In my first course on International Private Law at the Catholic University of Louvain, we were taught that tax laws could not extend beyond the borders of the taxation authorities. The territoriality of tax laws is confirmed by the literature.   The double taxation treaties confirm this principle to which the United States is the most significant exception.

As we write this post, Switzerland is confronted with an “emergency” law submitted to its Parliament to accommodate Uncle Sam’s disclosure requirements. The justification is unambiguous: if you don’t do it, we will ban your banks from operating in the United States.  The Swiss lower house refused the emergency required by the Government to deal with the agreement with the US tax authorities. A Swiss government plan to protect the country’s banks from U.S. criminal charges has been thrown into doubt by a Swiss parliamentary committee’s rejection of the proposed bill on Tuesday.

The US applies Universal tax Law

To the best of my knowledge, the United States is the only country that taxes its nationals on a worldwide basis, at least individual taxpayers. The Ways and means Committee of the US Congress recently questioned the idea that the United States can tax its citizens worldwide.

Our “worldwide” system of taxation is a remnant from the Cold War: While it has been 25 years since we reformed the tax code, it has been almost 50 years since we undertook a bottom-up review of our international tax laws. In other words, our international tax rules were written when the United States accounted for 50 percent of the global economy and had no serious competition from others, a far cry from today’s fiercely competitive global economy.

Interestingly, it is probably the strongest incentive for US firms operating abroad to recruit local staff rather than US tax residents. The cost of hiring US taxpayers abroad is sometimes as high as twice the cost of hiring locally.

Foreign Account Tax Compliance Act (FATCA)

For the IRS, it is an important development in U.S. efforts to improve tax compliance involving foreign financial assets and offshore accounts.  FATCA includes two major features:

1. It requires US taxpayers to declare the existence of their foreign accounts, wherever they are in the world, if they reach $ 50,000 for singles and $ 100,000 for married couples. This is consistent with the universal tax principle.  This is in addition for the Report of Foreign Bank and Financial Accounts (FBAR) that requires a reporting to the US Treasury under the Bank Secrecy Act.
2.  The IRS, armed with its whip, requires foreign banks to provide information on such accounts if the accountholder is a US national or a US resident. The negotiations are managed country by country by IRS officials. It is therefore a use of the US political muscle and ability to threaten foreign financial institutions to withdraw their license to operate in the United States. The FATCA rules essentially require a “foreign financial institution” (“FFI”) to enter into, and to comply with, a reporting and withholding agreement (“FFI Agreement”) with the IRS with respect to US account holders. An FFI that enters into an FFI Agreement is referred to as a “Participating FFI.” An FFI that does not enter into an FFI Agreement (referred to as a “Non-Participating FFI”) would be subject to a 30% gross withholding tax on withholdable payments, unless it is otherwise exempted from the FATCA regime.  
   

FATCA raises fundamental questions of privacy, but also raises questions about how it can be properly executed. Why, as a Belgian-born, dual-citizen, grandfather, am I no longer allowed to use or send money from my Belgian account for my granddaughter in Paris by using Internet banking? Why is my account subject to all kinds of FATCA restrictions while I am not required to disclose the account because its amount is below the IRS thresholds? Why can I not view the balance of my account on line?

Effectively, those accounts become useless, and it is equivalent to inciting US tax persons to close those accounts, pushing them to less regulated and transparent jurisdictions if they need capital abroad, whether it is for their business or their household.

Is the IRS targeting some categories of taxpayers because it is hungry for American money abroad?  Of course not:  it does not intend to tax corporate revenues abroad. This debate is now largely open. This is just against the individual US taxpayers. This discrimination is even more surprising that it has become blatantly obvious during the Apple hearing that the money that sits in foreign jurisdictions is much more important, and that it escapes taxation.

The US is basically using its political power with the support of foreign banks who have become tax collectors for Uncle Sam. I even received in my mail a US W9 form from my bank in Brussels. The IRS is effectively recruiting tax informants who, at their cost and expenses, need to provide ways and means to comply and change their systems.

Not surprisingly, one by one, banks refuse to open accounts for US residents or nationals. A friend of mine was refused the opening of a bank account last week in Tokyo. It has become simply too cumbersome and too onerous for them to spend millions to become tax collectors for Uncle Sam.  The cost burden for the UK is not insignificant: HMRC estimates the cost for UK business over the first 5 years to be £1.1bn-£2bn ($ 1.7-3.2 bn), running thereafter at an annual cost of £50m-£90m. ($80- 150 m) HMRC’ estimates its own one-off IT and staff project costs at approximately £5m, with ongoing annual costs of £1.4m ($ 2m) from 2016.

This will affect Americans working outside of the United States who are not going to be able to use local banking facilities. It’s a strange version of a self imposed Yankees go home. The study published by Shearman & Sterling on the subject is a glimpse into that complexity.

Towards a European FATCA?

The opposition to FATCA is growing in Europe and, after pretending that it did not matter, some European Governments, in particular Germany and France, are now looking at a European version of FATCA.

Europe is looking for ways to create an EU version of FATCA. If it were effectively imposed it would make sure that no European taxpayer can use US banks for investment purpose, and that US banks will report all revenues of European taxpayers to the authorities of the taxpayer. This would threaten a substantial part of the international private banking or brokerage operations of US financial institutions, a multi-billion business for large US banks.

The European Parliament has started studying the project.

Rethinking US international tax laws.

I am not an international law expert, but I would strongly argue for a delay to FATCA and the opening of serious discussions at the OECD to figure out an acceptable way to ensure equity between countries.  Why would the US be the only tax authorities to benefit from information provided foreign tax authorities?

I would not dare to even suggest how this could be achieved. In the meantime the movement to repeal FATCA is growing. Should all countries decide that their citizens will be taxed on a worldwide basis, as the United States does, working abroad will become increasingly onerous and create absolute confusion?  The core of this debate is only emerging: Either the system is based on territoriality, or it is based on nationality. Having it both ways won’t work.

The United States has to ask itself the question of whether its actions are legitimate and question its objectives and the ways it goes about achieving them. This is especially pertinent at a time when the United States seems to reserve a right to eavesdrop upon foreign nationals.

Is US foreign policy using all its weaponry, including the FCPA and FATCA to impose a Lex Americana (i.e., American law regime) upon the rest of the world? Shouldn’t the US first look more closely at its own taxation system and corruption? International tax law is in urgent need of modernization with a focus on equity and fairness rather than threat and blackmail.

Could the IRS have been an apprentice sorcerer? Might it have opened the Pandora box? The next few months will certainly provide further interesting developments. But it is questionable, to say the least, to see Uncle Sam recruiting for free tax informants around the world. Is it the price for the Pax Americana?

Thank you Danny [McCoy] for your very kind introduction.  I am delighted to be able to participate in this conference, and especially proud as an Irish-American that it is being held in conjunction with Ireland’s Presidency of the Council of the European Union.  This conference is particularly valuable because it provides a forum for executives, directors, investors, and policy makers to have a frank and productive dialogue on important corporate governance issues.

Before I go any further, I need to provide the standard disclaimer that my remarks today are my own and do not necessarily reflect the views of the Securities and Exchange Commission or my fellow Commissioners.

Today I would like to talk about the increasing role that governments – particularly, in the United States, the federal government – play in corporate governance as well as the increasingly prominent influence of proxy advisory firms on how companies are governed and on how shareholders vote.  These changes have led to, among other things, new limitations and requirements being imposed on boards of directors and companies.  And while the resulting costs to investors are easily apparent, the purported benefits are harder to discern.  Although today I will for the most part discuss these issues as they apply to U.S. companies, I note that there is a related trend in Europe.  As such, I hope that my comments may help inform your approach to regulating corporate governance as well.

Corporate governance involves three traditional actors: shareholders, management and boards of directors.  Shareholders provide corporations with capital, management makes use of that capital, and the board of directors supervises management to ensure that it is allocating that capital appropriately.  Shareholders, in turn, discipline the board’s efforts.  The interests of these three actors are not always aligned.

Traditionally, the law has provided a general framework within which those three actors interact.  Regulators are tasked with protecting shareholders yet at the same time allowing management and directors to do their jobs growing the company and thereby creating value for shareholders.  In the United States, governments at the state level have historically been the stewards of corporate governance, a distinction which the federal government has typically respected.  However, this deference has slowly been eroding and a continuing trend has been developing: “the federalization of corporate law”¹ and the stripping away of states’ prerogatives with respect to corporate governance matters.

Why has this been the case? In the U.S., federal involvement in corporate governance matters has usually occurred on the heels of scandals and economic crises.  Indeed, one need not look further than the very names of the most recent efforts by Congress at corporate governance reform to see the effect of public outrage on the legislative process.  The Sarbanes-Oxley Act, which followed the Enron and WorldCom scandals, is formally known as the “Public Company Accounting Reform and Investor Protection Act.”  The progeny of the most recent financial crisis is titled, in full, the “Dodd–Frank Wall Street Reform and Consumer Protection Act.”  A hallmark of these sweeping new laws is the imposition of new requirements, often inappropriate and almost always burdensome, as “feel good and cure all” responses to perceived problems presented as grand gestures with which one would be hard pressed to disagree.  For example, who can be against such stated goals as better disclosure, increased transparency, and heightened accountability?

The truth of the matter is that such reactive legislation and the resulting regulatory mandates are often based upon false narratives and in the end lead to the expansion of a universal law: the law of unintended consequences.  This threat is especially acute in the realm of corporate governance, where the costs of good intentions are actually borne directly by “Main Street” investors.

Take Sarbanes-Oxley.  If you were to ask executives and boards of directors today who they believed were the biggest beneficiaries of this well-intentioned legislation, few would cite shareholders.  Instead, many would answer that it was accountants, non-U.S. markets, and lawyers that truly benefited.  For example, the SEC estimated at the time that compliance with Section 404 of Sarbanes-Oxley would cost on average roughly $91,000 a year to implement.²  Instead, the costs of Section 404, in conjunction with the related PCAOB Auditing Standard 2, have been exponentially higher.

U.S. regulators responded, albeit too slowly for some, and attempted to address the issues presented by 404 implementation.  Congress also heard the complaints and created certain exemptions from 404(b) for emerging growth companies and non-accelerated filers in both the Dodd-Frank Act and last year’s JOBS Act.  Although these were very positive steps that relieved small companies from substantial audit and legal costs and made it more palatable for smaller companies to go public, the damage caused by this provision, in particular to the US capital markets competitiveness, may never be undone.

And then there is Dodd-Frank, the 2,319 page result of a determination to not let a crisis go to waste.  Although it will be many years before the Act is fully implemented and years after that until its impact is fully felt, it has already significantly affected U.S. capital markets and will continue to do so for many years to come.  Indeed, the Act is a good example of many legislative efforts that have followed the crisis — a core concept, in this case regulatory reform, overwhelmed by a grab bag of wish-list items.

Of course this shouldn’t be a surprise given that the statute was not the product of bipartisan compromise and was enacted shortly after the onset of the crisis — many months before the bodies charged by the government with examining the causes of the crisis issued their reports.

In total, the Dodd-Frank Act contains approximately 400 specific mandates to be implemented by agency rulemaking, with approximately a hundred applying directly to the SEC.  Several Dodd-Frank required rulemakings, although couched as disclosure rules, are, it would appear, in fact meant to affect the behavior of companies and boards rather than to provide information that investors would find useful.  Take executive compensation for example.  Listed companies are already required to disclose the compensation of their executives in granular detail as well as in narrative format.  What do investors gain when a listed company provides additional information regarding how much a CEO’s compensation compares to the “median of the annual total compensation of all employees of the issuer”?³  The Act is filled with a litany of similar requirements that, while small individually, collectively add up to “death by a thousand cuts” to the detriment of investors.

Given all of these unintended consequences and the lack of a discernible benefit in federally regulating corporate governance, it is important that the SEC and Congress remain mindful of the traditional role of the states in regulating corporate governance.  As I have noted in the past, states are inherently better suited to address the varied and complex issues that arise in corporate governance.  Allowing states the flexibility to tailor their corporate governance regimes can lead to corporate innovation, while applying prescriptive boundaries and a one-size fits all corporate governance regime can correspondingly stunt such innovation.

With respect to legislative and regulatory oversight, state law confers greater flexibility than federal law to deal effectively with the myriad of different circumstances that legislators and rule makers cannot anticipate.  State laws and regulations have the benefit of being more easily revisited than federal legislation, thus allowing the legislature to amend rules and regulations that are failing to meet their intended purpose.  Additionally, given the historical treatment of companies as creatures of state law, there is a wide body of legal precedent, attentive industries and experienced state judges who are well versed in corporate matters.

State courts have also been able to build a greater body of jurisprudence which has enabled private ordering as opposed to forcing companies to comply with one-size fits all mandates.  Deference to private ordering enables a body of law to evolve based on competition, market discipline, and efficiencies.  I agree with my friend and colleague Troy Paredes that the “enabling” rather than “mandatory” approach to corporate governance adopted by states is the proper one.⁴  The advantages of state regulation of corporate governance are coupled with the fact that the federal government, as demonstrated so clearly by the implementation of Section 404 of Sarbanes-Oxley, has not been very effective at predicting the costs and outcomes of federal corporate governance legislation.  And who bears the costs of these unintended consequences? The answer is investors in particular, and the U.S. capital markets in general.

Alas, the encroachment of the federal government on corporate governance and the strain on the director-shareholder dynamic has not been limited to our side of the Atlantic.  Both the European Parliament and national governments in Europe have increasingly proposed corporate governance measures and mandates, ostensibly providing shareholders more influence in matters traditionally left to the discretion of boards.  One example of this has been with respect to “say-on-pay” legislation, where there is a push to let shareholders have a louder, and often final, voice with respect to executive compensation.  In 2012, the European Commission announced its intention to allow shareholders to approve the remuneration policy of listed companies incorporated in the E.U.,⁵  and there have been recent indications from E.C. officials that such legislation is in the works.⁶  In addition, proposals to regulate executive compensation have been announced in Germany, Spain, Switzerland, and the United Kingdom.⁷  In fact, in March of this year, 68% of Swiss voters voted to approve the so-called “popular initiative against excessive pay,” sometimes referred to as the “Rip-Off Initiative.”⁸  This initiative requires, among other things, that shareholders have a binding vote to approve the pay of executives and board members of public companies, that pension funds holding shares in a company vote and disclose how they voted, and that golden handshakes and parachutes be eliminated.  It further mandates that violations of these new requirements could result in severe fines and even prison time.

The Swiss legislature is now obligated to pass legislation implementing this proposal within one year.  Additionally, a potential new proposal which seeks to limit salaries of certain executives to 12 times those of a company’s lowest-paid employee has garnered more than 100,000 signatures of support in Switzerland.⁹

At the E.U. level, the European Parliament approved last month certain elements of Capital Requirements Directive IV, which include restrictions on bonus payments to employees of certain financial institutions.  The bonus cap will apply to institutions in the E.U. as well as non-E.U. subsidiaries and will affect not only European employees, but certain non-European employees (of E.U. companies) that are located in Europe.¹⁰

This movement to national and federal corporate governance standards, towards a one-size-fits-all set of standards, is troubling.  From a practical perspective, I question efforts to strip away oversight of executive compensation from boards of directors.  They have traditionally been left with this responsibility for many reasons, including the sheer complexity of executive compensation, as we have seen in the financial services area.  Executive compensation decisions are incredibly complicated decisions that are made by boards after a long and deliberative process.  This process cannot be reduced to a few over-simplified propositions, or to a simple yes or no, without sacrificing all of the benefits flowing from a serious and thoughtful debate among directors knowledgeable about the company.  And, of course, eroding the board’s authority with respect to executive compensation also reduces their leverage and weakens their ability to oversee executives.

The question that policymakers need to answer at the end of the day is: do all of these mandates aid the average investor?  At best, it is questionable.  For example, an unintended consequence of the disclosure requirements imposed at the federal level in the U.S. over the past 15 years is that proxy statements now resemble law school text books.  Who can blame an investor for not voting when reading a proxy and voting a proxy card evoke memories of studying for a final exam?

Another arguably unintended consequence of stricter and more prescriptive corporate  governance rules is the rise of proxy advisory firms and the increasing willingness of investment advisers and large institutional investors to rely on such firms to meet their fiduciary duties.

The SEC has played a significant role in this area.  In 2003, the SEC adopted a new rule and rule amendments under the Investment Advisers Act of 1940 addressing an investment adviser’s fiduciary obligation to its clients when such adviser has authority to vote its clients’ proxies.  Pursuant to the new rule, an investment adviser that exercises voting authority over its clients’ proxies became required, among other things, to adopt policies and procedures reasonably designed to ensure that it votes those proxies in the best interests of its clients.¹¹  One concern that the SEC was trying to address was an adviser’s potential conflicts of interest when it voted a client’s securities on matters that affected its own interests.  In the 2003 adopting release, the SEC noted that “an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party.”¹²  I am sure this was music to proxy advisors’ ears.  As it had earlier done with the credit rating agencies, the SEC had essentially mandated the use of third party opinions.  In fact, proxy advisors became focused on this and asked the SEC staff for guidance and clarity.  In two SEC staff no-action letters issued in 2004 the proxy advisers got their wish.¹³

It has been argued that these two letters provide institutional money managers and other investment advisers a potential safe harbor against claims of conflicts of interest when they vote their client proxies.  In one  letter, the SEC staff advised that “[A]n investment adviser that votes client proxies in accordance with a pre-determined policy based on the recommendations of an independent third party will not necessarily breach its fiduciary duty of loyalty to its clients even though the recommendations may be consistent with the adviser’s own interests.  In essence, the recommendations of a third party that is in fact independent of an investment adviser may cleanse the vote of the adviser’s conflict.”¹⁴

One proxy adviser asked whether a proxy voting firm would be considered independent if it received compensation from an issuer for providing advice on corporate governance issues.  In its response letter, the Staff noted that the mere fact that a proxy voting firm provided advice and received compensation from an issuer for its services, “generally would not affect the firm’s independence from an investment adviser.”¹⁵  The effects of these letters were not lost on the judiciary.  In a 2005 law review article, a vice Chancellor of the Delaware court of Chancery wrote that following the recommendation of a proxy advisory firm “constitutes a form of insurance against regulatory criticism” and results in such firm having a large voice in the affairs of American corporations.¹⁶

I have previously spoken about my concern with the increased role of proxy advisory firms in today’s corporate governance world, and particularly whether investment advisers are fulfilling their fiduciary duties when they rely on and follow recommendations from proxy advisory firms.  I am not alone, as former SEC Chairman Harvey Pitt has recently voiced similar concerns,¹⁷ and the Mercatus Center at George Mason University recently published a paper on the proxy advisory system and concerns raised by its current structure.¹⁸  I am concerned that unless these no-action letters are reviewed and possibly revisited, the SEC may find it difficult to ensure that fiduciaries are conducting proper due diligence with respect to proxy votes.¹⁹

Some would argue that the role of proxy advisers has been overstated.  However, one would be hard pressed not to notice the stream of concern from regulators, directors, and even shareholders themselves over the increasing role that proxy advisory firms play in the board room.  A recent survey found that more than 70 percent of directors and executives reported that their compensation programs were influenced by guidelines and policies of proxy advisory firms.²⁰  As discussed in the Mercatus Center paper, a concern many people have is that “to a large degree, corporate directors and executives are now subject to decision making on critical issues by organizations that have no direct stake in corporate performance and make poor decisions as a result.”²¹  Commenters have also raised other concerns about the lack of standing and skin in the game that proxy advisory firms have in advising shareholders.  As stated in one law review article, “Proxy advisors do not have a financial stake in the companies about which they provide voting advice; they owe no fiduciary duties to the shareholders of these companies; and they are not subject to any meaningful regulation.”²²

I understand that there is concern in Europe as well regarding the increased role of proxy advisory firms.  The European Securities and Markets Authority recently suggested that the proxy advisory industry may want to provide greater clarity to subscribers and stakeholders on what they can rightfully expect from them.  ESMA’s chair noted that “[t]here are a number of concerns regarding conflicts of interest management and the transparency of analysis and advice, which we believe would benefit from improved clarity on the part of the industry.”²³  ESMA also concluded that although it currently did not favor the introduction of binding measures, it encouraged the proxy advisory industry to develop its own code of conduct focusing on certain principles, including identifying, disclosing and managing conflicts of interest and fostering transparency to ensure the accuracy and reliability of the advice it provides, which entails disclosing general voting policies and methodologies, considering local market conditions and providing information on engagement with issuers.²⁴  I hope the proxy advisory industry follows this advice and look forward to seeing such a code of conduct.  I believe these issues of conflicts and transparency identified by ESMA and market participants are the same on both sides of the Atlantic.  It is critically important for policymakers to understand, evaluate, and if necessary address the practices and business models of proxy advisory firms.

Given the increased questions raised about proxy advisory firms, I think it is important to ensure that advisers to institutional investors – which, let’s not forget, are generally simply collections of individual investors – are not over-relying on analyses by proxy advisory firms.  No one should be able to outsource their fiduciary duties, a point that is especially poignant in light of the fact that we are still dealing with the painful fallout from the actions and role of credit rating agencies in the subprime mortgage securitization fiasco – but that’s a topic for another time.

Ultimately, I think policy makers, regulators, fiduciaries, and market participants need to ask tough questions about the current proxy advisory regime, such as:

• Does following recommendations by proxy advisory firms increase shareholder value?
• What research do proxy advisory firms conduct to ensure that their recommendations increase shareholder value, and how is that research documented?
• How much transparency should proxy advisory firms provide subscribers with respect to how such research is conducted?
• Should proxy advisory firms be subject to proxy solicitation rules?
• Do governments provide preferred treatment to proxy advisory firms and advisors that rely on them, and is that appropriate?
• How can proxy advisory firms be held accountable for their recommendations?
• How should proxy advisory firms, and subscribers which use their recommendations, address potential conflicts of interest?

I hope that increased awareness of the role of proxy advisory firms in today’s corporate governance world encourages advisers, investors and policymakers to think about what that role should be.

Thank you all for your attention.  I’ve appreciated the opportunity to be here today and share my views on these vitally important subjects, and I wish you a successful conclusion to this conference.

 describing in greater detail the required content of the public disclosure of the mid-year stress test results;
 providing additional details with respect to the methodologies and capital distribution assumptions covered companies must employ in developing their scenarios and running the required stress tests; and
 providing specific instructions on the use of Form FR Y-14A for reporting mid-year stress test results to the Federal Reserve.

In addition, the 2013 summary instructions indicate that although the mid-year company-run stress tests are not part of the Federal Reserve’s Comprehensive Capital Analysis and Review Program (“CCAR”), the Federal Reserve “will incorporate information from the companies’ mid-cycle stress tests into its ongoing assessment of covered companies through the normal supervisory process.”

The full memo, published by Sullivan & Cromwell on May 20, 2013, is available here.

My paper also explores the skirmishing over the assumptions (and proof) of market efficiency and its relationship to materiality, reliance, causation and damages.  Even though there are ample muddles in the law, none is so troubling as to call Basic into question, as Justice Alito’s concurrence suggests, especially if one believes in the relevance of not only what Congress did but also did not do in 1995.  The paper draws from private correspondence between Justices Blackmun and Brennan when the Basic opinion was being drafted, which Adam Pritchard has unearthed, that sheds interesting light on the presumption and its contemporary meaning.

In his dissent, Justice Thomas traces the history of the fraud-on-the-market theory prior to Basic by reference to two “signposts,” one of which was the seminal Ninth Circuit case of Blackie v. Barrack. That was a fruitless effort in terms of reading it to say that materiality was crucial to class certification—it holds no such thing—but is also ironic.  Famously, Blackie justified the fraud-on-the-market presumption entirely in pragmatic terms.  While it expresses an intuition about organized markets and the importance of price integrity, the main idea is simple: without class certification there will be no practicable mechanism to address the harm from securities fraud.   Candidly admitting that its approach risked over-inclusion in the plaintiff class, Blackie reminded its readers that the securities statutes were to “be liberally construed to effectuate its remedial purposes, and that that purpose may be served only by allowing an over-inclusive recovery to a defrauded class if the unavailability of the class device renders the alternative a grossly under-inclusive recovery.”

Basic starts out saying much the same thing, stressing that presumptions exist mainly to do justice, but then wanders into the efficient markets discussion as if it offers a better way of understanding reliance in modern financial markets.  It doesn’t, generating the uncertainty about class certification that eventually led to Amgen.

Today the Supreme Court is no long enamored with the “liberally construed” rhetoric, which naturally invites those dissatisfied with how things have turned out to question the premises on which the fraud-on-the-market presumption rests.  The majority in Amgen responds to the defense-side request to allow them an early shot at materiality within the class certification decision by invoking old-school civil procedure.  How much this was also animated by sense that the relative balance between plaintiffs and defendants struck at the time Congress entered the debate twenty years ago should be respected will determine much about the future of private securities class actions.

A link to the full paper is available here.  Comments are welcomed.

The newly amended credit rating agencies regulation coming into force on 20 June will expand the scope and application of disclosure requirements and other ratings related regulation for structured finance instruments – a concept wide enough to include many transactions not traditionally thought of as securitisations. It imposes potentially extensive disclosure requirements and rules requiring at least two ratings. It also promotes the use of smaller credit rating agencies. Previously it had been possible for parties to ignore most disclosure requirements provided that the transaction in question was not offered to the public or listed on a regulated market. Read on if you are interested in finding out more about the impact of these changes.

The comment period for the proposed cross-border rules ends 90 days after publication in the Federal Register. The comment period for the previously proposed rules and policy statement ends 60 days after publication in the Federal Register.

The memorandum (available here) provides an overview of key provisions of the SEC’s proposal, highlighting the most important differences from the CFTC Proposal. We focus on those provisions of the SEC’s proposal that address the regulation of security-based swap dealers and security-based swap end users, but we note that the SEC’s proposal also addresses the cross-border regulation of clearing agencies, security-based swap data repositories and security-based swap execution facilities.

Thank you for inviting me to join you here today.

Before I launch into my remarks, I need to note that, as a matter of policy, the SEC disclaims responsibility for the private statements of SEC employees. The views I express today are my own, and do not necessarily reflect the views of the SEC, the Commissioners, or my colleagues on the staff.

Today, I’d like to describe the Commission’s recent set of proposals on the cross-border regulation of derivatives. First, though, I’ll describe the state of play among international regulators, both in developing their derivatives regimes and in grappling with the thorny cross-border aspects of derivatives trading.

Status of International Regulatory Efforts

Countries are at various stages of implementing their derivatives regimes in response to the G20 commitments.

The U.S. is further along in this effort. The SEC has now proposed substantially all of the rules required by Title VII, and we have adopted the foundational definitional rules and those governing swap clearing agencies standards, among others. The CFTC is further along in the adoption mode and is on track to complete the adoption of their rules later this year.

Other jurisdictions are further behind, which means that it is difficult to assess at this point how similar their requirements may be to those that the U.S. is implementing.

At the same time, regulators are grappling with the cross-border impact of their individual requirements. Last year, the CFTC proposed an interpretive statement describing how their rules would apply off-shore, and we were able to consider the comments received on their proposals in fashioning our own. No other jurisdictions have laid out a comprehensive view of how their rules would apply to cross-border activity.

There are however, various so-called “equivalence” efforts underway. In general, an equivalence assessment looks at the full sweep of another jurisdiction’s rules to determine whether they should be deemed comparable. If they are, participants trading cross-border have the choice of which country’s rules to apply.

One problem with this approach is that it requires an “all or nothing” determination. If another regime is found to be comparable notwithstanding significant gaps in coverage, the markets are ripe for regulatory arbitrage, since participants will always opt for the lower-burden alternative.

On the other hand, if an equivalence assessment requires that rules be mostly identical, it will be very difficult to ever make that determination, which would fail to recognize legitimate differences that are likely to arise among global regimes.

Even more problems can arise if an equivalence review is coupled with a reciprocity element. In that case, one jurisdiction makes its own equivalence decision dependent on the decision of the other jurisdiction to make the same finding. To me, that looks less like a comparability review than a trade negotiation. A reciprocity condition could be used as a cudgel to coerce other regimes to adopt regulations that are very close to those of the country that is making the determination. Or, on the other hand, it could be used as a protectionist measure to wall off markets from the impact of another country’s rules.

Then-Chairman Elisse Walter laid out these concerns in more detail, when she previewed our cross-border approach in a recent speech, and I commend those remarks to you if you haven’t read them.

There are also various multi-lateral and bilateral efforts underway to find some convergence on these issues, and notwithstanding some differences in how individual jurisdictions approached these questions at the outset, there does seem to be genuine interest in finding common ground.

You may have read that a number of foreign finance ministers sent a letter recently to the Secretary of the Treasury on this topic. Although the reason for the letter was to express concern about slow progress in finding an international solution to overlapping or conflicting rules, there were some positive messages. All of the signatories expressed support for the development of regimes consistent with the G20 goals and their desire to avoid cross-border conflicts. They also committed to staying “vigilant against regulatory arbitrage”, which is a good cause to rally around.

Principles Driving the Cross-Border Proposal

Those are just a few of the key undercurrents of the global efforts to reform the derivatives markets. And it is within that context that the SEC has proposed its rules and interpretations pertaining to cross-border derivatives transactions and activities.

They may seem complicated because the subject matter is complicated, but our approach proceeds from some pretty simple principles and observations.

First, financial crises tend to be global in scope. That was true in 2008, and it is likely to be true in the future. It was the recognition of this truth that gave birth to the G20 commitments, which led to Title VII.

Second, much if not most of the trading in derivatives markets tends to have an international component. Therefore, I don’t think it is much of a stretch to suggest that Congress did not expect that our rules would only apply to activity that occurs exclusively within the United States. That would lead to the lion’s share of much security-based swap activity that impacts the United States being beyond the reach of our rules. That simply doesn’t make sense as a matter of statutory interpretation or regulatory policy.

At the same time, we don’t view the statute as calling on U.S. regulators to export Dodd-Frank to the world. Doing so could well lead to geographic segmentation of the market. That won’t make the global trading markets safer. Global dealers today allocate positions around the globe based on their assessment of where their own risk can best be managed. That’s a mindset we want to encourage; erection of geographic barriers distorts the way that risk is managed, which is bad for the global system.

In this regard, there are already warning signs in global markets about the potential for protectionist or retaliatory measures to be adopted. For example, the Fed’s proposal to impose capital surcharges on large foreign banking organizations in the U.S. has raised concerns about possible protectionist responses or retaliation. I’m not speaking to the merits of that particular proposal, only noting that there are various pressures that could push global markets toward fragmentation.

So our proposed cross-border rules try to fulfill the goals of Title VII in light of the realities of global trading and the goal of preserving the benefits of integrated markets. In general and as I will explain in just a moment, we have proposed to answer the question by applying our registration and other threshold requirements to activities that in some respects occur in the United States, but provide the ability to make broad substituted compliance determinations or grant exemptions to allow foreign firms to comply with home requirements, or to clear or execute trades through offshore facilities, where the foreign regimes aim at the same outcomes as ours.

As Commissioner Walter put it in her speech, we have tried to find a “middle ground”.

In putting forward this proposal, we are conscious of the importance of the Title VII provisions in reducing risk throughout the system, but we also know that we are not the only game in town. We in the U.S. are further along in this effort, but it should be possible to attain strong global standards in a cooperative way, and it should be possible to lead without arrogance.

Overview of the Proposal

We proposed the cross-border rules and interpretations relating to all of the Title VII requirements at the same time so that people could consider how the individual parts relate to each other and decide if they work as a coherent scheme. Also, we proposed our approach in the form of rules and interpretations subject to notice and comment and backed up by a very thorough economic analysis. In fact, the economic analysis substantially accounts for the length of the release.

The proposal covers many topics but primarily it addresses:

• Regulation of dealers and major participants, which includes both entity requirements like capital and transaction requirements like certain business conduct rules;
• Registration of infrastructure entities (data repositories, clearing agencies and execution facilities);
• What I think of as “market-wide transaction requirements”, which apply to dealers and non-dealers, including regulatory reporting and trade dissemination, mandatory clearing requirements, and mandatory trade execution.
• We also proposed a way to avoid adverse impacts from the provision of Dodd-Frank that asks for regulators to indemnify trade repositories before obtaining data from them.

In broad terms, it may be best to understand the proposal by separating two main questions that are addressed. The first is whether particular entities or transactions are captured by the rules because there is a sufficient nexus to the U.S. The second question is how they comply with the rules when the tripwire is crossed. It is in answer to the second question that the idea of substituted compliance comes into play.

Specifics of the Proposal

Territorial Approach and the Definition of “U.S. Person”

As to the first question, in general we have taken a “territorial” and “entity-based” approach. A key issue under that first heading is whether an entity is conducting enough business to require it to register as a dealer in security-based swaps, after considering the rules we’ve previously adopted requiring that an entity conduct more than a threshold amount of dealing activity to trigger registration.

In answering that question, dealers located in the U.S. consider all of the business they conduct, foreign and domestic. Also, consistent with the treatment of bank branches in other contexts, branches located overseas are considered part of the U.S. entity they are attached to.

In contrast, entities located off-shore count only the business they conduct within the United States or with U.S. persons. In defining the term “U.S. person”, we took a simple, straightforward approach: U.S. persons are residents, those that are incorporated or organized here, and those that have their principal place of business in the U.S.

We proposed to treat transactions executed, solicited, negotiated, or booked in the U.S. as U.S. business because that reflects common sense and in order to level the playing field. Consider a scenario that reflects trades that happen every day. A bank based in the U.K. uses its New York mid-town office to negotiate and document a CDS trade with a German hedge fund. If this trade was not considered to be U.S. business, a U.S. dealer with offices in the very same building might have to operate under a very different set of rules if it did precisely the same trade with the same counterparty.

To summarize, U.S. dealers have to register if they conduct more than a minimal amount of dealing business in derivatives that we regulate, while foreign-based firms need to register if they do more than a minimal amount of dealing business either with U.S. persons, or where key aspects of the business occur in the U.S.

The Treatment of Foreign Branches and Guaranteed Subsidiaries

We gave a lot of thought as to how Title VII should apply to foreign branches of U.S. banks and guaranteed subsidiaries of U.S. holding companies. We considered how to best account for the risk conducted in those entities while avoiding competitive distortions.

First, as to branches, foreign dealers would not be required to count trades with foreign branches of U.S. banks as U.S. business, even though for most purposes a branch is considered to be a part of the larger corporate entity. Our concern was that otherwise, foreign firms would curtail their business with those branches in order to avoid being subject to the U.S. dealer regime.

Also, in many cases those branches would not be subject to U.S. clearing, trade execution, and dissemination requirements when they deal with foreign counterparties.  Again, we thought it made sense to give some flexibility for those firms to do business outside the U.S. on the same basis as their competitors.

Similarly, our proposal would not require guaranteed foreign subsidiaries of U.S. holding companies to register as dealers if they conduct no or minimal U.S. business. We understand that the fact of a U.S. guarantee could transfer risk back to the U.S. But, instead of applying the full raft of U.S. dealer rules to those entities, we thought that risk was better accounted for by the major participant regime.

So, in the case of a U.S. holding company guaranteeing trades of its foreign subsidiary, which does not itself conduct U.S. business, the guarantee would not cause the subsidiary to register as a dealer, but the holding company might well need to register as a major security-based swap participant and be subject to the standards of that regime.

Triggering of Other Regulatory Requirements

We also addressed the application of U.S. rules to what I’ll call “infrastructure” entities – the clearing agencies, data repositories and swap execution facilities. Subject to the ability to obtain exemptions where they are subject to comparable regulation off-shore, which I’ll address in a moment, each would be required to register if there are specific identified activities in the U.S.

The extent and nature of the required U.S. activity would depend on the type of entity. For example, clearing agencies could be subject to U.S. rules if they have any U.S. members, on the theory that U.S. membership transfers the risk of the clearing house directly to U.S. markets.

Registration of execution facilities could be required if the facility provides U.S. persons with the direct ability to trade on a foreign market. This is consistent with the approach that has been followed before in determining whether more traditional trading venues are subject to U.S. requirements.

We also proposed to apply what I call the “market-wide” transaction requirements – trade reporting and transparency, clearing, and trade execution – to trades where there is specific and identifiable U.S. activity.

The nature and extent of U.S. activity, again, depends on the specific requirement. The proposal contains a fair amount of complexity in this regard. We were concerned that, by making it simpler, we might capture more activity than was warranted, or else cede authority over transactions that directly involve participants and markets here.

The rules on trade reporting would be somewhat more broadly applied than the others, given the regulatory interest in having a complete view of all transactions that impact U.S. markets.

The Use of Substituted Compliance and Exemptions

To this point, I’ve been talking about what may trigger the U.S. requirements. I’d now like to address the second question: how may parties located outside the U.S. comply with those requirements?

In general, we have proposed a method whereby participants in cross-border transactions could “substitute” compliance with home country rules in place of the U.S. requirements if the Commission has found those home country rules to be comparable.

This determination would be made considering the similarity of outcomes under each set of rules. This scheme would not involve a granular or rule-by-rule comparison and would recognize that it is possible to get to the same place by more than one path.

Also, unlike the equivalency assessments I described earlier, this would not be an “all or nothing” process. The Commission would consider comparability according to four general categories – 1) regulation of non-U.S. dealers; 2) regulatory reporting and public dissemination of trade data; 3) mandatory clearing of security-based swaps; and 4) mandatory trade execution.

Under our plan, a participant or group could request a substituted compliance determination for one or all of these categories on a jurisdiction-by-jurisdiction basis. If granted, the determination would be available to all participants who trade in that jurisdiction.

Because this would not be an “all or none” exercise, for example, the Commission could allow foreign participants to follow the capital and margin rules of their home country if they were found to be comparable. At the same time, if the same regime did not have comparable reporting and transparency requirements, the SEC rules governing those elements would apply.

Also, as I mentioned earlier, clearing agencies, trade repositories, and swap execution facilities could be the subject of exemptions if their home countries are found to have comparable rules in place to those that govern the same entities here.

So, for example, a trade between a foreign dealer and a U.S. fund that is required to be cleared under the U.S. regime could be cleared instead at a non-U.S. registered European clearing agency if that entity was subject to a comprehensive and comparable system of oversight in its home country.

What I like about the substituted compliance concept is that it recognizes that different regulatory regimes can have different ways of achieving the same outcomes. More than that, it allows U.S. regulators to encourage continuing dialogue with our colleagues in other countries in aiming at strong global standards that reduce risk everywhere. If we insisted on applying U.S. rules to all cross-border trades, regulators in other places may feel they have no incentive to continue the conversation. Instead, they may have a big incentive to erect barriers against the long arm of the U.S. laws.

Conclusion

In closing, I want to emphasize that in crafting our cross-border approach, our aim has been to apply our laws in a way that achieves the financial stability, market transparency, and investor protection objectives of the Dodd-Frank Act while preserving the globally-integrated, dynamic character of the OTC derivatives market. We have done our best to frame a proposal that achieves these twin goals, and we look forward to your comments as well as comments from others.

Thank you for your time today.

Despite its sweeping reach, however, the Dodd-Frank Act fails to articulate a unifying vision – a philosophy, if you will – of systemic risk regulation in today’s financial marketplace. Mandating numerous regulatory “fixes” to specific problems exposed during the last crisis, the new statute does not offer an answer to the fundamental question: what does it really mean to regulate private participants and transactions in financial markets with the ultimate goal of protecting the national (and global) economy and citizenry – the public – from the next systemic crisis? How should we manage the inevitable trade-offs involved in that regulatory enterprise?

In two recent companion-articles, I explore one possible answer to this critical question and outline the rough contours of a highly unorthodox regulatory scheme for systemic risk prevention: mandatory pre-market government licensing of complex financial instruments (including derivatives, asset-backed securities, and other structured products).

The defining feature of the proposed regime is that it explicitly aims to reduce and control the amount and types of risk before such risk is introduced into the financial system. In that sense, mandatory pre-approval of financial products represents a true gatekeeping mechanism, a form of ex ante regulation that targets directly and proactively the levels of risk, leverage, and complexity in the financial system.

The general principle of pre-market product approval is not new. The main real-life experiments with product approval regulation include licensing of pharmaceutical drugs by the U.S. Food and Drug Administration, chemicals regulation in the European Union, and a system of mandatory pre-approval of commodity futures contracts administered by the Commodity Futures Trading Commission from 1974 to 2000. Complex and controversial as they may be, these examples offer valuable insights into whether – and, more importantly, how – a similar regime can potentially operate as a model of systemic risk regulation in financial markets.

However, shifting the focus of the product approval scheme from primarily consumer-safety and market-manipulation issues toward broader systemic stability concerns—such as socially unproductive levels of complexity, leverage, speculation, regulatory arbitrage, and interconnectedness in financial markets—complicates the task of designing it. A rigorous product approval regime can inadvertently slow down the development and marketing of potentially beneficial financial instruments and impede socially useful financial innovation. To avoid or minimize this danger, it is critical to structure the new regime to target, primarily and explicitly, what I call strategic complexity in financial markets: constant introduction of new complex financial instruments into the market, regardless of actual demand or true economic need for such instruments.

To operationalize this regulatory objective, I propose a process for product approval, which would require financial institutions to make an affirmative showing that each complex financial product they intend to market meets three statutory tests: (1) an “economic purpose” test, which would place the burden of proving commercial utility of each proposed financial instrument on the financial institutions seeking approval; (2) an “institutional capacity” test, which would require a review of the applicant firm’s ability to manage the risks and monitor the market dynamics of the proposed product effectively; and (3) a broad “systemic effects” test, which would require a finding that approval of the proposed product does not pose an unacceptable risk of increasing systemic vulnerability and otherwise does not raise significant public policy concerns.

Framed around this dynamic three-part test, the proposed regime does not necessarily prohibit any financial activities. It merely imposes the duty to provide information necessary for evaluating potential risks and benefits of a specific financial product on the party that has the best access to such information and the greatest incentives not to disclose it voluntarily. Yet, by altering underlying presumptions and shifting the burden of proof in this way, the proposed regulatory scheme is likely to have profound effects on the fundamental dynamics of our financial markets.

Of course, implementing such an ambitious and novel regulatory scheme in practice is bound to generate criticism and raise many difficult questions, both politically and as a matter of regulatory design. To many, the very idea may appear unrealistic or misguided. Nevertheless, it is vital to put this reform option on the table for a full and open-minded discussion. Implementation challenges notwithstanding, mandatory product approval offers a potentially effective method of advancing the public interest in more robust systemic risk prevention, as well as enhancing the efficient operation of financial markets. It deserves our attention and a thorough analysis.

The full text of my article detailing the proposal is available here. A shorter article highlighting key ideas is available here.

Federal Reserve Issues Rule to Classify Uninsured U.S. Branches and Agencies of Foreign Banks as Insured Depository Institutions for Purposes of the Swaps Push-out Provision of the Dodd-Frank Act and Explain the Process for Obtaining Transition Period Relief

The Supreme Court’s decision to hear the case is noteworthy because the First Circuit’s decision in Lawson conflicts only with decisions from the Review Board of the Department of Labor (“ARB”) and, as highlighted by the respondents, the parties could “not [cite] a single case in which [the Supreme Court] has granted certiorari to review a conflict between a court of appeals decision and a decisions of an administrative tribunal like the ARB.”   Section 1514A prohibits a publicly traded company, a mutual fund or “any officer, employee, contractor, subcontractor, or agent of such company [or mutual fund]” from discriminating against the employee for reporting potential securities violations.  The First Circuit found that § 1514A prohibits privately held contractors or subcontractors from retaliating against employees of the public companies with which they work, but did not bar privately-held companies from retaliating against their own employees.  Lawson v. FMR, LLC, 670 F. 3d 61 (1st Cir. 2012).  After the First Circuit’s decision, the ARB disagreed and found the SOX’s whistleblower protections did extend to employees of privately held contractors.  Spinner v. David Landau & Assocs. LLC, No. 10-111 (ARB May 31, 2012).

In Lawson, two Plaintiffs brought separate suits alleging unlawful retaliation by their employers, who were privately held investment advisors and sub-advisors to the Fidelity family of mutual funds.  It was not disputed that the mutual funds were “public companies” because they are required to file reports to Section 15(d) of the 1934 Act.  However, these funds, as it is for most mutual funds, have no employees of their own.  Instead, the directors of the funds contract with an investment advisor to provide advising and/or management services.  The First Circuit construed Section 1514A as providing protection only for employees of publicly traded companies and that the provision’s language referencing contractors and subcontractors merely identifies who is barred from taking retaliatory action against the employees of public companies.

In their petition for a writ of certiorari, the petitioners argued that the consequences of the First Circuit’s decision are serious for the mutual fund industry because “[v]irtually all of the workers in the mutual fund industry are employed, not by the funds, but by investment advisors, and many of the advisors themselves are privately held companies,” thus, leaving many potential whistleblowers unprotected.  The respondents countered that this concern as overstated because, inter alia, the Dodd-Frank Act provides employees of privately held companies a private cause of action if they are discriminated by their employers for providing information to the SEC.

As mentioned above, this decision has far reaching consequences for the mutual fund industry as well as all privately held companies that assist public companies with their financial reporting obligations.  Drinker Biddle will keep you posted on the Supreme Court’s decision during its upcoming term.