2011 – Page 20 – Compliance Building

More Information on Part 2 of Form ADV

In October 2010, the Securities and Exchange Commission created a new Part 2 for Form ADV. Instead of filling in blanks, investment advisers need to create a brochure for delivery to clients and prospective clients. For fund managers getting ready to register, that means writing a brochure, not just filling in boxes.

One question for fund managers is “who do you have to give the brochure to?” The SEC answered that question and many others about Part 2 of Form ADV.

Question III. 2

Q: Rule 204-3 requires an adviser to deliver a brochure and one or more brochure supplements to each client or prospective client. Does rule 204-3 require an adviser to a hedge or other private fund to deliver a brochure and supplement(s) to investors in the private fund?

A: Rule 204-3 requires only that brochures be delivered to “clients.” A federal court has stated that a “client” of an investment adviser managing a hedge fund is the hedge fund itself, not an investor in the hedge fund. (Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006)). An adviser could meet its delivery obligation to a hedge fund client by delivering its brochure to a legal representative of the fund, such as the fund’s general partner, manager or person serving in a similar capacity. (Posted March 18, 2011)

Question III. 3

Q: Must an adviser to a hedge fund or other private fund file as part of its Form ADV the brochure it is required to deliver to the hedge fund or other private fund?

A: Yes.

That answers the legal questions. You don’t have to deliver it to investors, but you do need to file it with the SEC. From a practical perspective, potential investors in the fund often ask for a copy of the Form ADV as part of their due diligence. So you end up giving it to many of your investors and not just the fund.

The other missing piece for fund managers is the new Part 1 of Form ADV. The SEC proposed some significant changes and has not yet released the final form. The SEC is cutting this one close. Early June is the hard deadline for filing. Before that the SEC will need to get the IARD system updated with the new fields. Perhaps they are updating IARD now so it will be ready when the final rule comes out? I doubt it.

Sources:

Want to Attend Interact 2011?

I’m not going to be able to make it to Interact 2011 this year, but the event organizers have offered some conference passes for me to dole out to readers of Compliance Building. (You will have to get there on your own and pay for accommodations.)

If you are interested in attending, leave a comment below or send an email to the contest line at [email protected].

[button link=”mailto:[email protected]?subject=I want to go to Interact 2011″ color=”red”]Enter the Contest[/button]
The entry deadline is March 30, 2011. I’ll randomly pick a winner from the entries I receive by the deadline. If you are the winner, I’ll contact you for your mailing address.

Last year, I attended Interact 2010, learned a great deal, did some great networking and had a great time.

About Interact 2011

Todayʼs corporate environment demands that every department adopt the “Do More with Less” mantra. In enterprise legal operations that means General Counsel need to effectively balance a growing portfolio of litigation, strict regulatory enforcement, growing risks and heavy penalties while being held to the same operating standards and performance metrics as any other core business unit.

Chief Compliance Officers are similarly affected. Complicating a new array of regulations has been hiring freezes, layoffs, and budget cuts. The result has been predictable: More work for compliance officers and their staff with fewer resources available. The demand for greater business agility, efficiency, and effectiveness in legal and compliance operations drives decision-makers from the nationʼs leading enterprise to uncover new strategies and technologies at Interact 2011.

Each year, legal and compliance decision-makers attend Interact to discuss key issues, build career-enhancing networks, and discover best-in-class products and services to improve success.

Agenda:

Monday, May 16, 2011

Innovations in Legal & Compliance Technologies

Legal Keynote Session

Promise and Peril: Considerations When Moving to the Cloud

Roundtable 2

Is E-Billing Obsolete in an Age of AFAs?

Effective Project Management for your Outside Counsel Engagements

Nursing Mothers and Compliance

An amendment to the Fair Labor Standards Act included in the recent Health Care reform law imposes a new requirement on the workplace. Employers must now provide “reasonable” unpaid breaks to nursing mothers in the first year after birth. The health care law adds a new provision to the FLSA, 29 U.S.C. §207(r)(1), which allows nursing mothers to take a break every time they need to express breast milk and requires employers to provide a private location, other than a bathroom, where such employees may express milk. This provision under the Patient Protection and Affordable Care Act amended the FLSA effective March 23, 2010.

Employers of fewer than 50 employees are exempt if the breastfeeding requirements would “impose an undue hardship by causing the employer significant difficulty or expense.” You can read more on the U.S. Department of Labor Website, Fact Sheet #73: Break Time for Nursing Mothers under the FLSA

The new legislation only covers women who are paid hourly, not a salary, although some state laws cover both. If you work in a state that is more favorable to the employee than the federal law, you’ll need to follow your own state’s rule. Here’s a link to all the state breastfeeding rules. Twenty-four states have laws related to breastfeeding in the workplace: Arkansas, California, Colorado, Connecticut, Georgia, Hawaii, Illinois, Indiana, Maine, Minnesota, Mississippi, Montana, New Mexico, New York, North Dakota, Oklahoma, Oregon, Rhode Island, Tennessee, Texas, Vermont, Virginia, Washington and Wyoming, plus the District of Columbia and Puerto Rico.

Section 7 of the Fair Labor Standards Act of 1938 (29 U.S.C. 207) is amended by adding at the end the following:

(r)(1) An employer shall provide—

1. a reasonable break time for an employee to express breast milk for her nursing child for 1 year after the child’s birth each time such employee has need to express the milk; and
2. a place, other than a bathroom, that is shielded from view and free from intrusion from coworkers and the public, which may be used by an employee to express breast milk.

(2) An employer shall not be required to compensate an employee receiving reasonable break time under paragraph (1) for any work time spent for such purpose.

(3) An employer that employs less than 50 employees shall not be subject to the requirements of this subsection, if such requirements would impose an undue hardship by causing the employer significant difficulty or expense when considered in relation to the size, financial resources, nature, or structure of the employer’s business.

(4) Nothing in this subsection shall preempt a State law that provides greater protections to employees than the protections provided for under this subsection.

Section 7 of the Fair Labor Standards Act of 1938 (29 U.S.C. 207)

If you like the picture, you can purchase that jumper on Zazzle: I LOVE BREAST MILK! T-SHIRTS

Lawyers and Insider Trading

Even smart people do dumb things. Lawyers presumably know the law, but still break it. That means they occasionally take some short term profits through insider trading and get caught red-handed.

Everyone is focused on the Galleon Group insider trading trial happening in Manhattan, threatening to put Raj Rajaratnam in jail. That case is complicated and big, with wire taps and cooperating witnesses.

The SEC’s case against Todd Treadway seems more straight-forward.

Treadway was an attorney in the Executive Compensation, employee Benefits & Employment practice group at Dewy & LeBoeuf.

According to the SEC complaint, Treadway bought shares in Dewey’s client, Accredited Home Lenders, after reviewing a draft merger agreement for the company’s acquisition by Lone Star Funds in June 2007. He used his office computer to scoop up shares three days before the deal was announced publicly. Not being subtle, he used all of the available cash in the account to buy the stock.

According to the SEC complaint, once was not enough. Later, in May 2008, Treadway bought shares in CNET before the announcement that CBS Corp. planned to buy it. After reviewing various documents as part of his work on the transaction, Treadway bought CNET stock using four different brokerage accounts eight days before the deal was announced.

How did he get caught?

With any public M&A deal where there is a spike in trading activity before the deal is announced, the Financial Industry Regulatory Authority pokes around the accounts that traded in those shares to see if anyone trading was an insider. FINRA began looking into trading around the CBS/CNET deal. They asked Dewey to circulate to people in the firm who had knowledge of the deal a list of individuals and entities, one of whom was Treadway’s fiancée. Treadway responded to the questionnaire by replying “I have no knowledge of such person/entities.”

The complaint does not state that Treadway’s name was on the FINRA list. That seems odd. Maybe that part was left off the complaint and the SEC just wanted to point out that he lied about his fiancee.

Dewey’s enforcement was quicker than the SEC’s enforcement. The law firm fired Treadway in November 2008.

All this for only $27,000 in trading profits. Treadway made only $388 from the Accredit Home/Lone Star merger. That’s small dollars for a lawyer who presumably was making at $160,000 as an associate in a big new York City law firm. I suppose loading up on options would not have been subtle enough for Treadway.

Treadway is merely the latest attorney at a big law firm who has been caught taking a quick buck through insider trading. Two lawyers at Ropes & Gray, Arthur Cutillo and Brien Santarlas, pleaded guilty in 2009 for passing along tips about deals the firm was working on in exchange for kickbacks. Melissa Mahler, a lawyer at Nixon Peabody pleaded guilty in 2010 to making trades on a deal underway at the firm.

Sources:

SEC Complaint against Todd Treadway
Former Dewey Associate Charged with Insider Trading by Nathan Koppel in WSJ.com’s Law Blog
Former Dewey & LeBoeuf associate charged with insider trading by Nate Raymond in the National Law Journal

Compliance Bits and Pieces for March 18

Here are some compliance-related stories that recently caught my eye:

April 5 Webcast: The SEC’s Asset Management Unit and Strategies for Avoiding Trouble in 2011 and Beyond in Securities Docket

In this webcast, Bruce Karpati, the co-head of the SEC’s Asset Management unit since its inception, will discuss his unit’s successes over the past year, and what it is currently prioritizing and pursuing. He will be joined on the panel by John Reed Stark, Managing Director of Stroz Friedberg and former Chief, SEC Office of Internet Enforcement; and Bradley J. Bondi, a litigation partner at Cadwalader, Wickersham & Taft LLP and former counsel to SEC Commissioners Troy Paredes and Paul Atkins for enforcement matters.

Wall Street’s Biggest Bargain May Be Wall Street Office Space by David M. Levitt in Bloomberg

Demand for downtown space, like in much of the city, froze after the global credit crisis and plunge in financial-industry jobs. Wall Street was hurt by two additional factors: Goldman Sachs Group Inc. (GS)’s decision to sublease space at a building a block south, and departures at Donald Trump’s 40 Wall St., the biggest multitenant tower on the street, according to Shapses.

Luddites and the Law by Simon Fodden in SLAW

Over the last couple of decades as the rate of change in information technology has accelerated, it’s become fashionable for some to claim with pride and others to award with scorn the title of Luddite. As it happens, this March marks the bicentennial of the real Luddite uprising in the north of England. Richard Conniff has written a piece, “What the Luddites Really Fought Against,” that’s available on Smithsonian.com, correcting the misunderstandings that most of us have about who these followers of Ludd actually were and why they took to breaking machines.

Financial services & corruption: Private Equity in the spotlight? and Financial Services: M&A, Private Equity and the lifebelt in thebriberyact.com

We wrote on Tuesday about Private Equity and increased interest by US investigators. Anti-corruption and money laundering laws touch on Financial Services and Private Equity in a number of ways. One obvious hot spot is M&A activity. The US Securities & Exchange Commission has recently targeted Private Equity for activities of a portfolio company. We wrote yesterday that what happens accross the Atlantic has a habit of turning up in the UK.

Should You Invest in the World’s Most Ethical Companies 2011 Edition

The Ethisphere Institute announced its fifth annual selection of the World’s Most Ethical Companies, highlighting 110 organizations that lead the way in promoting ethical business standards. Of the 110 companies honored this year, 74were on the 2010 list. (If you need help with the math, 36 are new to the list in 2011 and 26 companies dropped off from the 2010 list.)

As they did with the 2010 list, Ethisphere is emphasizing the better financial performance by the companies on this year’s list.

“The World’s Most Ethical Companies, if indexed, would have significantly outperformed the S&P 500 by delivering a nearly 27 percent return to shareholders since 2007, compared to the S&P’s negative 8.5 percent shareholder return during the same period, proving there is a strong correlation between a company’s ethics program and its performance,” said Alex Brigham, Executive Director of the Ethisphere Institute.

Personally, I think its bit misguided to judge the past performance of companies on the 2011 list by looking backwards, especially for the new companies included in the list. As we hear for all investments, past performance is no measure of future performance. A good investor would want a tool to help decide whether to invest in a company, not whether they should have invested 5 years ago.

Is inclusion on the list of Most Ethical Companies an indicator of future performance?

Last year, I looked at Ethisphere’s 2007 World’s Most Ethical Companies and tracked their performance forward to determine whether you should invest in ethical companies. The answer was “yes.” That first class, as a whole, did outperform the broader markets.

I decided to update my study and see if it still held true. The answer is still “yes.” Those public companies on the 2007 list significantly outperformed the broader markets. If you bought one share of each, you would have realized a 3.96% return. That compares to a -12.36% loss on the S&P index and a -9.1% loss on the Dow Jones Industrials.

You can see my calculations in this spreadsheet (in Google Docs):
https://spreadsheets.google.com/ccc?key=0AuuCq02eKVqldDhydERtRmVsdVo2X0NfOUdXbkZTcmc&hl=en

They are not all winners. About half outperformed and half underperformed. But as a whole, you came out ahead. Salesforce is the bigger gainer on the list with a 126% gain. Nokia is pulling up the rear with a 70% loss.

The weak spot in my analysis is that it leaves out the effect of dividends on the returns. In looking through the Ethisphere list, they seem to be a broad mix of companies so I assumed the dividends of these companies would be similar to the dividends from the companies in that broader indexes.

My conclusion is that the companies on the 2007 list of the most ethical companies were a good investment. I may just put some money on some of those new 26 companies on the 2011 list.

The Small Business Capital Access and Job Preservation Act

With the House of Representatives’ change in political control, the Republicans are taking some steps to cut back on Dodd-Frank. Earlier this week the House Committee on Financial Services distributed a press release about five potential bills that would revise the financial service legislation:

The Asset-Backed Market Stabilization Act
The Small Company Capital Formation Act
The Small Business Capital Access and Job Preservation Act
The Business Risk Mitigation and Price Stabilization Act
The Burdensome Data Collection Relief Act

Besides the sensationalist graphics, the Small Business Capital Access and Job Preservation Act caught my attention because it is targeted at private equity fund managers:

The Financial Services Committee has received testimony regarding the role private equity firms play in preserving existing jobs and creating new ones by providing capital to struggling and growing companies. The Dodd-Frank Act requires most advisers to private investment funds to register with the SEC, including advisers to private equity funds. The Small Business Capital Access and Job Preservation Act exempts advisers to private equity funds from the registration requirements. The draft legislation will be sponsored by Representative Robert Hurt.

It sounds like a nice bill. But I’m skeptical that it could enacted before the July 21 deadline for private equity fund managers to register under Dodd-Frank (assuming it could pass at all).

The Committee is holding testimony on Wednesday, March 16 at 2 p.m. in room 2128 Rayburn. Scheduled to appear are:

Kenneth A. Bertsch, President and CEO, Society of Corporate Secretaries & Governance Professionals
Tom Deutsch, Executive Director, American Securitization Forum
Pam Hendrickson, Chief Operating Officer, The Riverside Company
David Weild, Senior Advisor, Grant Thornton, LLP
Luke Zubrod, Director, Chatham Financial

The text of the proposed legislation is just in the form of discussion drafts and I have not been able to find copies. I’m sure much will hinge on the definition of “private equity fund managers” just as Dodd-Frank created a new category of venture capital fund managers.

Sources:

Press Release – Garrett Announces Subcommittee Hearing To Review Proposals That Promote Job Creation And Capital Formation
House Financial Services Committee Unveils Four Pieces of Draft Legislation Amending Dodd-Frank in Jim Hamilton’s World of Securities Regulation

More on the Proposed Limitations on Compensation for Fund Managers

There is a new joint federal rule in the works for all financial institutions. This will lump together banks, credit unions, broker-dealers and investment advisers. If you have more than $1 billion in assets under management, you need to pay attention to this rule.

Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires federal regulators to

“prescribe regulations or guidelines to require each covered financial institution to disclose to the appropriate Federal regulator the structures of all incentive-based compensation arrangements offered by such covered financial institutions sufficient to determine whether the compensation structure:

(A) provides an executive officer, employee, director, or principal shareholder of the bank holding company with covered financial institution with excessive compensation, fees, or benefits; or

(B) could lead to material financial loss to the covered financial institution.”

The proposed rule is tied to the proposed method of calculation for the investment advisers and private fund managers released in November 2010. Unfortunately, the Form ADV in that proposed rule has not yet been finalized, so we don’t know exactly how that assets under management will be calculated. Assuming there are not big changes to the new Form ADV, if your fund assets plus uncalled capital commitments are in excess of $1 billion, then you are a “covered financial institution.

If you are a “covered financial institution” then you must submit a new report to the SEC. In that report you will need to describe the structure of your incentive-based compensation arrangements and whether they provide for excessive compensation or could lead to to material financial loss. This report must include the following:

A clear narrative description of the components of the covered financial institution’s incentive-based compensation arrangements applicable to covered persons and specifying the types of covered persons to which they apply;
A succinct description of the covered financial institution’s policies and procedures governing its incentive-based compensation arrangements for covered persons
If the covered financial institution has total consolidated assets of $50 billion or more, an additional succinct description of incentive-based compensation policies and procedures specific to the covered financial institution’s:
(i) Executive officers; and
(ii) Other covered persons who the board of directors, or a committee thereof, of the covered financial institution has identified and determined under §248.205(b)(3)(ii) of subpart C of this part individually have the ability to expose the covered financial institution to possible losses that are substantial in relation to the covered financial institution’s size, capital, or overall risk tolerance;
Any material changes to the covered financial institution’s incentive-based compensation arrangements and policies and procedures made since the covered financial institution’s last report submitted under paragraph (a) of this section; and
The specific reasons why the covered financial institution believes the structure of its incentive-based compensation plan does not encourage inappropriate risks by the covered financial institution by providing covered persons with:
(i) Excessive compensation; or
(ii) Incentive-based compensation that could lead to a material financial loss to the covered financial institution.

“Covered person” means any executive officer, employee, director, or principal shareholder of a covered financial institution. (So, everyone.)

According to the SEC’s Office of Risk, Strategy and Financial Innovation there are about 132 broker-dealers with assets of $1billion or more and 18 with assets in excess of $50 billions. Since investment advisers do not currently report their assets so the SEC lacks hard numbers. They estimated that about 70 investment advisers meet the $1 billion asset threshold and only about 10 would be large enough to get hit by the proposed bonus retention rules. (see page 70 of the proposed draft (.pdf).)

I assume that the investment adviser counts do not take into account the thousands of hedge fund, private equity fund and real estate fund managers who will be registering with the SEC in the next few months.

The rule will not require a report on the actual compensation. But it does try to limit incentive-based compensation that is “unreasonable or disproportionate to the services performed.”

For private equity funds, this should just be a paperwork issue and not a substantive issue. Since private equity funds pay most of their performance based on the final realization of assets in the fund, there are generally few short-term incentives. Private equity fund managers get their incentive pay when their investors get paid.

Nevertheless, this rule will be a headache for registered private fund managers.

The rule has not yet been officially published by the SEC. They are waiting for the other federal regulators to formally approve the draft.

Sources:

Proposed Draft – This release was approved by the Commission on March 2, 2011, but it has not yet been
approved by all of the other agencies listed in the release. When all the agencies have taken
final action on this release, it will be published in the Federal Register and this release will be
replaced by the Federal Register version.
SEC, in Split Vote, Backs Bonus Curbs on Brokers, Hedge Funds by Jessica Holzer in the Wall Street Journal
Incentive Compensation Limitations and Disclosures for Private Fund Managers – prior post in Compliance Building

The Buck Stops Here – Harry S. Truman Presidential Museum and Library – Independence, Missouri / Marshall Astor / http://creativecommons.org/licenses/by-sa/2.0/

SEC’s Pay-to-Play Rule Is Effective Today

If you have (or want to have) government investors in your private fund then you need to be in compliance with Rule 206(4)-5 starting today.

Summary (from the SEC):

The Securities and Exchange Commission is adopting a new rule under the Investment Advisers Act of 1940 that prohibits 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. The new rule also prohibits 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, unless such third parties are registered broker-dealers or registered investment advisers, in each case themselves subject to pay to play restrictions. Additionally, the new rule prevents 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. The Commission also is adopting rule amendments that require a registered adviser to maintain certain records of the political contributions made by the adviser or certain of its executives or employees. The new rule and rule amendments address “pay to play” practices by investment advisers.

Limitations on Political Contributions

It is now unlawful for an investment adviser to provide “investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any covered associate of the investment adviser.”

The rule defines an official as candidate for an elective office that can

directly or indirectly influence the hiring of an investment adviser, or
has the authority to appoint a person who can directly or indirectly influence the hiring of an investment adviser.

Unfortunately, investment advisers are left on their own to figure out if any political position is one that falls into the prohibited bucket.

De Minimis Exception

There are two de minimis exceptions. For an official they are entitled to vote for, a covered associate can contribute up to $350 per election. That exception is lowered to $150 if they are not entitled to vote for the official.

Record-Keeping

The new rule also imposes new record-keeping requirements. A private fund will need to keep track of

its covered associates
all government entities that are investors
all contributions made to an “official of a government entity”
all contributions made to a political party
all contributions made to a political action committee

You don’t need to keep records if you have no government clients.

Covered Associates

The limitation on contributions only applies to “covered associates.” they key will be identifying who in the organization falls into this category. Who is a Covered Associate?

Any general partner, managing member or executive officer, or other individual with a similar status or function;
Any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee; and
Any political action committee controlled by the investment adviser or by any person described in 1 or 2.

Good luck.

Sources:

SEC Release No. IA-3043 Political Contributions by Certain Investment Advisers
A Closer Look at the new SEC Rule 206(4)-5 on Pay to Play – prior post on Compliance Building

Compliance Bits and Pieces for March 11

These are some compliance-related stories that recently caught my eye.

Inside The Mind of An Inside Trader by Francine McKenna in re: The Auditors

No Big 4 audit firms or their partners have been named in the insider trading scandal surrounding the now-defunct hedge fund Galleon Management. But the SEC has accused one of the most prominent businessmen ever implicated in such crimes, Rajat Gupta, a former McKinsey & Company Global Managing Director.

SEC `Capacity Gap’ Risks Oversight Lapses as Regulator’s Targets Multiply by Robert Schmidt and Jesse Hamilton in Bloomberg

The U.S. Securities and Exchange Commission is about 400 employees short of what it needs to manage its current workload, according to a consultant’s four- month internal review mandated by the Dodd-Frank Act. The preliminary findings by Boston Consulting Group Inc. reinforce arguments by SEC officials that the agency is underfunded and understaffed as it takes on oversight of derivatives, credit-rating firms and municipal bonds, according to a draft copy of the report obtained by Bloomberg News.

Is it Really Illegal to Require an Applicant or Employee to Disclose her Password to a “Friends-Only” Facebook Page? in Littler’s Workplace Privacy Counsel

Recently, the American Civil Liberties Union of Maryland tried to publicly embarrass the Maryland Department of Public Safety and Correctional Services (the “Maryland Corrections Department”) into suspending its practice of asking job applicants to disclose their Facebook password so that the Department could check whether the applicant’s wall or stored e-mail revealed any connection to criminal activity. According to a letter dated January 25, 2011 (pdf), sent by the ACLU to the Maryland Corrections Department, this practice “is illegal under the federal Stored Communications Act (SCA), 18 U.S.C. §§2701-11 and its state analog, Md. Courts & Jud. Proc. Art., §10-4A-01, et seq.” The ACLU’s contention is inaccurate.

Buying a Private Fund Manager: An Overview of Legal Issues by Nathan J. Greene, Kwang-Duk (Kasey) Choi of Shearman & Sterling

An unprecedented degree of uncertainty has characterized the asset management business environment over 2009 and 2010—a period that saw extreme market volatility, threatened changes to key tax structures, a rapidly shifting regulatory environment, and rising expectations from institutional investors. One collateral result is a dramatic fall-off in asset management industry mergers-and-acquisitions (M&A) deal activity relative to 2006 and 2007. But the same forces of change that put dealmakers on the sidelines carry the seeds for a rebound in activity. Moreover, the Volcker Rule and other significant regulatory changes under the Dodd- Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)—the import of which are just becoming clear—will themselves prompt new M&A activity.

FASB Sounds Retreat on New Accounting Standards for Leases by John W. Hanley, Jr. in Davis Wright Tremaine LLP’s Corporate Finance Law Blog

It now appears that the FASB may be ready to reverse course, and perhaps even to adhere to its current rules, which draw a bright line between capital and operating leases. We believe that those who have been preparing for the new rules may want to hold tight until the FASB’s direction becomes more certain. In a nutshell, the new rules would discard the fundamental distinction in today’s generally accepted accounting principles (GAAP) between an operating lease and a capital lease. The premise of the new rules is that all leases—no matter the duration or economic terms—should give rise to an asset, and a liability, on the balance sheet of both the lessor and the lessee. These new accounting standards would create real challenges for lessees, since a lessee is required to value the future liability created by a lease using a complex “expected outcome analysis.”