Regulators Issue Joint Staff Report on Volatility in Treasury Markets

Staff members from the U.S. Treasury Department (“Treasury”), the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the SEC and the CFTC (the “Regulators”) issued a joint report that analyzed the “significant volatility” in the Treasury markets on October 15, 2014.

The joint report highlighted specific developments that most likely created or contributed to the volatility, including: (i) changes in investor positions and sentiments about global risk, (ii) a decline in order-book depth and (iii) changes in order flow and liquidity provisions.

The report also recommended possible methods for increasing the public and private sectors’ understanding of changes in the structure of the Treasury market and their implications. These changes included: (i) increased focus on trading and risk management practices and (ii) continued efforts to strengthen monitoring and inter-agency coordination related to trading across the Treasury cash and futures markets.

Lofchie Comment: Staff writers recognized the argument that regulatory changes may have contributed to the extreme volatility that occurred on October 15. In this regard, the report notes the following: “Some market participants have argued that recent regulatory initiatives have increased trading and inventory costs and forced a reduction in risk-taking, prompting them to shift their allocation of capital away from market making for low margin transactions, and instead towards other business areas that may yield greater returns on equity. Indeed, some of this capital reallocation could have been expected from regulatory changes intended to increase the resiliency of financial institutions and of the financial system” (emphasis added).

To put this differently, rules that are intended to have a beneficial effect can, when implemented, have a negative effect. In particular, imposing high capital requirements on all firms might seem to make each firm safer when viewed in isolation, but if the effect of the requirements is to discourage any firm from acting as a buyer when markets fall, then the net effect of the requirements will be to make all firms riskier in the aggregate. See, e.g., The Bank for International Settlements Issues 85th Annual Report (with Lofchie Comment) emphasizing increased systemic risk.

On another note, regulators’ inability to identify the causes of the volatility on October 15 demonstrates how absurd it was for the CFTC to announce that improper trading by a reasonably small-time futures trader had caused the Flash Crash. See, e.g., Finance Professor Calls CFTC Allegations That Nav Sarao Caused Flash Crash ”Outrageous” (with Lofchie Comment and Video Selection).

SIFMA Submits Comments to United States Trade Representative Regarding TTIP and Financial Services

SIFMA submitted comments to the United States Trade Representative affirming its support for the inclusion of a framework to discuss financial services regulations in the Transatlantic Trade and Investment Partnership (“TTIP”).

Lofchie Comment: It is clear that the CFTC’s race to take the lead in imposing regulations on firms providing or receiving financial services, and attempting to force the Europeans to follow them, has failed. The CFTC is presently engaged in a much more reasonable effort to coordinate on requirements such as clearing and margin. These efforts at cooperation ought to be expanded and formalized, albeit without surrendering ultimate rights of sovereignty with respect to U.S. institutions.

NYSE Halts Trade due to Technical Issues

The NYSE halted trading before noon and resumed trading before the end of the day due to what the NYSE described as internal technical issues. SEC Chair White announced that the SEC was in contact with the NYSE.

Lofchie Comment: The trading halt at the NYSE will pose an interesting challenge to the regulators. Will they respond to the NYSE’s technical failure by bringing an enforcement action? Previous cases demonstrate that enforcement actions are simply not an effective means of preventing future technology failure. Instead, the regulators need to encourage information sharing that will enable firms to develop more robust systems to prevent and respond to failures. In this case, it does appear that the markets as a whole were completely robust in working around the NYSE’s shutdown.

Senate Banking Committee Holds Hearing Regarding the Role of FSB

The Senate Committee on Banking, Housing and Urban Affairs held a hearing focusing on the role of the Financial Stability Board (“FSB”) in the U.S. regulatory framework.

The following witnesses testified:

  • The Honorable Dirk Kempthorne, President and CEO American Council of Life Insurers (“ACLI”) (view testimony);
  • Mr. Eugene Scalia, Partner Gibson, Dunn, & Crutcher Mr. Paul Schott Stevens (view testimony);
  • Mr. Paul Schott Stevens, President and CEO Investment Company Institute (view testimony);
  • The Honorable Peter Wallison, Arthur F. Burns Fellow in Financial Policy Studies American Enterprise Institute (“AEI”) (view testimony); and
  • Dr. Adam S. Posen, President Peterson Institute for International Economics (view testimony).

Lofchie Comment: The debate over the FSB reflects different perspectives on power and authority. One question is whether U.S. legislators and regulators should be deferential to a global regulator. In this regard it is notable that Senator Warren describes the FSB as the “key to preventing another financial crisis.” This is an atypical position, as U.S. legislators, in general, argue that national regulatory U.S. bodies should act more independently of supranational organizations. Others argue that the FSB is not controlling the Fed; rather, the Fed is controlling the FSB, presumably to create an “international voice” that will advance the Fed’s position in the United States.

These differing views highlight the battle for authority between the banking (prudential) regulators and the capital markets regulators, in which the bank regulators assert the view that credit activities undertaken by non-banks are “shadow banking” that should presumably be regulated by banking regulators. Additionally, there seems likely to be an impending battle for control over insurance companies by the states (which currently regulate insurance companies) and the federal government (which has asserted control over those insurance holding companies that are deemed to be systemically significant, but perhaps with more federal control to follow).

Almost as interesting as the conflict over authority are the questions regarding competence; i.e., do the bank regulators understand the insurance business, and are they correct in approaching capital markets activities with the viewpoint that they should be subject to “prudential” (bank-like) regulation?

FINRA Podcast: Regulatory and Examination Priorities for 2015 – Part 2

FINRA issued the second in a six-part series of podcasts about its Regulatory and Examination Priorities for 2015. The second podcast examines FINRA’s sales practice priorities when it comes to specific products.

Interest-Rate Sensitive Fixed-Income Securities

  • FINRA emphasized that it is critical for firms to discuss the impact of interest-rate changes on prices when marketing fixed-income products. Examiners are looking for concentrated positions and products that are highly sensitive to interest rates, such as high-yield bonds and mortgage-backed securities. FINRA noted that examiners may choose to review a firm’s efforts to educate registered representatives and customers about fixed-income products.

Variable Annuities

  • FINRA focused on new purchases as well as 1035 exchanges. FINRA stated that it assesses compensation structures to evaluate how firms incentivize variable annuity sales. Additionally, examiners concentrate on the design and implementation of procedures and training by compliance and supervisory people to test brokers and supervisors’ product knowledge. FINRA also mentioned particular interest in the sale and marketing of so-called L-share annuities.

Alternative Mutual Funds

  • FINRA recommended that firms market alternative mutual funds by referring to them based on specific strategies instead of bundling them under a single umbrella category. FINRA also suggested that firms’ communications describe how such funds work accurately and fairly, and that the descriptions are consistent with those in the prospectuses.

Non-Traded Real-Estate Investment Trusts

  • FINRA advised firms to continue to be mindful of risks to investors when making recommendations about such products, and stressed the importance of performing due diligence on an ongoing basis on the REITs that firms allow their representatives to recommend.

Structured Retail Products

  • FINRA stated its concern that certain brokers and retail investors might not understand the complexities of structured retail products. In light of that fact, FINRA reminded firms that retail communications about such products must be filed with FINRA within ten business days of the communications’ first use. Additionally, FINRA pointed out its focus on the incentive to increase the revenue from structured-product sales through distribution channels that may not have enough controls to protect customers’ interests.

Securities-Backed Lines of Credit

  • FINRA recommended that firms put proper controls in place to supervise these programs, and that customers be made fully aware of the programs’ characteristics, including loan restrictions and how changing market conditions could affect customers’ brokerage accounts and ability to draw on loans. Lastly, FINRA noted that firms should maintain operational procedures for interacting with lending institutions to monitor customers’ accounts.

Lofchie Comment: Firms that do retail business should attend to FINRA’s list closely.

See: Transcript of FINRA Podcast; Listen to FINRA Podcast.

House Financial Services Committee Announces Three Hearings Regarding Dodd-Frank

The House Committee on Financial Services announced that it will conduct three hearings to examine how Dodd-Frank has impacted the financial regulatory landscape.

The first hearing will be held on July 9 at 10:00 a.m. and is titled “Dodd-Frank Five Years Later: Are We More Stable?” The second hearing will occur on July 28 and is titled “Dodd-Frank Five Years Later: Are We More Prosperous?” A third hearing, titled “Dodd-Frank Five Years Later: Are We More Free?” will be scheduled at a later date.

Lofchie Comment: These hearings are unlikely to present opportunities for critical thinking about fixing the regulatory framework. Neither side will be interested in crediting the other with honesty or even good faith. No doubt, many of the statements will be impossible to prove. No matter how many regulators assert that the markets are now much “safer” than before, such a conclusion is not obvious, nor is it clear how such claims could be substantiated. It is clear, however, that prior positive predictions about the effects of Dodd-Frank on the market have fallen short. For example, it is obvious now that non-U.S. investors are disinclined to trade under the rules of Dodd-Frank. Also, regulators’ previous irrational exuberance over the benefits of central clearing has given way, even among those who strongly favor the process, to increasing concern that central clearing has become a potential threat to systemic safety.

SEC Commissioners Take Conflicting Public Stands on Proposed Compensation Clawbacks

SEC Commissioner Kara M. Stein issued a statement supporting the proposed rule that would require “the majority of listed issuers to adopt a recoupment, or clawback, policy for when an executive’s incentive-based pay is based on erroneous financial reports.”

Commissioner Stein declared that this proposed rule would further develop the Dodd-Frank Act’s original attempts to increase executive accountability and refocus executives on long-term results by mandating that “the issuer clawback erroneously or incorrectly awarded compensation.” She stated that the rule would also discourage artificially inflated financial statements by requiring companies to clawback incentive-based executive compensation if there are material errors in its financial statements. Furthermore, the proposal expands the definition of incentive-based pay to include metrics (such as stock price and total shareholder return) that, according to Commissioner Stein, often constitute crucial factors in determining incentive-based pay. Additionally, the proposed rule provides that disclosures be tagged in eXtensible Business Reporting Language (“XBRL”), which Commissioner Stein firmly believes enables more comparability across companies and improves investors’ searches for company information.

In marked contrast, SEC Commissioner Daniel M. Gallagher vehemently refused to recommend the proposed rule. He declared that it was a considerable waste of time and resources. First, he argued that “subjecting a broad swath of executive officers to a no-fault recovery mandate creates the potential for substantial injustice,” especially with no “relief valve,” and casts the corporate board “as the enemy of the shareholder.” Second, he objected to the inclusion of weaker entities unable to bear the cost of compliance such as smaller reporting companies (“SRCs”), emerging growth companies (“EGCs”), foreign private issuers (“FPIs”), and registered investment companies (“RICs”). Finally, he disagreed with basing the required compensation to be clawed back on inconclusive share price metrics such as Total Shareholder Return (“TSR”).

Commissioner Gallagher stated that he could accept a “reasonable clawbacks rule,” but that the unveiled proposed rule is like the “newest Goya, tortured and and nightmarish.”

SEC Issues Interpretive Guidance on the Terms ”Spouse” and ”Marriage” (Fed. Reg.)

The SEC issued interpretive guidance clarifying how it will interpret the terms “spouse” and “marriage” in light of the Supreme Court’s ruling in United States v. Windsor. The interpretive guidance was published in the Federal Register.

The interpretive guidance stated that the SEC will read the terms “spouse” and “marriage” to include, respectively: (i) “an individual married to a person of the same sex if the couple is lawfully married under state law, regardless of the individual’s domicile,” and (ii) “such a marriage between individuals of the same sex.”

This interpretive guidance became effective as of July 1, 2015.

Lofchie Comment: The rule change will affect a number of definitions under the securities laws, such as that of “accredited investor” in Rule 501 under the Securities Act. Regulated firms and individuals also should give consideration to how they phrase and respond to questions concerning “household members” for significant purposes, such as determining the obligation to provide account statements in order to prevent possible instances of insider trading.

SEC Proposes That Firms Adopt Clawback Policies on Executive Compensation

By a vote of three to two, the SEC approved a proposal to adopt listing standards for the mandatory repayment by executive officers of erroneously awarded compensation. The proposal would direct national securities exchanges and associations to establish the standards, and companies to adopt policies that obliged their executive officers to repay inapposite compensation that was intended to be incentive-based. It is the final proposal involving executive compensation rules to be required by Dodd-Frank.

The proposal creates Rule 10D-1 requiring listed companies to develop and enforce recovery policies that would, in the event of accounting restatements, “claw back” from current and former executive officers any incentive-based compensation that the restatements show to have been awarded based on previous accounting errors. Requirements of the policies in the proposal include the following:

  • recovery must be on a “no-fault” basis from current and former executive officers who received incentive-based compensation during the three fiscal years preceding the date on which a company is required to prepare an accounting restatement to correct a material error;
  • companies must recover the amount of incentive-based compensation received by an executive officer that exceeds the amount the officer would have received if the compensation had been based on the accounting restatement;
  • companies have discretion not to recover excess incentive-based compensation received by executive officers if the direct expense of enforcing recovery would exceed the amount to be recovered or, for foreign private issuers, in specified circumstances where recovery would violate home country law; and
  • a firm would be subject to delisting if it did not adopt a compensation recovery policy in accordance with the SEC rules.

The proposed rules also include a definition of “executive officer” that is distinct from that of “officer” under Exchange Act Section 16. The proposal specifies that the positions defined by “executive officer” include the company’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit, division or function, and any other person who performs policy-making functions for the company.

Additionally, the proposed rules would require a firm to file its compensation recovery policy as an exhibit to its Exchange Act annual report. If during its last completed fiscal year a listed company either (i) prepared a restatement that required the recovery of excess incentive-based compensation, or (ii) carried an outstanding balance of excess incentive-based compensation relating to a prior restatement, then the company would be required to disclose:

  • the date on which it was required to prepare each accounting restatement, the aggregate dollar amount of excess incentive-based compensation attributable to the restatement, and the aggregate dollar amount that remained outstanding at the end of its last completed fiscal year;
  • the name of each person who was subject to recovery and from whom the company decided not to pursue it, the amounts due from each such person, and a brief description of the reason the company decided not to pursue recovery; and
  • if amounts of excess incentive-based compensation are outstanding for more than 180 days, the name of each person so compensated and the amount due from them at the end of the company’s last completed fiscal year.

Commissioner Michael S. Piwowar issued a statement that called into question whether the “broad approach” of the approval would “impose a substantial commitment of shareholder resources and, unintentionally, result in a further increase in executive compensation.” He warned that a recovery policy would create uncertainty among executives regarding the amount of incentive-based compensation that they would ultimately retain. The uncertainty in compensation levels, according to Commissioner Piwowar, could increase total executive compensation. He asked the public to comment on (i) whether recovery policies should be voluntary for emerging and smaller companies; and (ii) if it would be better to take a more comprehensive approach to providing interactive data contained in the proxy statement, as well as in the non-financial section of the annual report on Form 10-K, rather than requiring individual items to be added in an ad hoc manner.

Commissioner Daniel M. Gallagher issued a statement of dissent in which he explained that the proposal puts “corporate boards not just in handcuffs but in a straitjacket,” and added that the proposal reflects the view that a corporate board is the enemy of the shareholder.

Lofchie Comment: Although this rule proposal seems to have a sound and objective basis (why should an executive object to repaying money that was not genuinely deserved, since the amount was based on flawed accounting?), the determination of whether an accounting restatement may be required in any particular instance is, in many cases, subjective. Accordingly, a corporation might be far more likely to issue a restatement of its accounting when there is a change in leadership, and the new management may have an incentive to reduce or claw back compensation that was paid to old leadership. The new rule is also likely to serve as a substantial disincentive to companies going public. As more and more companies of significant size are able to raise sufficient capital in the private markets and so avoid the expenses and burdens (such as Sarbanes-Oxley) of going public, this rule will only discourage emerging issuers even more from going public. Is the rule worth the costs? The answer is not obvious and the question poses yet another question: Would it have been better to adopt a narrower rule that required issuers to seek restitution only from the top few executives, and only in the event of demonstrated malfeasance?

OCC Issues Report on Risks Faced by National Banks and Federal Savings Associations

The Office of the Comptroller of the Currency released a report providing an overview of various risks facing the banking industry.

The report, “Semiannual Risk Perspective for Spring 2015,” contains an analysis of data in four key areas: the operating environment, bank conditions, key risk issues and regulatory actions. Highlights from the report include the following:

  • for the banking industry to identify and mitigate their associated risks, evolving cyber threats and information technology vulnerabilities require heightened awareness and appropriate controls;
  • competition for limited lending opportunities is intensifying and has resulted in looser underwriting standards and layered risk, particularly in indirect auto lending, asset-based lending, commercial real estate lending, and commercial and industrial loans;
  • banks continue to reevaluate their business models and the potential risk of their appetites for generating returns against the backdrop of low interest rates; and
  • a prolonged low-interest-rate environment continues to lay the foundation for future vulnerability.

Lofchie Comment: One risk is that by maintaining very low interest rates, the government encourages asset bubbles and other high-risk investment strategies. In addition, high-capital requirements, combined with liquidity and other investment restrictions, discourage regulated institutions from acting as buyers in case of a sell-off. In that scenario, central clearinghouses exacerbate systemic risk – not because the clearinghouses fail, but because they demand higher margin for open positions, which sucks out of a system ever more liquidity. In other words, overly aggressive regulation intended to eliminate risk becomes the source of risk.