NASAA's List of Investor Traps

The North American Securities Administrators Association (NASAA) has issued an alert to investors advising them of ten "investment traps" identified by NASAA's Enforcement Trends Project Group. Each of these ten investment schemes promises very high returns, but furnishes very little or no disclosure of the risks, high commissions, and other fees related to these investments. Of the ten traps listed, NASAA "identified real estate investment schemes, leveraged ETFs, private placement offerings and natural resources investments, and Ponzi schemes as the greatest potential threats to investors this year."

Each of the investment traps identified by NASAA are listed below, with a link to an example, advisory, or additional explanation:

1. Entertainment Investments. These unregistered investments, encompassing a variety of products including movies, infomercials, internet gambling and pornography sites, promise high returns while offering little disclosure of risk.

2. Gold Bullion and Currency Scams. With the high price of gold, investors should beware of gold bullion scams in which the seller offers to retain “purchased” gold in a “secure vault” and promises to sell the gold for the investor as it gains in value. In many instances the gold does not exist. Similar are the many forms of foreign exchange (forex) trading schemes. Trading in foreign currencies requires resources far beyond the capacity of most individual investors. Promoters profit by charging high commissions or selling investment strategies assuming that trades are actually made. In many instances there are no trades; the money is simply stolen.

3. Leveraged Exchange-Traded Funds (ETFs). As we mentioned in our August 24 post, "Regulators Warn Investors About Leveraged and Inverse ETFs," this relatively new financial product has been offered to individual investors who may not be aware of the risks these funds carry. The funds, which trade throughout the day like a stock, use exotic financial instruments, including options and other derivatives, and promise the potential to provide greater than market returns as the value of the underlying assets rise or fall. Given their volatility, these funds typically are not suitable for most retail investors.

4. Life Settlements. State securities regulators long have been concerned about life settlements, or viaticals, and the rising popularity of these products among investors has prompted a recent congressional investigation. While life settlement transactions have helped some people obtain funds needed for medical expenses and other purposes, those benefits come at a high price for investors, particularly senior citizens. Wide-ranging fraudulent practices in the life settlement market include Ponzi schemes; fraudulent life expectancy evaluations; inadequate premium reserves that increase investor costs; and false promises of large profits with minimal risk.

5. Natural Resource Investments. NASAA expects to continue to see a rise in energy and precious metals scams promising quick, high returns. Investors anxious to recover losses quickly likely will be hooked by oil and gas schemes, as well as fraudulent offerings of investments tied to natural gas, wind and solar energy, and the development of new energy-efficient technologies.

6. Ponzi Schemes. Despite the heightened awareness of Ponzi schemes following Bernard Madoff’s multi-billion dollar fraud and 150-year prison sentence, these scams continue to trap investors. The Ponzi scheme is a house-of-cards swindle in which high returns are paid to initial investors out of the funds of later investors, who end up losing all or most of their money to the promoter.

7. Private Placement Offerings. Private placements offer businesses the opportunity to raise capital by selling securities to a relatively small number of investors as opposed to a public offering made through national securities markets. State securities regulators have observed a steady and significant rise in the number of private placement offerings that are later discovered to be fraudulent, especially those made under a federal registration exemption (Regulation D, Rule 506). Companies using this exemption can raise an unlimited amount of money without registering the offering with the SEC as long as they meet certain standards. Although properly used by many legitimate issuers, the exemption has become an attractive option for con artists, as well as individuals barred from the securities industry and others bent on stealing money from investors through false and misleading representations.

8. Real Estate Investment Schemes. NASAA members have noted a rise in scams disguised as offers to help homeowners caught up in the turbulent housing market “save” their homes or “fix” their mortgages, usually in exchange for a fee paid in advance. “Most of these advance-fee offers only generate a quick profit for the con-artist and provide no benefit to the consumer,” Joseph said. Some homeowners, particularly seniors, may be attracted to reverse mortgages, which are a legitimate lending option. However, the resulting lump sum home equity payment makes them an attractive target for unscrupulous salesmen, who may attempt to direct these funds toward worthless or unsuitable investment products.

9. Short-term Commercial Promissory Notes. Many seniors have lost their life savings by investing in short-term commercial promissory notes that are nine months or less in duration. These notes may be touted as being “insured” or “guaranteed,” but the insurance companies generally are located outside of the United States, are not licensed to do business in the United States, and lack the resources necessary to deliver on the promised guarantees. Unlike publicly advertised promissory notes, promoters of these notes usually attempt to use commercial paper exemptions as a basis for selling the products without registration. The commercial paper exemptions apply only to high-grade commercial paper traded by major corporations – not to these risky notes pushed to the public by a sales force paid with extremely high commissions.

10. Speculative Inventions and New Products. New products are for venture capitalists who know how to assess the risks. They are not good investments for your retirement money even though they may promise high returns.

The full text of NASAA's advisory on investment traps is available at: http://www.nasaa.org/NASAA_Newsroom/Current_NASAA_Headlines/11129.cfm

SEC and CFTC Announce Meetings on Harmonizing Regulations

The SEC and CFTC announced last week that the two agencies will hold joint meetings to seek input from the public on harmonization of the regulation of similar types of over the counter (OTC) financial instruments. The first meeting will be held at the CFTC on Sept. 2, 2009. The second meeting, on Sept. 3, 2009, will be held at the SEC. These meetings are being held in response to the Obama Administration's White Paper on Financial Regulatory Reform which called on the SEC and CFTC to “make recommendations to Congress for changes to statutes and regulations that would harmonize regulation of futures and securities.” The White Paper also recommended that the two agencies submit a report to Congress by September 30, 2009 identifying the conflicts that currently exist in statutes and regulations governing OTC instruments, and either justifying or making recommendations to eliminate these differences.

The SEC announcement of the joint meetings is available at: http://www.sec.gov/news/press/2009/2009-186.htm

The CFTC announcement of the joint meetings is available at: http://www.cftc.gov/newsroom/generalpressreleases/2009/pr5696-09.html

Regulators Warn Investors About Leveraged and Inverse ETFs

The SEC and FINRA issued a joint release warning individual investors of the dangers of leveraged and inverse exchange traded funds (ETFs). According to the alert, these specialized and complex products, designed to achieve their stated performance on a daily basis, pose extra risk for individual investors, who tend to buy-and-hold. The thrust of the alert is that "investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives."

The release describes leveraged ETFs as:

Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. Inverse ETFs (also called “short” funds) seek to deliver the opposite of the performance of the index or benchmark they track. Like traditional ETFs, some leveraged and inverse ETFs track broad indices, some are sector-specific, and others are linked to commodities, currencies, or some other benchmark. Inverse ETFs often are marketed as a way for investors to profit from, or at least hedge their exposure to, downward moving markets.

Leveraged inverse ETFs are described as:

Leveraged inverse ETFs (also known as “ultra short” funds) seek to achieve a return that is a multiple of the inverse performance of the underlying index. An inverse ETF that tracks a particular index, for example, seeks to deliver the inverse of the performance of that index, while a 2x (two times) leveraged inverse ETF seeks to deliver double the opposite of that index’s performance. To accomplish their objectives, leveraged and inverse ETFs pursue a range of investment strategies through the use of swaps, futures contracts, and other derivative instruments.

The primary risk the alert warns of is that leveraged and inverse ETFs "are designed to achieve their stated objectives on a daily basis. Their performance over longer periods of time -- over weeks or months or years -- can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. This effect can be magnified in volatile markets." The release also includes some "real-life" examples of the magnified negative effects these kinds of ETFs can have for investors who make the mistake of holding them for longer periods.

As with all investments, the alert warns that the best way for investors to protect themselves is to understand thoroughly the instruments or vehicles before investing. This includes reading the prospectus, seeking the advice of a qualified investment professional who understands these products, and also understands the investor's individual risk tolerance and investment goals. With respect to leveraged or inverse ETFs, the release advises investors to ask:

• How does the ETF achieve its stated objectives? And what are the risks?
  
  
• What happens if I hold longer than one trading day?
  
  
• Is there a risk that an ETF will not meet its stated daily objective?
  
  
• What are the costs?
  
  
• What are the tax consequences?

The full text of the SEC and FINRA investor alert is available at: http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm

SEC Seeks Comments on New Short-Selling Price Test

As we reported in April in our post, "SEC Proposes Short-Selling Restrictions," the Commission proposed amendments to Regulation SHO to restrict short sales. In that rule proposal, the Commission sought comment on two alternative short sale price tests, one based on the national best bid and the second based on the last sale price:

• Proposed Modified Uptick Rule: A market-wide short sale price test based on the national best bid (a proposed modified uptick rule).
  
  
• Proposed Uptick Rule: A market-wide short sale price test based on the last sale price or tick (a proposed uptick rule).

Yesterday, the SEC announced that it would seek "public comment on an alternative approach to short selling price test restrictions that may be more effective and easier to implement than previously proposed price test restrictions currently under consideration." According to the SEC, this alternative approach, the "alternative uptick rule," unlike the proposals in April, "would not require monitoring of the sequence of bids (that is, whether the current national best bid is above or below the previous national best bid), and as a result the alternative uptick rule would be easier to monitor. It also may be possible to implement this approach more quickly and with less cost than the prior proposals." The comment period on the original April proposal closed June 19, and the comment period for the new release will close thirty days from the publication in the Federal Register of the "alternative uptick rule" release. In other words, the period will likely close in late September.

The full details of the alternative uptick rule are available in a new release: http://www.sec.gov/rules/proposed/2009/34-60509.pdf

The original proposals are available at: http://www.sec.gov/rules/proposed/2009/34-59748.pdf

Related article:

• "SEC Proposes Short-Selling Restrictions," April 16, 2009
  

Fed and Treasury Extend TALF

Yesterday, the Federal Reserve Board and the Treasury Department announced that they will extend the the Term Asset-Backed Securities Loan Facility (TALF) through March 31, 2010 for newly issued asset-backed securities (ABS) and legacy commercial mortgage-backed securities (CMBS), and newly issued CMBS through June 30, 2010. Previously, loans through the TALF had been set to expire on December 31, 2009.

As we reported in our March 17, 2009 post, "Details of the Term Asset-Backed Securities Loan Facility,"

The TALF is not part of the Troubled Asset Relief Program, but a joint public-private investment program dramatically expanded under Treasury's recently announced Financial Stability Plan. The TALF was expanded by Treasury and the Federal Reserve Bank to create incentives for market participants such as hedge funds and other investment companies to return to the securitization market, thereby unfreezing that market and allowing banks to resume functioning within it. The Financial Stability Plan calls for the expansion of the TALF facility up to $1 trillion for permitted investments, and TALF may be further expanded to include commercial mortgage-backed securities, private-label residential mortgage-backed securities, and other asset-backed securities

Though financial market conditions have improved in the past few months, according to the Fed and Treasury, "the markets for asset-backed securities (ABS) backed by consumer and business loans and for commercial mortgage-backed securities (CMBS) are still impaired and seem likely to remain so for some time." Consequently, the Fed and Treasury are extending TALF loans; however at the present time, they will not be making any further additions to the types of collateral that are eligible for the facility:

After having conducted a thorough analysis of a number of potential candidates, the Federal Reserve and Treasury announced on Monday that they are holding in abeyance any further expansion in the types of collateral eligible for the TALF. The securities already eligible for collateralizing TALF loans include the major types of newly issued, triple-A-rated ABS backed by loans to consumers and businesses, and newly issued and legacy triple-A-rated CMBS. The Federal Reserve and Treasury are prepared to reconsider their decision if financial or economic developments indicate that providing TALF financing for investors' acquisitions of additional types of securities is warranted.

The text of the Fed and Treasury announcement of the TALF extension is available at: http://www.treas.gov/press/releases/tg264.htm

Related articles:

• "Details of the Term Asset-Backed Securities Loan Facility," March 17, 2009
  
  
• "Details of the Public-Private Investment Funds," April 2, 2009

Forum Comments on Proxy Access Proposal

Yesterday, the Forum submitted a comment letter on the first of two proxy rule proposals issued by the SEC this summer, "Facilitating Shareholder Director Nominations."  As we summarized in our July 1, 2009 post, "SEC Proposes Shareholder Access to Director Nominations," the proposed rule is designed to enhance shareholders’ ability to nominate directors, within certain ownership limitations. Because the proposal applies to mutual funds, the Forum submitted a comment letter on behalf of independent fund directors.  Though the letter indicates that the Forum shares the Commission’s desire to ensure that boards of directors are responsive to the needs of shareholders, and agrees that funds should be treated similarly to operating companies with respect to shareholder access to proxy statements, it also lays out some fundamental differences between mutual funds and operating companies the Commission and investors should keep in mind:

• [O]pen-end funds, the dominant form of investment companies, rarely solicit proxies and most open-end fund boards oversee multiple separate funds within a complex, thereby achieving various efficiencies and benefits of scale.
  
  
• [M]utual funds are generally not required to hold annual shareholder meetings. Funds are required to solicit proxies to elect or reelect their boards only when less than two-thirds of the sitting directors have been elected by shareholders.
  
  
• While a publicly traded operating company is a single corporate entity, mutual funds are often part of complexes composed of numerous separate investment companies. The different investment companies, however, generally do not each have a distinct set of directors overseeing each separate investment company.

The Forum's letter further notes that, given these differences and the resulting efficiencies and benefits to shareholders, "in order to exercise their vote intelligently and responsibly, fund shareholders must weigh the potential costs of effectively altering the structure of their fund’s board against any perceived benefits."

The full text of the Forum's comment letter is available at:  http://www.mfdf.com/site/pages/documents/MFDFCommentletter-FacilitatingShareholderDirectorNomination.pdf

The full text of the rule proposal, "Facilitating Shareholder Director Nominations," is available at:  http://sec.gov/rules/proposed/2009/33-9046fr.pdf

Related articles:

• "SEC Proposes Shareholder Access to Director Nominations," July 1, 2009

The Forum's Annual Accounting Series

Each fall, the Forum, in conjunction with the "Big Four" accounting firms, presents a series of programs designed to help fund directors understand their responsibilities for financial oversight of their funds, and keep them up to date on current and emerging financial topics.  The series features two distinct programs, one basic and comprehensive, and one more advanced covering specific and sophisticated financial reporting issues.  The number of registrants is limited for each course, and their small size makes these programs intimate, conversational, and interactive, while spending time on the topics most interesting to the directors.  Also, because the courses are taught by the top financial, accounting, and auditing professionals in the industry, directors take away the most current practical guidance, useful right away in the boardroom. 

The basic course, "Mutual Fund  Accounting and Financial Oversight: What Every Director Needs to Know," offers practical guidance to help in the basic understanding of directors' accounting oversight responsibilities.  The basic program is an excellent introduction to financial oversight for newer directors, and directors new to their boards' audit committees.   At the basic program, experts from the "Big Four" accounting firms  cover hot topics in the fund industry as they discuss:

• Audit committee responsibilities;
• Oversight of third party service providers;
• Tax issues;
• The internal control structure and environment;
• Financial reporting requirements;
• The annual audit; and
• The 15(c) Reporting Process.

This year, the basic program will be held in Washington, DC on October 5, hosted by KPMG LLP at their 2001 M Street offices, and will feature Gene Gohlke, Associate Director of the SEC's Office of Compliance, Inspections, and Examinations.  Mr. Gohlke will update attendees on the fund/adviser inspection program and where it will be going in fiscal 2010. 

The more advanced program, "Complex Financial Oversight Issues," provides more in-depth information about sophisticated accounting issues and emerging financial oversight issues confronting fund directors.  At the advanced accounting programs this year, experts from the "Big Four" accounting firms will discuss:

• Updates on FASB and SEC rules and pronouncements;
• Internal control and SEC compliance issues;
• Emerging financial disclosure and reporting issues for money market funds; and
• Valuation and pricing issues.

The advanced course will be offered in three cities on three separate dates. 

• October 15, 2009, Chicago, IL
  Hosted by PricewaterhouseCoopers, LLP at their offices located at 1 North Wacker Drive, 14th Floor
  
  
• November 10, 2009, New York, NY
  Hosted by Ernst & Young, LLP at their offices located at 5 Times Square
  
  
• December 9 , 2009, Boston, MA
  Hosted by Deloitte & Touche, LLP at their offices located at 200 Berkeley Street 

To learn more about this series of programs, to download a brochure, or to register, please visit the Accounting Series page on  Forum's website at:  http://www.mfdf.com/AccountingPrograms2009.html

Latest FINRA Podcast: "Organize Your Financial Records"

In the latest FINRA Investor Podcast, Dan Rutherford and Gerri Walsh discuss tips to help investors organize their financial documents and keep track of their investments. An investment portfolio can generate a great deal of paperwork, including trade confirmations, account statements, and 1099 tax records. Managing account information properly can help investors track their investments better, ensure they are being managed in accordance with their instructions, and can help alert investors in the unlikely event of identity theft or other unauthorized activities. Good recordkeeping can also help in dealings with brokers, advisers, and tax advisers and preparers.

FINRA's latest podcast provides some practical advice on how to keep and safeguard your paper and electronic investment records, including how to dispose of these sensitive documents, and how long to retain your records.

This and other FINRA Investor Podcasts are available at: http://www.finra.org/Investors/Subscriptions/Podcasts/index.htm

OTC Legislation Delivered to Congress

On August 10, the Administration delivered the “Over-the-Counter Derivatives Markets Act of 2009” to Congress for approval. This piece of legislation is intended to regulate comprehensively the OTC derivative markets for the first time by providing for "regulation and transparency for all OTC derivative transactions; strong prudential and business conduct regulation of all OTC derivative dealers and other major participants in the OTC derivative markets; and improved regulatory and enforcement tools to prevent manipulation, fraud, and other abuses in these markets."

The bill proposes to subject the credit default swap markets and all other OTC derivative markets to comprehensive regulation in order to:

1. Guard against activities in those markets posing excessive risk to the financial system;

1. Promote the transparency and efficiency of those markets;
   
   
2. Prevent market manipulation, fraud, insider trading, and other market abuses; and
   
   
3. Block OTC derivatives from being marketed inappropriately to unsophisticated parties.

These goals will be reached through regulation by the Securities and Exchange Commission and the Commodity Futures Trading Commission that includes:

• Regulation of OTC derivative markets by dividing jurisdiction for the various types of derivatives between the CFTC and SEC;
  
  
• Regulation of all OTC Derivative dealers and other major market participants through registration reporting requirements;
  
  
• Preventing market manipulation, fraud, insider trading, and other market abuses by providing the CFTC and SEC with the tools and information necessary to prevent manipulation, fraud, and abuse, including making transactions more transparent using central clearing and exchange trading, as well as robust prudential regulation;
  
  
• Protecting unsophisticated investors by tightening the definition of eligible investors that are able to engage in OTC derivative transactions to better protect individuals and small municipalities.

The Department of the Treasury's summary of the bill is available at: http://www.treas.gov/press/releases/tg261.htm

The full text of the “Over-the-Counter Derivatives Markets Act of 2009” is available at: http://www.hedgefundlawblog.com/wp-content/uploads/2009/08/over-the-counter-derivatives-markets-act-of-2009.pdf


Related articles:

• "SEC Approves Two More OTC Central Counterparties," July 29, 2009
  
  
• "Regulatory Reform of OTC Derivatives Markets," May 18, 2009
  
  
• "Waxman-Markey Bill Closes OTC Loopholes," June 11, 2009
  
  
• "PWG Initiatives on OTC Derivatives Oversight and Infrastructure," November 14, 2008

Capital Gains Tax Bill Aimed at Mutual Funds

In May, Senator Michael Crapo (R-ID) introduced a bill to amend the Internal Revenue Code to allow individuals to defer recognition of capital gains distributions from mutual funds, so long as they reinvest the distributions in the fund.  If passed, the bill would defer the recognition of any capital gains until the mutual fund shareholder takes an actual distribution of gains from the fund, or redeems his or her shares.  A similar bill was introduced in July in the House of Representatives by Rep. Paul Ryan (R-WI), Rep. Arthur Davis (D-AL), and Rep. Joe Crowley (D-NY). 

Under the current law, in order retain their status as a Regulated Investment Company under IRS Subchapter M, mutual funds must pass through essentially all of their profits to shareholders, and shareholders incur capital gains taxes just for holding their shares, even if the capital gains are reinvested in the fund, rather than taken out as cash.  Though mutual fund investors also incur capital gains when they sell shares at a NAV for a gain, the bills do not address this kind of capital gain.  The treatment of taxing reinvested capital gains in mutual funds has long been considered by many to be unfair to shareholders because:  (1) funds do not pass through losses to shareholders, only gains, so shareholders cannot use them to offset gains (or carry them forward to years when they do have gains); and (2) this treatment complicates shareholder decisions about when to purchase and sell shares.

The House and Senate bills, both entitled, the "Generate Retirement Ownership Through Long-Term Holding Act of 2009," seek to remedy what has been seen as an impediment to holding mutual fund shares for a long term.  Though both the House and Senate bills' titles contain the word "retirement," neither bill is aimed at taxation of mutual fund shares held through IRA, 401(k), or other qualified retirement vehicles.  Funds held through these kinds of retirement accounts already receive preferred tax treatment.  Rather, these bills are aimed at capital gains on mutual fund shares held directly.  As we reported in our December 23, 2008 post, "Scholar Examines the Effect of the Tax Code on US Mutual Funds," some experts in mutual fund taxation see the change to capital gains treatment proposed by the Generate Retirement Ownership Through Long-Term Holding Act of 2009 as potentially having a significant effect on the competitive position of U.S. mutual funds in the global market.

The full text of H.R. 3429 is available at:  http://thomas.loc.gov/cgi-bin/query/z?c111:H.R.3429:

The full text of S. 1082 is available at:  http://www.opencongress.org/bill/111-s1082/text

Related Article:

• "Scholar Examines the Effect of the Tax Code on US Mutual Funds," December 23, 2008
  

New SEC Enforcement Chief Reflects on First 100 Days

At a recent speech before the New York City Bar, Robert Khuzami, Director of the SEC's Division of Enforcement, took the opportunity to reflect on changes an initiatives in his division since he took the lead.  He highlighted the increased pace of enforcement activity, noting that:

Comparing the period from late January to the present to roughly the same period in 2008, the Division has opened 10% more investigations (approximately 525, compared to 475); has been granted 118% more formal orders (which grants us subpoena power) (275, compared to 126); has filed 147% more TROs (52, compared to 21); and has filed nearly 30% more actions (397, compared to 306).

Embracing the criticisms of the effectiveness of the SEC's enforcement efforts, Khuzami told his audience that he had implemented a new enforcement philosophy:

• First, to be as strategic as possible. This means a focus on cases involving the greatest and most immediate harm and on cases that send an outsized message of deterrence.
  
  
• Second, to be as swift as possible. A sense of urgency is critical. Long gaps between conduct and atonement undermine the deterrent impact of our cases, and result in missed opportunities to achieve a permanent change in behavior and culture.
  
  
• Third, to be as smart as possible. Our resources are finite and critically limited. We must better determine on an informed basis whether to continue an investigation, who to continue it against, how to shape it and how to charge it.
  
  
• And last, to be as successful as possible. This means building strong cases so that defendants settle quickly on the Commission's terms or face a trial unit armed with compelling evidence.

In addition to his new philosophy, Khuzami also started a program whereby specialized enforcement units are being created to "provide the structure and resources for staff to "get smart" about certain products, markets, regulatory regimes, practices and transactions."  The program will start with five specialized units: 

1. Asset management,
   
2. Market abuse,
3. Structured and new products,
4. Foreign Corrupt Practices Act, and
   
5. Municipal securities
   

Subject matter specialization, according to Khuzami, "will permit us to be better investigators, because we will be more efficient and less likely to be misled by those who use complexity to conceal their misconduct. Specialization will also permit us to be more proactive in deciding on an informed basis where to focus our investigations, as opposed to being more reactive to public information or the vast number of undifferentiated tips we receive. It will also enable us to attack problems systemically, swiftly and thoroughly and on an industry-wide basis where appropriate."

Khuzami reported that he'd also streamlined management and internal processes in his division to speed up and make more efficient the investigations the Division pursues. 

These initiatives — flattening of management and more streamlined process and procedure — are designed to achieve one goal — to move our cases more quickly and to free up time and resources to take on new matters with greater urgency and impact.

The Division has also created an Office of Market Intelligence, designed to collect, analyze, and triage tips and complaints, making referrals to the proper investigative staff at the Commission.  This new office will also liaise with the other divisions to coordinate the staff's efforts to address tips and complaints identifying wrongdoing. 

During his address, Khuzami highlighted some of the Division's higher profile investigations, like those involving Countrywide, Reserve Management Company, the Stanford Group, Bank of America, GE, and others. 

The full text of Robert Khuzami's August 5, 2009 address before the New York Bar is available at:  http://www.sec.gov/news/speech/2009/spch080509rk.htm

E&Y Looks at the State of the Fund Industry

In a recently released document, "US Mutual Funds: Unprecedented Challenges, Compelling Opportunities," Ernst & Young LLP took a look at the current state of the mutual fund industry, and makes some predictions about where the industry may be headed.  The fund industry, though resilient, faces unprecedented challenges:

Clearly, these are unprecedented times for the US mutual fund industry. What marks the present crisis as unique from earlier ones is the sheer range and magnitude of the challenges confronting all mutual fund sponsors — from the smallest regional shops right up to the top-tier global asset managers with the farthest-reaching fund complexes. The most direct impact of the financial crisis and the ensuing global economic slowdown has been on the investment performance among mutual funds in a variety of asset classes, sectors and strategies. Although absolute performance has picked up since early March 2009, equity funds have a long way to go before they recoup the significant negative returns they experienced in 2008 and early 2009 as stock markets tumbled.

With these challenges in mind, Ernst & Young envisions that this period presents some unique opportunities for the industry to reform and evolve.

So with performance track records in many instances tarnished, fee revenues in decline and dramatic shifts in investor risk appetite and the competitive landscape, the US mutual fund industry stands at a crossroads. In some cases, the challenges have been caused by the financial crisis, while in others, the turmoil has merely hastened the nee to tackle preexisting challenges and issues head-on.

The document makes some predictions about the future of the industry as well.  The firm predicts that money market mutual fund assets will
become much more concentrated among the larger players in the coming years, and larger firms are likely to maintain money market offerings for two key reasons:

1. With a larger, more diversified fund complex, advisers are reasoning that they can ride out the current low-yield environment until stronger profitability returns.
   
   
2. Investor risk aversion can only last so long. Making new sales is difficult and costly; money market funds are viewed as a future gateway for directing client money into equity and fixed-income mutual funds.

Future regulation of money market funds will focus more on strengthened risk management and increased liquidity, increasing the operating costs of money market funds and lowering their yields.  E&Y expects that the effect of such regulation will be that, in order for money market funds to succeed, they will need to exploit economies of scale, thereby rewarding consolidation in the money market fund product line. 

E&Y also predicts that funds will reevaluate their offerings bearing in mind the strategic value of each fund or product, and rationalizing the range of products they offer by consolidating similar products, and liquidating those not expected to rebound as the economy recovers.  E&Y anticipates growth in the retirement market, particularly among target-date funds and exchange traded funds.  Though target-date funds performed poorly in the recent downturn, and are subject to intense scrutiny by the SEC and DOL, E&Y expects the target-date fund to survive and, indeed, flourish as managers reassess the modeling assumptions used in target-date fund glide paths. 

Given the federal government's support for distressed credit markets, E&Y also predicts that credit-focused funds will also be lucrative and popular.  Given restrictions on mutual fund leverage, mutual funds may find themselves competing with hedge funds in the credit-focused space; but innovative advisers may be able to create cross-over "hedge fund style" mutual funds to participate in the credit-focused market.  E&Y cautions:

Executives moving into this space need to carefully examine how they structure these funds from a regulatory perspective. They must consider mutual fund requirements on such factors as liquidity, leverage, redemption risk, valuation and the use of cash.

Given the new market landscape and mood of mutual fund investors, E&Y predicts mutual funds will return to a "back to basics" approach overall. 

The current market conditions have given fund companies the platform to re-evaluate and rationalize their products, people and operations. After years of high growth and a proliferation of new products with less focus on costs and risk management, investment managers have been forced to “go back to their core business.”

This means less reliance on exotic and complex securities, and adoption of complex-wide risk management approaches addressing market, credit, operational, and liquidity risks. 

The full text of E&Y's "US Mutual Funds: Unprecedented Challenges, Compelling Opportunities" is available at:  https://eyaprimo.ey.com/natlmktgaprimoey/etrack.aspx?DSN=NationalMarketing&FORMID=57115&INTID=60934&AUDID=714597&URL=https://eyaprimo.ey.com/natlmktgaprimoey/Attachments/AssetMgmt_J00352.pdf

Treasury Campaigns for Consumer Protection Agency

As part of the Obama Administration's efforts to build support for a new federal agency, the Consumer Financial Protection Agency, Deputy Treasury Secretary Neal S. Wolin published an op-ed in The Hill. In his op-ed piece, Wolin argues that creating an agency focused on the interests of consumers of financial products would level the playing field and eliminate what he terms as the "race to the bottom" among firms and regulators.

Wolin argues that the systemic problems encountered over the past year and half cannot be solved by a council of regulators like the Financial Services Oversight Council, a council comprised of the heads of the Treasury, Federal Reserve Board, Comptroller, SEC, CFTC, FDIC, FHA, and other regulators. Rather, Wolin states:

The regulation of the most interconnected financial institutions and critical financial systems requires tremendous institutional capacity and accountability. We must leave no room for doubt about who is responsible for supervising them. The Federal Reserve is the only regulatory body with the experience and with the broad and deep knowledge of the capital markets that the task requires. You cannot supervise financial holding companies by committee.

Wolin also argues that separating rulemaking for consumer protection from enforcement and supervision makes no sense.

What does cause problems is separating consumer protection rule-writing from enforcement and supervision, as we do today. That separation deprives the rule-writer of market information and causes the rule-writer and the supervisor to point fingers instead of acting.

Wolin also rejects any assertions that this new agency might stifle innovation and limit the new financial products in the market available to consumers.

The agency will not limit consumers' ability to choose the products they want. But it will make it harder to sell consumers products that they don't understand and cannot afford.

We reject the false choice between consumer protection and innovation. Americans deserve a financial system that both fosters innovation and provides strong consumer protections.

Given the controversy surrounding this new proposed Consumer Financial Protection Agency, there will no doubt be more op-ed articles and efforts in other media on both sides of the argument, designed to sway opinion both of the public and in Congress.

The full text of Neal Wolin's July 22, 2009 op-ed in The Hill is available at: http://thehill.com/op-eds/consumer-protection-agency-would-stop-companies-race-to-the-bottom-2009-07-22.html

Related articles:

• "Consumer Protection Legislation Delivered to Congress," July 14, 2009
  
  
• "President's Plan Maintains and Strengthens SEC's and CFTC's Powers," June 18, 2009
  
  
• "Commissioner Aguilar - Putting Investors First in Regulatory Reform," June 4, 2009

SEC Publishes "Pay to Play" Rule Proposals

As we mentioned in our July 21, 2009 post, "Pay to Play" Rule Proposals on SEC Agenda, at its July 22 open meeting, the Commission proposed rules designed to address "pay to play" practices in the investment adviser industry. These rule proposals would:

1. prohibit an investment adviser from providing advisory services for compensation to a government client for two years after the adviser or certain of its executives or employees make a contribution to certain elected officials or candidates;
   
   
2. prohibit an adviser from providing or agreeing to provide, directly or indirectly, payment to any third party for a solicitation of advisory business from any government entity on behalf of such adviser;
   
   
3. prevent an adviser from soliciting from others, or coordinating, contributions to certain elected officials or candidates or payments to political parties where the adviser is providing or seeking government business; and
   
   
4. require a registered adviser to maintain certain records of the political contributions made by the adviser or certain of its executives or employees.

The full text of these rule proposals is now available on the SEC's website at: http://www.sec.gov/rules/proposed/2009/ia-2910.pdf

Comments on the proposal, "Political Contributions by Certain Investment Advisers," are due by October 6, 2009. Comments submitted may be found at: http://sec.gov/comments/s7-18-09/s71809.shtml

SEC's Investor Advisory Committee Announces Agenda

At it's first meeting on Monday, July 27, the SEC's Investor Advisory Committee, formed by the SEC to give investors a greater voice in the Commission's work, announced an ambitious agenda. According to a press release issued yesterday, the Investor Advisory Committee will focus on:

1. Advising the Commission on matters of concern to investors in the securities markets;
   
   
2. Providing the Commission with investors' perspectives on current, non-enforcement, regulatory issues; and
   
   
3. Serving as a source of information and recommendations to the Commission regarding the Commission's regulatory programs from the point of view of investors.

The release also outlined the topics and areas the new committee will direct its energies:

• Fiduciary duty: Should all financial intermediaries who provide investment advice to their customers be subject to the same fiduciary duties, and how should those duties be defined? Many investors rely heavily on financial advisors for investment decisions, but may not understand the different standards that apply to brokers and investment advisers.
  
  
• Proper disclosures: Does the information that investors currently receive — both before making an investment decision and afterwards — meet their needs, and if not, what changes are necessary to ensure that investors have the information that they need, when they need it?
  
  
• Technology: Can technology be better used to improve the flow of information to and from investors?
  
  
• Financial Literacy: Should there be a distinction between "investor information" and "investor education," and if so, what is that distinction? What is the role of "financial literacy," and how can the SEC promote early education of these issues?
  
  
• Valuation: Do investors fully understand the role that underlying asset valuation plays in portfolio and fund valuation? For example, do investors in variable annuities understand that guaranteed minimum payouts do not necessarily hold if the underlying investments (mutual funds, etc.) decline by a certain amount? Do fixed income investors understand that high yield bond funds involve more risk than other fixed income investments, or that fixed income investments are typically much less liquid and, therefore more difficult to definitively value, than are equities?
  
  
• Majority Voting: Should majority voting for directors be mandatory for all U.S. companies? Although most large U.S. companies have adopted a form of "majority voting," many other companies still enable directors to be elected based only on plurality support.
  
  
• Director-Investor Communications: Are there more effective ways for investors and directors to communicate with one another and what steps can the Commission take to facilitate dialogue and help ensure that corporate manager interests are aligned with investor interests?
  
  
• Proxy Voting: Do investors — both institutional and individual — have the information they need to make informed proxy voting decisions, and are these decisions effective in holding corporate directors accountable? Does the proxy voting process and system foster informed decision-making? Should there be more transparency to the market about investors' proxy decisions? What is the role of proxy advisory firms, and should they be subject to more oversight by the Commission?
  
  
• Resources: Does the SEC have the resources it needs to effectively achieve its investor protection mission?

Materials considered by the Committee at its meeting are posted on the SEC's Web site at http://www.sec.gov/spotlight/
investoradvisorycommittee.htm.

The full text of the SEC's July 29, 2009 press release is available at: http://www.sec.gov/news/press/2009/2009-175.htm

Related articles:

• "Investor Advisory Committee to Hold Public Meeting," July 9, 2009
  
  
• "SEC Forms Investor Advisory Committee," June 5, 2009

SEC Announces Roundtable on Short Selling and Securities Lending

The SEC has announced that it will hold a roundtable on September 30, 2009 to solicit views of investors, issuers, financial services firms, self-regulatory organizations and the academic community on issues related to securities lending, pre-borrowing, and possible additional short sale disclosures. According to the SEC press release:

The roundtable panelists will consider, among other things, additional means to foster transparency, such as adding a short sale indicator to the tapes to which transactions are reported for exchange-listed securities, and requiring public disclosure of individual large short positions. Panelists will also consider whether it would be appropriate to impose a pre-borrow or enhanced "locate" requirement on short sellers, potentially on a pilot basis. Additionally, panelists will discuss issues related to securities lending such as compensation arrangements, disclosure practices, and methods of collateral and cash-reinvestment.

Typically, SEC roundtables are held at the agencies headquarters in Washington, DC, and are webcast via a link on the SEC's website, www.sec.gov. We will post more details about the September 30th roundtable when they are made available.

In conjunction with its announcement of the September 30 roundtable, the agency also announced that the SEC has made permanent Regulation SHO Rule 204T, an interim final temporary rule designed to prevent fails and "naked" short selling. Rule 204T was adopted as an interim final temporary rule in October of 2008, with an expiration date of July 31, 2009. In addition, the Commission stated that it is working with "several self-regulatory organizations (SRO) to make short sale volume and transaction data available through the SRO Web sites. This effort will result in a substantial increase over the amount of information presently required by another temporary rule, known as Temporary 10a-3T. That rule, which will expire on August 1, applies only to certain institutional money managers and does not require public disclosure."

The Commission continues to consider the comments on its April 2009 rule proposals on approaches to restricting short sales, the "short sale price test" and the "circuit breaker" approaches.

The full text of the SEC's announcement of the roundtable and actions on short selling regulation is available at: http://www.sec.gov/news/press/2009/2009-172.htm

The full text of the April 2009 proposed amendments to Reg SHO is available at: http://www.sec.gov/rules/proposed/2009/34-59748.pdf

Related articles:

• "SEC Proposes Short-Selling Restrictions," April 16, 2009
  
  
• "OCIE's Director Shares Focus of SEC Compliance Exams," October 23, 2008
  
  
• "SEC Extends Short-Selling Orders," October 2, 2008

SEC Approves Two More OTC Central Counterparties

Last week, the SEC issued exemptive orders that will add two European entities to the list of approved central counterparties for clearing credit default swaps. The orders issued on July 23 provide the necessary regulatory exemptions to allow ICE Clear Europe Limited and Eurex Clearing AG to join two other companies, ICE US Trust LLC and the Chicago Mercantile Exchange, Inc., approved in March, as central counterparties. Though the Commission's jurisdiction over the over the counter markets for credit default swaps is limited, or those CDS that are not swap agreements (“non-excluded CDS”), the Commission’s exemptive orders for these counterparty designations provides conditional exemptions from certain requirements of the Exchange Act, will provide the SEC with extensive oversight of the central counterparties, "and should enhance the quality of the credit default swap market and the Commission's ability to protect investors."

The Commission believes that using well-regulated CCPs to clear transactions in CDS would provide a number of benefits, by helping to promote efficiency and reduce risk in the CDS market and among its participants, requiring maintenance of records of CDS transactions that would aid the Commission’s efforts to prevent and detect fraud and other abusive market practices, addressing concerns about counterparty risk – through the novation process – by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of the counterparties to a CDS, contributing generally to the goal of market stability, and reducing CDS risks through multilateral netting of trades.

The SEC's announcment of the new central counterparties is available at: http://www.sec.gov/news/press/2009/2009-170.htm

The exemptive orders are availble at:

• Exemptive Order Release No. 34-60372
  
  
• Exemptive Order Release No. 34-60373

Related article:

• "SEC Permits CME to Operate as Central CDS Counterparty," April 9, 2009
  

Credit Rating Agency Reform Legislation Sent to Capitol Hill

Given the role the credit rating agencies, agencies the SEC calls "NRSROs," played in the recent housing and credit crises, strengthened regulation of the NRSROs was high on the list of reforms identified by the Obama Administration and regulators. The bill is intended to strengthen the SEC's oversight of the agencies, address conflicts of interest, increase transparency and disclosure, and reduce reliance by regulated entities on ratings from NRSROs. According to the Treasury's fact sheet on this legislation each of the areas is addressed as follows:

Conflicts of Interest

Bar Firms From Consulting With Any Company That They Also Rate: Credit ratings agencies will face similar restrictions to other professional service providers, like accountants, and will be prohibited from providing consulting services to companies that contract for ratings.

Strengthen Disclosure And Management Of Conflicts Of Interest: The legislation will prohibit or require the management and disclosure of conflicts arising from the way a rating agency is paid, its business relationships, affiliations or other conflicts.

Disclose Fees Paid By An Issuer Along With Each Rating Report: Each rating report will disclose the fees paid by the issuer for a particular rating, as well as the total amount of fees paid by the issuer to the rating agency in the previous two years.

Look-Back Requirement To Address The Conflicts From A "Revolving Door": If a rating agency employee is hired by an issuer and if the employee had worked on ratings for that issuer in the preceding year, the rating agency will be required to conduct a review of ratings for that issuer to determine if any conflicts of interest influenced the rating and adjust the rating as appropriate.

Designate A Compliance Officer: Each rating agency will be required to designate a compliance officer – reporting directly to the board or the senior officer of the firm – with direct responsibility over compliance with internal controls and processes. The compliance officer will not be allowed to engage in any rating activities, marketing, sales, or setting of compensation; and will be required to submit a report annually to the SEC.

Transparency & Disclosure

Require Disclosure Of Preliminary Ratings To Reduce "Ratings Shopping": Currently, an issuer may attempt to "shop" among rating agencies by soliciting `preliminary ratings' from multiple agencies and then only paying for and disclosing the highest rating it received for its product. We would shed light on this practice by requiring an issuer to disclose all of the preliminary ratings it had received from different credit rating agencies so that investors will see how much "shopping" happened and whether there were discrepancies with the final rating.

Require Different Symbols To Be Used To Distinguish The Risks Of Structured Products: One of the challenges in the current crisis was that investors did not fully realize that the risks posed by structured products such as asset-backed securities are fundamentally different from those posed by corporate bonds, even with similar credit ratings. Our proposal requires rating agencies to use different symbols for structured finance products as an indication of these disparate risks.

Require Qualitative And Quantitative Disclosure Of The Risks Measured In A Rating: Agencies will be required to provide a much fuller picture of the risks in any rated security through the addition of qualitative and quantitative disclosure of the risks and performance variance inherent in any given security. Ratings cannot be a substitute for investor due diligence. Therefore, to facilitate investor analysis, we will require that each rating also include a clear report containing assessments of data reliability, the probability of default, the estimated severity of loss in the event of default, and the sensitivity of a rating to changes in assumptions. This report will present information in a way that makes it simple to compare this data across different securities and institutions. This additional information will increase market discipline by providing clearer estimates of the risks posed by different investments.

Strengthen SEC Authority and Supervision

Establish A Dedicated Office For Supervision Of Rating Agencies: Our legislative proposal establishes a dedicated office within the SEC to strengthen supervision of rating agencies and to carry out the enhanced regulations required.

Mandatory Registration: Unlike the current voluntary system of registration, our proposal would make registration mandatory for all credit rating agencies. This will bring all ratings firms into a strengthened system of regulation.

SEC Examination Of Internal Controls And Processes: The SEC will require each rating agency to document its policies and procedures for the determination of ratings. The SEC will examine the internal controls, due diligence, and implementation of rating methodologies for all credit rating agencies to ensure compliance with their policies and public disclosures.

Reduce Reliance on Credit Rating Agencies

PWG Review of Regulatory Use of Ratings: Treasury will work with the SEC and the President's Working Group on Financial Markets to determine where references to ratings can be removed from regulations.

SEC Recently Requested Public Comment on Whether to Remove References to Ratings in Money Market Mutual Fund Regulation: As part of a comprehensive set of money market fund reform proposals, the SEC requested public comment on whether to eliminate references to ratings in the regulation governing money market mutual funds, as a way to reduce reliance on ratings. Treasury will work with the SEC to examine opportunities to reduce reliance and increase the resilience of the money market mutual fund industry.

Require GAO Study On Reducing Reliance: In addition to regulatory efforts to reduce reliance on credit ratings, this legislation would require the GAO to study and issue a report on the reliance on ratings in federal and state regulations.

Strongly Support SEC Actions on Credit Rating Agencies

Enable Additional Ratings On Structured Products: Because structured products are often complex and require detailed information to assess, it can be difficult for a rating agency to provide "unsolicited ratings" – ratings on products it was not paid to rate. These ratings, while in existence previously, were ineffective because investors understood that these unsolicited ratings did not benefit from the same information as the fully contracted ratings. The SEC has proposed a rule that would require issuers to provide the same data they provide to one credit rating agency as the basis of a rating to all other credit rating agencies. This will allow other credit rating agencies to provide additional, independent analysis to the market.

Require Disclosure Of Full Ratings History: The SEC has proposed to require NRSROs to disclose, on a delayed basis, ratings history information for 100% of all issuer-paid credit ratings.

Strengthen Regulation And Oversight Of Credit Rating Agencies: In response to the credit market turmoil, in February the SEC adopted several measures to increase the transparency of the rating agencies' methodologies, strengthen disclosure of ratings performance, prohibit certain practices that create conflicts of interest, and enhance recordkeeping and reporting obligations to assist the SEC in performing its regulatory and oversight functions. The SEC has allocated resources to establish a branch of examiners dedicated specifically to conducting examination oversight of rating agencies.

Although the text of the bill presented to Congress appears to be unavailable at the moment, the full text of Treasury's fact sheet on this legislation is available at: http://www.ustreas.gov/press/releases/tg223.htm

Related Articles:

• "SEC Publishes NRSRO Rule Releases," February 5, 2009
  
  
• "Rules Implementing the Credit Rating Agency Reform Act," December 8, 2008
  
  
• "April 15 Roundtable on Credit Rating Agencies," March 30, 2009
  

SEC's Indexed Annuity Rule Under Legal Cloud

A new SEC rule we posted about late last year requiring certain indexed annuities to register with the Commission was challenged recently by an insurance company, American Equity Investment Life Ins. Co., whose annuity products would fall under the new rule. The challenged rule, Securities Act Rule 151A, adopted late in December of 2008, defines "indexed annuities," and requires indexed annuities that satisfy the rule’s definition and are issued on or after January 12, 2011 to register under the Securities Act. As we reported in our December 29, 2008 post about the new rule:

Section 38(a)(8) of the Securities Act exempts annuity contracts and optional annuity contracts from regulation under the Securities Act. But, the Section 38(a)(8) exemption is not available to all contracts that are “annuity contracts” under state law (e.g., variable annuities). Whether or not indexed annuities fell within the scope of the exemption, however, had not been clarified until now. Under the new rule 151A, indexed annuities are not "annuity contracts" and are not exempt from the Securities Act if the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract. The rule also provides a principles-based manner in which this determination is made.

The rule was challenged on the grounds that the SEC's interpretation of the term "annuity contract" was unreasonable, and also on the grounds that the Commission failed to assess sufficiently the effect of the rule on efficiency, competition, and capital formation under as required for SEC rulemaking by the Securities Act. The DC Circuit found that the SEC's interpretation of the term "annuity contract" was reasonable, but remanded the case to the SEC to address the deficiencies in its analysis of the effect of the rule on efficiency, competition, and capital formation. Should the Commission remedy the analysis sufficient to meet what the Court sees as the SEC's obligations under the Securities Act, it is likely that Rule 151A will survive this round of challenges.

The full text of the DC Circuit Court's opinion in American Equity Investment Life Ins. Co. v. SEC (D.C. Cir. 7/21/09) is available at: http://lawprofessors.typepad.com/files/d.c.opiniononindexannuities.pdf

Related Articles:

• "Indexed Annuities Under the SEC's Eye," December 29, 2009

UCLA Prof. Stout: Re-regulation of Derivatives

In a piece posted on Harvard Law School's Forum on Corporate Governance and Financial Regulation blog, Lynn A. Stout, Paul Hastings Professor of Corporate and Securities Law at UCLA Law School posits that the freeze up of the credit markets in late 2008 was both predictable and preventable, and may be averted in the future by carefully crafted re-regulation of the derivatives markets.

It was the deregulation of financial derivatives that brought the banking system to its knees. The leading cause of the credit crisis was widespread uncertainty over insurance giant AIG’s losses speculating in credit default swaps (CDS), a kind of derivative bet that particular issuers won’t default on their bond obligations. Because AIG was part of an enormous and poorly-understood web of CDS bets and counter-bets among the world’s largest banks, investment funds, and insurance companies, when AIG collapsed, many of these firms worried they too might soon be bankrupt.
. . .
This could have been avoided if we had not deregulated financial derivatives.

According to Professor Stout, derivatives are not new, "are not really 'products' and they are not really 'traded.'" Rather, they are simply documented bets on future outcomes, typically used to hedge against risks, but sometimes used for pure speculation. It is this speculative use that amplifies their risk, because it disconnects the transaction from the economic interest underlying the the transaction, encouraging more speculation and risk-taking, and creating "asset price bubbles, reduced returns, price manipulation schemes, and other economic ills."

Regulations designed to keep this kind of speculation in check were removed, beginning with the Financial Services Act of 1986 in the UK and accompanied by the Commodity Futures Modernization Act (CFMA) of 2000, to disastrous effect.

The CFMA not only declared financial derivatives exempt from CFTC or SEC oversight, it also declared all financial derivatives legally enforceable. The CFMA thus eliminated, in one fell swoop, a legal constraint on derivatives speculation that dated back not just decades, but centuries. It was this change in the law—not some flash of genius on Wall Street—that created today’s $600 trillion financial derivatives market.

Professor Stout argues that re-regulating the derivatives market would preserve the beneficial uses of derivatives, that is, allowing market participants to use them as economic hedges, while eliminating, or at lest curtailing their use for speculation. This re-regulation presumably would reduced the potential catastrophic risk posed by widespread speculative derivatives.

Unchecked derivatives speculation thus adds risk to the system by making it possible for individual speculators, like AIG (and Barings and LTCM and Enron and Bear Stearns) to lose very large amounts of money very unexpectedly.

. . .

Yet the data suggests that speculation, not hedging, drives over-the-counter financial derivatives markets. For example, we know the CDS market was dominated by speculation in 2008.

Professor Stout's proposed regulatory solution is a simple return to the rules of the past that refuse to enforce derivatives contracts with purely speculative motives.

The old common law rule against difference contracts was a simple, elegant legal sieve that separated useful hedging contracts from purely speculative wagers, protecting the first and declining to enforce the second. This no-cost, hands-off system of “regulation” (there is no cheaper form of government intervention than refusing to intervene at all, even to enforce a deal) did not stop speculators from using derivatives. But it did require speculators to be much more careful about their counterparties, and to develop private enforcement mechanisms like organized exchanges that kept speculation confined to an environment where traders were well-capitalized and knew who was trading what, with whom, when. This approach kept runaway speculation from adding intolerable risk to the financial system. And it didn’t cost a penny of taxpayer money.

The full text of Professor Stout's blog post is available at: http://blogs.law.harvard.edu/corpgov/2009/07/21/how-deregulating-derivatives-led-to-disaster/