 10-Ks, what did it apply to?
Enhance the auditor’s responsibility with respect to other information by adding procedures for the auditor to perform in evaluating the other information based on relevant audit evidence obtained and conclusions reached during the audit. Seems as if this was implied by “read and consider,” although perhaps the new standard is a little more explicit about recalculating things that can be recalculated.
Require the auditor to evaluate the other information for a material misstatement of fact as well as for a material inconsistency with amounts or information, or the manner of their presentation, in the audited financial statements. Nothing new here.
Require communication in the auditor’s report regarding the auditor’s responsibilities for, and the results of, the auditor’s evaluation of the other information. No such requirement, but there are lots of things that auditors do that are perhaps more important that aren’t called out in an auditor’s report.
Auditor finds something wrong, and after discussion with management and the audit committee the matter is not corrected: 

  • Must determine the auditor’s responsibilities under Section 10A of the Exchange Act, 15 U.S.C. § 78j-1; AU sec. 316, Consideration of Fraud in a Financial Statement Audit; and AU sec. 317, Illegal Acts by Clients; and

 

  • Should determine whether to:
    • Issue an auditor’s report that states that the auditor has identified in the other information a material inconsistency, a material misstatement of fact, or both that has not been appropriately revised and describes the material inconsistency, the material misstatement of fact, or both; or
    • Withdraw from the engagement.

 

 Seems to add nothing new unless you make the intellectual leap that an auditor would issue his or her opinion when the 10-K included material errors.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

 

A bill pending in the House of Representatives (H.R. 2274) would provide some relief for M&A advisers from the broker-dealer registration rules.  The bill would permit the sale of privately held businesses that have EBITDA of less than $25,000,000 or gross revenues of less than $250,000,000.  Other requirements include the buyer (alone or in concert) must control the business after the transaction and the buyer must be provided certain financial and business information.

The crowdfunders will smile because the bill directs the SEC to issue implementing regulations within 180 days after enactment.

It may not be complete regulation lite, however, because the bill incorporates a host of provisions of the Exchange Act applicable to broker-dealers – See Section 2(a)(13)(G).

Perhaps the most problematic provision, which may render the entire thing useless, is the bill directs the SEC to “codify the interpretative guidance issued by the staff of the Commission in the no-action letter to International Business Exchange Corporation dated December 12, 1986, and in the no-action letter to Country Business, Inc., dated November 8, 23 2006, with respect to circumstances under which registration as a broker under this section is not required.”

In International Business Exchange Corporation, the SEC conditioned no action relief only if IBEC has a limited role in negotiations between the purchaser and seller.  IBEC had represented to the SEC that it’s activities included “Assisting in the negotiations, to some degree, between buyer and seller. (Transmitting Documents Between Parties).”

In Country Business, Inc. the SEC conditioned its no action position as follows: “if a decision is made to effect the transaction by a sale of securities, CBI will have a limited role in negotiations between the seller and potential purchasers or their representatives as described in your letter and will not have the power to bind either party in the transaction.”  The letter described the following:  “CBI’s role will be limited to the following: (1) transmitting documents between the parties; (2) valuing the assets of the business as a going concern; (3) providing the seller with administrative support; and (4) assisting the seller with preparation of financial statements.”

If you want to learn more about dealing with unregistered broker-dealers and the potential hazards, see Part VI of our publication JOBS Act and Other Securities Law Essentials for Growing Companies.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

Courts have recently rendered two say-on-pay decisions.  The first is Gordon v. Symantec Corporation.  The recent decision follows on the heels of an earlier dismissal.  The plaintiff then filed an amended complaint.  In the amended complaint, plaintiff claimed the proxy was materially misleading because it failed to provide  a fair summary of the advice, counsel and analysis provided to the board and/or the compensation committee by the compensation consultant.  Some of the deficiencies alleged include:

  • Nondisclosure of certain information had the likely effect of causing shareholders to assume that Symantec’s performance metrics are generally aligned with the 50th to 65th percentile of its peer group andws misleading.
  • Failure to disclose total shareholder return, or TSR, as a key metric for an informed shareholder vote on compensation.
  • Failure to disclose a fair summary of the peer benchmarking analysis.  Plaintiff claimed without the information shareholders were unable to determine if executive compensation was being appropriately targeted and if executive salaries were properly aligned with performance metrics and, as a result, were unable to cast informed votes on the say-on-pay proposal.

The court held the plaintiff failed to allege a direct disclosure claim because the purported omissions only allege the possibility of harm to Symantec.  Assuming the plaintiffs alleged a direct disclosure claim, the court found the plaintiff’s case should still be dismissed.  The court found:

  • None of the compensation-related information was rendered materially misleading by omission of information about the financial performance of Symantec or the other companies in the peer group.
  • It was not substantially likely that disclosure of the comparative TSR information would have significantly altered the total mix of information available to the Symantec shareholders.
  • The proxy adequately disclosed what the pay targets were based on, as well as the fact that compensation may be above the positioning benchmark based on consideration of factors other than performance.

The defendants in Dennis v Pico Holdings, Inc. removed state course case to federal court, which was originally filed following a failed say-on-pay vote.  The Ninth Circuit remanded the case to state court.  The Ninth Circuit held that that removal of the suits from state court was improper because the plaintiffs asserted state-law causes of action, and, under the well-pleaded complaint rule, their allegations regarding the say-on-pay vote were insufficient to establish federal-question jurisdiction. The panel rejected defendants’ arguments that federal jurisdiction existed under § 27 of the Securities Exchange Act of 1934, the “significant federal issue” rule, or the complete preemption doctrine.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The SEC has updated its frequently asked questions on Form PF.  The updates include:

  • General filing information: Questions A.7 through A.9 on rounding, amendments to Form ADV on new private funds, and liquidation of funds.
  • Question 14.2 on assets and liabilities in the cost-based column that would be presented in a fund’s financial statements using a measurement attribute other than fair value.
  • Question 24.3 on use of gross notional values for trading data.
  • Question 35.2 indicating cash and cash equivalents are not a “position” for purposes of reporting open positions in Questions 35 and 57.
  • Question 46 addressing whether guidance provided by the staff regarding borrowings for Question 12 and 43 also apply to how borrowings should be interpreted for Questions 46 and 47.
  • Question 47, which refers to Question 46.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The SEC’s Division of Investment Management recently offered guidance on the custody of privately offered securities.  The SEC noted that although a security evidenced by a private stock certificate does not technically meet the custody rule’s definition of “privately offered security” because of the existence of a “certificate,” advisers contend that such securities are similar in all material respects to a privately offered security because the client’s ownership interest in the security is not impacted by the existence (or lack thereof) of the certificate.

The SEC noted that advisers assert that beyond the substantial investor protections provided by  financial statement audits, maintaining private stock certificates at a qualified custodian does not  provide meaningful protection to investors in pooled investment vehicles.  An auditor conducting an audit of a pooled investment vehicle’s financial statements in accordance with generally accepted auditing standards performs substantive procedures to verify the existence of the pool’s investments,  including securities that are privately issued, regardless of whether the private stock certificates are held at a qualified custodian. Moreover, advisers have informed the Division that maintaining private stock certificates at a qualified custodian can add substantial costs, which are typically borne by investors in pooled investment vehicles as an expense paid by such vehicles.

The Division of Investment Management advised it would not object if an adviser does not maintain private stock certificates with a qualified custodian, provided that:

  • the client is a pooled investment vehicle that is subject to a financial statement audit in accordance with paragraph (b)(4) of the  custody rule;
  • the private stock certificate can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer;
  • ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client;
  •  the private stock certificate contains a legend restricting transfer; and
  • the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The Dodd-Frank Act provided the SEC with new authority, and directed it to use this authority to require registered investment advisers to maintain records and file reports regarding the hedge funds, private equity funds and other private funds they advise. The Commission implemented this aspect of the Dodd-Frank Act in 2011 when it adopted new Form PF that requires certain registered investment advisers that advise private funds to report information to the SEC.

While the primary aim of this provision was to create a source of data for the Financial Stability Oversight Council, or FSOC, to use in assessing systemic risk, the SEC is using the information to support its own regulatory programs, including examinations, investigations and investor protection efforts relating to private fund advisers. The Dodd-Frank Act also required that the SEC report annually to Congress on how it has used the data to monitor the markets for the protection of investors and the integrity of the markets. The SEC has released its the first annual report submitted to Congress to satisfy this obligation.  This post is comprised of the executive summary of the report.

Due to the rolling compliance dates the SEC adopted for Form PF, the SEC has only recently received a complete set of initial filings. Commission staff has begun to assess the quality of the data collected — including evaluating the consistency of filer responses and differences in approaches or assumptions made by filers — and has used the data on occasion to obtain information regarding a specific or small number of private funds. In addition, a number of uses of the information have already been identified across various Commission Divisions and Offices. In particular, the Division of Economic and Risk Analysis has successfully incorporated Form PF data into its proprietary analytical tool; the Division of Investment Management’s Risk and Examinations Office is working to develop analytics using Form PF information that will allow it to monitor the risk-taking activities of investment advisers to private funds; and the Office of Compliance Inspections and Examinations anticipates using the information collected on Form PF in conducting pre-examination due diligence and in risk identification. In addition, the Commission staff intends to provide certain aggregated, non-proprietary Form PF data to the International Organization of Securities Commission (IOSCO) regarding large hedge funds so IOSCO has a more complete overview of the global hedge fund market for a report that will be shared with the Financial Stability Board. In the coming months the staff will continue to assess data quality, and will develop data analytics incorporating Form PF data to further the Commission’s mission.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The United States District Court has invalidated the Fed’s Interchange Rules in NACS et al v Board of Governors of the Federal Reserve Board.  The reasons are almost too numerous to mention, with the court at one point calling the Fed’s rules “utterly indefensible.”

The court winds up by noting “First, the interchange transaction fee and network non-exclusivity regulations are fundamentally deficient. It appears that the Board completely misunderstood the Durbin Amendment’s statutory directive and interpreted the law in ways that were clearly foreclosed by Congress.”

One interesting point is what happens next.  The court stated it would stay vacatur, to provide the Fed an opportunity to replace the invalid portions of the final rule. In so doing, the court believes it can prevent the Fed from adopting similar regulations while at the same time avoid the disruption of vacating the entire regime. To properly effect the stay of vacatur, two issues remain:

  • the appropriate length of the stay; and
  • whether current standards should remain in place until they are replaced by valid regulations or the Fed should develop interim standards sufficient to allow the court to lift the stay.

Because the parties failed to address the proper remedy in their motions, the court invited supplemental briefing on these issues, stating it was inclined toward a stay of vacatur “for months, not years.”

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

 

The SEC has amended certain broker-dealer annual reporting, audit, and notification requirements. The amendments include a requirement that broker-dealer audits be conducted in accordance with standards of the Public Company Accounting Oversight Board, or PCAOB, in light of explicit oversight authority provided to the PCAOB by the DoddFrank Wall Street Reform and Consumer Protection Act  to oversee these audits. The amendments further require a broker-dealer that clears transactions or carries customer accounts to agree to allow representatives of the Commission or the broker-dealer’s designated examining authority, or DEA, to review the documentation associated with certain reports of the broker-dealer’s independent public accountant and to allow the accountant to  discuss the findings relating to the reports of the accountant with those representatives when  requested in connection with a regulatory examination of the broker-dealer. Finally, the  amendments require a broker-dealer to file a new form with its DEA that elicits information  about the broker-dealer’s practices with respect to the custody of securities and funds of  customers and non-customers.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

Three federal bank regulatory agencies are seeking comment on proposed guidance describing supervisory expectations for stress tests conducted by financial companies with total consolidated assets between $10 billion and $50 billion.

These medium-sized companies are required to conduct annual company-run stress tests beginning this fall under rules the agencies issued in October 2012 to implement a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).

To help these companies conduct stress tests appropriately scaled to their size, complexity, risk profile, business mix, and market footprint, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency are proposing guidance to provide additional details tailored to these companies.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.