Wednesday, August 23, 2017

SEC updates pay to play rule FAQ for capital acquisition brokers

By Amanda Maine, J.D.

The SEC has issued an update to its staff response to questions about Investment Advisers Act Rule 206(4)-5, known as the “pay to play” rule. The rule prohibits certain investment advisers from providing investment advisory services for compensation to a government client (or to an investment vehicle in which a government entity invests) for two years after the adviser or certain of its executives or employees makes a campaign contribution to certain elected officials or candidates who can influence the selection of certain investment advisers. FINRA adopted its own rules modeled on the SEC rules in August 2016.

Capital acquisition brokers.
The Commission’s most recent update concerns a set of FINRA rules that apply only to firms that meet the definition of “capital acquisition broker” (CAB). CABs are registered broker-dealers that engage in a limited range of activities, including distribution and solicitation activities with government entities on behalf of investment advisers.

The third-party solicitation ban became effective in July 2015, but because FINRA had not yet adopted pay to play rules at that time, the Division of Investment Management indicated that it would not recommend enforcement action until FINRA enacted its pay to play rules. FINRA’s pay to play rules were approved by the SEC in August 2016, with the Division relief provided to firms to expire on August 20, 2017.

The latest SEC guidance on the pay to play rule includes an inquiry as to whether the Division would recommend enforcement action for the payment of any person that is a CAB to solicit a government entity for investment advisory services. FINRA had filed a proposed rule change with the SEC that would apply the FINRA pay to play rules to CABs on August 18, 2017. The staff reply clarifies that until the rules subjecting CABs to the FINRA pay to play rules are effective, the Division would not recommend that an enforcement action be undertaken under the SEC’s Rule 206(4)-5.

Tuesday, August 22, 2017

Staff updates interpretations on emerging growth company filing requirements

By John Filar Atwood

An emerging growth company (EGC) may omit from its draft registration statements interim financial information that it reasonably believes it will not be required to present separately at the time of the contemplated offering, according to the staff of the Division of Corporation Finance. The staff provided clarification on what financial information EGCs and non-EGCs may omit from registration statements in an update to its Compliance & Disclosure Interpretations (C&DI) on the FAST Act and Securities Act forms.

In the FAST Act C&DI, the staff noted that under Section 71003 of the FAST Act, an EGC may omit from its filed registration statements annual and interim financial information that “relates to a historical period that the issuer reasonably believes will not be required to be included … at the time of the contemplated offering.” Interim financial information that will be included in a longer historical period relates to that period, the staff stated.

Staff policy. As a result, interim financial information that will be included in a historical period that the issuer reasonably believes will be required to be included at the time of the offering may not be omitted from filed registration statements. However, the staff’s policy is to permit an EGC to omit from its draft registration statements interim financial information that it reasonably believes it will not be required to present separately at the time of the planned offering.

The staff offered the example of a calendar year-end EGC that submits a draft registration statement in November 2017 and reasonably believes it will commence its offering in April 2018 when annual financial information for 2017 will be required. According to the staff, the issuer may omit from its draft registration statements its 2015 annual financial information and interim financial information related to 2016 and 2017.

In addition, assuming that the company were to first publicly file in April 2018 when its annual information for 2017 is required, it must separately prepare or present interim information for 2016 and 2017, the staff said. If the issuer were to file publicly in January 2018, it may omit its 2015 annual financial information, but it must include its 2016 and 2017 interim financial information in that January filing, according to the staff, because the interim information relates to historical periods that will be included at the time of the public offering.

Non-EGCs. With respect to an issuer that is not an EGC, the relief provided by Section 71003 of the FAST Act is not available. However, the staff noted in the Securities Act Forms C&DI that its policy is to allow an issuer that is not an EGC to omit from its draft registration statements interim and annual financial information that it reasonably believes it will not be required to present separately at the time it files its registration statement publicly. The staff noted that the issuer may not omit any required financial information from its filed registration statements.

The staff cited the example of a calendar year-end issuer that is not an EGC that submits a draft registration statement in November 2017 and reasonably believes it will first publicly file in April 2018 when annual financial information for 2017 will be required. According to the staff, the issuer may omit from its draft registration statements its 2014 annual financial information and interim financial information related to 2016 and 2017 because the information would not be required at the time of its first public filing in April 2018.

Monday, August 21, 2017

Bad faith claim rejected in MeadWestvaco-Rock-Tenn merger suit

By Mark S. Nelson, J.D.

The Delaware Chancery Court dismissed a bad faith claim brought by shareholders of MeadWestvaco Corporation against the company’s board of directors over the alleged undervaluation of non-core assets in a merger of equals between MeadWestvaco and Rock-Tenn Company. The court likewise dismissed a related aiding and abetting claim against Rock-Tenn. MeadWestvaco’s shareholders had theorized that MeadWestvaco’s board acted hastily when an activist investor appeared, but the court ultimately focused on bad faith rather than the more recent Corwin cleansing vote option or on Revlon enhanced scrutiny or entire fairness (In re MeadWestvaco Corporation Stockholders Litigation, August 17, 2017, Bouchard, A.).

Flying blind. The MeadWestvaco shareholders’ complaint asserted that the company’s board was “flying blind” in order to rush a deal to mollify an activist shareholder (Starboard Value LP) whom it was feared may bring a proxy contest. The shareholders claimed that in its haste to procure a deal, MeadWestvaco’s board disregarded their fiduciary duties and allowed what the shareholders characterized as a low-ball valuation of MeadWestvaco’s four non-core assets. All told, the shareholders claimed they had been shortchanged by $3 billion in a deal that should have been worth $12 billion instead of the agreed $9 billion.

MeadWestvaco and Rock-Tenn each have core packaging businesses, while MeadWestvaco also has several non-core assets or businesses in diverse fields: specialty chemicals, a Brazilian subsidiary, and real estate holdings in the U.S. MeadWestvaco also has a pension surplus. Starboard made several proposals to extract greater value from MeadWestvaco, including cost cutting measures, a stock repurchase, sale of the company, or sale of the specialty chemicals business (Starboard later suggested a spin-off of the specialty chemicals unit). MeadWestvaco and Rock-Tenn engaged in merger negotiations from time to time, but MeadWestvaco spurned Rock-Tenn twice before they finally reach agreement.

The MeadWestvaco-Rock-Tenn deal involved a stock-for-stock merger of equals that paid a premium to MeadWestvaco’s shareholders. Despite deal protections, a lack of other suitors, the board’s “probing questions” to MeadWestvaco’s CEO, and the presence of eight outside directors on a board of nine that approved the merger, the shareholders still pursued their twin claims of bad faith and aiding and abetting a breach of fiduciary duty, both of which the court has now dismissed.

Bad faith claim falls short. Chancellor Bouchard quickly dismissed the notion that entire fairness would apply ab initio, while also dispelling the need for Revlon’s enhanced scrutiny. Instead, the focus was on whether the complaint alleged that a majority of MeadWestvaco’s board was not disinterested and independent (this was not truly in dispute) or whether the board acted in bad faith (this was in dispute). The defendant companies replied that either the complaint failed to plead bad faith or that Corwin cleansed the deal. Given the focus on bad faith, the chancellor never had occasion to discuss Corwin.

Chancellor Bouchard explained that bad faith claims in Delaware often face many hurdles. Chief among them are the alternative theories of bad faith: (1) extreme facts showing that otherwise disinterested directors intentionally disregarded their duties; or (2) a decision that is so outlandish that it could only be explained as having resulted from bad faith.

According to the court, the shareholder’s theory did not hold up in the face of months-long consideration of the deal by MeadWestvaco’s board, at least six board meetings to discuss the deal, and the receipt of multiple valuations secured from prominent financial advisers. MeadWestvaco had even rebuffed prior merger entreaties by Rock-Tenn and only agreed to the deal that eventually closed because of that deal’s increased premium. Moreover, eight of the nine MeadWestvaco directors who approved the merger were disinterested and independent, a fact not seriously challenged by the shareholders.

The decision by MeadWestvaco’s board to approve the deal price ($9 billion) also did not reflect bad faith. The merger agreement had reflected a 9.1 percent premium in a merger of equals (MeadWestvaco got 50.1 percent of the combined entity, but contributed under 50 percent of the new entity’s revenues, net income, and EBITDA) and without any sale of control. Three allegedly unconflicted financial advisers said the deal was fair, the merger agreement contained reasonable deal protections, and two major proxy advisory firms recommended that MeadWestvaco’s shareholders approve the merger (the approval vote reached 98 percent on voting by 83 percent of outstanding shares).

Aiding and abetting claim fails. MeadWestvaco’s shareholders also claimed that Rock-Tenn aided and abetted a breach of fiduciary duty by MeadWestvaco’s board. Although Chancellor Bouchard said this claim would fail due to the lack of a predicate breach, he nevertheless discussed the scienter component of one of the elements of an aiding and abetting claim, which requires the defendant’s knowing participation in the breach. The court described this aspect of the shareholders’ claim as a “stringent” requirement.

Accordingly, the court found no non-conclusory allegations that Rock-Tenn knew of fiduciary duty breaches by MeadWestvaco’s board. Instead, the court said the complaint itself suggested that the MeadWestvaco-Rock-Tenn merger was the product of “genuine arm’s-length bargaining.”

The case is No. 10617-CB.

Friday, August 18, 2017

Former Bankrate execs to pay combined $291K to settle SEC charges

By Mark S. Nelson, J.D.

Edward DiMaria and Matthew Gamsey will pay combined penalties of over $291,000 to resolve the SEC’s charges that they manipulated Bankrate Inc.’s financials to assuage the expectations of analysts who followed the company. DiMaria had also been charged with taking advantage of the manipulation to sell Bankrate stock at inflated prices. DiMaria, Bankrate’s ex-CFO, and Gamsey, Bankrate’s former accounting director, consented to entry of final judgments by a judge in the Southern District of New York without admitting or denying the SEC’s allegations (SEC v. DiMaria (Gamsey), August 16, 2017, Woods, G.).

According to the SEC’s complaint, the Bankrate scheme emerged after the company missed analysts’ expectations in Q2 2012. The SEC said DiMaria enlisted Gamsey and ex-Bankrate VP of Finance Hyunjin Lerner to book unsupported revenue that impacted the company’s insurance and credit card divisions, the latter of which objected before booking some of the additional revenue.

Bankrate paid $15 million to settle the SEC’s charges against it; Lerner also settled for $180,000. But DiMaria and Gamsey chose to fight the SEC’s charges. The SEC’s case against DiMaria and Gamsey was trimmed in some respects last year.

Moreover, DiMaria and Gamsey separately agreed to be suspended from appearing or practicing before the SEC as accountants, although both can later seek reinstatement (DiMaria in five years; Gamsey in three years). Of the more than $291,000 total judgment obtained by the SEC, DiMaria will pay $231,159 in penalties, disgorgement and prejudgment interest, while Gamsey will pay a $60,000 penalty. DiMaria also is subject to a five-year officer and director bar.

The case is No. 15-cv-07035 (DiMaria; Gamsey).

Thursday, August 17, 2017

Repeal of FSOC’s SIFI designation authority urged

By J. Preston Carter, J.D., LL.M.

The Financial Stability Oversight Council’s Dodd-Frank Act authority to designate nonbank financial companies as systemically important financial institutions (SIFIs) should be repealed, according to the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness. Absent repeal of the Section 113 determination authority, CCMC believes that exercise of the Section 120 recommendation authority, in coordination with a company’s or industry’s primary federal regulator, is a “more effective means of addressing systemic risk, promoting financial stability, and encouraging economic growth.”

In a letter to Treasury Secretary Steven T. Mnuchin, CCMC called Section 113 determinations “blunt tools that have harmed the efficiency of our capital markets and have not improved the ability of the United States to mitigate systemic risk.” The letter was in response to President Trump’s Presidential Memorandum directing the Treasury Secretary to review the SIFI designation process to ensure that it is "a fair and transparent process." The memorandum also required that the Treasury Secretary issue a report within 180 days of the date of the memorandum.

Recommendations. CCMC argued that, absent a repeal of Section 113, the FSOC should rescind outstanding determinations and refrain from consideration of future determinations. The organization also offered a number of recommendations:
  • Replace SIFI designations with an enhanced role of the primary regulator through Section 120 recommendations to apply new or heightened standards and safeguards for a particular financial activity or practice;
  • The FSOC should establish its jurisdictional authority early in the designation process and provide the company with a detailed preliminary notice of consideration.
  • Exempt certain classes of nonbank financial companies from potential SIFI designation.
  • Make the SIFI determination process transparent and embrace due process by providing designee targets with an opportunity to review the record for the determination recommendation and an opportunity to rebut the record.
  • Ensure that consultation with the primary financial regulatory agency is substantive and meaningful.
  • Conduct a pre-designation economic analysis.
  • Provide an opportunity for a company and its primary functional regulator to address the FSOC’s concerns and make appropriate changes in its operations, or regulations, prior to preliminary designation.
  • Improve policies with respect to annual reevaluations and opportunities to appeal.

Wednesday, August 16, 2017

Revised opinion expands list of vacated pre-Dodd-Frank bars

A petition for rehearing by the SEC has resulted in the 11th Circuit vacating and revising a month-old opinion. The panel had previously denied an unregistered broker's petition for review of a lifetime bar from the securities industry imposed by the Commission. The court also vacated, at the Commission's request, a portion of the order imposing two industry bars based on pre-Dodd-Frank conduct. In the revised, unpublished opinion, the court vacated a total of five industry bars in order to avoid impermissible retroactive effects of the Dodd-Frank Act (Imperato v. SEC, August 11, 2017, per curiam).

Bar orders. In 2012, the Commission filed a complaint against broker Daniel Imperato charging 17 violations of the securities laws and associated regulations. A district court granted summary judgment in favor of the Commission on all counts, and the Eleventh Circuit later affirmed this judgment. While the appeal was pending, the SEC brought an administrative proceeding to determine whether to impose additional sanctions. The ALJ permanently barred Imperato "from associating with a broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization, and from participating in an offering of penny stock."

On appeal of the SEC's order, the appellate court concluded that the Commission's imposition of the bar was not a gross abuse of discretion. The findings were supported by substantial evidence, the panel said, and each of the six factors considered by the SEC weighed against Imperato and substantially in favor of the imposition of a lifetime industry-wide bar. Imperato's other arguments, based on due process and the statute of limitations were also without merit.

The court went on to grant the SEC’s request to vacate the portion of the Commission's order barring Imperato from association with municipal advisors and NRSROs. The Commission noted that these bars were based on conduct before the passage of the Dodd-Frank Act and that the bars could have an impermissible retroactive effect, since the Act itself gave the authority to impose the bars.

Vacated and revised. After considering a petition for rehearing filed by the Commission, the court vacated the June 30 opinion and issued a revised opinion in its stead. The bulk of the opinion, finding no merit in Imperato's petition for review, is unchanged. The panel, however, added three more industry bars to the previous list and vacated that portion of the SEC’s order that imposed the five industry bars prohibiting Imperato from associating with investment advisors, municipal securities dealers, transfer agents, municipal advisors, and NRSROs.

The case is No. 15-11574.

Tuesday, August 15, 2017

ISDA opposes EC’s proposed amendments on harmonization of moratoria powers

By Amanda Maine, J.D.

The International Swaps and Derivatives Association (ISDA) has published a position paper outlining its concerns with the European Commission’s proposed amendments to its Bank Recovery and Resolution Directive (BRRD). A bank resolution occurs when authorities determine that a failing bank cannot go through regulatory insolvency proceedings without harming public interest and causing financial instability. ISDA addressed in particular two proposals relating to moratoria powers by EU resolution authorities for use in pre-resolution and for use in resolution.

Proposals. The amendments, which are part of a proposal to amend the EU BRRD, were published in November 2016 (known as BRRD 2). The proposals would give new powers to authorities to suspend payment and delivery obligations (the moratoria proposal). According to the EC, the purpose of BRRD 2 is to harmonize the application by resolution authorities of the use of moratoria tools. The new moratoria powers would have the effect of suspending payment and delivery options for up to five working days. Other amendments to the moratoria proposals could reduce in-resolution power to a three-day working period or extend it up to 20 days.

ISDA concerns. The position paper laid out a number of concerns troubling ISDA. The moratoria power would trigger a corresponding stay of termination rights under Article 68, leading to the inability of the parties to enforce payment and delivery obligations and negating their rights to terminate, close out, or net any agreements, according to ISDA.

ISDA also claims that the proposed moratoria powers would put institutions subject to BRRD 2 at a competitive advantage as it would be a “substantial departure” from already existing frameworks put in place by the Financial Stability Board (FSB), global regulators, and market participants, pointing out that the FSB’s two-business-day limitation on stays is a “carefully negotiated balance.” The EU would be out of synch with other jurisdictions if the proposed moratoria are adopted, ISDA stated.

Extending the length of the existing stay periods could also result in significant and adverse increases in capital and margin requirements from loss of netting, as well as increasing counterparties’ margin period of risk and requiring them to account for the exposure to market movements for a potentially undefined number of days, ISDA advised.

In addition, ISDA argued that a freeze on the making and receiving of payments, which is fundamental to the business of BRRD institutions, would increase the risk that the bank at issue would fail, which is contrary to the principle objective of the BRRD. The EC’s stated purpose of the proposal—harmonizing European moratoria provisions—would not be achieved if authorities are provided the discretion to extend the in-resolution moratorium up to 20 days, according to ISDA.

Monday, August 14, 2017

ABA says costs of PCAOB’s proposed standard on auditing estimates will exceed benefits

By Jacquelyn Lumb

While PCAOB standards technically apply only to audits of public companies, the American Bankers Association (ABA) believes the Board’s proposal on auditing estimates, including fair value measurements, will have a significant impact on the audits of banking institutions. In a comment letter to the PCAOB, the ABA noted that accounting estimates and fair value measurements are pervasive throughout bank financial statements, primarily through the allowance for loan and lease losses (ALLL) and the measurement of other financial assets and liabilities. The PCAOB’s proposal mirrors an IAASB proposal to a large degree, according to the ABA, and since the Auditing Standard Board of the AICPA is likely to adopt the IAASB proposal without significant modification, the proposal will affect non-public companies in the U.S.

High cost of compliance. The ABA wrote that the PCAOB’s proposal appears to codify the extensive documentation that auditors of large banks have demanded in response to PCAOB inspections in order to support the quantitative assumptions made by management in its accounting estimates. The language the proposal uses to encourage auditors to challenge any potential bias in management’s judgments will result in substantially higher audit costs, in the ABA’s view, and could endanger the ability of local auditing firms to audit community banks if they would have to hire valuation and credit risk specialists. The costs of the expanded documentation and responsibilities will exceed the benefits without any significant improvement to the auditing of the ALLL—the most import item on the balance sheet, the ABA warned.

Unlikely benefit. The ABA advised that any declines in investor confidence in bank financial statements have not been the result of insufficient auditor scrutiny, but because of highly judgmental estimates of the fair value of financial instruments and ALLL made during periods of illiquidity in the markets and economic uncertainty. No auditing standard will increase investor confidence in the assumptions during these times, according to the ABA. With the standard’s requirement to forecast the depth and timing of future economic uncertainty, the ABA said there is probably nothing an auditor can do to increase investors’ confidence in estimates at any point in the economic cycle, which renders the benefits of the proposal highly questionable.

Bias inherent in credit losses standard. The proposal’s focus on professional skepticism and the elimination of management bias in accounting estimates seem reasonable for fair value estimates since they should be determined by market-based assumptions, but the ABA said that subjectivity and bias are inherent features of the credit losses on financial instruments standard. By that standard’s design, there is no practical way to reduce management bias in a way that brings investor confidence in the financial statements, the ABA advised, and it recommended that any guidance related to reducing management bias should not apply to the standard.

The ABA also recommended that the PCAOB specifically address the work of regulatory examiners in assessing the reasonableness of management assumptions since their work and those of auditors are similar and many of the same substantive tests are conducted by both parties.

Method for determining accounting change. If a company changes its method for determining an accounting estimate, the proposal would require auditors to determine the reasons for the change and evaluate the appropriateness of the change. This would require onerous documentation by banks, according to the ABA. The PCAOB should clarify the difference between methods and analyses, the ABA advised, and it should provide guidance on how auditors and bankers can interpret when a change in method occurs in a fluid environment, such as credit risk analysis.

The ABA included a copy of its comment letter to the IAASB in which it addressed some of the same criticisms it has with the PCAOB’s proposal.

Friday, August 11, 2017

ICI urges SEC adoption, DOL recognition of best-interest standard for all brokers

By Amy Leisinger, J.D.

In letters to SEC Chair Jay Clayton and the Department of Labor, the Investment Company Institute urges Commission adoption of a consistent best-interest standard of conduct for brokers providing recommendations to retail investors in retirement or non-retirement accounts. Establishing a consistent standard for brokers with regard to all non-discretionary accounts regardless of account goals would ensure that investors’ interests are put first while avoiding the potential pitfalls of the DOL’s rule, ICI states. The SEC should coordinate closely with the DOL, and the department should explicitly recognize the SEC’s best-interest standard of conduct in a streamlined exemption for service providers subject to the standard, according to ICI.

Establishing a consistent standard for brokers providing recommendations to retail investors in all non-discretionary accounts would ensure investor protection while preserving access to the products and services necessary to meet savings goals, ICI states.

Proposed best-interest standard. In the response to the SEC chair’s request for comments on the standards governing broker-dealers and investment advisers, ICI advocates that the SEC adopt a clearly defined best-interest standard of conduct for SEC-registered brokers to enhance the current “suitability” standard applicable to brokers under federal securities laws and FINRA rules. The current standard requires a broker to reasonably believe that investments and strategies recommended are suitable for a customer, but ICI contends that it should be expanded to provide explicit duties of care and loyalty, specifying that a recommendation must not put the broker’s or any individual’s interests before the client’s and that the broker exercise diligence and prudence in making a recommendation. In addition, according to ICI, the SEC should provide that a broker may receive only reasonable compensation, must provide specified disclosures about services, and is prohibited from making misleading statements regarding transactions, compensation, or conflicts of interest.

ICI also suggests that the SEC define “recommendation” consistently with FINRA’s definition of the term, as opposed to the DOL fiduciary rule’s expansive approach. FINRA takes a “facts and circumstances” approach using objective criteria in determining whether an interaction or communication involves a recommendation and has issued a great deal of guidance on the issue, ICI notes. This will clarify the status of activities currently uncertain or ambiguous under the fiduciary rulemaking, according to ICI.

A best-interest standard would avoid inconsistent application of rules to broker-dealer conduct based on whether an account is a retirement account, ICI explains. In addition, the SEC could enforce a best-interest standard directly, unlike the DOL, which would address the many concerns currently surrounding the litigation risks and uncertainty the DOL’s best-interest contract exemption has created due to the need for a private right of action for enforcement.

Related DOL exemption. In coordination with the SEC’s new standard, ICI urges the DOL to establish a prohibited-transaction exemption relating to its fiduciary rulemaking for brokers subject to the new best-interest standard of conduct and investment advisers remaining subject to the SEC’s fiduciary duty standard. An exemption would ensure that these SEC-registered entities are subject to consistent standards regardless of whether accounts involve retirement or non-retirement goals, ICI explains.

ICI also requests other changes to the DOL’s fiduciary rulemaking to avoid limitations on investor access to products and services necessary for retirement saving. If implemented in its current form, the fiduciary rulemaking will bring on billions in financial harm to retirement savers, primarily as a result of reduced product choice, costly moves to asset-based arrangements, and increasing account minimums for commission-based accounts, ICI explains. The “fiduciary” definition is too broad and threatens to turn many common interactions into fiduciary relationships, which can dramatically reduce exchanges of information currently provided at no cost to investors. The DOL should immediately postpone the implementation of its fiduciary rulemaking to January 1, 2019, to allow time for SEC and DOL cooperation to achieve coordinated standards, ICI concludes.

Thursday, August 10, 2017

OCIE reports improvements in cybersecurity preparedness

By Jacquelyn Lumb

The SEC’s Office of Compliance Inspections and Examinations has seen an improvement in firms’ awareness of cyber-related risks and in the implementation of cybersecurity practices since its first cybersecurity examination initiative undertaken in 2014. OCIE recently released a summary of its observations following cybersecurity examinations of 75 broker-dealers, investment advisers, and investment companies. The staff assessed industry practices and compliance with cybersecurity preparedness and included more validation and testing of procedures and controls than in previous examinations.

Policies and procedures. The staff found that all of the broker-dealers, all funds, and most the advisers had written policies and procedures to address the protection of customer or shareholder records and information. Most of the registrants conducted periodic risk assessments, penetration tests, and vulnerability scans of critical systems. All of the firms had methods for detecting data loss relating to personally identifiable information.

Maintenance and response. All of the broker-dealers and most of the funds and advisers had maintenance systems, including software patches to address security vulnerabilities, but some of the firms had not installed critical security updates. Most of the broker-dealers had plans for data breach incidents and for notifying customers of material events, but less than two-thirds of the funds and advisers had such plans. Almost all of the firms conducted vendor risk assessments or required vendors to provide their risk management and performance reports and security reviews or certification reports.

Areas for improvement. The staff concluded that firms could improve in a number of areas, including the adoption of more tailored policies and procedures in place of general or vague guidance; the enforcement of policies such as conducting required annual customer protection reviews and cybersecurity awareness training, and conducting adequate system maintenance, such as the installation of software patches to address vulnerabilities.

Best practices. OCIE also reported on a number of elements found during the review that reflected robust controls, including the maintenance of inventories of data, information, and vendors, and maintaining detailed cybersecurity-related instructions on conducting penetration tests, security monitoring and system auditing, access rights, and reporting of incidents. Some firms had prescriptive schedules and processes for testing data integrity and vulnerabilities; established and enforced controls to access data and systems; had mandatory employee training; and had policies and procedures that were vetted and approved by senior management.

OCIE advised that cybersecurity remains a top compliance risk for financial firms and the staff will continue to examine for compliance procedures and controls.

Wednesday, August 09, 2017

SEC failed to make specific findings in approving OCC capital plan

By Amy Leisinger, J.D.

A D.C. Circuit panel remanded an SEC order approving the Options Clearing Corporation’s proposed rule change to implement a capital plan to help fulfill its role as an FSOC-designated systemically important financial market utility. According to the court, the Commission order was arbitrary and capricious in that the agency did not make specific findings that the plan avoids undue burdens, protects investors and the public, and does not discriminate among interested parties. Instead, the SEC accepted OCC’s findings with minimal evidence of the basis for the company’s own determinations, the court found (Susquehanna International Group, LLP v. SEC, August 8, 2017, Garland, M.).

OCC’s capital plan. OCC, which is owned by five shareholder exchanges, currently is the only clearing agency for standardized U.S. options listed on U.S. exchanges. Trading of listed options can take place on exchanges run by OCC’s shareholder exchanges and on seven other national securities exchanges that are not OCC owners. Changes in market conditions led to a need to boost capital, which OCC planned to do through capital contributions from its shareholder exchange owners, who also could be called upon to make additional replenishment contributions. The shareholder exchanges would be eligible to receive dividends, and the OCC would impose enough fees to meet expenses and provide for a business risk buffer. The dividends were intended to serve as consideration for the exchanges’ capital contributions.

In February 2016, the SEC approved OCC’s proposal, determining that the capital plan and its dividend structure was consistent with the Exchange Act because it would enhance OCC’s capital with relative fairness. Two non-shareholder exchanges, a clearing member, and a market participant sought judicial review, arguing that OCC’s plan failed to satisfy Exchange Act requirements. Specifically, they contended that the dividend rate represented an unnecessary windfall for the shareholder exchanges and that the plan inappropriately burdened competition, harmed investors, and unfairly discriminated against non-shareholders and clearing members. They also moved to stay the SEC’s order, but a D.C. Circuit panel denied the motion.

Remand for further consideration. The Administrative Procedure Act requires a court to hold unlawful any agency action that is arbitrary, capricious, or unsupported by evidence, the panel stated, and, to avoid this, the agency must provide a satisfactory explanation for its action and a “rational connection” between the facts and the final determination. The petitioners argued that the plan burdens completion by overcompensating the shareholder exchanges, harms the public by turning OCC into a “profit-seeking monopoly,” and unfairly discriminates between shareholder exchanges and non-shareholder exchanges by denying non-shareholders the opportunity to contribute capital in exchange for dividends and denying clearing members compensation for capital contributed as fees.

However, it is not necessary to reach a decision on these arguments because the SEC’s approval of the plan “fails in a more basic respect,” the panel found. The Commission did not itself make findings that the plan met Exchange Act requirements, instead relying on OCC’s own determinations. The order states that the SEC made the necessary findings but that is not the same as actually considering the factors, the panel explained. The agency found that the plan met statutory requirements because the dividends represented a reasonable return on the capital contributions and accepted OCC’s claims that the plan would not increase fees, all without justification; “the SEC took OCC’s word for it,” the panel stated.

Finding that the SEC may be able to approve the plan again after a proper analysis and that the Commission and OCC can unwind the plan later as necessary, the panel remanded the matter to the SEC for additional consideration.

The case is No. 16-1061.

Tuesday, August 08, 2017

Shkreli securities fraud, conspiracy convictions follow multiple jury instruction drafts

By Anne Sherry, J.D.

Martin Shkreli’s conviction of securities fraud and conspiracy last week followed some fine-tuning of the instructions to be sent to the jury. The final instructions spanned nearly 90 pages and included a definition of what it means to be an “affiliate” of Shkreli’s company Retrophin for purposes of count eight, conspiracy to commit securities fraud. Shkreli was convicted on that count and on two direct securities fraud counts relating to MSMB Capital and MSMB Healthcare (U.S. v. Shkreli, August 4, 2017).

Conspiracy instructions. The parties stipulated that the term “affiliate” be defined as “a person that directly, or indirectly through one or more intermediaries controls, or is controlled by, or is under common control with, such issuer.” The instruction further stated that whether a person is a Retrophin affiliate is a question of fact for the jury.

According to the superseding indictment, Shkreli sent an email terminating all but four Retrophin employees, including employees and contractors who had received unrestricted and free trading shares. Shkreli then filed Schedules 13D with the SEC that failed to disclose his control over the unrestricted or free trading shares. In another email, Shkreli wrote that shares paid to a defrauded MSMB Healthcare investor could be “Take[n] from anyone—I don’t care—do the math?”

Securities fraud instructions. The final jury instructions also struck language from a previous draft that incorporated a “knowing and intentionally” state of mind into the first element of securities fraud. The government wrote the court objecting to the inclusion of this language, which it said neither party requested at the July 26 charge conference. Instead, the prosecutors wrote that the intent standard for securities fraud is discussed in detail in the other elements of securities fraud; the first element—the requirement of a fraudulent act—is distinct. The pattern jury instructions also did not include the “knowing and intentionally” language. The final jury instructions strike the language for the first count but retain the language on the second element of securities fraud: knowledge, intent, and willfulness.

Although the jury convicted Shkreli on the direct securities fraud charges, it acquitted him of conspiracy to commit securities fraud in connection with MSMB Capital and MSMB Healthcare. Shkreli was also acquitted of conspiracy to commit wire fraud, including in connection with Retrophin. This Retrophin count, count seven, charged Shkreli with conspiring to defraud Retrophin by causing it to transfer shares to MSMB Capital, enter into settlement agreements with defrauded investors in MSMB Capital and MSMB Healthcare, and enter into a sham consulting agreement with a defrauded investor to settle other liabilities.

The case is No. 10-cr-637.

Monday, August 07, 2017

Business Roundtable asks SEC to exclude non-U.S. and non-full time employees from pay ratio rule

By Jacquelyn Lumb

The Business Roundtable has written to SEC Chair Jay Clayton to recommend specific changes to the pay ratio rule, pending what it hopes will be a full repeal of the rule. The Roundtable submitted a response in March when then Acting Chair Michael Piwowar first sought views on implementing the CEO pay ratio rule. Following Clayton’s remarks at the Economic Club of New York on July 12, the Roundtable wrote that it wanted to emphasize specific changes that should be made to the rule, including the exclusion of employees outside of the U.S. and non-full time employees.

Delay in compliance. The SEC adopted the pay ratio disclosure rule in August 2015 to implement Section 953(b) of the Dodd-Frank Act. The rule requires the disclosure of the median of the annual total compensation of all employees to the annual total compensation of the chief executive officer. The SEC delayed compliance with the rule until companies’ first fiscal year beginning on or after January 1, 2017, but Piwowar issued a public statement on February 6 advising that companies were encountering difficulties with the rule’s implementation. He asked for comments on the challenges that issuers were encountering and directed the staff to reconsider the implementation of the rule based on those comments.

Non-U.S. employees. The Roundtable said the rule should exclude workers located outside of the U.S. in determining the median employee in order to create a more consistent common denominator. Some of its members have said that the inclusion of employees outside the U.S. makes compliance with the rule difficult due to the size and complexity of their workforces, the variety of business models, staffing strategies, and compensation and benefit arrangements that make up an employee’s total compensation package.

The rule contains a data privacy exception and a de minimis exception to the requirement that companies include their total employee population, but the Roundtable noted that the international data privacy regime is complex and constantly changing, so a company’s analysis could change every year. This could lead to fluctuations in inputs based on factors that are not relevant to a company’s compensation practices and are outside the company’s control. If non-U.S. employees are excluded, it would result in a more consistent common denominator over time, the Roundtable explained.

Non-full time employees. The exclusion of non-full time employees would also help prevent distortion, in the Roundtable’s view. The inclusion of part-time, seasonal, and temporary workers would have a disproportionate impact on the CEO pay ratios of companies that employ large numbers of those types of workers, such as retail and certain service industries. Companies may reduce those types of workers out of fear of a negative reaction to the CEO pay ratio, according to the Roundtable, which could have a negative impact on students, retirees, working parents, and second earners for whom these non-traditional employment opportunities are important.

If non-U.S. and non-full time employees were excluded from the data collection requirement, the Roundtable said it would significantly reduce the compliance costs. The Roundtable cited a study by the Center on Executive Compensation which found that permitting companies to exclude non-U.S. employees would reduce compliance costs by 47 percent. If the SEC changes the rule to exclude these categories of employees, the compliance cost savings could be used for more productive purposes, the Roundtable advised.

Friday, August 04, 2017

Shareholder did not show Icahn underdisgorged premiums

By Amy Leisinger, J.D.

A Second Circuit panel has affirmed the Southern District of New York’s dismissal of a stockholder’s attempt to recover short-swing insider trading profits obtained on cancellation of put options within six months of writing them by several entities in which Carl Icahn held an ownership interest. According to the panel, the complaint failed to allege that the transactions resulted in short‐swing profits beyond the $0.01 per share premium for writing the put options and relies on comparisons to options traded on the open market with no “meaningful similarities” to the options at issue. Under Exchange Act Section 16(b) and Rule 16b-6, the entities were required to disgorge profits only up to the amount of the premium received by the writer of the put, the panel stated (Olagues v. Icahn, August 3, 2017, Lohier, R.).

Icahn transactions. The defendants entered into agreements in which they acquired puts and corresponding calls for certain stock, and the premium paid to Icahn for writing the puts was $0.01 per share. The put and call options were structured so that the put options would expire immediately if the corresponding call options were exercised. Approximately two weeks after entering into the agreements, Icahn exercised the call options and all of the put options were cancelled or expired. Because the put options were cancelled within six months, Icahn reimbursed the company the amount of the premium received—$0.01 per share.

A shareholder filed a complaint alleging that Icahn and related entities understated the short-swing profits they received upon the cancellation of the put options. Under Exchange Act Section 16(b) and Rule 16b-6 any profit realized by an insider from any purchase or sale of any equity security (including derivatives) within a period of less than six months shall be recoverable by the issuer. According to the shareholder, the correct measure of profits was not the $0.01 premium received, but instead included the value from alleged discounts received on purchases of the call options. The Southern District of New York rejected this theory, noting that the shareholder’s “chain of counterfactual hypotheses, assumptions, and inferences” was “a bridge too far” and that the rule requires reimbursement of “premium received,” not “premium consideration obtained.” Finding no amount was paid to Icahn other than the $0.01 per share, the court granted dismissal with prejudice.

No additional premium. While agreeing with the shareholder that Icahn and his entities must disclose all premiums actually received and not just those reported, the panel found that the complaint failed to plausibly allege that the defendants disgorged less than the total amount of premiums received. The complaint describes an unreported “discount,” but the open‐market option contracts cited are not “meaningfully comparable” to the option contracts bought and sold by the defendants because the parties were effectively bound to an exchange of shares at a fixed price on or before the expiration date, the panel stated. As such, according to the panel, the transactions do not raise the concerns underlying Rule 16b‐6(d), which include stopping insiders from receiving and retaining a premium for an option while knowing that the option will not be exercised within six months.

The complaint does not allege facts demonstrating that the transactions resulted in short‐swing profits beyond the $0.01 per share premium, and the district court properly dismissed the complaint for failure to state a plausible claim for additional disgorgement, the panel concluded.

The case is No. 16‐1255‐cv.

Thursday, August 03, 2017

NASAA offers views on FINRA’s capital formation rules

By John M. Jascob, J.D., LL.M.

Responding to a request for comments under the FINRA360 initiative, NASAA offered the views of state securities regulators on FINRA’s funding portal rules and rules concerning direct participation programs. NASAA also commented on FINRA’s proposed amendments to Rule 5110 governing underwriting compensation.

Funding portal rules. NASAA commended FINRA for finalizing its Funding Portal Rules, which took effect on January 29, 2016. NASAA urged FINRA to closely monitor the portals to ensure that they are operating according to regulatory requirements. In NASAA’s view, FINRA should require funding portals to conduct due diligence to determine if crowdfunding issuers are in compliance with SEC rules and remove any offerings that do not comply with those rules.

If funding portals are providing additional services that are unnecessary or provided at unreasonably high prices, NASAA believes that FINRA should address this issue through rulemaking or enforcement. NASAA also encouraged FINRA to provide greater guidance regarding the forms of compensation, such as options and warrants, which a funding portal can receive from listed issuers. Finally, NASAA urged FINRA to work with the SEC and state regulators to address potential issues that may prohibit certain funding portals or intermediaries from effectively participating in intrastate crowdfunding offerings.

Direct participation programs. With regard to direct participation programs, NASAA encouraged FINRA to address complex deferred compensation arrangements that have now become commonplace following FINRA Regulatory Notice 15-02, which discussed rule amendments requiring members to provide more accurate per share estimated values on customer account statements. NASAA believes that FINRA should reevaluate the net investment methodology under 15-02 and consider revisions to avoid certain broker compensation being disclosed as an expense. NASAA noted that offering circulars have disclosed deferred broker-dealer compensation as “ongoing shareholder servicing” or “distribution fees.” In NASAA’s view, this fee should be referred to as a deferred commission and should be fully deducted from the value attributed to the account statement.

NASAA also urged FINRA to continue to watch valuations closely, and require additional due diligence from member firms that use valuations of valuation firms on customer account statements. FINRA should also evaluate the advertising review for these offerings, perhaps disclosing risks on the same line as the advertising content, NASAA wrote.

Corporation Financing Rule. NASAA also offered comments on proposed amendments to Rule 5110, which requires FINRA members who participate in an offering in which they are providing services to the issuer to file certain information with FINRA for approval prior to the offering taking place. NASAA supported FINRA's proposal to change the lock-up period for securities considered to be underwriting compensation to 180 days following the date of commencement of sales of securities, rather than from the date of effectiveness. NASAA believes this change will provide increased protection for investors, as the first sale may not occur until long after the date of effectiveness.

NASAA noted, however, that NASAA's Promotional Shares Statement of Policy requires a lock-in period of at least one to two years in order to ensure that investors and promoters assume similar risks in the offering. Accordingly, NASAA urged FINRA to consider requiring a longer lock-in period under Rule 5110 in order to more closely align the interests of the underwriters with those of the investors in the offering.

Wednesday, August 02, 2017

Blank checks continue to drive IPO market

By John Filar Atwood

Industrea Acquisition and Pensare Acquisition completed their IPOs last week, making four deals by blank checks companies (SIC 6770) in the past two weeks. The industry now accounts for 19 of the year’s new issues, one more than the pharmaceutical preparations sector. Only 13 blank checks deals were completed in all of 2016. Pensare Acquisition raised $270 million for the potential acquisition of a company on the U.S. wireless telecommunications industry. Industrea, which will target industrial manufacturing and service companies, is run by the founders of private equity firm Argand Partners. California is home to two of last week’s new issuers, RBB Bancorp and Sienna Biopharmaceuticals. The RBB Bancorp deal is the second state commercial bank IPO (SIC 6022) of 2017. Four state commercial banks went public last year. Sienna is the ninth pharmaceutical preparations IPO company since the start of June. Redfin made its public market debut, and is the first Washington-based company to go public in the U.S. since last September. The real estate broker’s $138 million offering was led by Goldman Sachs. The week’s other new issuer was China’s Newater Technology. The water purification treatment company had been publicly registered since mid-April.

New registrations. IPO market activity included no new registrations for a second straight week. The most recent filing is a July 14th registration by oil and gas pressure pumping services provider BJ Services.

Withdrawals. The market also has gone consecutive weeks without a withdrawal of a pending IPO registration statement. There have been only two Forms RW filed since May 5th.

The information reported here was gathered using IPO Vital Signs, a Wolters Kluwer Regulatory U.S. database that includes all SEC registered IPOs, including REITs and those non-U.S. IPO filers seeking to list in the U.S. markets. IPO Vital Signs does not track closed-end funds, best efforts or non-underwritten deals, or IPO offerings for amounts less than $5 million.

Tuesday, August 01, 2017

Rep. Waters to introduce SEC bad actor bill

By Mark S. Nelson, J.D.

House Financial Services Committee Ranking Member Maxine Waters (D-Calif) plans to introduce a bill that would reform the SEC’s bad actor waiver process. The bill would include a sense of Congress stating that automatic disqualifications deter securities fraud, but that current SEC practice skews the waiver process in favor of grants to large firms without adequate transparency. The Waters bill contrasts with provisions contained in the Financial CHOICE Act of 2017 that would eliminate many automatic disqualifications.

Too-big-to-bar. Waters said the Bad Actor Disqualification Act of 2017 is needed to ensure the SEC is accountable for its waiver decisions. “The SEC should not automatically give those who break the law a free pass by allowing them to continue to conduct business as usual,” said Waters. “This commonsense legislation will subject waiver requests to public scrutiny and robust SEC review so that the law protects investors, the markets, and the public. No one is above the law, including large financial firms.”

Waters also noted in a bill summary that waivers tend to be granted in favor of the largest firms resulting in an implicit “too-big-to-bar” scenario. Despite more recent changes to the Commission’s waiver process, Waters said not enough had been done to eliminate defects in that process, which Waters said had been highlighted in Commissioner Kara Stein’s 2014 dissent from a waiver granted to Royal Bank of Scotland Group, plc.

Waiver procedure. The bill would establish a process for an ineligible person to obtain a temporary or general waiver. Significantly, the bill would shift accountability from the SEC staff level to the Commission by requiring commissioners to vote on waiver petitions.

The Commission could grant a single, 180-day temporary waiver upon determining that a petitioner had demonstrated immediate irreparable injury. The Commission would then publish the petition and an order explaining its vote.

The Commission could then consider a general waiver, but may not vote to waive a disqualification unless it determines that the waiver is in the public interest, is necessary for the protection of investors, and promotes market integrity. The Commission’s determination must not consider the “direct costs” of a denial to an ineligible person.

A general waiver would be published in the Federal Register so the public can offer views at a hearing or otherwise. SEC staff also would be prohibited from having advance discussions with anyone regarding a recommendation to the Commission that a waiver be granted or denied.

“Ineligible person” is used throughout the draft legislation. The term is defined with reference to a variety of securities laws and regulations, including:
  • Securities Act Rule 405—Ineligible issuer not eligible to be a well-known seasoned issuer; 
  • Securities Act Rules 505 and 506—Regulation D private offering exemptions; 
  • Securities Act Section 27A(c) and Exchange Act Section 21E(c) —Safe harbor for forward-looking statements;
  • Investment Advisers Act Rule 206(4)-3—Denial of cash fee for adviser solicitation activities; 
  • Securities Act Rule 262—Regulation A exemptions; and
  • Securities Act Rule 602—Regulation E exemptions. 
Waiver data. The Commission would be required to maintain and publish records of withdrawn waiver requests under the Waters bill. The Commission also would have to establish a database of ineligible persons for whom a wavier was denied or who made a disclosure to the Commission indicating their ineligibility.

GAO study. The GAO would be tapped to perform a study of waivers of automatic disqualifications in the context of investment companies. The GAO, among other things, would be asked to compare Investment Company Act and Exchange Act provisions. The GAO also would make recommendations for improving the transparency of the waiver process for investment companies and for increasing public participation regarding waivers.

CHOICE Act. Section 827 of the Financial CHOICE Act (H.R. 10) would remove many automatic disqualifications by providing, in part, that a non-natural person cannot be disqualified or made ineligible to use exemptions or registration provisions unless the Commission holds a hearing and determines that the non-natural person should be disqualified or ineligible. The provision would alter much of the work the Commission was required to do by Dodd-Frank Act Section 926, with an implicit reference to lawmakers’ earlier attempts via the crowdfunding title of the Jumpstart Our Business Startups (JOBS) Act, to leverage Regulation A’s Rule 262 for purposes of conforming the various bad actor provisions across the securities laws.

The CHOICE Act is the Republican-led effort to revise the Dodd-Frank Act that passed the House in June, and from which selected provisions may yet be attached to appropriations bills. This is the CHOICE Act’s second go-around, after having been first introduced during the Obama Administration when it would have faced a presidential veto. House Financial Services Committee Chairman Jeb Hensarling (R-Texas), sponsor of the CHOICE Act, has said the bill would broadly meet the principles of financial reform developed by the Treasury Department in response to a request by President Trump.

By contrast, Michael Rothman, president of the North American Securities Administrators Association, Inc., called Section 827 “baffling and misguided” in a statement to the House Financial Services Committee in advance of the House vote on the CHOICE Act. “If enacted, this provision would create procedural burdens to necessary disqualifications, allowing bad actors to continue to rely on exemptions, registrations, and activities that led to those bad acts.”

Monday, July 31, 2017

SEC awards two whistleblowers $4.2M, provides info on government employee eligibility

By Lene Powell, J.D.

In two whistleblower awards two days apart, the SEC awarded $2.5 million to a government employee and $1.7 million to a company insider who provided tips and continuing assistance in SEC enforcement actions. The orders were redacted to preserve confidentiality, but offer some information on award eligibility for employees of government agencies and factors in the size of awards (Release Nos. 34-81200 and 34-81227).

Government employee. In an award of almost $2.5 million, the claimant was “an employee of a domestic government agency” who reported suspicions about a company’s improper conduct to the SEC and provided supporting documentation. As the investigation progressed, the claimant continued to provide “specific, timely, and credible information, helpful documents, significant ongoing assistance, and relevant testimony that accelerated the pace of the investigation.”

The order notes that an employee of a federal, state, or local government agency can be eligible for an award under the SEC whistleblower program, subject to two statutory exceptions:
  • The claimant cannot be an employee of “an appropriate regulatory agency,” defined under Exchange Act Section 3(a)(34) as the Commission and any of the banking agencies listed in the definition, including the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation. 
  • The claimant cannot be an employee of an employee of “a law enforcement organization.” Neither the Exchange Act nor the whistleblower rules define this term, but the Commission interpreted it as “having to do with the detection, investigation, or prosecution of potential violations of law.” Although certain components of the claimant’s governmental employer have law enforcement responsibilities, those responsibilities are housed in a separate, different component of the agency. The SEC said that for appropriate cases, it makes sense to apply the term “only to employees of a clearly separate agency component that performs law enforcement functions, rather than to all employees of an entire agency that happens to have been granted law enforcement powers among its many other separate responsibilities and powers.” 
The claimant did not meet either exception, so was eligible for the award.

Company insider. The SEC awarded $1.7 million to a company insider who alerted the SEC to a serious, multi-year fraud that otherwise would have been difficult to detect, allowing the SEC to return millions of dollars to injured investors and prevent further harm.

“When whistleblowers tip the SEC, it not only can bring wrongdoers to justice but also relief to investors,” said Jane Norberg, Chief of the SEC’s Office of the Whistleblower. “This whistleblower's valuable information enabled us to stop further investor harm and ultimately return money to victims.”

The SEC made the award even though the claimant did not comply with Exchange Act Rule 21F-9(d), relating to submission of a signed Form TCR and submissions after the Dodd-Frank Act was enacted but before the effective date of SEC whistleblower rules. Normally this omission might require an award denial, but claims review staff found it appropriate to waive the requirement given “unusual circumstances”:
  1. SEC staff was already actively working with the Claimant before enactment of the Dodd-Frank Act; 
  2. The claimant provided the new post-Dodd-Frank Act information in the format requested by Enforcement staff; 
  3. The policy underlying the Rule 21F-9(d) writing provision, relating to the indicia of reliability and the certainty as to the time the information was provided, was clearly satisfied in the context of this claim. 
In considering whether the claimant’s delay in reporting the fraud should reduce the award, the Commission said it did not apply the delay factor as severely as it otherwise might have had the delay occurred after the whistleblower program was established and whistleblower protections were in place. The award was also affected to some extent by the claimant’s limited culpability in the fraud.

The releases are Nos. 34-81200 and 34-81227.

Friday, July 28, 2017

Alpine case prominent at outreach panel on money laundering

By Mark S. Nelson, J.D.

The 2017 National Compliance Outreach Program for Broker-Dealers featured anti-money laundering (AML) compliance on its early afternoon panel. The SEC’s recently filed case against Alpine Securities Corporation weighed heavily on the discussion and Q&A session. The event was sponsored by the SEC’s Office of Compliance Inspections and Examinations and the Financial Industry Regulatory Authority.

Kristin Snyder, Associate Regional Director (Examinations) of the SEC’s San Francisco Regional Office, said Bank Secrecy Act suspicious activity reports (SARs) are a key component of the agency’s broker-dealer enforcement examination program. The BSA requires these reports for transactions a broker-dealer knows, suspects or has reason to suspect, involve funds derived from illegal activity or were conducted to disguise such activity, were designed to evade the BSA, or involved the use of a broker-dealer in facilitating criminal activity.

According to Snyder, SARs do not require absolute certainty regarding wrongdoing. But she noted that the Alpine case, filed by the SEC in June, was an important example of SARs that lacked context.

The SEC charged Alpine with violating Exchange Act Section 17(a) and Rule 17a-8, which require broker-dealers to comply with the BSA. Over a 4.5 year period, Alpine allegedly omitted “red-flag” data from SARs, filed SARs for deposits of securities without also filing reports on later transactions involving the deposits, and failed to file hundreds of SARs within 30 days of detecting suspicious activity.

The complaint further alleged that the bulk of Alpine’s business involved clearing microcap transactions by persons with checkered backgrounds on behalf of Scottsdale Capital Advisers Corp., whose owner, John Joseph Hurry, had acquired Alpine. Alpine has been registered with the Commission for 33 years, but also has a history of discipline by FINRA. The SEC has asked a court to permanently enjoin Alpine from violating federal securities laws and to impose civil money penalties on the firm.

During a brief Q&A session, Snyder fielded a question about the impact of Alpine on the broker-dealer industry. According to Snyder, clearing firms are not subject to more duties as a result of Alpine. Previously, Snyder recommended that firms review available guidance on what constitutes a red flag in the AML setting.

Susan Axelrod, Executive Vice President of Regulatory Operations at FINRA, said that FINRA and the SEC often have different goals when it comes to AML compliance. She said the SEC is more focused on SARs, while FINRA looks at firms’ supervision of AML programs.

When it comes to AML compliance, Snyder also said firms need to know the basics. Georgia Bullitt, a partner at Willkie Farr & Gallagher LLP, suggested one way to achieve this is to read the AML laws to top executives who may fail to grasp the importance of AML compliance. As part of the outreach event, the SEC posted a set of resources on AML compliance.

Thursday, July 27, 2017

Delaware court endorses stricter standard for preclusion of derivative suits

By Anne Sherry, J.D.

The Delaware Supreme Court seems poised to adopt a rule that could give shareholders a second bite at derivative complaints. After the chancery court dismissed a derivative suit as precluded by the dismissal of a similar suit in federal court, the Supreme Court remanded to ask whether it should adopt the chancery court’s holding in EZCORP. The EZCORP court held that subsequent shareholders are not precluded until a derivative complaint overcomes a motion to dismiss or the board declines to oppose the litigation (In re Wal-Mart Stores, Inc. Delaware Derivative Litigation, July 25, 2017, Bouchard, A.).

The case involves two derivative suits arising from an alleged bribery scandal at a Wal-Mart subsidiary that was reported in the New York Times. Believing they had learned enough from the Times article to proceed, a group of plaintiffs filed a derivative action in district court in Arkansas without first demanding to inspect the company’s books and records. A second group filed a derivative action in the chancery court in Delaware, but when then-Chancellor Strine warned them that their complaints would likely be dismissed, they took his advice to pursue a books-and-records demand. The books-and-records lawsuit lasted nearly three years. Meanwhile, in Arkansas, the judge dismissed the complaint.

Back in Delaware, Chancellor Bouchard also dismissed the derivative suit there. “Subject to Constitutional standards of due process,” he wrote, “Arkansas law governs the question of issue preclusion.” Although Arkansas courts had not addressed issue preclusion in the context of derivative suits, the chancellor reasoned that an Arkansas court would likely find privity between the two groups of plaintiffs.

Appeal to Delaware Supreme Court. In its remand order, the Supreme Court gave credence to the Delaware plaintiffs’ argument that the chancery court conflated privity and due process analyses. The appellants argued that, while acknowledging that privity is a matter of Arkansas law as long as federal constitutional due process is not offended, the court focused almost exclusively on privity as a matter of state law and never addressed the due process analysis as it related to nonparty preclusion.

The appellants offered instead a more refined argument based on the chancery court’s EZCORP opinion. The court there noted that in the first phase of derivative litigation, the stockholder is suing individually to obtain authority to assert the corporation’s claim. He then held that “until the derivative action passes the Rule 23.1 stage, the named plaintiff does not have authority to sue on behalf of the corporation or anyone else.” It then followed that subsequent shareholders are not precluded—privity does not attach—unless and until a derivative plaintiff survives a motion to dismiss or the board declines to oppose the suit. The Supreme Court remanded the case so that the chancellor could express his views on this reasoning.

A troubling case. On remand, the chancellor concurred in the Supreme Court’s view that it is “a troubling case.” The trouble, he said, “arises from a tension in competing policies.” Delaware courts encourage stockholders to inspect books and records before filing a derivative suit to develop a factual record for purposes of the demand futility inquiry. But on the other hand, public policy discourages duplicative litigation, and contingent fee arrangements create incentives to be the first to file.

The chancellor recommended that the Supreme Court adopt the EZCORP rule, reasoning that it would better safeguard the due process rights of stockholder plaintiffs while mitigating fast-filer problems. Derivative suits and class actions share similarities, and both were governed by Federal Rule of Civil Procedure 23 until Rule 23.1 was adopted. Unlike with class actions, however, a court does not do a front-end evaluation of a derivative plaintiff’s adequacy as representative. The current state of the law, “automatic privity” with other stockholders the moment a derivative suit is filed, is far less favorable to would-be derivative plaintiffs than it is to unnamed members in class actions.

The EZCORP approach would also further public policy. The court noted that when a stockholder fails to establish demand futility, it’s rare that another stockholder simply files a substantially similar complaint. Instead, the second plaintiff will file a more refined complaint with particularized allegations or more tailored legal theories, perhaps after obtaining books and records. A court presumably would be cautious about following earlier rulings in cases brought by less prepared stockholders.

The case is No. 7455-CB.