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Federal
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May 2007
Technical Amendments Process Begins for PPA; Action Not Likely Until Later This Year The House Education and Labor Committee has begun the process of developing technical corrections to the 2006 Pension Protection Act (PPA). However, based on discussions with Hill staff on other Committees with jurisdiction over portions of the PPA, it appears that action on such technical corrections may be delayed until later in the year when another pension bill with more substantive provisions will be advanced. While there is general agreement among Congressional aides that amendments to the new public safety retiree health benefit are likely, they apparently will be limited to the issue of self-insured health plans. On May 3, 2007, the Subcommittee on Health, Employment, Labor, and Pensions of the House Committee on Education and Labor held the first Congressional hearing on the need for technical corrections to provisions of the PPA within the Committee’s jurisdiction. Topics covered included suggested modifications to the ERISA funding rules for single-plan, large private sector employers; the notice and disclosure requirements for small private sector employers; additional relief to airline pilots whose underfunded plans were terminated and shifted to the Pension Benefit Guaranty Corporation (PBGC); and funding rules affecting multiemployer plans. Subcommittee Chairman Robert Andrews (D-NJ) made it clear that he was only interested in discussing technical changes, acknowledging that the conference process dealing with the PPA was “contentious” and that he was not interested in upsetting “the delicate balance” struck in 2006. He outlined two criteria that he would require be met before he would consider a suggested change in the PPA as a “technical” correction: (1) truly minor fixes such as correcting misplaced punctuation; and (2) what he referred to as “anomalies,” which would be instances in which an intended policy goal was being subverted due, for example, to deadlines that could not be met or “ambiguous definitions” and the like. The PPA’s new public safety retiree health benefit was not a topic of discussion, as that provision falls within the jurisdiction of the House Ways and Means Committee, which is also expected to begin developing its list of technical changes in the near future. Under this new optional health benefit, an annual exclusion of up to $3,000 from gross income is provided for distributions from an eligible retired public safety officer’s retirement plan that are used to pay “qualified health insurance premiums.” However, according to guidance issued by the Internal Revenue Service (IRS) in January of this year, the accident or health plan receiving the payments of qualified health insurance premiums cannot be a self-insured plan. (See January 2007 NCTR Federal E-news.) Based on conversations with Congressional tax aides on both sides of the Hill, it appears that this problem is viewed as an anomaly, and will be addressed as a technical correction. However, preliminary reactions to other possible changes to the new retiree health benefit dealing with plan administrative burdens -- such as allowing individual retirees the option of taking the income exclusion for qualified health insurance premiums on their individual annual tax returns -- have not been positive. As one Senate staffer explained, the benefit was always envisioned as being linked to employer-provided health insurance. In addition, some Treasury Department officials also indicated serious problems with the idea, raising the auditing difficulties that such a shift from plans to individual retirees would create for the IRS. The technical corrections package is expected to be completed by late May/early June, so that the IRS and Treasury can be “put on notice” as to which problem areas Congress is likely to address. However, Congressional staff indicates that the actual vehicle for passage of the technicals will probably be a package of substantive pension amendments expected to move later in the year. House
Ed and Labor Hearing NCTR and other public pension plan advocates, attorneys and accountants met with Treasury Department and Internal Revenue Service (IRS) officials in late April to explain problems with proposed definitions, to be issued by the IRS for ERISA plans pursuant to amendments made by the Pension Protection Act (PPA), that are cross-referenced in the Age Discrimination in Employment Act (ADEA). The fear is that the IRS definitions will make many public plan refund features, DROP plans, and other incidental “hybrid” options subject to legal challenge as age discriminatory if they have anything other than a “market” interest rate attached to them. The reaction was not sympathetic, and it appears that other corrective efforts may eventually prove to be necessary. However, a recent letter from key Republicans indicates that there may be more flexibility in defining a market rate of return than has been suggested, which could help ease the impact of any such cap were it to be applied to public plans. In a nutshell, the PPA amends ERISA, the Internal Revenue Code (IRC) and ADEA to require that cash balance plans and other “hybrid” defined benefit (DB) pension plans must provide that any applicable interest credit “shall be at a rate which is not greater than a market rate of return.” (Treasury will be providing further guidance on this rate, but for now, it is essentially the interest rate on long-term investment-grade corporate bonds.) Paying a higher rate of interest will constitute age discrimination. Earlier this year, the IRS released Notice 2007-6. This notice provides transitional guidance on this new PPA provision, including a proposed definition of DB plans subject to this new requirement that is so broad that it could include traditional DB plans with fixed interest features such as annuity savings accounts, DROPs, and refunds of employee contributions -- even if such features are ancillary and only apply to certain participants or only a portion of a participant’s accrued benefit. (See March 2007 NCTR Federal E-news.) Cash balance provisions of the PPA were aimed at problems involved with private sector conversions of DB plans, and had to do with effects created by ERISA rules that do not apply in the public sector. In addition, while public sector DB plans can be frozen, they simply cannot be converted to cash balance plans due to anti-cutback rules. Furthermore, those features that could subject public sector plans to treatment as a “hybrid” plan based on the IRS’ broad definition are often ancillary to a primary DB benefit, and not a replacement for it. Finally, interest rate features are often set by statute and could possibly exceed a “market rate” of return should such limits be made applicable. Therefore, NCTR and NASRA requested a meeting with Treasury and IRS staff in order to explain these distinguishing factors for public pension systems, and to discuss the problems that would be created depending on the nature of any interest rate cap that might be applied to the governmental sector’s plans. Unfortunately, these Federal officials essentially said that their hands were tied. Given that the section of the IRC amended by the PPA cash balance/hybrid changes -- namely, Section 411, dealing with vesting and benefit accrual -- generally does not apply to public pension plans, Treasury and IRS argued that definitions developed pursuant to these amendments did not apply to governmental plans and therefore it would be inappropriate to modify them to address public plans’ concerns. However, ADEA does apply to public pension plans, and the PPA requires that the “applicable defined benefit plans” to which the new ADEA provision will apply are to have the same meaning given such term by section 411 of the IRC. This means that the Equal Employment Opportunity Commission (EEOC), to whom it was suggested that this request for an exemption be directed, would similarly be bound by the IRS definition. An EEOC official present at the meeting essentially confirmed this by reference to Executive Orders directing Treasury to take the lead in such multi-agency situations. So, Treasury can’t make an exception since their definition doesn’t apply to public plans under the IRC, but their definition does apply to us because it is cross-referenced by ADEA, and the EEOC, which implements ADEA, is required to follow Treasury’s lead in this area. Ever heard of “Catch 22?” Therefore, since Treasury and the IRS believe that they do not have the authority to make exceptions for governmental plans, a legislative approach may be required. However, if such an approach is to succeed, it will be important to ensure that all administrative avenues for relief have been exhausted. Furthermore, it will also be necessary to make clear that any discussion of exemptions or exclusions in this area is not misinterpreted as an effort to obtain a complete exemption for public plans from ADEA itself. While such a legislative fix would not likely qualify as a technical amendment, it could be a candidate for a more substantive pension measure expected later this year. On a more positive note, a recent letter from key GOP members of Congress indicates that when it comes to the definition of market rates of interest applicable to cash balance and other similar arrangements, there may be more room to accommodate a variety of rates than might have appeared at first glance. In a May 8, 2007, letter to Treasury Secretary Henry Paulson, Senator Michael Enzi (R-WY) and Congressman Howard “Buck” McKeon (R-CA), who were in majority leadership positions when the PPA was drafted and adopted, along with several other Republicans, stressed that the legislation “was intended to permit a broader array of interest crediting rates under cash balance plans than were previously permitted.” Furthermore, the letter noted that in determining whether an interest
crediting rate is to be considered “above market,” any "reasonable
minimum guaranteed rate of return" is to be disregarded. Thus,
an equity-based crediting rate should not be reduced by reason of the
application of a reasonable minimum guaranteed rate of return. “Any
contrary guidance,” the Senators and Congressmen warned, “would
be inconsistent with the statute and the legislative history”
and “would be very harmful to participants, since it would require
plans across the country to reduce their interest crediting rate.”
In the public sector, where such rates are often set by statute, this
would also be very problematic given anti-cutback restrictions. House Passes Executive Comp Legislation; Senate Companion Introduced The House of Representatives has approved legislation that would require companies to allow shareholders to cast non-binding advisory votes on executive compensation plans. Debate on the issue now shifts to the Senate side of the Hill, where a companion measure was introduced by Presidential hopeful Barack Obama (D-IL) on the same day that the House bill passed. The fate of any such legislation will ultimately turn in large part on whether or not the Congress believes additional measures should be deferred until the 2006 efforts by the Securities and Exchange Commission (SEC) in this area are permitted to fully take effect. To help in this decision-making process, the Congressional Research Service (CRS) has recently issued a report examining the premise that executives are generally overpaid from an economic perspective. On April 20, 2007, the Shareholder Vote on Executive Compensation Act, H.R. 1257, introduced by Congressman Barney Frank (D-MA), passed the House of Representatives by a vote of 269-134. Fifty-five Republicans voted in favor of final passage. The bill would require that public companies include in their annual proxy to investors the opportunity to conduct an advisory vote on the company’s executive pay plans, but would not provide the ability to set limits on compensation. Corporate boards would not be required to take any action in response to such votes. Finally, the bill also contains a separate advisory vote if a company gives a new, not yet disclosed, “golden parachute” while simultaneously negotiating to buy or sell a company. In the Senate, Barack Obama introduced a companion measure, S. 1181, on that same day. “It’s time that we not only make executive compensation packages more transparent, but that we also allow shareholders to express and debate their views on those packages,” he is reported to have written to his Senate colleagues in seeking support for his bill. As of this writing, five Senators have signed on as cosponsors: Sherrod Brown (D-OH), Richard Durbin (D-IL), Tom Harkin (D-IA), John Kerry (D-MA), and Carl Levin (D-MI). Congressman Frank, Chairman of the House Financial Services Committee, claims that his legislation would “further the workings of the capitalist system of the United States.” By giving shareholders a so-called "say on pay" vote, supporters argue that corporate boards would have an incentive to engage shareholders in meaningful discussions concerning appropriate levels of executive compensation before approving a compensation plan that might be seen as excessive. However, Congressman Spencer Bachus (R-AL), the Ranking Republican on the House Financial Services Committee, opposed the legislation, warning his colleagues during House floor debate that “[w]hen Congress becomes a second-guesser and a judge of executive pay for every corporation in America, every public corporation,” then “we are getting on a slippery slope.” The White House also opposes the legislation, saying that it “does not believe that Congress should mandate the process by which executive compensation is approved” and that the SEC’s 2006 pay disclosure rules “should be given time to take effect” before additional corporate governance requirements are legislated. Is excessive executive pay the result of corporate boards that are not sufficiently independent of management, warranting legislative action, or has the increase in CEO salaries largely been a function of natural market-driven changes in the demand for and supply for CEOs? In case you haven’t made up your own mind yet, the CRS, Congress’ nonpartisan public policy research function housed within the Library of Congress, recently addressed whether the managerial power or the market-based view of executive pay is the accurate one. Their report, in its own words, “examines critical and supportive evidence surrounding the premise that the executives are generally overpaid from an economic perspective,” providing a brief history of executive pay regulation and an analysis of policy options. Still enough time to add it to your Memorial Day beach reading list!
White
House Position on Executive Comp Legislation NCTR Opposes Latest Effort by DOE to Discourage Contractor Use of DB Plans
On May 11, 2007, NCTR and 19 other national organizations representing public employers, employees, retirees and pension plans filed formal comments with the DOE opposing any change in policy that would deny reimbursement of contractor costs associated with DB pension plans for new employees, and urged the agency “to cease consideration of this proposal.” The letter was in response to a DOE Request for Public Comment on what it referred to as its “contractor employee pension and medical benefits challenge.” The DOE action is a renewal of its effort to impose new restrictions on its Management and Operating (M&O) and other site management contracts. Currently, under these arrangements, DOE reimburses its contractors for allowable costs incurred in providing employee pension and medical benefits to current employees and retirees who are eligible to participate in the contractors’ pension and medical benefit plans. In April of last year, the DOE issued a notice whereby it proposed to change this approach. Under the new proposal, the DOE would continue reimbursing contractors for costs for current and retired contractor employee pension and medical plans under existing contract provisions, but would begin requiring “market-based” defined contribution pension plans and medical plans for new employees, except where to do so would be inconsistent with the terms of a collective bargaining agreement. The proposal immediately sparked objections from DB supporters. NCTR’s president at the time, Clare Barnett, wrote a strong letter to Vice President Richard Cheney, who had addressed the 2006 Saver Summit that she attended. In her letter, Mrs. Barnett expressed "in the strongest terms" her objections to the policy, and warned that "by financially coercing their contractors into 'freezing' their DB plans, the DOE's actions threaten the future financial security of these existing DB plans, present the possibility of greater contractor costs, and could even increase the potential liability of taxpayers." (See July 2006 NCTR Federal E-news) Members of Congress from both sides of the aisle also strongly objected, and in a rare display of bipartisanship at the time, the House of Representatives approved a rider on the DOE's FY2007 Appropriations bill that would prohibit the use of any funds to pursue the new policy. In response, the DOE suspended its proposal in June of 2006 for one year “pending consultation with stakeholders.” With the one year period almost up, the DOE has renewed its efforts, asking for public comments. The PPN letter presents a united public sector response that not only decries the proposal as “simply bad public policy,” but also accuses the DOE of being “irresponsible” in trying to limit the type of benefits a public or private contractor may provide its employees. “This is particularly true for the DB model that has proven invaluable in the management of human resources as well as one of the most efficient means of providing retirement security,” the letter points out. Of the 46 contracts that would be affected by the DOE change, over
one quarter are either directly with state and local agencies or with
consortiums involving public entities, and several other contracts appear
to also include in one manner or another public employers. Accordingly,
the PPN letter also stresses likely cost increases that would therefore
result if the many State and local agencies that contract with the DOE
are required to take on the administrative burdens and transition costs
associated with freezing existing DB plans and operating new DC plans
for future employees associated with the performance of such work. Such
action “sets a very dangerous precedent with regard to other intergovernmental
agency contracts and Federal-State shared programs,” the letter
warns. PPN
Letter Opposing DOE Contract Change Public Pensions are Increasingly Implicated in a Number of Areas as Hedge Funds, Private Equity Market Become Lightning Rod for Possible Congressional Action
The hedge fund industry continues to grow by leaps and bounds. According to Hedge Fund Research Inc., a Chicago-based research firm specializing in the aggregation, dissemination and analysis of alternative investment information, including standard benchmarks of hedge fund performance, the industry had record inflows of more than $60 billion during the first quarter of 2007. This represents a 295% increase over the fourth quarter of 2006, and equals almost half the record $126 billion in asset growth for 2006, bringing total assets currently under management to $1.57 trillion. As has been previously reported, this growth in hedge funds has some people very alarmed, and a recent report by the New York Federal Reserve is not helping. Tobias Adrian, one of the New York Fed’s capital markets economists, suggests that, using at least one yardstick, there are strong parallels between today’s level of hedge fund risks and those present before the collapse of Long-Term Capital Management (LTCM) in 1998. (LTCM was a hedge fund that got into trouble when the Russian government defaulted on its bonds; the Federal Reserve ultimately bailed out the hedge fund giant.) Specifically, the New York Fed report notes that recent high correlations among hedge fund returns -- returns moving in the same direction when facing similar market conditions -- could suggest concentrations of risk comparable to those preceding the 1998 hedge fund crisis. “Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock,” the Adrian study explains. Many funds had to close out positions during the LTCM collapse to meet margin calls and satisfy risk management constraints, exacerbating the crisis. However, Adrian also notes that there is a key difference between today and 1998, namely that the increased correlation of hedge fund returns is now produced by an overall decline in the volatility of returns in financial markets. This provides little solace to some, however, who are concerned with the relatively light regulation of the hedge fund industry and who believe that the LTCM crisis is a prime example of the need for increased scrutiny – and perhaps even increased regulation – of this market. For example, on the same day that the New York Fed’s report was coming out, International Monetary Fund (IMF) Managing Director Rodrigo Rato expressed concerns with the proliferation of hedge funds, and questioned whether their purported benefits in terms of market efficiency (improved market liquidity; spreading of risks) are actually being delivered. “Returns of some equity based hedge funds may have become more correlated with market returns recently, casting doubt on their contribution to risk diversification,” he pointed out in a speech on May 2, 2007, to the 37th annual Washington Conference of the Council of the Americas. While Rato believes that private equity market risks should be controlled mainly through investor due diligence, he also thinks that as the structure of these markets changes, it may be necessary “to adapt the framework of supervision to improve investor protection and reduce systemic risks and vulnerabilities.” Rato also touched upon another factor involved with the boom in hedge funds that is of growing concern to many, and that is the involvement of pension funds in the process. As he pointed out, “about 30 percent of investment in hedge funds now comes from pension funds.” While Rato noted that the diversification of risk is important, he also said that a “situation where almost one-third of the capital for institutions on the cutting edge of financial risk comes from institutions whose first priority is safe investments certainly bears watching.” New studies confirm that public pension plans are increasingly willing to consider investments with higher risk tolerances. For example, the 5th annual Pyramis Global Advisors Defined Benefit Survey of more than 200 of the largest U.S. corporate and public DB pension plans, released in mid-April of this year, showed that public plans are focused primarily on investment performance, with 53% citing a low-return environment as their biggest concern. Peter Chiappinelli, senior vice President of Pyramis (a unit of Fidelity Investments), has been quoted as saying that the survey shows that DB plans, both public and private, “are loosening many of the historical constraints they've been under” and “are interested in non-traditional strategies to help meet their return targets in a low-yielding, single-digit return environment." As has been noted previously, this involvement of pension plans in hedge funds specifically, and in the private equity market in general, is troubling to an increasing number of members of Congress. (See March 2007 NCTR Federal E-news; November 2006 NCTR Federal E-news). Some think Federal regulation of pension investments in this area may therefore be needed. Included among them is the Chairman of the House Financial Services Committee, Congressman Barney Frank (D-MA), who has been quoted as saying that he sees “some restriction on the pension fund-hedge fund interaction” in the future. One approach that has been suggested is for pension plans to be restricted to investing only in hedge funds that are registered with the Securities and Exchange Commission (SEC). Even though a Federal court threw out earlier efforts by the SEC to establish the prerequisite registration process, the Ranking Republican on the Senate Finance Committee, Charles Grassley (R-IA), attempted to reinstate such a registration scheme earlier this year, stating that the “secretive way that hedge funds operate might not be an issue for the super rich who first invested in hedge funds, but today the average Joe has a stake as pension funds are invested in hedge funds.” While his attempt to add SEC registration – in the form of an amendment to H.R. 4, the Homeland Security legislation – did not succeed, it can be expected that other similar efforts will continue. The examination of hedge funds, the private equity market, and their interrelationships with pension plans is now spreading beyond regulatory schemes to encompass tax issues as well. Senate Finance Committee Chairman Max Baucus (D-MT) has confirmed that his Committee is "looking at the general question" of how hedge funds and private-equity firms are taxed. Indeed, there appears to be a convenient convergence of interests, one dealing with concerns about the general policies that such tax treatments represent, the other dealing with the need to come up with additional revenues to be used to pay for other initiatives under the pay-as-you-go (PAYGO) rules of the new Democratic Congress. On the one hand, some believe that current tax policies toward private equity threaten jobs. For example, it is reported that a number of trade unions are urging Congress to closely examine the large profits associated with recent buy-outs of public firms by private equity groups, including the tax treatment afforded them. In April, the Service Employees International Union (SEIU) issued a new report entitled “Behind the Buyouts: Inside the World of Private Equity.” Noting that there is “no doubt” that buyouts are helping to concentrate wealth among the top 1 percent of Americans, the report asserts that there “is more than enough wealth in the private equity industry for the buyout firms to continue to prosper while also adapting their business model to expand opportunities to benefit workers, communities, and the nation.” SEIU points out that while the private equity industry enriches a small group of executives, “the hundreds of thousands of portfolio company employees and contract workers have no seat at the table in these deals and do not receive any of the benefits, despite their everyday hard work that contributes to building the value of these companies.” Conceding that there no reliable quantitative data “to adequately evaluate the impact of private equity buyouts on overall job creation,” SEIU claims that “it is clear that the growing influence of the private equity buyout industry on the American economy calls for a much closer look at the impact that its business practices have, not only on workers, but on communities and other stakeholders affected by corporate buyouts.” Hearings on this aspect of the overall hedge fund/private equity issue will continue in the House of Representatives with a hearing before the Financial Services Committee scheduled for May 16, 2007, on “Private Equity’s Effects on Workers and Firms.” Then there are those who say they are concerned with the potential underpayment of taxes as a consequence of the current tax treatment of the private equity industry. The SEIU reports that the Blackstone Group, with more than $78 billion in assets under management, paid taxes at a rate of 1.4 percent in 2006. “If it had been taxed at the 34.5 percent rate that applies to companies such as Goldman Sachs, for example, Blackstone’s tax bill last year would have increased from just $32 million to nearly $800 million,” the SEIU report asserts. Consequently, according to the press, Senator Grassley (R-IA) may want to close what he thinks of as a potential “tax loophole” by making “carried interest” subject to regular tax rates. “Carried interest,” often also referred to as simply “carry,” refers to a common aspect of hedge fund managers' pay, whereby they are paid a management fee (typically 2 percent of a fund's assets) and usually a 20 percent share of future profits. Structured in this manner, the managers effectively pay only a 15 percent rate on most of their income, since carried interest is taxed as capital gains as it is distributed. “If it's earned income, it ought to be taxed at 35 percent instead of 15 percent. If it's capital gains, then we'll just leave it the way it is," Grassley is reported as saying. Another area of potential underpayment that is drawing attention involves what some tax staff characterize as the sidestepping of rules intended to block charities from acquiring for-profit businesses with borrowed money using “offshore blockers.” “Offshore blockers,” or blocker corporations, are used by hedge funds and other private equity funds to permit tax-exempt investors to avoid “unrelated business income taxation” (UBIT) on profits received from debt-financed investing unrelated to such entity's tax exempt purpose. A private equity fund will set up an offshore, foreign corporation in which the tax exempt can invest, thereby making the tax exempt no longer a partner in the fund, but simply an investor in the offshore “blocker,” which is the owner of the equity in the fund. This means that the tax-exempt investor’s hedge fund income technically comes from the “offshore blocker,” and is treated as dividend income, which effectively “blocks” any UBIT. Currently, the focus in this area appears to be on university endowments’ investments in hedge funds, including those of Harvard, Yale and Stanford. According to surveys such as one by the National Association of College and University Business Officers, about 18 percent of university endowment money, on average, was invested in hedge funds as of June 30, 2006. So how are public pension plans implicated in this debate? First, based on recent meetings with staff of members on both the Senate Finance Committee and the House Ways and Means Committee, public plans are being used by hedge funds and other private equity industry representatives in their arguments opposing changes in the treatment of carried interest. Reportedly, these changes are being characterized as a blow to public pension funds because it will mean fewer private equity deals, which in turn will mean a reduction in hedging strategies and fewer opportunities for increased investment returns. Similar adverse effects on other investment funds that rely on carried interest, such as real estate and oil and gas partnerships, as well as venture capital funds, are also stressed. The argument is summarized in an item entitled “Assault on the Investor Class” in the May 7th Wall Street Journal’s Review and Outlook section: “The biggest losers from a private equity tax hike may be pension funds, which have become large investors in these funds; their high performance has made millions of Americans wealthier in their retirement.” And not just pension funds, but public pension funds: “The California public employee pension system is thought to be one of the largest private equity investors in the country,” the WSJ item reminds us. But do public pension funds really have a dog in this fight? If so, then we should discuss our concerns with any changes in the treatment of carried interest directly with Congress. Our positions should not be delivered by the public equity industry on our behalf in a transparent attempt to gain sympathy for their views by leveraging the good will felt toward the public pension community by many key players in this debate. As has been noted, Senator Grassley and others are already worried about pension fund investments in hedge funds. It is therefore very important that the public pension community maintain credibility with him so that our concerns with any restrictions on pension fund investment authority in this area are given an objective hearing and are not colored by some perceived relationships between us and the hedge fund community. In addition, it must be kept in mind that this is as much about a search for revenues to pay for other Congressional priorities as it is a true tax policy debate. It may well be that it is as simple as the WSJ article puts it: “Congress wants money and private equity funds have lots of it.” But which so-called tax “loophole” is more important for public funds to protect from repeal: “carried interest” or the IRC Section 414 employer pick-up? Finally, the potential impact of the application of UBIT to areas currently
viewed by public plans as exempt is probably of much greater concern
to public institutional investors than the effects of a change in carried
interest. If political capital must be spent in this hedge fund/public
equity tax debate, this may be the better place in which to spend it.
New
York Fed Report on Hedge Fund Risks SEC Discusses Shareholder Rights, Access to the Proxy; New Proxy Rule Expected this Summer
The SEC will hold three roundtables in the month of May as part of what Chairman Cox has described as a "top-to-bottom review" of shareholder proxy-voting issues before the Commission announces its proposals for new rules later this summer. The first session on May 7th consisted of panels addressing the Federal role in upholding shareholders' state law rights; the purpose and effect of the Federal proxy rules; non-binding proposals under the proxy rules; and binding proposals under the proxy rules. The first roundtable’s focus on state law is thought to be significant because some have argued that access to the proxy is more appropriately a state law issue, and that the SEC does not have the authority to mandate companies to provide for such. An alternative model that would provide state policymakers with the central role was suggested last year by Leo Strine, Vice Chancellor of the Delaware Chancery Court, and may provide the basis for an approach that could garner corporate support according to some reports. Strine believes that “States are the primary source of substantive corporate law and elections are a core aspect of substantive corporate law.” According to him, “Congress has not broadly authorized the SEC to make corporate election policy.” Under the Strine model, instead of an annual requirement imposed under Federal law, there would be a “State-authorized ballot access statute” approach providing that every three years, all public companies without staggered boards could distribute a proxy card that included the name of any qualified director candidate who has been timely nominated by a qualified stockholder or stockholders owning at least 5% of the company’s voting stock. Companies would reimburse the reasonable solicitation costs of any qualified director candidate who received at least 35% of the votes cast. To address concerns about the costs of expanded ballot access, under Strine’s proposal the SEC could allow exclusion of precatory (non-binding) resolutions at annual meetings. However, regulation of the proxy process is one of the SEC’s “core” functions and one of the original responsibilities assigned to the Commission by the Securities Exchange Act of 1934. Therefore, others argue that there is a clear Federal role in “vindicating shareholders' state law rights,” as Chairman Cox puts it. Richard Ferlauto, director of pension benefit policy at the American Federation of State, County, and Municipal Employees (AFSCME) has been quoted as warning that to do away with investors’ ability to file non-binding shareholder proposals “would open up a Pandora’s box” and would be strongly opposed by investor organizations. Can Chairman Cox fashion a compromise that will satisfy both business and investors and therefore receive bipartisan support from his fellow Commissioners? These roundtables may provide a good sense as to whether or not this is possible – and if so, what such a compromise might contain. The second and third roundtables on proxy voting will take place on
May 24th and 25th. A final agenda and list of participants and moderators
will be published for each roundtable closer to the dates of the roundtables.
The roundtables will begin at 9:00 a.m. at the SEC’s headquarters
in Washington, D.C and are open to the public with seating on a first-come,
first-served basis. They will also be available via webcast on the Commission's
Web site at www.sec.gov.
SEC
Briefing Paper for May 7th Meeting Sarbanes-Oxley Appears Safe and Sound
as Senate Rejects Effort to Gut Section 404 Reforms; SEC Continues to
Support Regulatory Approach to Address Impact on Smaller Firms On April 24, 2007, the Senate defeated an effort by Senators Jim DeMint (R-SC), Mel Martinez (R-FL), John Cornyn (R-TX), and John Ensign (R-NV) that would have made Section 404 of SOX optional for smaller companies with market capitalization of less than $700 million, with revenue of less than $125 million, or with fewer than 1,500 shareholders. The defeat came on a motion to table (thereby killing) their amendment to S. 761, the “America COMPETES Act,” dealing with the competitiveness of the United States in the global economy. Fourteen Republicans joined with fifty-one Democrats in stopping the effort by a vote of 65 to 32. DeMint and his supporters cited a recent report by McKinsey & Company commissioned by Senator Charles Schumer (D-NY) and New York City Mayor Michael Bloomberg (R) that found that over the first ten months of 2006, U.S. exchanges attracted barely one-third of the share of IPOs compared with 2001 numbers, while European exchanges increased their market share by 30 percent and Asian exchanges doubled their share during that same time period. One reason for this trend, according to the study, was “non-US issuers’ concerns about compliance with Sarbanes-Oxley Section 404 and operating in what they see as a complex and unpredictable legal and regulatory environment.” However, opponents, including both the Chairman of the Senate Banking Committee, Chris Dodd (D-CT), and its Ranking Republican, Richard Shelby (R-AL), argued that the SEC and the Public Company Accounting Oversight Board (PCAOB) were working to address the impact of Section 404 compliance on smaller firms, and should be given adequate time to see their efforts to completion. Indeed, two weeks prior to the amendment, the SEC voted to continue to work closely with the PCAOB to make the internal controls provisions of Section 404 of the Sarbanes-Oxley Act of 2002 more efficient and cost effective. Specifically, the Commission ordered its staff to focus its work in four areas: aligning the PCAOB's new auditing standard with the SEC's proposed new management guidance under Section 404, particularly with regard to prescriptive requirements, definitions and terms; scaling the 404 audit to account for the particular facts and circumstances of companies, particularly smaller companies, encouraging auditors to use professional judgment in the 404 process, particularly in using risk-assessment; and following a principles-based approach to determining when and to what extent the auditor can use the work of others. The Commission expects the new PCAOB auditing standard will be submitted for SEC review by the end of May or early June, in time for the 2007 financial statement audits. "These needed improvements in the Sarbanes-Oxley process are especially urgent for smaller companies, who will begin complying with Section 404 this year," said SEC Chairman Christopher Cox." The result of the new auditing standard for 404, together with the SEC's new guidance to management, should make the internal control review and audit more efficient by focusing the effort on what truly matters to the integrity of the financial statements," he added. Senator John Kerry (D-MA), Chairman of the Senate Committee on Small Business and Entrepreneurship, called the DeMint amendment “an overreaching, premature policy reversal that preempts years of thoughtful regulatory consideration on the part of the SEC and the PCAOB.” SEC Chairman Cox had testified before Senator Kerry’s Committee on April 18th that “[f]ocusing on the implementation of 404, rather than changing the law, is consistent with the SEC's view that the problems we've seen with 404 to date can be remedied without amending the Sarbanes-Oxley Act.” Furthermore, despite what he called “the unduly high costs of implementing section 404 of the Act,” Chairman Cox said that he believed “that the Act overall -- including section 404 -- may be fairly credited with correcting the most serious problems that beset our securities markets just a few years ago, and with restoring investor confidence in our markets.” Finally, the Council of Institutional Investors (CII) weighed in with a letter to Senator Dodd expressing concerns with the DeMint amendment and echoing Cox’s comments, stating that the Council “believes that the internal control requirements of Section 404 are a core element of SOX and play a vital role in restoring and maintaining investor confidence in the markets.” Furthermore, CII stressed that “any company tapping the public markets to raise capital, regardless of size, should have appropriate internal controls.” This is not to say that all concerns with the implementation of SOX
Section 404 have been allayed. Indeed, Senators Dodd, Shelby and Kerry
all spoke of their concerns with the greater-than-anticipated costs
of compliance. Senator Shelby pointed out during debate that “there
is no question” that the implementation of Section 404 “has
been too costly, particularly for small public companies. We know this.
This is a given.” Shelby also said that “I don’t disagree
with what Senator DeMint is trying to do, but I think it is premature.”
He warned that “I am willing to give the SEC and the PCAOB some
additional time, but I am not willing to give them unlimited time.”
CII
Letter on the DeMint Amendment Senate Approves New FDA Bill after Dealing with a Number of Major Healthcare Reform Issues Legislation to reauthorize the U.S. Food and Drug Administration (FDA) has cleared the Senate overwhelmingly, but not before a number of contentious votes and heated debate over a number of issues of significance to public healthcare purchasers, including drug reimportation, biogenerics, and payments by branded drug manufacturers to keep new generic versions of their products off the markets. Unlike the process for earlier legislation on other subjects, which started in the House and then moved to the Senate, the Democratic leadership has reversed the order in the case of this major health bill, and has used the Senate to define the parameters of what is “do-able” in an effort to ensure that action does not become bogged down on a topic that is of increasing interest and concern to American voters – namely healthcare reform. S. 1082, the Prescription Drug User Fee Act, (commonly referred to as the FDA Reauthorization bill) was approved by the Senate on a vote of 93-1 on May 9, 2007. Prescription drug user fees (fees paid to the FDA by pharmaceutical companies) were created in 1992 to expedite the FDA’s consideration and approval process in order to get drugs to market more quickly. Due to expire on Sept. 30, 2007, the Prescription Drug User Fee Act is considered a “must-pass” bill and is therefore a convenient vehicle to carry other issues. Perhaps the most controversial of these added items dealt with drug reimportation. Proponents of reimportation believe the provision could save payors somewhere between $10-$20 billion over 10 years, while opponents argue that cutting into industry profits in this manner will undercut incentives for new drug creation. As if this wasn’t a sufficient reason for controversy, things really heat up when the issue of safety is raised – i.e., are drugs being reimported from nations deemed to have sufficient safety standards, such as Canada, or from other locations, such as Mexico, where safety concerns have been noted? A veto from the White House over safety concerns was threatened, thereby kicking the entire debate up a notch or two. The problem was “solved,” however, when two reimportation approaches were adopted. One, offered by Senators Byron Dorgan (D-ND) and Olympia Snowe (R-ME), would permit consumers, pharmacies and wholesalers to purchase FDA-approved prescription drugs that are manufactured at FDA-inspected facilities in 19 industrialized nations, and establishes a regulatory framework for reimportation. The second, offered by Senator Thad Cochran (R-MS), would prohibit any reimportation until the Department of Health and Human Services (HHS) certified that reimportation presented no additional risk to the public and would save the public money. Given that HHS has consistently refused to guarantee that it could certify the safety of drugs imported from other countries, the Cochran amendment is viewed by some as effectively negating the Dorgan-Snowe amendment. The vote for the Cochran amendment was 49 to 40 in favor of passage, with an odd assortment of Democrats and Republicans on both sides of the issue. Thirty-three Republicans, 15 Democrats and one independent voted in favor of the Cochran amendment, including the authors of the underlying bill, Senators Edward Kennedy (D-MA) Chairman of the Senate Health, Education, Labor and Pensions (HELP) Committee and Senator Mike Enzi (R-WY), the HELP Committee’s Ranking Republican. Twenty-eight Democrats, eleven Republicans and one independent voted against it. Depending upon your point of view, the vote in favor was an effort to avoid a threatened Bush veto, or simple pandering to the prescription drug industry. Another issue dealt with in the bill on which public healthcare purchasers had specifically weighed in concerned so-called biogenerics (See April 2007 NCTR Federal E-news.) As expected, the issue of creating a generic approval process for biologic drugs encountered resistance on the Senate floor. In the end, Senators Schumer (D-NY), Hatch (R-UT), and Clinton (D-NY), who had sponsored an amendment to add a biogeneric process directly to the bill, finally decided to join forces with HELP Committee Chairman Kennedy and Ranking Member Enzi in passing a non-binding resolution endorsing the general goals of their free-standing biogeneric bill, S. 623. Kennedy, with Enzi’s general concurrence, promised a mark-up of the proposal on June 13th, with the stated intention to add the marked-up bill to the conference report, assuming the House can pass its own version of the overall bill. The decision -- both for proponents of biogenerics as well as their opponents -- is apparently to put all eggs into one basket, namely the June 13th mark-up. Interestingly, the prescription drug industry must have felt that it did not have a strong enough hand to kill the biogenerics measure outright on a procedural vote, which supports the reported split in the industry between large companies who want to preserve their monopoly on brand name biopharmaceuticals and smaller biotech firms, who see new profit opportunities in generic competition. Can biogeneric advocates get everything they want from the June HELP Committee mark-up? Or will the crucial support of Hatch and Enzi require them to accept a more moderate plan for easing into what everyone admits is a complex problem? In any case, it would appear that something helpful to public health purchasers could eventually emerge in this important area. Yet another topic of interest involves brand name drug manufacturers’ settlements with generic competitors in order to effectively extend the formers’ patents on their brand name products by paying to keep competing products of the latter off the market for as long as possible. While Senators Leahy (D-VT), Schumer (D-NY), Kohl (D-WI), and Grassley (R-IA) filed their bill to ban such “pay to not play” practices as a possible amendment to the FDA bill, it was not offered – perhaps a victim to the negotiations involving biogenerics? However, this issue will almost certainly see action when the House considers its version of the legislation. Letting the Senate go first on this major health bill clearly indicates that the Democratic Congressional leadership is inclined to let the Senate craft compromise legislation that could survive the process in that body when complex issues with a lot of controversy surrounding them must be advanced. While House rules allow the majority to essentially have its way on the agenda and specifics of legislation, Senate rules offer numerous opportunities to insist on 60-vote, super-majority procedural votes (necessary in order to obtain cloture on issues, thereby ensuring that endless debate can be avoided and they can be brought to a final vote). This requires much more in terms of bipartisan negotiations, especially given the narrow 51-49 Democratic control. Thus, although many members of the House Democratic Caucus might prefer stronger bills, the Senate defines the limits of what is possible in Congress and also stands as a good measure of what can gain the President’s signature. The GOP is, of course, aware of this tactic as well. They will therefore consider carefully whether to try to defeat bills entirely in the Senate (Medicare bargaining for drug prices, for example) or use their leverage in that body to maximize their ultimate bargaining position in conference with the House, as was likely the case with the Cochran amendment on drug reimportation. (Although the White House has signaled that it would veto a drug bill with a reimportation provision, the consensus is that the Cochran amendment addresses the concerns raised by the Administration with enough vigor to allow the President to accept this version of reimportation.) Reauthorizing the Prescription Drug User Fee Act is a priority for the drug industry and this fact alone likely ensures that something will therefore clear the President’s desk this Congress. Furthermore, Billy Tauzin, president of the Pharmaceutical Research and Manufacturers of America (PHARMA), is reported to have said that they are "generally pleased" with the Senate bill. Overall, the Senate made substantial progress on a variety of important issues for public healthcare purchasers as well. Additional opportunities will be presented as the House considers its version of the legislation, which many think will be tougher on the industry. However, senior House lawmakers are reported to be pleased with the Senate's basic approach.
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