In January 2014, the Board of Governors of the Federal Reserve System (“FRB”) issued an Advance Notice of Proposed Rulemaking (“ANPR”) soliciting comments on various issues related to physical commodity activities conducted by financial holding companies, including the risks that such activities pose to the safety and soundness of depository institutions and the financial system generally. The activities covered by the ANPR included physical commodities activities that have been found to be “complementary to a financial activity” under section 4(k)(1)(B) of the Bank Holding Company Act (“BHC Act”), investment activity under section 4(k)(4)(H) of the BHC Act and physical commodity activities grandfathered under section 4(o) of the BHC Act.

During the ANPR’s comment period, the FRB received a number of letters from various institutions, trade associations and individuals.  Among these were several letters from financial holding companies, including those from both the Goldman Sachs Group, Inc. (“Goldman”) and Morgan Stanley. Goldman’s letter noted the role that financial holding companies play as intermediaries in commodities markets, including serving as efficient means of providing financing and hedging products to producers and end users. The letter acknowledged that there are potential risks associated with such activities, but emphasized that those risks are manageable and not significantly different from those associated with other financial activities.

Morgan Stanley’s letter reviewed the scope of the activities covered by the ANPR and acknowledged the importance of conducting each of them pursuant to a robust risk management framework. The letter then discussed the public benefits of physical commodities activities, which Morgan Stanley stated are “real and significant,” and highlighted the risks faced by firms that produce, distribute and consume commodities, concluding that financial holding companies are uniquely positioned to provide financing and risk management solutions to such firms. The letter cited several specific scenarios – such as helping renewable energy producers build wind farms, or helping an airline reduce fuel costs – that were enabled by Morgan Stanley’s ability to engage in certain physical commodities activities.

See: Morgan Stanley’s Comment Letter; Goldman Sachs’ Comment Letter.
See also: FRB ANPR on Complementary Activities, Merchant Banking Activities and Other Activities of Financial Holding Companies Related to Physical Commodities.
Related news: Trade Associations Submit Joint Comment Letter to FRB Regarding Activities of Financial Holding Companies Related to Physical Commodities (April 21, 2014).

Mercatus Scholar and former congressional staffer Hester Peirce published an article discussing a recent report by the U.S. Government Accountability Office (“GAO”) on SEC information security controls.  The GAO report identified a number of specific security weaknesses at the SEC.

Lofchie Comment: One significant theme of Ms. Peirce’s paper is that the SEC tends to be harder on private companies than it is on itself.

Click here to view the commentary by Hester Peirce.
See: GAO Report.
Related news: GAO Report: SEC Needs to Improve Controls over Financial Systems and Data (April 21, 2014).

The North American Securities Administrators Association (“NASAA”) and the Conference of State Bank Supervisors (“CSBS”) announced the development of model consumer guidance to assist state regulatory agencies in providing consumers with information about virtual currency and factors that consumers should consider when transacting with or investing in virtual currency.

The model guidance explains what virtual currency is, provides a short list of risks that consumers should consider when investing, and reminds consumers to research what sort of regulation, if any, applies to virtual currency transactions or investments in their states.

See: Model State Consumer and Investor Guidance on Virtual Currency.

SEC Commissioner Luis A. Aguilar delivered a speech, as a part of the Corporate Governance Lecture Series at the Emory University School of Law, in which he asserted that, in order to restore trust between Wall Street and Main Street, it is crucial to have corporate governance practices that foster the principles of (i) accountability, (ii) transparency and (iii) engagement. Framed within the context of the executive compensation process, Commissioner Aguilar stated that these principles should drive the establishment of an effective corporate governance regime, and highlighted a few of the ways in which the SEC incorporates these important principles into its rulemaking and enforcement programs.

On the principle of accountability, Commissioner Aguilar commented that corporate governance can only embody accountability if shareholders know that performance will be measured: good performance will be rewarded, poor performance will not and misconduct will not be tolerated. Regarding both executive compensation and say-on-pay, the Commissioner suggested that SEC enforcement actions are a key mechanism for imposing accountability on “corporate officers and gatekeepers.” Commissioner Aguilar emphasized the importance of this in instances in which self-dealing or other breaches of duty result in violations of the SEC rules regarding fraud, reporting requirements, books and records, and financial controls. A robust enforcement program, he argued, helps to “reinforce the principle of accountability by punishing those in a position of trust and responsibility who cross the line.”

The Commissioner also addressed the principle of transparency. Without it, he said, it is extremely difficult to have accountability. Commissioner Aguilar stated that the SEC promotes the principle of transparency by “requiring that public companies shine a light on the information that investors need to make good investment and voting decisions.” He remarked that this is accomplished through SEC rules which require the public disclosure of a description of a company’s business, its board and management, and financial and operating data, both historical and forward-looking, among other information. Commissioner Aguilar noted that access to audited financial information and other required public disclosure is particularly important when shareholders hold officers and directors responsible for corporate performance, and that all of these disclosures enhance transparency.

Concerning the disclosure rules relating to executive compensation, the Commissioner cited the Dodd-Frank mandated rules, which include disclosures as to:

• the relationship between executive compensation actually paid and the financial performance of the issuer;
• company policies regarding the hedging of equity securities held or awarded to directors and employees; and
• the ratio between the compensation of the chief executive officer and the total annual compensation of its average worker (known as “Pay Ratio”).

Commissioner Aguilar urged the SEC to adopt rules requiring the mandated pay-for-performance and hedging disclosures which, taken together with the Pay Ratio Rule, he argued, will “foster accountability by making compensation decisions more transparent, and will help investors to make more informed investment decisions when they exercise their rights as shareholders and owners.”

Lastly, Commissioner Aguilar addressed engagement. Traditionally, he commented, the primary opportunity for shareholders to communicate with a company was at the annual shareholder meeting, which was neither practical nor provided sufficient opportunity for shareholders to exercise their rights as owners of the company. Focusing on (i) informal engagement with investors, (ii) engaging retail shareholders, and (iii) shareholder proposals, Commissioner Aguilar urged the further development of mechanisms through which shareholders can communicate with their companies, which he believes will be mutually beneficial for shareholders and companies.

Commissioner Aguilar concluded by stating that the underlying corporate governance issue regarding executive compensation is not simply about the amount of the compensation, but also about whether the decision-making process enables accountability through transparency and shareholder engagement.

Lofchie Comment: Over time, the Pay Ratio Rule will almost certainly demonstrate that the pay ratio of successful companies reveals a greater discrepancy than that of unsuccessful companies, since people at the top receive a larger portion of their pay through bonuses. The various ratios cited in the Commissioner’s speech are not meaningful without significantly more underlying information. For example, pay ratios might be significantly different between domestic companies with a larger U.S. work force and global companies with a significant number of foreign employees earning locally appropriate though lower wages. Financial regulators should focus on adopting rules that are genuinely meaningful. The Pay Ratio may be a popular rule, but that does not make it meaningful disclosure.

See: Commissioner Aguilar’s Speech.

The United States Government Accountability Office (“GAO”) released a report assessing the SEC’s information security controls as part of its audit of the SEC’s financial statements from fiscal years 2013 and 2012.

The report noted that, while the SEC had implemented and made progress in strengthening information security controls, weaknesses limited their effectiveness in protecting the confidentiality, integrity and availability of a key financial system.  The report noted further that the information security weaknesses existed because the SEC did not sufficiently oversee and manage the implementation of information security controls during the migration of this key financial system to a new location.

GAO recommended that the SEC take action to (i) more effectively oversee contractors performing security-related tasks and (ii) improve risk management.

In a separate report for limited distribution, GAO will make specific recommendations to address weaknesses in security controls.

See: GAO Report.