President Trump Nominates OFR Director

President Trump nominated Dino Falaschetti to serve as the Director of the U.S. Treasury Department Office of Financial Research.

Mr. Falaschetti is currently the Chief Economist for the House Committee on Financial Services, and served previously as a senior economist on President George W. Bush’s Council of Economic Advisers. He was also a law, economics and finance professor and a corporate finance professional in the private sector.

Treasury Department Researchers Analyze Form PF Data

Researchers at the U.S. Treasury Department’s Office of Financial Research (“OFR”) analyzed information gathered from Form PF and described trends in the activities of private equity funds and their controlled portfolio companies (“CPCs”). As stated in a recent SEC comment request, “Form PF is designed to facilitate the Financial Stability Oversight Council’s (“FSOC”) monitoring of systemic risk in the private fund industry and to assist FSOC in determining whether and how to deploy its regulatory tools with respect to nonbank financial companies.” Investment advisers with greater than $150 million in private fund assets under management are required to provide information on Form PF, such as (i) the funds they advise, (ii) private fund assets under management, (iii) fund performance and (iv) the use of leverage.

The OFR researchers found:

  • borrowing and leverage increased among certain CPCs from 2013 to 2016, which could signal a greater likelihood of default;
  • some CPCs had significant short-term debt exposures, which “should continue to be monitored”; and
  • investment in financial CPCs has shifted toward non-bank entities.

The analysis, published in the OFR Brief Series, stated that the views and opinions of the authors do not necessarily represent the views of the OFR or the U.S. Department of the Treasury.

Lofchie Comment: The report concludes as follows:

“Form PF is not a perfect tool for monitoring trends in the private equity industry. The data collection lacks a long history, and reporting errors persist. Still, the analysis in this brief illustrates that Form PF data can be useful for monitoring basic fund characteristics. . . .”

There is only so much that analysts can do with data that is both limited and flawed. The report itself contains some moderately informative background as to the state of the private equity industry. However, observations such as “if a company borrows more money, then it is more likely to default” do not really add much to the government’s ability to understand financial markets or systemic risk.

The government would be better off scrapping Form PF and trying to understand why the process of creating it went so wrong. This is not intended as a criticism of the report’s authors. It is just the reality of so-so in, so-so out.

CFS Monetary Measures for May 2018

Today we release CFS monetary and financial measures for May 2018. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.5% in May 2018 on a year-over-year basis versus 4.6% in April.

For Monetary and Financial Data Release Report:
http://www.centerforfinancialstability.org/amfm/Divisia_May18.pdf

For more information about the CFS Divisia indices and the data in Excel:
http://www.centerforfinancialstability.org/amfm_data.php

Bloomberg terminal users can access our monetary and financial statistics by any of the four options:

1) {ALLX DIVM }
2) {ECST T DIVMM4IY}
3) {ECST} –> ‘Monetary Sector’ –> ‘Money Supply’ –> Change Source in top right to ‘Center for Financial Stability’
4) {ECST S US MONEY SUPPLY} –> From source list on left, select ‘Center for Financial Stability’

Bondi Testimony on SEC Seform

CFS senior fellow Bradley J. Bondi testified before the U.S. House of Representatives Subcommittee on Capital Markets, Securities, and Investment at a hearing entitled, “Ensuring Effectiveness, Fairness, and Transparency in Securities Law Enforcement” on June 13, 2018.

In his testimony and written statement, Brad advocated for transparency and reform from the SEC with respect to the imposition of issuer/shareholder penalties and disgorgement, advised against extending the statute of limitations for SEC enforcement actions, and discussed pending legislation to reform SEC administrative proceedings and to preempt enforcement of certain state securities laws.

Testimony and written statement
https://financialservices.house.gov/calendar/eventsingle.aspx?EventID=403565

Bondi’s CFS Ten-Point Blueprint for SEC Reform
http://www.centerforfinancialstability.org/research/Bondi_8_17_17.pdf

FinCEN Calls Attention to Transactional Red Flags Associated with International Corruption

The U.S. Treasury Department Financial Crimes Enforcement Network (“FinCEN”) issued an advisory describing how corrupt foreign “politically exposed persons” (“PEPs”) access the U.S. financial system. The advisory provides guidance on the (i) risks that U.S. financial institutions face when providing banking services to PEPs and their financial facilitators and (ii) types of suspicious transactions that may trigger reporting obligations under the Bank Secrecy Act.

The advisory includes the following non-exclusive list of red flags that may help identify methods used to hide the proceeds of human rights abuses and other illicit international activities:

  • using third parties when it is not normal business practice;
  • using third parties to shield the identity of a PEP;
  • using family members or close associates as legal owners;
  • using corporate vehicles such as limited liability companies (LLCs) to hide ownership, involved industries or countries;
  • receiving information from PEPs that is inconsistent with publicly available information;
  • transactions involving government contracts that (i) are awarded to companies in a seemingly unrelated line of business, or (ii) originate from or are going to shell companies that appear to lack a general business purpose;
  • documents supporting transactions regarding government contracts that include (i) charges that are higher than market rates, (ii) overly simplistic information or (iii) insufficient detail;
  • payments connected to government contracts that come from third parties that are not official government entities; and
  • transactions involving property or assets expropriated or otherwise taken over by corrupt regimes, including senior foreign officials or their cronies.

The advisory also provides examples of suspicious activities by PEPs and their financial facilitators, such as:

  • moving funds repeatedly to and from countries with which the PEP does not have ties;
  • requesting to use services of a financial institution or a designated non-financial business or profession (“DNFBP”) not normally associated with foreign or high-value clients;
  • holding substantial authority over or access to state assets and funds, policies and operations; and
  • controlling the financial institution or DNFBP that is a counterparty or correspondent in a transaction.

The advisory indicated that FinCEN would update these red flags and typologies in the future, and reminded financial institutions of their obligation to identify suspicious transactions and file suspicious activity reports (SARs) under the Bank Secrecy Act.

Banking Agencies Issue Statement on Enforcement Coordination

The Office of the Comptroller of the Currency, the FDIC and the Board of Governors of the Federal Reserve System (“Agencies”) issued an updated policy statement on coordination among the federal banking agencies during formal enforcement actions. The text of the statement was published in the Federal Register. The statement reflects the recent rescission of the Federal Financial Institutions Examination Council’s Revised Policy Statement on “Interagency Coordination of Formal Corrective Action by the Federal Bank Regulatory Agencies.”

The new statement outlines how a federal banking agency should proceed after deciding to take a formal enforcement action against any federally insured depository institution, depository institution holding company, non-bank affiliate or institution-affiliated party. According to the statement, each agency should first evaluate if the enforcement action relates to any areas that are regulated by other agencies. If it is determined that another agency has an interest in the enforcement action, then the agency proposing to take the action should notify the relevant agency (i) before notifying the party to the action or (ii) when the appropriate official determines that a formal action is expected to be taken. An agency should also share information with the other agency that will enable it to investigate the party.

Additionally, two or more agencies that plan to bring a complementary action are expected to coordinate on the preparation, processing, presentation, potential penalties, service and follow-up of the enforcement action.

SEC Commissioner Calls for Revision of Stock Buyback Rules

SEC Commissioner Robert J. Jackson Jr. advocated for the review and revision of SEC rules to limit executives from using stock buybacks to cash out at the expense of investors. Mr. Jackson was responding, in part, to the “unprecedented wave of buybacks” following the Trump Administration’s Tax Bill in December 2017.

In a speech at the Center for American Progress, Mr. Jackson expressed concern that current rules incentivize corporate executives to pursue “short-term stock-price spikes rather than long-term growth.” According to Mr. Jackson, the current regulatory approach is based on the belief that paying executives in stock incentivizes them to create long-term sustainable value. However, Mr. Jackson argued, that theory “only works when executives are required to hold the stock over the long term.” Mr. Jackson stated that sponsors of the recent Tax Bill believed incorrectly that the deduction would encourage corporations to invest that money in innovation or into their workforce. He observed that within the first quarter of 2018, American corporations bought back a record $178 billion in stock instead, often causing a spike in the companies’ share prices. During that same period, Mr. Jackson found, executives in those companies sold more of their own shares shortly after a buyback announcement than before, and without a requirement for the contemporaneous disclosure of their actions.

Mr. Jackson urged the SEC to (i) amend its buyback rules to deny “safe harbor” from securities-fraud liability to companies that allow executives to cash out during a buyback, and (ii) encourage corporate executives to “keep their skin in the game for the long term.” Mr. Jackson also called on corporate boards and their counsel to analyze the “implications of a buyback for the link between pay and performance” of their executives.

Additionally, Mr. Jackson requested an open comment period to allow the SEC to review stock buyback rules.

Lofchie Comment: The role of an SEC commissioner is to establish securities law policy, not to rewrite tax policy. Tax policy is driven by considerations that are somewhat larger than executive stock buybacks. From an economic standpoint, Commissioner Jackson’s observation that companies used the reduction in taxes to buy back their stocks, largely from U.S. investors, as opposed to investing in “innovation,” is an inconsequential one. If money sitting overseas is returned to U.S. investors, those investors can buy consumer goods (boosting the economy), invest in other companies (boosting the economy) or put their money in the bank (saving and bringing down the cost of lending). Buying back stock is not a destructive act.

As to securities law policy, the Commissioner first questions whether issuers should be prevented from making false assertions that they intend to buy back stock. Though that concern is somewhat inconsistent with the Commissioner’s assertion that issuers really were buying back massive amounts of stock, it seems perfectly reasonable for the SEC to investigate whether issuers may falsely assert that they will buy back their own stock when they have no intention of doing so. Second, the Commissioner expresses concern that executives who receive stock as part of their compensation resell it (an economically rational move, for example, assuming it would diversify the executive’s total investments), rather than maintaining their investment in their companies. The relevant question is whether there should be a mandatory period of time for which executives should be required to hold stock that they receive as part of their compensation. Assuming that this is a question for the SEC to answer, rather than one that should be left to each corporate board, the question would have relevance as to any executive holding corporate stock. Tying the issue to corporate buybacks diminishes the universality of the issue.

In short, the Commissioner could better advance his recommendations if he did so by arguing from a policy basis that is founded on the mission of the SEC, rather than by using uncertain claims (albeit claims worth looking into) as justification for what appears to be a partisan attack on the tax law.

SEC Chief Accountant Details Recommendations for Improving Quality of Financial Reporting

SEC Chief Accountant Wesley Bricker described his recommendations to improve and sustain the quality of financial reporting.

In remarks at the Institute of Chartered Accountants in England and Wales, Mr. Bricker asserted that the integrity of the financial reporting process remains crucial to the strength of our capital markets. He noted that in our highly connected world of global investing, technologies that help retail investors may also provide opportunities for fraudulent activity. To maintain the quality of financial reporting and reduce risk to investors, Mr. Bricker recommended:

  • minimizing expectation gaps between the levels of expected performance and actual performance by investors and accountants;
  • keeping general purpose financial reporting separate from reports with different objectives, such as special purpose financial reports;
  • promoting the financial education and literacy of members of the financial reporting structure; and
  • encouraging collaboration among participants in the financial reporting structure.

Mr. Bricker also highlighted the importance of audit regulators and audit standard-setters in maintaining the structure of financial reporting. Mr. Bricker recommended ensuring the quality of international audit-related standards, which impact (i) U.S. investors and asset managers with foreign equity and long-term debt securities, and (ii) U.S.-based multinational companies.

SEC Chair Says Bitcoin Are Not Securities

SEC Chair Jay Clayton asserted that bitcoin and other cryptocurrencies that are replacements for U.S. dollars or other sovereign (fiat) currencies do not constitute securities under federal securities laws (see Securities Act Section 2(a)(1); Exchange Act Section 3(a)(10)).

In an interview on CNBC, Mr. Clayton contrasted cryptocurrencies with other blockchain technologies, such as tokens, in which money is invested in a venture in exchange for a direct return on the token, or for the ability to earn a return by selling the token on a secondary market. These types of tokens are considered securities, and both their issuance via initial coin offerings (“ICOs”) and their trading on an exchange are subject to SEC registration and oversight. Mr. Clayton said that if an unregistered ICO is to be conducted via an unregistered private placement, the SEC will expect adherence to the private placement rules.

Mr. Clayton ruled out amending the statutory definition of securities to expressly address cryptocurrencies and other blockchain technologies, saying that the SEC would not “do any violence to the traditional definition of security that has worked for a long time.” He also declined to comment on whether various specific bitcoin alternatives, or “Altcoins” – such as Ethereum and Ripple – constituted securities, saying instead that the analysis of each was effectively case-specific.

When asked about the current bitcoin futures market and what criteria issuers would need to meet in order to start a bitcoin exchange-traded fund, Mr. Clayton cited guidance from the Division of Investment Management on features the SEC will look for – such as accurate pricing and asset verification – before approving any asset class.

SEC Addresses Delivery of Mutual Fund Documents to Shareholders

The SEC approved a rule and two requests for comments relating to mutual fund disclosure. The SEC voted to (i) adopt a new rule that will implement an optional, online delivery method for fund shareholder reports, (ii) request input from fund investors on how to enhance fund disclosures and (iii) request feedback on the processing fees charged by broker-dealers and other intermediaries for the delivery of fund materials.

First, the SEC adopted ICA Rule 30e-3, which provides funds with an optional “notice and access” method for delivery of shareholder reports by making such reports available on a website specified in a notice to investors. The rule requires funds relying on Rule 30e-3 to, among other things:

  • provide the current shareholder report and the most recent prior shareholder report on a publicly accessible website, free of charge;
  • make quarterly holdings available for the last fiscal year;
  • ensure the accessibility of reports, including their format and location;
  • issue a paper notice that the online report is available with instructions for accessing it;
  • provide a free paper copy of the shareholder report upon request; and
  • allow investors to elect to receive all future reports on paper.

SEC Chair Jay Clayton stated that the final rule contains several changes to the proposed rule aimed at improving investor protections, such as (i) an extended transition period and (ii) more flexibility in communications with investors. SEC Commissioner Kara M. Stein criticized the rule for requiring an extra step for an investor to select paper delivery, warning that it may be “too high” a hurdle for some. She advised the SEC to view the rule as a pilot program and reevaluate its effectiveness after it has been implemented. Funds will be allowed to rely on the new rule beginning January 1, 2021. In general, funds will be required to provide shareholders with two years’ notice if relying on the rule before January 1, 2022.

Second, the SEC issued a request for comments, particularly from individual investors, on how to improve the “delivery, design and content of fund disclosures.” The SEC is seeking comments on, among other things, preferred methods of delivery and the modernization of disclosure requirements.

Third, the SEC requested comments on the current framework for processing fees charged by broker-dealers and intermediaries for delivering fund shareholder reports and other materials to investors. The SEC is requesting comments on:

  • the assessment of the processing fees;
  • the transparency of these fees;
  • remittances received by financial intermediaries for delivery of fund documents;
  • whether the structure and level of processing fees should be set by another entity; and
  • fees in cases where intermediaries are paid shareholder servicing fees separately from fund assets.

Comments on the two requests must be submitted by October 31, 2018.

Lofchie Comment: This should be the first among several steps that the SEC takes to make it easier for regulated firms to electronically deliver all documents. By way of example, broker-dealers should be able to assume, in the absence of client objection, that they may deliver all required disclosure documents electronically.

The printing and transmission of paper documents, many of which go right into the wastebasket, is expensive and wasteful (and anti-green).