Securities Mosaic® Blogwatch
September 29, 2014
Cadwalader discusses Third-Party Due Diligence Reports for Asset-Backed Securities
by Cheryl Barnes

On August 27, 2014, the Securities and Exchange Commission (the "SEC") adopted final rules[1] (the "Final Rules") implementing, among other things, provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act") relating to third-party due diligence reports for asset-backed securities[2] ("ABS"). As adopted, the Final Rules will require:

(i) issuers and underwriters of rated ABS, whether or not registered with the SEC, to file with the SEC, at least five business days before the first sale in the ABS offering, a Form ABS-15G containing the findings and conclusions of reports of third-parties who have been employed to provide due diligence services,

(ii) third parties who provided due diligence services in connection with ABS offerings to make available to nationally recognized statistical rating organizations ("NRSROs"), pursuant to a prescribed form, information regarding the scope of their due diligence services, a summary of their findings and conclusions, and a certification as to the due diligence review, and

(iii) NRSROs to make publicly available in connection with rating actions for ABS offerings the forms furnished by third-party due diligence services providers and referred to in clause (ii) above.

The Final Rules take effect nine months after they are published in the Federal Register.

New Rule 15Ga-2 and Amendments to Form ABS-15G

Background

Section 932(a)(8) of the Dodd-Frank Act amended Section 15E of the Securities Exchange Act of 1934 (the "Exchange Act") to require the issuer[3] or underwriter[4] of any ABS to make publicly available the findings and conclusions of any third-party due diligence report[5] obtained by the issuer or underwriter. In the Final Rules, the SEC adopted new Rule 15Ga-2 and amendments to Form ABS-15G to implement this provision of the Dodd-Frank Act.

What Does Rule 15Ga-2 Require?

Rule 15Ga-2 requires any issuer or underwriter of any ABS that are to be rated by an NRSRO to furnish a Form ABS-15G containing the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter, not just third-party due diligence reports made available to NRSROs. Form ABS-15G must be filed at least five business days prior to the first sale[6] in the related offering.[7] The Final Rules clarify that a single Form ABS-15G may be filed when the issuer and/or one or more underwriters obtained the same third-party due diligence reports.[8]

Rule 15Ga-2 Applies to Registered and Unregistered Offerings of ABS

Rule 15Ga-2 applies to both registered and private offerings of ABS. The SEC stated that issuers and underwriters can disclose the information required by Rule 15Ga-2 without jeopardizing their reliance on private placement exemptions and safe harbors, so long as the only information made publicly available on Form ABS-15G is information required by Rule 15Ga-2, and the issuer does not otherwise use Form ABS-15G to offer or sell securities in a manner that conditions the market for offers or sales of its securities.

The Final Rule contains limited exclusions from the requirements of Rule 15Ga-2 for offshore transactions[9] and municipal issuer offerings.[10]

Required Content of Rule 15Ga-2 Disclosure

In the Final Release, the SEC rejected comments to the Proposed Rule that would have limited reporting pursuant to Rule 15Ga-2 to the findings and conclusions contained in final third-party due diligence reports. Therefore, the findings and conclusions of third-party due diligence reports contained in any draft or interim reports provided to the issuer and/or the underwriters must also be reported on Form ABS-15G.

In response to one commenter, the SEC also stated that a summary of findings and conclusions was contrary to Congressional intent, as expressed in the Dodd-Frank Act. In addition, the SEC stated that findings and conclusions themselves were required to be made public rather than having an issuer or underwriter summarize those findings and conclusions because a summary runs the risk of excluding information that could be important to a user of credit ratings. In the SEC's view, "users of credit ratings should be able to compare the totality of third-party due diligence information with what was provided to, and used by, an NRSRO, as disclosed under Rules 17g-7 and 17g-10"[11].

Note: In its discussion in the Final Release, the SEC stated that disclosure of the findings and conclusions necessarily requires disclosure of the criteria against which the loans were evaluated, and how the evaluated loans compared to those criteria along with the basis for including any loans not meeting those criteria.[12]

Commenters on the Proposed Rule noted that Rule 193 requires issuers to review the underlying assets included in any ABS offering. This review may be substantially similar to the third-party due diligence services subject to Rule 15Ga-2. To avoid duplicative filings of substantially similar information, Rule 15Ga-2 provides that if the disclosure required by Rule 15Ga-2 has already been included in the prospectus (including an attribution to the third party that provided the due diligence report)[13], and the prospectus is publicly available at the time Form ABS-15G is furnished by the issuer or underwriter, the issuer or underwriter may refer to that section of the prospectus in Form ABS-15G rather than providing the findings and conclusions directly in Form ABS-15G. However, the SEC stated that the issuer and/or underwriter is still required to file Form ABS-15G referring to that information.

Note: If the issuer and an underwriter obtain the same third-party due diligence report, and one of them timely furnishes a Form ABS-15G for that report, the other of them would not be required to furnish a Form ABS-15G for the same report.[14]

The Final Rules also clarify that Form ABS-15G need only be furnished in connection with the initial credit rating, and not with respect to any subsequent ratings actions, such as a ratings downgrade.[15]

New Rule 17g-10: Certifications Required From "Due Diligence Services" Providers

Background

The Dodd-Frank Act also amended Section 15E of the Exchange Act to require that, in any case in which third-party due diligence services are employed by an NRSRO, issuer or underwriter in connection with a rated ABS offering, the person providing the due diligence services provide a written certification to any NRSRO that produces a credit rating to which such services relate. The certification must state that the person has conducted a thorough review of data, documentation and other relevant information necessary for an NRSRO to provide an accurate rating. To implement this provision of the Dodd-Frank Act, the SEC adopted new Rule 17g-10 and a new Form ABS Due Diligence-15E that must be provided by third-party due diligence service providers to any NRSRO that produces a credit rating to which such services relate.

"Due Diligence Services"

As defined in Rule 17g-10, an entity is deemed to have provided "due diligence services" if it engaged in a review of the assets underlying an ABS offering for the purpose of making findings with respect to:

  1. the accuracy of the information or data about the assets, provided, directly or indirectly, by the securitizer or originator of the assets;
  2. whether the origination of the assets conformed to, or deviated from, stated underwriting or credit extension guidelines, standards, criteria or other requirements;
  3. the value of collateral securing the assets;
  4. whether the originator of the assets complied with federal, state or local laws or regulations; or
  5. any other factor or characteristics of the assets that would be material to the likelihood that the issuer of the ABS will pay interest and principal according to applicable terms and conditions.

The SEC stated in the Final Release that the first four prongs of the definition of "due diligence services" are based upon industry practices with respect to residential mortgaged-backed securities "because due diligence services traditionally have been performed with respect to RMBS"[16]. Although the fifth prong of the definition appears to be very broad, the SEC stated that the "catchall" fifth prong is intended to apply to reviews, current and future, that may cover additional asset classes, such as commercial loans, corporate loans, student loans, or credit card receivables.[17]

Note: There appears to be a disconnect between Rule 15Ga-2, which requires the filing of a Form 15G-ABS in connection with findings and conclusions in a third-party due diligence report obtained by the issuer or underwriter, and Rule 17g-10, which requires the delivery to NRSROs of a Form ABS Due Diligence-15E promptly after completion of the due diligence services by the third party. In other words, the obligations under Rule 17g-10 seem to be triggered upon completion of the due diligence services, whether or not a report has been delivered relating to those services.

Implications for AUP Letters

The SEC noted in the Final Release that the first prong of the definition of "due diligence services" includes findings typically covered within the scope of agreed-upon procedures engagement letters that issuers and/or underwriters enter into with accounting firms ("AUP Letters"). While the SEC agreed that certain other procedures performed by accounting firms pursuant to typical AUP Letters, such as recalculating projected cashflows and performing procedures that address information included in offering documents, are not intended to be "due diligence services," the SEC stated that one procedure typically reported in AUP Letters, comparing the information on a loan tape with the information contained on the hard-copy documents in a loan file, is an activity that falls under the first prong. The SEC stated that this may necessitate changes to the scope of typical AUP Letters to take into account applicable professional standards. The SEC further stated that the requirements and limitations resulting from relevant professional standards described in those AUP Letters may be included in the written certifications required by third-party diligence services providers on Form ABS Due Diligence-15E.[18]

Note: Although in the discussion of the definition of "due diligence services" in the Final Release, the SEC appears to be focusing on practices that are "commonly understood in the securitization market" to be third-party due diligence services, the broad definition of the term and the explicit application of it to accountants' AUP Letters raises the question as to what other activities by securitization participants or their representatives would constitute "due diligence services."

Non-U.S. Transactions Exempt from the Requirements of Rule 17g-10

Rule 17g-10 does not apply to ABS issuances with obligors or issuers who are non-U.S. persons if the NRSRO has a reasonable basis to conclude that the transactions in the ABS issued by the obligor or the issuer will be effected only outside of the United States. However, the third-party due diligence services provider is still required to deliver an executed Form ABS Due Diligence-15E to any NRSRO that requests it.

Rule 17g-10 "Safe Harbor"

At the time they conclude their services, persons providing due diligence services may not know the identity of NRSROs to which the Form ABS Due Diligence-15E certification must be delivered. To address this concern, the SEC, following the suggestion of many commenters, agreed to include in Rule 17g-10 a "safe harbor" such that if the specified conditions are satisfied, the third-party due diligence services provider will be deemed to have satisfied its obligation to provide the Form ABS Due Diligence-15E under 17g-10. To avail itself of the safe harbor, third-party due diligence services providers must provide an executed Form ABS Due Diligence-15E to:

  1. any NRSRO that provided a written request for the form prior to the completion of the due diligence services stating that the services relate to the credit rating the NRSRO is producing;
  2. any NRSRO that provides a written request for the form after the completion of the due diligence services stating that the services relate to a credit rating the NRSRO is producing; and
  3. the issuer or underwriter of the ABS for which the due diligence services relate that maintains the Rule 17g-5 website with respect to the ABS.

In this way, each NRSRO that is providing a credit rating will have access to the Form ABS Due Diligence-15E, even when an NRSRO is rendering an unsolicited credit rating. It also eliminates the obligation of third-party due diligence services providers to ascertain the identities of every NRSRO producing a credit rating based upon that third-party's due diligence services. To avail themselves of the safe-harbor, third-parties must deliver an executed Form ABS Due Diligence-15E "promptly" after completion of their due diligence services.[19]

New Form ABS Due Diligence-15E

Required Content of New Form ABS Due Diligence-15E

The new Form ABS Due Diligence-15E required to be filed pursuant to Rule 17g-10 requires the following five items:

  1. the identity and address of the provider of third-party due diligence services;
  2. the identity and address of the issuer, underwriter, or NRSRO[20] that employed the provider of third-party due diligence services;
  3. if the due diligence performed by the third party is intended to satisfy the criteria for due diligence published by an NRSRO, the third-party must identify the NRSRO and the title and date of the published criteria in a table provided in the form;
  4. a description of the scope and manner of the due diligence services provided in connection with the review of assets that is sufficiently detailed to provide an understanding of the steps taken in performing the review, including in that description: (i) the type of assets that were reviewed; (ii) the sample size of the assets reviewed; (iii) how the sample size was determined and, if applicable, computed; (iv) whether the accuracy of information or data about the assets provided, directly or indirectly, by the securitizer or originator of the assets was reviewed and, if so, how the review was conducted; (v) whether the conformity of the origination of the assets to stated underwriting or credit extension guidelines, standards, criteria or other requirements was reviewed, and if so, how the review was conducted; (vi) whether the value of collateral securing the assets was reviewed and, if so, how the review was conducted; (vii) whether the compliance of the originator of the assets with federal, state, and local laws and regulations was reviewed and, if so, how the review was conducted; and (viii) any other type of review that was part of the due diligence services conducted by the person completing the Form ABS Due Diligence-15E; and
  5. a summary of the findings and conclusions that resulted from the due diligence services that is sufficiently detailed to provide an understanding of the findings and conclusions that were conveyed to the person(s) identified in item 2 above.

Required Certification

Form ABS Due Diligence-15E is required to be executed by an individual who is duly authorized by the person providing the third party due diligence services to make the required certification. That person must represent and warrant that: (1) he or she has executed the form on behalf of, and on the authority of, the third party; and (2) the third party conducted a thorough review in performing the due diligence described in item 4 above and that the information and statements contained in the form, including the information and statements referred to in items 4 and 5 above, are accurate in all significant respects on and as of the date of the execution of the form.

NRSROs Must Make Forms ABS Due Diligence-15E Publicly Available

In addition to the certifications required to be made available to NRSROs by third party due diligence providers, the Dodd-Frank Act also required the SEC to adopt a rule requiring an NRSRO that receives a certification from a provider of third-party due diligence services to disclose the certification to the public in a manner that allows the public to determine the adequacy and level of the due diligence services provided by the third party. As a result, the SEC amended Rule 17g-7 to require an NRSRO to publish with any rating action[21] it takes with respect to ABS any executed Form ABS Due Diligence-15E subject to the rating action that is received by the NRSRO or obtained by the NRSRO through a Rule 17g-5 website.

Note: The requirement for an NRSRO to publish any Form ABS Due Diligence-15E is irrespective of whether and to what extent the NRSRO used the information in the form in taking the rating action.

Conclusion: Changes Ahead

The Final Rules impose new obligations and liabilities on providers of third-party due diligence services, NRSROs, issuers and underwriters of ABS. To satisfy the requirements of the Final Rules, we anticipate that participants in ABS transactions will need to do a review of their policies and procedures in connection with the employment of third-party providers of due diligence services, as well as a determination as to what services constitute due diligence services.

Parties to ABS transactions will also need to determine responsibility and liability for satisfying the requirements of the Final Rules, and determine the impact of the Final Rules on the timing of ABS transactions.

[1] For the text of the SEC's Final Rules adopting release (the "Final Release"), see http://www.sec.gov/rules/final/2014/34-72936.pdf. The Final Rules adopted in modified form the proposed rules (the "Proposed Rules") presented for public comment on May 18, 2011. For the text of the SEC's Proposed Rules release, see http://www.sec.gov/rules/proposed/2011/34-64514.pdf. The Proposed Rules were the subject of a prior Clients & Friends memorandum, dated July 8, 2011, "SEC Proposed Rules Regarding Third-Party Due Diligence Disclosure," available at http://www.cadwalader.com/resources/clients-friends-memos/sec-proposed-rules-regarding-third-party-due-diligence-disclosure.

[2] The portions of the Final Rules analyzed in this memorandum apply to "asset-backed securities" within the meaning of Section 3(a)(79) of the Exchange Act, as opposed to the more limited definition of that term in Item 1101(c) of Regulation AB.

[3] Because the Final Rules define "issuer" for the purposes Rule 17g-10 (implemented by the Final Rules), in the context of the Final Rules, that term includes the sponsor or depositor that participates in the offering of ABS. See Final Release at page 366.

[4] For the purposes of the Final Rules, "underwriter" refers to underwriters of both public and private offerings. See Final Release at pages 368-9.

[5] A "third-party due diligence report" means any report containing findings and conclusions of any due diligence services (as defined in Rule 17g-10, discussed below) performed by a third-party.

[6] The date of first sale in the offering would be the date on which a purchaser first makes an investment decision and commits to purchase the securities offered. See Final Release at page 371, footnote 1431.

[7] Form ABS-15G may be electronically filed with the SEC on the EDGAR system, so that all of the publicly filed information relating to an offering will be available in a single, central repository. The SEC noted that it already requires the filing of certain items on the EDGAR system in connection with private issuances.

[8] If Form ABS-15G is being filed by the issuer, it must be signed by the senior officer of the depositor in charge of securitization, or if it is being filed by the underwriter, it must be signed by a duly authorized officer of the underwriter.

[9] For the purposes of Rule 15Ga-2, this means an offering that is not required to be, and is not, registered under the Securities Act of 1933 (the "Securities Act"), that is not issued by a U.S. person, as defined in Rule 902(k), and in which the securities are offered and sold in transactions that occur outside the United States.

[10] The SEC noted that municipal ABS are still subject to the requirement of Section 15E of the Exchange Act to make publicly available the findings and conclusions of any third-party due diligence report that they obtain, notwithstanding that they are exempted from filing Form ABS-15G. However, the SEC found municipal ABS are not subject to Rule 15Ga-2 because they are subject to a different regulatory scheme. The municipal ABS exclusion applies to issuers and underwriters of an offering of ABS if the issuer is a municipal issuer (as defined in Rule 17g-10), and the offering is not required to be registered under the Securities Act.

[11] See the Final Release at page 375, footnote 1442.

[12] See the Final Release at page 375.

[13] Pursuant to Rule 436, any such third-party would be required to consent to being named as an expert in the related registration statement.

[14] See the Final Release at page 373.

[15] See the Final Release at page 373.

[16] See the Final Rules at page 396.

[17] "While the catchall provision is not being eliminated, the definition of due diligence services in Rule 17g-10 (including the catchall prong) is not intended to bring within the definition’s scope activities that are performed today in connection with the issuance of [ABS] that are not commonly understood as being third-party due diligence services... For example, it is not intended to cover every type of service that involves the performance of diligence in the offering process. The catchall provision is designed to incorporate within the definition reviews that are commonly understood in the securitization market to be third-party due diligence services or analogous services that may develop in the future but are not expressly covered by the first four prongs of the definition." Final Release at page 398.

[18] The content of Form ABS Due Diligence-15E is discussed below.

[19] Generally, this will be in connection with the issuance of the ABS. However, if any third party is employed by an NRSRO, issuer or underwriter to perform subsequent due diligence services with respect to an issuance, the third party will incur new obligations under Rule 17g-10.

[20] This requirement may be satisfied pursuant to the Rule 17g-10 "safe harbor" discussed above.

[21] Under Rule 17g-7(a), the term "rating action" means: (a) the publication of an expected or preliminary credit rating before the publication of an initial credit rating; (b) an initial credit rating; (c) an upgrade or downgrade of an existing credit rating (including a downgrade to, or assignment of, default); and (d) an affirmation or withdrawal of an existing credit rating if the affirmation or withdrawal is the result of a review of the credit rating assigned by the NRSRO using applicable procedures and methodologies for determining credit ratings.

The full and original memorandum was published by Cadwalader, Wickersham & Taft LLP on September 9, 2014, and is available here.

September 29, 2014
You Should Listen To The Goldman New York Fed Story
by David Zaring

This American Life has a banking supervision story (!) that turns on secret recordings made by a former employee of the New York Fed, Carmen Segarra, and it's pretty good, because it shows how regulators basically do a lot of their regulating of banks through meetings, with no action items after. That's weird, and it's instructive to see how intertiwned banking and supervision are. There's a killer meeting after a meeting with Goldman Sachs where Fed employees talk about what happened, and - though we don't know what was left on the cutting room floor - the modesty of the regulatory options being considered is fascinating. Nothing about fines, stopping certain sorts of deals, stern letters, or anything else.

The takeaway of the story, which is blessedly not an example of the "me mad, banksters bad!" genre, is that this kind of regulation isn't very effective. It clearly hasn't prevented banks from being insanely profitable until recently, in a way that you'd think would get competed away in open markets.

But here's the case for banking regulation:

  • Imagine what it would be like if Alcoa and GE had EPA officials on site, occasionally telling them to shut down a product line. That's what bank regulators do, and, more broadly, did with things like the Volcker Rule (with congressional help).
  • Since the financial crisis (and that's the time that's relevant here), regulation has made banking less profitable, not more, share prices are down, so are headcounts, etc.
  • Regardless of how it looks, regulators that essentially never lose on a regulatory decision - that includes bank supervisors, but also agencies like broad swaths of Justice and DoD - don't experience themselves as cowed by industry. Kind of the opposite, actually. So what you really worry about is the familiarity leading to complacency, not fear. Regulators can fine any bank any number they like. If they want someone fired, they could demand it without repercussion.

The fact that TAL pulled off this story, given that it was centered around an employee who lasted at the Fed for 7 months before being fired, who made secret recordings of her meetings with colleagues (who does that?), who mysteriously and obviously wrongly alleged during her time at the Fed that Goldman Sachs did not have a conflict of interest policy, whose subsequent litigation has gone nowhere, and whose settlement demand was for $7 million (so that's one million per month of working as a bank examiner, I guess), is impressive. But that's the former government defense lawyer in me, your mileage may vary.

Morover, even skeptical I was persuaded that maybe the Fed could do with a more ambitious no-holds-barred discussion among its regulators, at the very least.

September 29, 2014
SEC Charges Two Florida-Based Attorneys for Roles in Offering Fraud by Transfer Agent
by SEClaw Staff

The SEC charged two Florida-based attorneys for their roles in an offering fraud conducted by a transfer agent that was the subject of an SEC enforcement action two months ago.

The SEC alleges that the two attorneys were designated to receive wire transfers of funds from investors who were solicited by cold callers using boiler room tactics to convince them their investments would yield high rates of return.  Wiring the money to a licensed attorney bolstered the appearance of safety in the investment opportunity and concealed from investors how the money was really being spent after one of them received the funds.  The individuals  merely kept 2 percent of the funds they received from investors and transferred the remaining amounts to another individual, who promptly used it for personal expenses or to make Ponzi-like payments instead of investing in the high-yield investments or discounted stock promised to investors.  The SEC charged one of the attorneys and his firm International Stock Transfer Inc. (IST) with fraud in July.

The two attorneys were arrested earlier today in parallel criminal actions brought by the U.S. Attorney's Office for the Eastern District of New York.

Read more here.

September 29, 2014
Today: "Tackling Your 2015 Compensation Disclosures: Annual Proxy Disclosure Conference"
by Broc Romanek

Today is the "Tackling Your 2015 Compensation Disclosures: Annual Proxy Disclosure Conference"; tomorrow is the "Say-on-Pay Workshop: 11th Annual Executive Compensation Conference." Note you can still register to watch online by using your credit card and getting an ID/pw kicked out automatically to you without having to interface with our staff. Both Conferences are paired together; two Conferences for the price of one.

How to Attend by Video Webcast: If you are registered to attend online, just go to the home page of TheCorporateCounsel.net or CompensationStandards.com to watch it live or by archive (note that it will take about a day to post the video archives after it's shown live). A prominent link called "Enter the Conference Here" - on the home pages of those sites - will take you directly to today's Conference (and on the top of that Conference page, you will select a link matching the video player on your computer: Windows Media or Flash Player). Here are the "Course Materials," filled with talking points and practice pointers.

Remember to use the ID and password that you received for the Conferences (which may not be your normal ID/password for TheCorporateCounsel.net or CompensationStandards.com). If you are experiencing technical problems, follow these webcast troubleshooting tips. Here is today's conference agenda; times are Pacific.

How to Earn CLE Online: Please read these FAQs about Earning CLE carefully to see if that is possible for you to earn CLE for watching online - and if so, how to accomplish that. Remember you will first need to input your bar number(s) and that you will need to click on the periodic "prompts" all throughout each Conference to earn credit. Both Conferences will be available for CLE credit in all states except for a few - but hours for each state vary; see the CLE list.

What People Are Really Doing When They're on Earnings Calls

This article from the Harvard Business Review is pretty interesting.

One of the best Ted Talks: Brene Brown on "The Power of Vulnerability."

– Broc Romanek

September 29, 2014
Waiting for Dodd-Frank Clawbacks
by J Robert Brown Jr.

SOX for the first time provided a provision that allowed for clawbacks of executive compensation in certain limited circumstances.  The provision sought to fill a serious gap in the corporate governance process. Fiduciary duties were sufficiently anemic that they failed to compel boards to seek to recover compensation paid on the basis of financial statements that later proved to be materially inaccurate.  As a result, Congress was forced to imposed such an obligation, federalizing another aspect of corporate governance.

Section 304 of SOX allows for clawbacks of performance based compensation following an accounting restatement "due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws". 15 USC 7243.  The provision only allows for clawbacks of compensation paid to the CEO and CFO.  Neither officer, however, need to have actually engaged in the relevant misconduct.

SOX, however, was a tepid effort.  The provision essentially provided no enforcement mechanism for the failure of boards to clawback compensation following a triggering restatement.  With no private right of action, the only source of enforcement was the SEC.  The SEC has brought only a small number of claims seeking clawbacks, including one this week.  See In re Yazdani, Exchange Act Release No. 73201 (admin proc Sept. 24, 2014) ("Respondent... shall, within 30 days of the entry of this Order, reimburse Saba for a total of $2,570,596 in... bonuses, other incentive-based or equity-based... compensation, and... stock sale profits pursuant to Section 304(a) of SOX").

Dodd-Frank, however, provided a second generation clawback provision.  Specifically, Section 954 required listed companies to put in place a policy mandating that: 

  • in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentivebased compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement

The policy, therefore, expanded the circumstances that would trigger a clawback and expanded the persons subject to the requirement.  Most importantly, however, the provision imposed a burden on issuers to clawback the funds.  Thus, clawbacks would cease to be a matter left to the limited resources of the SEC.

Only the clawback provision remains an idea on paper but not one that has been put into practice.  The provision requires SEC rulemaking.  No rule proposal has yet to emerge, although the provision is on the SEC's rulemaking agenda.  As the Unified Agenda states:

  • The Division is considering recommending that the Commission propose rules to implement section 954 of the Dodd Frank Act, which requires the Commission to adopt rules to direct national securities exchanges to prohibit the listing of securities of issuers that have not developed and implemented a policy providing for disclosure of the issuer's policy on incentive-based compensation and mandating the clawback of such compensation in certain circumstances. 

Yet a proposal has not yet surfaced.  Until it does, the limited resources of the SEC effectively means that clawbacks are likely to remain an important but under-utilized tool in ensuring proper corporate governance.

For a discussion of the clawback provisions under SOX and Dodd-Frank, see Financial Institutions, the Market, and the Continuing Problem of Executive Compensation

September 28, 2014
Regulators Re-Propose Uncleared Swap Margin, Capital and Segregation Rules
by Annette L. Nazareth

Editor's Note: Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former commissioner at the U.S. Securities and Exchange Commission. The following post is based on a Davis Polk client memorandum; the complete publication, including sidebars and appendix, is available here.

On September 3, 2014, U.S. banking regulators re-proposed margin, capital and segregation requirements applicable to swap entities [1] for uncleared swaps. [2] The new proposed rules modify significantly the regulators' original 2011 proposal in light of the Basel Committee on Banking Supervision's and the International Organization of Securities Commissions' ("BCBS/IOSCO") issuance of their 2013 final policy framework on margin requirements for uncleared derivatives and the comments received on the original proposal. The revised proposal:

  • provides for a compliance deadline of December 1, 2015 for variation margin and a phased compliance schedule for initial margin, running from December 1, 2015 to December 1, 2019, with compliance timing dependent on the uncleared swaps exposures of a swap entity's affiliated group and each counterparty's affiliated group for the June to August period of each prior year;
  • does not require initial or variation margin for a swap entity's transactions with non-financial end users;
  • includes a revised, and very complex, definition of "financial end user," which differs significantly from the original proposal and existing definitions used by the CFTC and SEC;
  • outlines the specific collateral eligible to be used to satisfy the margin requirements and related "haircuts," expanding the list of collateral for initial margin and limiting variation margin to cash;
  • does not provide an exemption from the margin requirements for uncleared swap transactions between affiliates; and
  • excludes foreign uncleared swaps of foreign covered swap entities, each as defined, from the scope of the margin requirements and provides a process for the regulators to permit substituted compliance with a non-U.S. regulatory framework to satisfy the margin requirements.

The revised proposal would apply to swap entities that are regulated by one of the "Prudential Regulators" - the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Farm Credit Administration and the Federal Housing Finance Authority. The CFTC and SEC have previously issued proposed rules for margin, capital and segregation requirements that would apply to swap entities not regulated by a Prudential Regulator, which differ in many respects from the Prudential Regulators' proposal. However, the CFTC has scheduled a meeting to consider a re-proposed rule on margin requirements for uncleared swaps.

Initial and Variation Margin

The main topics covered in the margin aspects of the revised proposal are: collection and posting of initial and variation margin; calculation of initial margin; assets eligible to be posted as margin and related haircuts; phase-in compliance schedule; documentation requirements; extraterritorial application of the uncleared swaps margin rules; and third-party custodian requirements with respect to initial margin, each of which is discussed below. A summary comparison of the revised proposal, the original proposal and the BCBS/IOSCO final policy framework is included in Appendix A of the complete publication.

Counterparty Classifications and Material Swaps Exposure

Under the revised proposal, whether margin requirements would apply to the transactions between a swap entity and a particular counterparty generally would depend upon the type of counterparty, and for a financial end user whether it has a "material swaps exposure."

The revised proposal divides a swap entity's counterparties into four types: (i) swap entities; (ii) financial end users with a material swaps exposure; (iii) financial end users without a material swaps exposure; and (iv) other counterparties.

Essential to these counterparty classifications is the definition of financial end user, the key provisions of which are outlined in the sidebar and the full definition of which is located here. The proposed financial end user definition is significantly different from the original proposal as well as current definitions in the CFTC's and SEC's proposed and final regulations. As a general matter, the Prudential Regulators have proposed an approach to the definition of financial end user that provides an extensive list of regulated entities. The original proposal relied on a short list of enumerated entities and a catch-all prong to address those entities that are "predominantly engaged in activities that are financial in nature," as defined under the Bank Holding Company Act, as is the case with the CFTC's and SEC's definitions of financial entity.

The revised proposal's financial end user definition is very complex, and will in some cases require an extensive analysis of a counterparty's business. The application of the financial end user definition to non-U.S. counterparties is particularly convoluted. Under the revised proposal, a swap entity would need to determine whether a non-U.S. counterparty would fall within one of the prongs of the financial end user definition if the non-U.S. entity was organized under the laws of the United States or any State. The Prudential Regulators do not discuss whether a swap entity may rely upon a representation from its counterparty as to its financial end user status.

Under the revised proposal, the material swaps exposure for an entity is calculated for the entity's consolidated group on an aggregate basis - i.e., inclusive of all outstanding swap exposures for the entity and all of its affiliates. This calculation looks to whether the average daily aggregate notional exposure of the entity and its affiliates for uncleared swaps, FX forwards and FX swaps with all counterparties is greater than $3 billion, calculated on a daily basis for all business days in June, July and August of the previous calendar year.

Initial and Variation Margin Requirements

Based upon a counterparty's classification and the result of the material swaps exposure calculation, the revised proposal would require initial and variation margin to be posted and collected as follows:

Applicability of Margin Requirements to Counterparties of a Swap Entity
Counterparty Initial Margin Variation Margin
Swap entity Required to collect and post Required to collect and post
Financial end user with material swaps exposure Required to collect and post Required to collect and post
Financial end user without material swaps exposure Collect and post as determined appropriate by the swap entity Required to collect and post
Other counterparty Collect and post as determined appropriate by the swap entity Collect and post as determined appropriate by the swap entity

Notably, the revised proposal does not provide an exemption from the margin requirements for uncleared swap transactions between affiliates. Therefore, a swap entity would need to identify the counterparty type of each affiliate with which it transacts to determine the applicable margin requirements.

Because swap entities likely will not maintain calculations for the swaps exposures of counterparties and their affiliates (and may not even know the identities of a counterparty's affiliates), the "material swaps exposure" requirement, as proposed, may prove to be a challenging standard as a practical matter. The revised proposal does not provide for reliance upon a counterparty's representation concerning its material swaps exposure.

Generally, the revised proposal's margin requirements apply only to uncleared swaps to which the swap entity becomes a party after the applicable compliance date, as described below.

Notwithstanding the requirements described above for a swap entity to collect and post initial and variation margin, a margin transfer with a counterparty is not required unless and until the total amount of margin required to be collected or posted exceeds $650,000. Additionally, a swap entity will be deemed not to have violated its obligations under the rules to collect or post margin from or to a counterparty if the counterparty has refused or failed to provide or accept the required margin and the swap entity has made the necessary efforts to collect or post the required margin.

Calculating Initial Margin

Under the revised proposal, the minimum amount of required initial margin may be determined in one of two ways:

  • pursuant to the standardized look-up table (provided in the sidebar of the complete publication), which is similar to that outlined by the BCBS/IOSCO final policy framework; or
  • based upon an initial margin model that must conform to the requirements discussed below.

In each case, the initial margin required to be collected is equal to the amount determined by one of the above two methods less any initial margin threshold amount established by the swap entity, which may be no greater than $65 million.

The initial margin threshold is applied on a consolidated entity basis, thus the amount subtracted from the required initial margin for any one counterparty may not include any portion of the initial margin threshold already applied to other uncleared swaps with that counterparty or any of its affiliates. This proposed approach presents potential practical difficulties, particularly when allocating the threshold amount among affiliates and tracking these allocations accurately on a daily basis.

Similarly, a swap entity must post initial margin with respect to any uncleared swap with a financial end user with material swaps exposure in an amount that is at least as large as that which the swap entity would be required to collect if it were in the place of the counterparty.

In response to commenters, the revised proposal requires initial margin to be posted and collected on or before the business day following the day the uncleared swap is entered into, providing an additional day to comply as compared with the period specified in the original proposal.

Where a swap entity elects to use the standardized table to determine its initial margin requirement, the initial margin amount depends on the asset class and, in the case of certain asset classes, the duration of the underlying uncleared swap. A swap entity may apply the standardized table initial margin amounts to a portfolio of uncleared swaps, including across asset classes, so long as the entire portfolio is executed under a single eligible master netting agreement. In this case, the revised proposal permits risk offsets to the standardized amounts through the application of a net-to-gross ratio to determine the aggregate initial margin amount for the entire portfolio.

If a swap entity elects to use an initial margin model to calculate and comply with the initial margin requirements under the revised proposal, the swap entity must obtain written approval from its regulator prior to using the model and upon any changes to the model or to the products for which it is used. The models must set initial margin equal to the potential future exposure of the swap entity consistent with a one-tailed 99% confidence level over a 10-day close-out period. Additionally, the model must satisfy certain quantitative requirements that are similar to those required for internal regulatory capital models - capturing all of the material risks that affect the uncleared swap including material non-linear price characteristics of the swap, as well as the qualitative requirements that are discussed in the sidebar of the complete publication.

Calculating Variation Margin

The revised proposal requires a swap entity to collect and pay variation margin at least daily for uncleared swaps with a swap entity or a financial end user counterparty, regardless of the counterparty's material swaps exposure. Unlike the original proposal, the revised proposal does not allow a swap entity to establish a credit exposure limit for certain counterparties below which the swap entity would not need to pay or collect variation margin.

Swap entities are permitted to calculate variation margin requirements on an aggregate net basis across all uncleared swap transactions with a counterparty that are executed under a single eligible master netting agreement. While the revised proposal does not generally apply to uncleared swaps entered into prior to the applicable compliance date, all uncleared swaps under a single eligible master netting agreement must be included in the aggregate for calculating and complying with variation margin requirements if the swap entity chooses to calculate on an aggregate basis.

Eligible Collateral

For variation margin, the revised proposal permits a swap entity to collect or post variation margin only in cash denominated in either U.S. dollars or the currency in which payment obligations are required to be settled under the swap. Unlike the original proposal, a swap entity is not permitted to collect or post U.S. Treasuries to satisfy a variation margin requirement.

For initial margin, the revised proposal limits the collateral eligible to satisfy the required initial margin to those instruments and cash, subject to haircuts, each as listed in the sidebar of the complete publication. For initial margin purposes only, cash must be denominated in U.S. dollars, any "major currency" as listed in the rule, or the currency in which payment obligations are required to be settled under the uncleared swap.

While the revised proposal expanded the list of eligible collateral for initial margin as compared to the original proposal to include certain corporate securities and non-U.S. sovereign debt, it specifically excludes securities issued by:

  • a counterparty or an affiliate of the counterparty pledging the collateral; or
  • a bank holding company, a savings and loan holding company, a non-U.S. bank, a depository institution, a market intermediary, or an equivalent foreign institution.

Counterparties are permitted to pledge assets that do not qualify as eligible collateral with a lender in a separate arrangement and use the cash or other eligible collateral received from that separate arrangement to meet the minimum margin requirements. In addition, any collateral may be used to satisfy margin requirements imposed by counterparty agreement and not required by these rules, such as margin beyond the minimums outlined in the revised proposal.

A swap entity is required to monitor the market value and eligibility of all collateral that it collects to satisfy the initial margin requirements. To the extent the market value of such collateral declines or collected collateral is no longer eligible, the swap entity must promptly collect or obtain additional eligible collateral from its counterparty as necessary to comply with the margin requirements.

Phase-In Period

The revised proposal applies to all uncleared swaps to which a swap entity becomes a party on or after the relevant compliance dates set forth in the table below.

Swap entities must comply with the variation margin requirements by December 1, 2015. The compliance date on which initial margin requirements would apply depends on the average daily aggregate notional amount of uncleared swaps, FX forwards and FX swaps for the swap entity and its affiliates (collectively, the "swap entity group") and the particular counterparty and its affiliates (collectively, the "counterparty group"). The applicable compliance date will be triggered where the swap entity group and counterparty group each exceed the specified threshold.

Initial Margin Phased-In Compliance Schedule
Compliance Date Initial Margin Trigger Level*
December 1, 2015 June–August 2015: $4 trillion
December 1, 2016 June–August 2016: $3 trillion
December 1, 2017 June–August 2017: $2 trillion
December 1, 2018 June–August 2018: $1 trillion
December 1, 2019 For any other swap entities with respect to uncleared swaps entered into with any other counterparties that do not fall into any of the above categories.

*"Initial Margin Trigger Level" for each row above means both the swap entity group and the counterparty group each have an average daily aggregate notional amount of uncleared swaps, FX forwards and FX swaps that exceeds the amount specified.

Once a swap entity and its counterparty hit the initial margin trigger level, the swap entity and its counterparty remain subject to the uncleared swaps margin rules regardless of any future changes in the swaps exposure of the swap entity, the counterparty or the affiliates of either.

Documentation

The revised proposal requires a swap entity to execute trading documentation regarding credit support and dispute resolution arrangements with each counterparty that is either a swap entity or financial end user.

Third-Party Custody and Segregation

Under the revised proposal, any collateral posted by a swap entity, other than variation margin, must be held by one or more unaffiliated third-party custodians and any required initial margin collected by a swap entity must be held by one or more unaffiliated third-party custodians. The revised proposal requires the unaffiliated third-party custodian to act pursuant to a custody agreement that:

  • prohibits the custodian from rehypothecating, repledging, reusing or otherwise transferring the funds; and
  • is legal, valid, binding and enforceable under the laws of all relevant jurisdictions.

The custody agreement may permit the posting party to substitute or direct any reinvestment of posted collateral subject to restrictions on the types of funds that may be substituted or in which the funds may directly be reinvested.

The Prudential Regulators request comment on the circumstances under which one-time rehypothecation, repledge or reuse of initial margin posted by a financial end user would be permissible under the BCBS/IOSCO final policy framework and whether this would be a commercially viable option for market participants.

Extraterritorial Application

Similar to the original proposal, the revised proposal expressly excludes from the scope of the margin requirements any "foreign uncleared swap" of a "foreign covered swap entity," each as defined in the sidebar of the complete publication. Such foreign uncleared swaps could include uncleared swaps between a foreign covered swap entity and a counterparty that is a non-U.S. bank or a non- U.S. subsidiary of a U.S. bank or bank holding company, so long as that subsidiary is not itself a swap entity and provided that neither party is guaranteed by a U.S. entity. However, a foreign uncleared swap does not include a swap between a foreign covered swap entity and a non-U.S. branch of a U.S. bank or a U.S. branch or subsidiary of a non-U.S. bank.

In addition, the revised proposal permits a swap entity that does not have its obligations guaranteed by an entity organized under any laws of the United States or any State under an uncleared swap and that is (i) a non- U.S. swap entity; (ii) a non-U.S. bank or U.S. branch or agency of a non- U.S. bank; or (iii) a non-U.S. subsidiary of a depository institution, Edge corporation or agreement corporation to satisfy the requirements of the rule through substituted compliance with a non-U.S. regulatory framework for uncleared swaps where the Prudential Regulators have jointly made, by public order, a comparability determination. The Prudential Regulators, using an outcomes-based approach, will make these determinations on a jurisdiction-by-jurisdiction basis, either conditionally or unconditionally. Although the revised proposal provides a process for swap entities to request a determination, it appears that the Prudential Regulators may also make a determination without a specific request. Additionally, once the Prudential Regulators make a favorable comparability determination for a non-U.S. regulatory framework, any swap entity that could comply with such framework is permitted to do so.

Capital Requirements

The Prudential Regulators requested comment on whether:

  • a guarantee by a U.S. person should affect the availability of substituted compliance; and
  • whether the Prudential Regulators should clarify and define the concept of "guarantee," potentially including cross-default provisions, keepwell agreements and liquidity puts, to better ensure that uncleared swaps that may pose a risk to U.S. institutions are included in the scope of the margin rules.

Swap entities regulated by a Prudential Regulator, such as domestic and foreign banks, must comply with risk-based and leverage capital requirements that are already applicable to such entities. The Prudential Regulators believe that the regulatory capital rules address the safety and soundness risks posed by a swap entity's uncleared swap positions and that these regulatory capital rules have been strengthened since the original proposal through the adoption of a revised capital framework. As a result, no additional swap entity-specific capital rules are included in the revised proposal. This will result in potentially significant differences in required capital for a swap entity with prudential regulators and those regulated by the CFTC or the SEC.

The complete publication, including sidebars and appendix, is available here.


Endnotes:

[1] For purposes of this memo, "swap entities" refers to swap dealers, security-based swap dealers, major swap participants and major security-based swap participants. Unless otherwise specified in this memo, "swap entities" refers to covered swap entities that will be subject to the U.S. banking regulators' uncleared swap margin requirements.

[2] For purposes of this memo, "uncleared swaps" refers to both uncleared swaps and uncleared security-based swaps and the term "swap" is used to refer to both swaps and security-based swaps. As a result of the 2012 determination by the Secretary of the Treasury that FX forwards and FX swaps are not to be considered swaps under the Dodd-Frank Act for some purposes, such transactions are not subject to the margin and segregation requirements outlined in the revised proposal, except where specifically included, such as in calculating an entity's material swaps exposure and the applicable phase in compliance period.

September 28, 2014
More Broken Windows: The SEC and Ponzi Schemes
by Tom Gorman

Investment fund fraud actions - those in which investors are convinced to part with their hard earned cash on the promise of good, often guaranteed but illusory returns - have become a staple of SEC enforcement. Sometimes the scheme is an offering fraud. In other instances the scheme is more complex. Regardless of the structure, the end is always the same. Investors who thought they were maximizing their returns end up with little or nothing. Those running the scheme make off with the cash.

Last week the Commission brought two investment fund fraud actions. One was filed on Monday and announced on Tuesday. SEC v. Zhunrize, Civil Action No. 1:14-cv-0303 (N.D. Ga. Filed September 22, 2014). See Lit. Re. No. 32091 (Sept. 23, 2014). A second was brought on Wednesday. SEC v. eAGear, Inc. Civil Action No. 14-cv-04294 (N.D. Cal. Filed September 24, 2014). Both cases were packaged together into a press release issued on Friday, apparently as another example of "broken windows."

Zhunrize is discussed here. In eAdGear the defendants are eAdGear, an internet company; eAdGgear Holdins Ltd.; Charles S. Wang; Francis Yuen; and Qian Cathy Zhang. Mr. Wang is the founder and CEO of eAdGear Holdings, Mr. Yuen is the founder and CFO and COO of eAdGear Holdings and eAdGear; Ms. Zhang is a defacto officer of both companies.

eAdGear is represented to be a successful internet marketing and advertising company. The firm supposedly increases page rankings for customer websites on search engines.

Investors have the opportunity to profit in two ways. First, each investor account is credited daily with a share of the revenues generated from the collective efforts of the members. Second, investors are credited with a portion of the money generated from the referral of new investors who purchase a package for a fee. Investors are told that they have the potential for very significant returns.

The defendants have sold investors about $129 million in so-called memberships or business packages in eAdGear.com over the last four years. About 66,000 accounts for largely Chinese investors in the U.S. and abroad have been established.

Although eAdGear claims to generate millions of dollars in revenues from its internet marketing business, in fact it has no such business, according to the complaint. Rather, the records of the firm demonstrate that there is no search engine optimization business. Revenue was generated from the sale of memberships and then misappropriated by the defendants.

eAdGear is tottering on the brink of collapse. While the firm has about $370,000 in bank accounts, it owes investors at least $5 million. The Commission's complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and liability under Exchange Act Section 20(a). The case is pending.

September 27, 2014
Volcker Rule: Agencies Release New FAQ
by Kobi Kastiel

Editor's Note: The following post comes to us from Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication by Eric M. Diamond, Joseph A. Hearn, and Ken Li. The complete publication, including appendix, is available here.

[On September 10, 2014], the Board of Governors of the Federal Reserve System (the "Federal Reserve"), the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission (collectively, the "Agencies") provided an addition to their existing list of Frequently Asked Questions ("FAQs") addressing the implementation of section 13 of the Bank Holding Company Act of 1956, as amended, commonly known as the "Volcker Rule."

The Volcker Rule imposes broad prohibitions on proprietary trading and investing in and sponsoring private equity funds, hedge funds and certain other investment vehicles by "banking entities" and their affiliates. The final rule implementing the Volcker Rule issued by the Agencies (the "Final Rule") requires a banking entity to implement a compliance program the specifics of which are linked to the size of the business. For certain larger banking entities (generally those with total consolidated assets of $50 billion or more or, in the case of a foreign banking organization, total U.S. assets of $50 billion or more), the CEO must annually attest in writing to the relevant Agency that "the banking entity has in place processes to establish, maintain, enforce, review, test and modify the compliance program established under [the Final Rule] in a manner reasonably designed to achieve compliance" with the Volcker Rule and Final Rule.

Given that banking entities are generally not required to have fully established their compliance programs until July 21, 2015, there has been uncertainty with respect to exactly when a banking entity's initial CEO attestation will be due. The newly released FAQ indicates that "[t]he staffs of the Agencies believe" that banking entities subject to the CEO attestation requirement should submit their initial CEO attestations after July 21, 2015 and no later than March 31, 2016; subsequent attestations will then be due within one year of the filing of the previous attestation. The March 31, 2016 deadline is described as "allow[ing] the CEO time to review the design and operation of the entity's compliance program after the program is fully implemented to ensure it is reasonably designed to achieve compliance."

Finally, the FAQ also provides that a banking entity that becomes subject to the CEO attestation requirement after July 21, 2015 should submit its first CEO attestation within one year of becoming subject to the requirement.

A copy of the new FAQ is included in the complete publication as Appendix A.

September 26, 2014
SEC Charges Purported Health Food Company and CEO with Issuing False Press Releases in Microcap Fraud
by SEClaw Staff

The SEC charged a Florida-based penny stock company and its CEO with defrauding investors by issuing false and misleading press releases proclaiming large sales and fantastic revenue projections while the purported health food company actually was a failing enterprise.  

The SEC alleges that Heathrow Natural Food & Beverage Inc. touted sales of natural health food products that the company had not even manufactured as well as non-existent distribution agreements with major retail chains.  Meanwhile, its CEO was prompting the illegal, unregistered distribution of billions of shares of company stock to several people or entities, including himself.  The CEO profited by more than $150,000 by selling 877 million of his shares into the market as the false press releases were stimulating public demand for Heathrow stock.  The CEO is also charged with insider trading because he sold his shares while in possession of material nonpublic information about the falsehood of the press releases.

Read the full article here.

View today's posts

9/29/2014 posts

CLS Blue Sky Blog: Cadwalader discusses Third-Party Due Diligence Reports for Asset-Backed Securities
Conglomerate: You Should Listen To The Goldman New York Fed Story
The Securities Law Blog: SEC Charges Two Florida-Based Attorneys for Roles in Offering Fraud by Transfer Agent
CorporateCounsel.net Blog: Today: "Tackling Your 2015 Compensation Disclosures: Annual Proxy Disclosure Conference"
Race to the Bottom: Waiting for Dodd-Frank Clawbacks
HLS Forum on Corporate Governance and Financial Regulation: Regulators Re-Propose Uncleared Swap Margin, Capital and Segregation Rules
SEC Actions Blog: More Broken Windows: The SEC and Ponzi Schemes
HLS Forum on Corporate Governance and Financial Regulation: Volcker Rule: Agencies Release New FAQ
The Securities Law Blog: SEC Charges Purported Health Food Company and CEO with Issuing False Press Releases in Microcap Fraud

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