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June 2007

Published by RR Donnelley
Editorial Content by LegalWorks
Blake A. Bell, Editor in Chief

In This Issue:

SEC I: SEC Commissioners Testify Before House Committee on Financial Services

On June 26, the five Commissioners of the U.S. Securities and Exchange Commission testified in a full committee hearing before the House Committee on Financial Services. The Commissioners were required to defend what some contend is a recent record that tilts toward corporate America in pursuing business misconduct.

One of the more interesting revelations during the hearing was testimony by Chairman Christopher Cox indicating that the Commission has begun investigations of a dozen or so matters involving collateralized debt obligations. With the near collapse of two Bear Stearns hedge funds that invested in such instruments, it appears that the Commission is showing interest in the sorts of investments being pursued by hedge funds. It seems that the Commission is most interested in whether these investments are being properly valued by the funds.

In another interesting (though unsurprising) development, Committee Chairman Barney Frank (Democrat) pressed Chairman Cox to reveal when the Commission's long-awaited proposal to increase shareholder access to proxy proposals. The issue was addressed fleetingly in the prepared statement of the Commissioners, noting only that the new proxy rules would be in place "in time for the next proxy season to address the implications of the Court's decision in AFSCME v. AIG ".

The prepared statement of the Commissioners offers a summary description of a few of the principal projects now underway at the Commission. It provides, however, little insight into the substance of those projects.



SEC II: SEC Votes To Extend Interactive Data Voluntary Reporting Program on the EDGAR System to Include Mutual Fund Risk / Return Summary Information

During its June 20 open meeting, the Commission voted to adopt amendments to expand its interactive data voluntary reporting program to permit mutual funds to submit as exhibits to their registration statements supplemental tagged information contained in the risk / return summary section of prospectuses. The risk / return summary section of mutual fund prospectuses typically contains key mutual fund information such as investment objectives and strategies, risks and costs.

Interestingly, in a prepared statement issued in connection with the June 20 open meeting, Commissioner Roel C. Campos indicated:

"this initiative is just the first of several that will increase transparency and understanding for our investors and, specifically, our retirement investors. Among other initiatives, I hope that the Commission will soon consider a short-form prospectus proposal that will lay out for fund investors in one or two pages the most critical points of investment-related information. Such a document has the potential to not only clarify and simplify investment information for retail investors, but — if incorporated into relevant Department of Labor rules and regulations — for our retirement investors as well."



SEC III: SEC Proposes Six Measures To Modernize Small Company Capital-Raising and Disclosure Requirements

During its busy June 20 open meeting, the SEC also voted to propose amendments to Form 20-F, Rules 3-10 and 4-01 of Regulation S-X, Forms F-4 and S-4, and Rule 701 under the Securities Act, to accept financial statements prepared in accordance with International Financial Reporting Standards as published by the International Accounting Standards Board without reconciliation to generally accepted accounting principles as used in the United States when contained in the filings of foreign private issuers with the Commission.

Pundits already have begun to criticize the move. Jonathan Weil, a Bloomberg News columnist, prepared an interesting report made available by Bloomberg News on June 27 entitled "SEC Snaps Its Magic Fingers and Assets Appear". In it, he cites an extreme example where the lack of a GAAP reconciliation would lead to an interesting result. He wrote:

"Consider Tanzanian Royalty Exploration Corp., a gold-mining company based in Sharon, Connecticut, that issues lots of press releases but has no revenue or proven mineral reserves. Though its shares trade on the American Stock Exchange, it files its financial reports with the SEC using Canada's version of generally accepted accounting principles. By those standards, Tanzanian showed C$24.9 million ($22.6 million) of assets in its last annual report.

Under U.S. GAAP, all but C$11.2 million of those assets disappear. We know this only because the SEC now requires Tanzanian to show its financial results under both methods. In a couple years or so, if the SEC has its way, the company won't have to report U.S. GAAP figures at all."

Weil's report further notes that regarding the very issue that leads to the different results under Canadian versus U.S. GAAP requirements, "the Canadian rules and international standards are the same".

The debate that will follow the proposals promises to be interesting . . . .



SEC IV: SEC Adopts So-Called Universal "E-Proxy" Rules

The Commission also voted during its June 20 open meeting to adopt a mandatory version set of E-Proxy rules known as the Universal "E-Proxy" rules. Following the Commission's move earlier this year to permit voluntary e-proxy distribution, on June 20 the SEC voted to adopt amendments to the proxy rules under the Exchange Act to provide shareholders with the ability to choose the means by which they access proxy materials. Under the amendments, issuers and other soliciting persons will post their proxy materials on an Internet Web site and provide shareholders with a notice of the Internet availability of the materials. The issuer or soliciting person may choose to furnish paper copies of the proxy materials along with the notice. If the issuer or soliciting person chooses not to furnish a paper copy of the proxy materials along with the notice, a shareholder may request delivery of a copy at no charge to the shareholder.

One difference between the earlier voluntary version of the E-Proxy rules and the newly-adopted mandatory version of the rules is that the newly-adopted rules provide that the notice-and-access method of proxy distribution must be used for all proxy solicitations (other than business combinations).



SEC V: Commission Votes To Adopt Amendments to Rule 105 of Regulation M

In another development during the June 20 open meeting, the Commission voted to adopt amendments to Rule 105 of Regulation M that it says will "further safeguard the integrity of the capital raising process and protect issuers from manipulative activity that can reduce issuers' offering proceeds and dilute security holder value". The Commission has explained the rationale underlying its decision to adopt the Amendments as follows:

"When a trader expects to receive shares in an offering, there is an incentive to sell short prior to pricing an offering and then cover that short position with shares bought at the reduced offering price. By doing so, the trader can cover the short sale with minimal risk, and generally lock in a guaranteed profit — to the detriment of the issuer and the other shareholders.

The amendments change the way the rule works to prevent this from happening. They replace the rule's current limitation on covering the short sales in the offering with a prohibition on purchasing in the offering after a short sale in the securities. This change was triggered by persistent non-compliance with the rule and a string of strategies to conceal the prohibited covering. Under the amended rule, if a person sells short during the restricted period prior to pricing, that person is prohibited from purchasing the offered security. Thus, the amended rule changes the prohibited activity from covering to purchasing the offered security.

In order to ensure that the rule does not unduly limit the pool of possible purchasers in follow on and secondary offerings, it includes a provision to allow a restricted period short seller to participate in an offering if the seller makes a bona fide purchase prior to pricing an offering. Moreover, the amended rule also includes exceptions concerning investment companies and certain other entities that make separate trading and investment decisions. Thus, for example, the rule does not prevent one account from purchasing in an offering even though a related account sold short during the restricted period where the accounts were not coordinating their trading or sharing profits."

The amendments to Rule 105 will be effective 60 days after publication in the Federal Register .



SEC VI: SEC Votes To Amend Rules 200 and 203 of Regulation SHO, to Propose Additional Amendments to Rule 200 and to Re-Propose Certain Amendments to Rule 203

At its June 13 open meeting, the SEC voted to amend Rules 200 and 203 of Regulation SHO. The Commission also voted to propose additional amendments to Rule 200 and to re-propose certain amendments to Rule 203.

Amendments to Rules 200 and 203
The amendments to Rules 200 and 203 result, according to the SEC, in four principal changes to the rules:
  1. The amendments eliminate the grandfather provision in Rule 203(b)(3)(i) so that all "fail to deliver" positions in threshold securities will have to be closed out within 13 consecutive settlement days, regardless of whether they occurred before the security became a threshold security .
  2. The amendments permit previously-excepted grandfather positions that are threshold securities on the effective date of the amendment to be closed out within 35 settlement days of the effective date of the amendment.
  3. The amendments revised Rule 203 of Regulation SHO to extend the "close out requirement" from 13 to 35 consecutive settlement days for "fails to deliver" resulting from sales of threshold securities pursuant to Rule 144 of the Securities Act.
  4. The amendments revise Rule 200(e)(3) to (i) reference the NYSE Composite Index (NYA) instead of the Dow Jones Industrial Average (DJIA); (ii) add language to clarify that the two-percent limitation is to be calculated in accordance with NYSE Rule 80A; and (iii) provide that the market decline limitation will remain in effect for the remainder of the trading day.
Proposed Amendment to Rule 200 and Re-Proposed Amendment to Rule 203
According to the Commission, he proposed amendments would modify the long sale marking requirements of Regulation SHO to require that broker-dealers marking a sale as "long" document the present location of the securities being sold. The re-proposed amendments are intended to further reduce fails to deliver in certain equity securities by eliminating the options market maker exception to the close-out requirement of Regulation SHO. In addition, the Commission voted to solicit comment regarding two narrowly-tailored alternatives to elimination of the options market maker exception.

Additionally, the proposed amendments address the so-called "options market maker exception". (That exception provides that any fail to deliver position in a threshold security resulting from short sales effected by a registered options market maker to establish or maintain a hedge on options positions that were created before the underlying security became a threshold security do not have to be closed out.) The proposed amendments would eliminate this exception to the close-out requirement of Regulation SHO. The proposed amendments to eliminate the options market maker exception also include a one-time 35 consecutive settlement day phase-in period for previously-excepted "fail to deliver" positions.

Elimination of the So-Called "Tick Test"
The Commission voted to adopt amendments to Rule 10a-1 (17 CFR 240.10a-1) and Regulation SHO (17 CFR 242.200 et seq .) that will eliminate the tick test rule under Rule 10a-1 as well as any short sale price test of any self-regulatory organization (SRO). In addition, the amendments will prohibit any SRO from having a price test. The amendments will also include a technical amendment to Rule 200(g) of Regulation SHO that will remove the "short exempt" marking requirement of that rule.



SEC VII: SEC Issues Internal Controls Interpretive Guidance and Associated Adopting and Proposing Rules Releases

On June 20, the SEC issued internal controls management report interpretive guidance regarding Section 404 of Sarbanes-Oxley. It also issued an adopting release for related amended rules and a release seeking "additional comment on the definition of the term 'significant deficiency'" used in Sections 302 and 404 of the Sarbanes-Oxley Act.

In its 77-page adopting release setting forth its interpretive guidance, the Commission sets forth a detailed approach by which "management can conduct a top-down, risk-based evaluation of internal control over financial reporting." More importantly, the Commission affirms in its guidance that any such evaluation that complies with its interpretive guidance will "satisfy the evaluation requirements of Rules 13a-15(c) and 15d-15(c) under the Securities Exchange Act of 1934.

The Commission also issued its adopting release also affirming that evaluations conducted in compliance with its interpretive guidance are "one way to satisfy the requirement for management to evaluate the effectiveness of the issuer's internal control over financial reporting". The same adopting release specifies amendments to the Commission's rules to define the phrase "material weakness" and also to revise the requirements regarding the auditor's attestation report on the effectiveness of internal control over financial reporting.

In an interesting related development, the Commission has noted that in its December proposing release regarding interpretive guidance on internal controls management report it sought comment on the concepts of "significant deficiency" and "material weakness" but in its June 20 adopting release it adopted a definition for only the phrase "material weakness". Consequently, on June 20 the Commission also issued its request for additional comment regarding the definition of the phrase "significant deficiency". According to the request for additional comments, the Commission believes "that a definition of this term should also be in the Commission's rules, in addition to being in the auditing standards."

Comments are due on or before July 18.



SEC VIII: SEC Seeks "Additional" Comments on PCAOB's Auditing Standard No. 5

On June 15, the SEC issued a rather unusual solicitation of comments regarding the Public Company Accounting Oversight Board's Proposed Rule on Auditing Standard No. 5. The solicitation was unusual because it followed by only one week the Commission's issuance of a similar notice issued a week earlier on June 7 seeking comment on the same topic.

The Commission's June 15 notice identified seven specific issues that, it seems, the SEC intends to consider with care. They seek specific comment on:

  • The standard of materiality and whether it is appropriately defined throughout AS5 to provide sufficient guidance to auditors;
  • The requirement in paragraph 80 of AS5 that the auditor consider whether there are any deficiencies or combinations of deficiencies that are significant deficiencies and, if so, communicate those to the audit committee; specifically, will the communication requirement regarding significant deficiencies divert auditors' attention away from material weaknesses?
  • Whether AS5 is sufficiently clear that for purposes of evaluating identified deficiencies, multiple control deficiencies should only be looked at in combination if they are related to one another;
  • Whether the definition of "material weakness" in paragraph A7 (which is consistent with the SEC's recently-adopted definition) appropriately describes the deficiencies that should prevent the auditor from finding that ICFR is effective;
  • Whether AS5 is sufficiently clear about the extent to which auditors can use the work of others;
  • Whether AS5 will reduce expected audit costs under Section 404, particularly for smaller public companies; and
  • Whether AS5 inappropriately discourages or restricts auditors from scaling audits, particularly for smaller public companies.


SRO I: A Name That Will Be Familiar Soon - Securities Industry Regulatory Authority (SIRA)

On June 20, NASD Chairman and CEO Mary Schapiro delivered a speech at the Exchequer Club in Washington in which she revealed the name of the new regulatory organization formed from the consolidation of NASD and the New York Stock Exchange Member Regulation. It is a name that will soon become familiar to all readers of RealCorporateLawyer.com: the Securities Industry Regulatory Authority -- SIRA.

Ms. Shapiro noted in her speech that the consolidation of NASD and NYSE member regulation operations "is the most dramatic restructuring of the self-regulatory model since the 1930s". According to her prepared remarks, Ms. Shapiro built the drama of the moment for the announcement and introduced some levity. She said:

"Now, until this moment, we haven't revealed what the new organization will be called. But I think it's time to make the new name public and what better place than the Exchequer Club to make a little news.

But first, I want to admit something. The new name wasn't my first choice. I wanted the name to be Vanguard. What a perfect name for a regulator - "the Vanguard of investor protection, at the vanguard of regulatory innovation." That has a nice ring to it.

However, there is a small mutual fund company by the same name that refused to give it up. Hard as I tried, they wouldn't budge. So we went back to the drawing board.

I believe our new name describes the new organization very well. The new organization will be known as the Securities Industry Regulatory Authority or SIRA."



SRO II: NASD and NYSE Solicit Comments on Proposed Joint Guidance Regarding the Review and Supervision of Electronic Communications

On June 13, the NASD and NYSE issued notice that they seek comments on proposed "Joint Guidance Regarding Review and Supervision of Electronic Communications". Citing recent technological innovations and how they have altered how people deliver, receive, and store communications, the NASD and NYSE issued 11-pages worth of guidance on review and supervision of such communications. The guidance appears as an attachment to the NASD Notice to Members referenced above.

The guidance addresses review and supervision of electronic communications, generally. It also addresses written policies and procedures that should be maintained to ensure effective supervision of such communications. It specifies the types of external and internal communications that require review by a supervisor and the procedures that should be followed in connection with identification of the person or persons responsible for the review of electronic communications. Finally, it addresses the method and frequency of required review of "correspondence" as well as what documentation must be maintained of any such review.



Litigation I: U.S. Supreme Court Decides Tellabs Case

Tellabs, Inc., et al., v. Makor Issues & Rights, Ltd., et al. , No. 06-484, Slip Opinion , __ U.S. __ (June 21, 2007).

On June 21, 2007, the Supreme Court of the United States released its long-awaited opinion in Tellabs, Inc., et al., v. Makor Issues & Rights, Ltd., et al. , No. 06-484, Slip Opinion , __ U.S. __ (June 21, 2007). Broadly speaking, the Court held that in deciding whether the allegations of a securities fraud complete meet the "strong inference" of scienter required under the Private Securities Litigation Reform Act of 1995, a court must consider competing inferences.

The Court's opinion makes clear that securities plaintiffs now must plead facts that are cogent and compelling in support of their assertions of the requisite scienter and that such allegations must be as compelling as "any opposing inference" or the complaint must be dismissed.

RealCorporateLawyer.com is pleased to provide access to law firm memo guidance on the Supreme Court's decision in the Tellabs case.



PRACTICAL GUIDANCE: Courtesy of RealCorporateLawyer.com

RealCorporateLawyer.com provides its readers with free access to a very large collection of law firm memoranda providing practical guidance on current hot topics. Readers are encouraged to visit the frequently-updated "Emerging Legal Issues" area of the home page for such current memoranda, as well as the Expert Analysis: SEC Reform Portal section containing hundreds of other such memoranda. Recent additions include:

Also, don't forget that RR Donnelley's highly acclaimed Executive Compensation Handbook has been newly-revised and reflects the Commission's executive compensation rules announced on December 22, 2006. Additionally, a copy of the Presentation given during the RR Donnelley Executive Compensation Webcast on January 25, 2007 is available for free download by clicking here .



COMINGS AND GOINGS: Who's Doing and Saying What and Where?

On June 19, the PCAOB announced that C. Gregory Scates has been named Deputy Chief Auditor, reporting to Tom Ray, PCAOB Chief Auditor and Director of Professional Standards. See Public Company Accounting Oversight Board, PCAOB Names C. Gregory Scates Deputy Chief Auditor (June 19, 2007).

On June 15, the SEC announced that David Brown has become its first Archivist. Most recently he served as Special Assistant to the Archivist of the United States at the National Archives and Records Administration. See U.S. Securities and Exchange Commission, David Brown Becomes First Archivist of Securities and Exchange Commission, News Release 2007-119 (June 15, 2007).

The Commission also announced on June 5 that leading mutual fund lawyer Thomas R. Smith, Jr. has joined the SEC's Division of Investment Management as a Senior Advisor to Division Director Andrew J. Donohue . See U.S. Securities and Exchange Commission, Thomas R. Smith, Jr. Has Joined SEC's Division of Investment Management as Senior Advisor, News Release 2007-110 (June 5, 2007).

What Are the Commissioners and Commission Staffers Saying?

On June 20, Commissioner Roel C. Campos delivered " Remarks at the SEC Open Meeting: Extension of Interactive Data Voluntary Reporting Program on the EDGAR System to Include Mutual Fund Risk/Return Summary Information ". At the same meeting, he also gave " Remarks at the SEC Open Meeting: Amendments to Rule 105 of Regulation M ". SEC Chairman Christopher Cox delivered " Remarks to the New York Society of Security Analysts " on June 14. On June 13, Chairman Cox gave an " Opening Statement at the Commission Open Meeting ". Commissioner Paul S. Atkins delivered " Remarks at the Fund Governance Forum " on June 7. SEC Chairman Cox gave " Welcoming Remarks, SEC Historical Society's Commemoration of the Commission's Seventy-Third Year ," on June 6. The same day, Commissioner Annette L. Nazareth delivered " Remarks Before the PLI Hedge Fund Conference ". On June 4, Commissioner Kathleen L. Casey delivered " Remarks at the 15th International XBRL Conference ". Chairman Cox gave " Remarks to the Annual Meeting of the Association of Audit Committee Members " on June 1 and, on May 31, delivered " Address to the National Italian-American Foundation ".

Commission Staffers also had a busy month of speaking engagements. Andrew J. Donohue , Director of the Division of Investment Management, delivered " Remarks Before the NAVA Compliance and Regulatory Affairs Conference " on June 25. Erik R. Sirri , Director of the Division of Market Regulation, delivered " Remarks Before the SEC Open Meeting: Final Amendments to Rule 105 of Regulation M " during the Commission's June 20 open meeting. During the same open meeting, Michael D. Coco , Special Counsel, Office of International Corporate Finance, Division of Corporation Finance, gave " Opening Remarks at the SEC Open Meeting ". Also during the June 20 open meeting, Raymond A. Be , Special Counsel, Office of Rulemaking, Division of Corporation Finance, gave the " Opening Statement of the Division of Corporation Finance at the SEC Open Meeting ". On June 7, the SEC's Associate Director of OCIE, Mary Ann Gadziala , spoke on " The Regulatory Focus on Broker-Dealer Legal and Compliance Issues ". Chester S. Spatt (the SEC's Chief Economist and Director of the Office of Economic Analysis), spoke on June 1 regarding " Increased Importance of Models: Disclosure, Fair Value and Accounting ". On May 31, James L. Kroeker (the SEC's Deputy Chief Accountant in the Office of the Chief Accountant) spoke regarding " SEC and Financial Reporting Institute ". On May 24, James Freeman, an Investor Advocate in the SEC's Office of Investor Education and Assistance, delivered " Remarks for Financial Reporting Through XBRL Panel Discussion at FDIC Accounting Conference ".



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