Enforcement Merger; Options Reminder

T

he NASD and NYSE Group have laid the groundwork to consolidate their regulatory operations into a single self-regulatory organization in a plan the two groups say is expected to reduce regulatory costs to the industry by millions per year.

The consolidation ultimately would mean one set of rules for the roughly 5,100 securities brokers and dealers doing business in the United States. Nearly 200 of the largest broker-dealer firms are currently dually regulated by both the NASD and the New York Stock Exchange.

Kaufman

Brad Kaufman, chair of the national securities litigation group at the law firm Greenberg Traurig, says the move to one SRO makes sense. “The combined entity will have greater depth and greater specialization and will be able to supervise more closely,” he says.

Kaufman notes that those companies that are dually registered will benefit from the move. “They’ll only have to comply with one regulatory scheme,” he says. “Compliance will be easier and less costly.”

Raylesberg

Alan Raylesberg, co-chair of the commercial litigation practice at the law firm Chadbourne & Parke, says the merger is “good news for companies, particularly for Wall Street firms.”

“Instead of having to deal with two sets of regulators when there’s a regulatory inquiry or investigation, they’ll only have to deal with one set of people, one set of rules, and one set of procedures,” he says, Ditto for arbitrations.

The new SRO will be named at a later date and is expected to begin operations in second quarter 2007, with NASD chairman and CEO Mary Schapiro serving as CEO.

Schapiro said the plan establishes “a more sensible and less complex regulatory regime that makes private sector regulation more efficient and effective.”

Meanwhile, NYSE Regulation CEO Richard Ketchum will serve as non-executive chairman of the board of governors during a three-year transition period. He will remain CEO of NYSE Regulation, which will continue to oversee market surveillance and listed company compliance at the New York Stock Exchange and NYSE Arca.

Ketchum, who called the move “an idea whose time has come,” noted that the agreement marks the first major reform of the self-regulatory system for financial markets since its creation in the 1930s.

The new SRO will be responsible for all member examination, enforcement, arbitration, and mediation functions, as well as all other current NASD responsibilities, including market regulation by contract for NASDAQ, the American Stock Exchange, the International Securities Exchange, and the Chicago Climate Exchange. NYSE Regulation will continue to oversee the NYSE market through its market-surveillance division, related enforcement functions, and listed company compliance.

The boards of the NASD, NYSE Regulation, and NYSE Group unanimously approved a non-binding letter of intent last week.

Cox

While “some important details remain to be negotiated,” Securities and Exchange Commission Chairman Christopher Cox said he strongly supports the merger, which he called a “significant step forward for America’s investors and for our nation’s capital markets.”

“I’m firmly convinced that done properly, this could make our self-regulatory system more efficient and more robust from an investor protection standpoint,” Cox said in a statement.

To the extent that there are any inconsistencies or differences in the SROs’ rules, Kaufman says, “I expect that whichever rule or regulation is deemed to be in the best interest of the investing public would survive.” Still, he notes, “How this is going to shake out not entirely clear. We’re a lot of steps away from this coming to fruition.”

The transaction still will require public comment and SEC approval.

When the deal closes, NASD member firms will receive a one-time payment of $35,000 in anticipation of the resulting cost savings. Certain member fees will be reduced for five years. The transaction is structured to be financially neutral to NYSE Group shareholders.

The new SRO will consist of the current 2,400-person NASD organization and 470 of NYSE Regulation’s member regulation, arbitration, and related enforcement team. It will have operations in Washington, D.C., and New York, as well as 18 district and dispute resolution offices around the country.

Time Ticking Down On 409A, Backdated Option Compliance

A

reminder to public companies dealing with options backdating or misdating woes: Backdated or misdated awards must be revised before the end of the year to prevent the holders of such awards from facing significant adverse tax consequences under Section 409A of the Internal Revenue Code.

While options or stock appreciation rights with an exercise price equal to or greater than the fair market value of the underlying stock on the date of grant generally are excluded from the requirements of 409A, stock options or SARs granted at a discount are subject to the requirements. The regulation applies to options and SARs granted before Jan. 1, 2005, to the extent the recipient becomes vested in such options after Dec. 31, 2004.

Unless a discounted stock option or SAR has a fixed exercise schedule, it will typically run afoul of the Section 409A restrictions and cause adverse tax consequences for the holder of the award, law firm Neal Gerber Eisenberg warned in a Nov. 28 client alert (see box above, right).

Under previous transitional relief, issuers of discounted stock options were allowed to revise those awards to avoid the adverse tax consequences of Section 409A in three ways: (1) cancellation and replacement with awards that aren’t issued at a discount (which may or may not also include a cash payment to make up for the loss of the discount); (2) cancellation and replacement with restricted stock awards; or (3) amendment of such options or SARs to provide for fixed payment terms. Unlike other 409A transition relief that was recently extended until the end of 2007 by IRS Notice 2006-79, issued in November, the relief for discounted options still will expire at the end of this year.

While noting that it will be difficult for companies that still are investigating whether they have backdating problems and what to do about them, NGE said, “Public companies that are investigating these problems will need to consider the impact of these adverse tax consequences, along with their disclosure and accounting obligations and shareholder relations issues, in developing an overall strategy.”

Moreover, NGE noted that Section 409A isn’t the only tax provision that needs to be considered with backdated or misdated awards. Options designated as incentive stock options must be granted with an exercise price no less than the fair market value of the underlying stock. If the option was granted at a discount, it will lose the favorable tax treatment associated with incentive options.

A public company could lose its deduction with respect to the spread between the exercise price and the fair market value of the stock on the exercise date. Under Section 162(m) of the Internal Revenue Code, compensation paid to a named executive officer over $1,000,000 generally isn’t deductible by the company. While performance-based compensation is exempt from that limitation, if options were backdated or misdated, the taxable income recognized on the date of exercise will be counted toward the $1,000,000 deduction limit.