Funds Talk: February 2018
Topics covered in this issue include:
- Global Regulators Increasingly Shifting Focus to Cryptocurrency After years of allowing cryptocurrency transactions to fly under the radar, financial market regulators are beginning to turn their attention to virtual currencies — although the emerging regulatory landscape remains far from uniform.
- Overview of the Recent EU Adoption of Common Rules and Framework for Securitization Transactions in Europe As part of the Capital Markets Union action plan announced in September 2015, the European Parliament and the Council issued on Dec. 12, 2017, the regulation laying down a general framework for securitization and creating a specific framework for simple, transparent and standardized securitization (the regulation).
- SEC Releases Guidance on Near-Term Disclosure Regarding Effects of New Tax Law The tax reform signed into law by President Donald Trump on Dec. 22 (the tax act) presents public companies with several accounting and disclosure challenges. Although companies are still evaluating how they will be affected by the tax act, the Securities and Exchange Commission has released guidance to help navigate the disclosure issues.
Global Regulators Increasingly Shifting Focus to Cryptocurrency
Until recently, cryptocurrencies had largely avoided the regulatory spotlight. While financial market regulators monitored the emerging sector, they largely maintained a hands-off approach as it remained on the periphery of financial markets for the past several years.
That is now changing, and global regulators are taking tentative steps to respond to the unique challenges created by virtual currencies, which largely exist and operate outside of the traditional financial systems. However, although regulators are increasingly asserting jurisdiction over and taking action against cryptocurrency traders and transactions as they deem appropriate, the extent and scope of regulatory activity vary accross the world’s major financial markets.
Following a rapid rise of initial coin offerings (ICOs) and the surge in the value of Bitcoin in 2017, the Securities and Exchange Commission (SEC) issued an investor bulletin warning about the potential hazards associated with ICOs, and Chairman Jay Clayton later issued a statement urging individuals to understand the risks associated with virtual currencies before investing. However, as of the end of the year, the SEC had neither approved any exchange-traded products investing in cryptocurrencies, nor had it registered any ICOs.
Nonetheless, the SEC has entered into the cryptocurrency sector in other significant ways. In July 2017, the agency released an investigative report warning that “virtual” organizations’ offers and sales of digital assets may be subject to the requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934 — a meaningful step in establishing its regulatory jurisdiction over the cryptocurrency market. Similarly, the Commodity Futures Trading Commission (CFTC) waded into the cryptocurrency sector by designating Bitcoin as a commodity, placing the cryptocurrency and any related fraud or manipulation squarely under its authority.
The SEC also launched three enforcement actions against ICO sponsors in 2017. In one instance, it obtained an emergency asset freeze to halt an alleged ICO fraud that raised as much as $15 million from thousands of investors, while others exposed allegedly fraudulent schemes that violated the anti-fraud and registration provisions of federal securities laws. In January of 2018, the SEC halted trading of the shares of a Chinese blockchain technology company, citing potentially inaccurate company disclosure filings and “recent, unusual and unexplained market activity” around its stock.
Other U.S. agencies have also established an initial measure of supervision over cryptocurrencies. The Internal Revenue Service indicated that Bitcoin should be considered property for tax purposes and any associated capital gains or loss from trading in Bitcoin would be treated the same as property. The Treasury Department indicated it would review its Financial Crimes Enforcement Network’s cryptocurrency practices to ensure they adequately address any potential money laundering and terrorism financing risks. Finally, Keith Noreika, the acting U.S. Comptroller of the Currency, recently said he is considering licensing Bitcoin and other cryptocurrency exchanges via a nationwide licensing program similar to that in Japan.
While U.S. regulators largely began exercising jurisdiction over cryptocurrencies only in 2017, there is every indication that they will continue to do so in the year ahead in order to strengthen investor protections and take enforcement action as necessary.
No standardized regulatory framework currently exists across the EU, although both the regional government and individual member states have responded to one extent or another. Different approaches and legislation exist within individual member states, although financial regulators in many countries have issued statements warning investors of the inherent risks. In Germany, digital currencies are legal financial instruments and can be taxed as capital, although some uses require an additional license or permit. In contrast, there is currently an absence of any specific cryptocurrency regulations within the United Kingdom, although the British Treasury plans to adopt the planned EU legislation expected to enter into effect in late 2018. Designed to address concerns related to potential money laundering, those rules would require virtual currency traders to disclose their identities and report any suspicious activity to regulators. Meanwhile, Estonia has proposed the creation of a state-managed cryptocurrency called the “estcoin,” which it would launch via an ICO.
A wide range of regulatory approaches exist across the largest Asian economies. At the most stringent end of the spectrum, China has banned all cryptocurrency exchanges and fundraising through ICO activities, effectively rendering ICOs an illegal activity within its borders. Financial institutions and third parties are prohibited from using virtual currencies in any way as part of a transaction. The country has also taken a hard-line approach to Bitcoin miners due to concerns over resource allocation and a potential crash in value, with prospective measures including limiting power supply to computer servers used to mine Bitcoin or amending land use and taxation laws in order to effectively halt their activities. This approach could further affect global Bitcoin transactions, as China is home to the majority of the world’s Bitcoin mining operations. Chinese cryptocurrency traders have turned to over-the-counter platforms to invest in virtual currencies, although regulators may set their sights on that avenue in response.
At the other end of the spectrum, Japan adopted a law to regulate cryptocurrencies in 2016, which entered into effect in 2017, and cryptocurrencies are a legally recognized method of payment. Japan’s Financial Services Agency (FSA) has authorized a total of 15 virtual currency exchanges. Similar to the SEC, the FSA issued a statement in October 2017 warning investors about the potential risks, highlighting specifically the potential for price volatility and the potential for fraud. Also like the SEC, the Japanese market regulator reminded the industry that certain ICOs resembling investments would be subject to regulations under the Financial Instruments and Exchange Act.
Whereas China and Japan have implemented ample measures to respond to virtual currencies, India has thus far taken little action. The government does not regulate any cryptocurrency exchanges, although it has indicated it is examining moving in that direction. However, any looming regulation appears more likely to be designed to control the sector, rather than foster its growth, as the country’s finance ministry recently likened cryptocurrency trading to a Ponzi scheme and underlined the current absence of any investor protections.
Finally, South Korea had been similarly slow to impose regulations, despite being the third-largest cryptocurrency market in the world, behind the U.S. and Japan. However, late in 2017 the government unveiled additional measures to regulate the emerging sector and cool the “irrationally overheated” virtual currency speculation, and the Financial Services Commission issued a ban on ICOs, promising unspecified “stern penalties” for any violations. The new legislation prohibits anonymous cryptocurrency accounts and promises ongoing regulatory monitoring of cryptocurrency exchanges. The regulator has since launched inspections of six of the country’s largest commercial banks in order to ensure compliance with cryptocurrency anti-money-laundering obligations.
Although cryptocurrencies were previously banned in Russia, the past year saw a liberalization of the government’s approach in response to President Vladimir Putin’s public support for its greater adoption. This culminated in legislation in December that would allow for exchanges and ICOs, albeit with maximum amounts for both individual investors and total fundraising. The legislation is expected to be finalized in early 2018.
Obviously, the global regulatory environment in which cryptocurrencies operate is varied and rapidly changing. Now that regulators have waded into asserting a supervisory role over this emerging sector, further developments can be expected in the year ahead.
Overview of the Recent EU Adoption of Common Rules and Framework for Securitization Transactions in Europe
As part of the Capital Markets Union action plan announced in September 2015, the European Parliament and the Council issued on Dec. 12, 2017, the regulation laying down a general framework for securitization and creating a specific framework for simple, transparent and standardized securitization (the regulation). The regulation was published in the Official Journal of the European Union on Dec. 28, 2017, and will come into force on Jan. 17, 2018. In this article, we will discuss the key aspects of the new securitization framework.
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The regulation will apply only from Jan. 1, 2019; transactions issued before this will be subject to the existing rules under the Capital Requirements regulation, the AIFM Directive and the Solvency II Directive, as appropriate.
Following much political debate, the regulation keeps the required level of retention of net economic risk of not less than 5% in the securitization and discloses the risk retention to investors. However, the regulation tasks the European Systemic Risk Board with continuous monitoring of developments in the securitization markets and allows for a change of this level in the future.
The retention requirement now places an indirect obligation on all “institutional investors” to ensure retention requirements are met before they invest in a securitization position. Institutional investors will include a broader group of regulated financial entities so that the rules on risk retention apply in the same way to all Institutional investors investing in securitizations.
Moreover, the definition of “originator” in the risk retention rules is amended to ensure that the originator is an entity of substance and not one created as a vehicle, which technically meets the legal definition but was established for the sole purpose of purchasing assets and securitizing them. In addition, “sponsor” is defined by reference to MiFID II, which allows investment firms to no longer be restricted to European Union – licensed MiFID entities but now include any legal person whose regular occupation or business is the provision of investment services to third parties and/or the performance of investment activities on a professional basis.
New simple, transparent and standardized (STS) criteria
The regulation provides the STS label to term securitizations and ABCP’s meeting the detailed new criteria for STS transactions. Certain legacy transactions can achieve STS status if they meet specified conditions relating to simplicity, standardization and transparency (Articles 19 to 22 of the regulation). Some of these criteria are measured at the time of issuance and some at the time of notification of STS status. The criteria for a securitization to qualify as STS include there being a homogenous asset pool, no active discretionary portfolio management and no transferable securities (other than corporate bonds that are not listed on a trading venue) in the underlying exposures.
A third party shall be authorized by the competent authority to assess the compliance of securitizations with the STS criteria. The originator, sponsor and securitization special-purpose entity (SSPE) must be established in the EU for a securitization to be STS-eligible. After the originator or sponsor has notified the European Securities and Markets Authority (ESMA) of the transaction, the transaction will appear on the ESMA list.
Re-securitizations are prohibited under Article 8 of the regulation, except in limited circumstances. Those allowed are a re-securitization in order to facilitate a winding-up of an institution, its continuance as a going concern, or in order to preserve the position of investors where the underlying is nonperforming. The prior approval of the relevant competent authority will be required in both cases.
Amendment to European Market Infrastructure Regulation (EMIR)
The regulation modifies the EMIR regulation with the effect that SSPEs issuing solely STS transactions should not be subject to the clearing obligation, provided there is adequate mitigation of counterparty credit risk. In addition, the level of collateral required should take into account the specific nature of securitization arrangements and any impediments faced in exchanging collateral.
The regulation states that the requirements for “adequate mitigation of counterparty credit risk” are to be set out in regulatory technical standards (RTS) to be made under EMIR. The European Banking Authority is tasked with preparing the RTS before July 2018.
The transparency rules require that information from the originator, sponsor and SSPE be made available to newly established “securitization repositories” registered with the ESMA. The obligation to send information does not apply to private transactions (no prospectus is produced), but the prescribed information still needs to be made available to holders of a securitization position, to the competent authorities listed and, upon request, to potential investors. These requirements apply even for securitizations that do not meet the STS criteria.
Sales to retail investors
The regulation prohibits sales of securitization positions to retail investors with two exceptions: (1) If the retail investor’s financial instrument portfolio does not exceed €500,000, the seller shall ensure that securitization positions do not constitute more than 10% of the client’s financial instrument portfolio, including cash deposits, and that the initial minimum amount invested in one or more securitization positions is €10,000; or (2) the seller has conducted a suitability test confirming that the securitization position is suitable for the client.
Sanctions and penalties
Member states are required to implement appropriate administrative sanctions for infringements of the regulation, as a public statement, a temporary ban from producing STS notifications or a ban against any member of the originator’s, sponsor’s or a securitization special-purpose entities management body from exercising management functions, an order requiring the infringer to cease and desist the infringing conduct or a fine. This administrative pecuniary sanction can be up to €5,000,000 or up to 10% of annual net turnover or at least twice the amount of the benefit derived from the infringement.
The regulation will change the regulatory landscape for securitization transactions significantly, but some provisions must be detailed in further RTS by the European Banking Authority and the European Supervisory Authority. Within a year, we shall have a more complete securitization framework of standardized rules on due diligence, risk retention and disclosure.
SEC Releases Guidance on Near-Term Disclosure Regarding Effects of New Tax Law
The tax reform signed into law by President Trump on Dec. 22 (the Tax Act) presents public companies with several accounting and disclosure challenges. Although companies are still evaluating how they will be affected by the Tax Act, the Securities and Exchange Commission has released guidance to help navigate the disclosure issues.
Most of the SEC’s guidance is contained in a staff accounting bulletin (No. 118, available here). In the bulletin, the SEC acknowledges that the Tax Act was signed into law shortly before many companies’ fiscal year and quarter end, and that many companies will be unable to fully account for all effects of the Tax Act in their next financial statements. To the extent that a company can reasonably estimate the income tax effect of the Tax Act on its financial statements, the financial statements should reflect that estimate as a “provisional amount.” If a company cannot make such a reasonable estimate, it should continue to apply the provisions of the tax laws that were in effect before the Tax Act was enacted.
The SEC added that disclosure about material financial impacts of the Tax Act should be supplemented with the following types of information:
- Qualitative disclosures of the income tax effects of the Tax Act for which the accounting is incomplete
- Disclosures of items reported as provisional amounts
- Disclosures of existing current or deferred tax amounts for which the income tax effects of the Tax Act have not been completed
- The reason why the initial accounting is incomplete
- The additional information that needs to be obtained, prepared or analyzed in order to complete the accounting requirements under Accounting Standards Codification Topic 740, which deals with accounting and disclosure of income taxes under U.S. Generally Accepted Accounting Principles
- The nature and amount of any adjustments recognized during the reporting period
- The effect of adjustments on the effective tax rate
The bulletin adds that provisional amounts may only be provided during an interim period that should “in no circumstances … extend beyond one year from the enactment date.” Additionally, the bulletin provides that companies should disclose when they have completed accounting for the income tax effects of the Tax Act.
The rest of the SEC’s guidance is contained in a Compliance and Disclosure Interpretation (110.02, available here), which confirms that the accounting implications under the Tax Act do not trigger independent mandatory reporting obligations on Form 8-K.
In short, it appears that the SEC intends to grant reporting companies some measure of relief from accounting and disclosure obligations while they continue to assess the effects of the Tax Act. As stated by the SEC’s Chief Accountant Wes Bricker, “Allowing entities to take a reasonable period to measure and recognize the effects of the Tax Act, while requiring robust disclosures to investors during that period, is a responsible step that promotes the provision of relevant, timely, and decision-useful information to investors.”