Tuesday, March 28, 2017

Broker petitions SEC for rules on digital assets and blockchain tech

By Anne Sherry, J.D.

A broker-dealer that operates an alternative trading system (ATS) petitioned the SEC for guidance on when digital assets will be deemed securities and whether firms that facilitate their trading must register as a broker-dealer, ATS, or exchange. Ouisa Capital also asked the SEC to consider adopting a regulatory sandbox similar to those used in the U.K. and Singapore.

Ouisa plans to use blockchain technology as part of the operation of its ATS. It noted in its petition for rulemaking that the SEC evaluates digital assets in the same manner as traditional assets, but that the Commission has not adopted rules, regulations, or interpretive guidance on digital assets. The only guidance in this area is from enforcement actions that suggest a broad swatch of FinTech products and services that could be deemed investment contracts.

The petition recommends that the SEC publish a concept release on the regulation of FinTech and digital assets. The number of firms issuing and trading in digital securities is growing rapidly, and rather than publish a concept release or proposed rules, “the SEC has engaged in enforcement actions against FinTech firms that did not know they were operating in contravention of existing statutes.” A concept release would allow industry participants to raise questions and concerns, which the SEC could address in a regulatory framework. The release should be followed by specific rulemaking regarding when digital assets are securities.

Ouisa also recommends that the SEC explore adopting a regulatory sandbox. In a sandbox, as long as firms’ operations remain within enumerated boundaries, the firms can grow and experiment without excessive regulation. This system is already in place in the U.K. and Singapore, Ouisa notes. In the U.S., a similar approach could be modeled on the regulation of crowdfunding portals, which can opt for SEC or FINRA registration and are limited to certain activities.

Monday, March 27, 2017

Dissent asserts wrong question asked in failure of pipeline company merger

By R. Jason Howard, J.D.

On appeal from the Court of Chancery, the Delaware Supreme Court has affirmed the decision that Energy Transfer Equity, L.P. (ETE) did not breach its representations and warranties and that The Williams Companies, Inc.’s argument that ETE was estopped from terminating the pending merger agreement between the two companies failed, despite a dissent by the Chief Justice that reasoned the majority was entertaining the wrong issue just as the lower court had done (The Williams Companies, Inc., v. Energy Transfer Equity, L.P., March 23, 2017, en banc).

Merger. Both companies are involved in the transmission of fossil fuels and the contemplated merger involved two steps. The first step would involve the merger into a new entity, Energy Transfer Corp LP (ETC) and the transfer of over $6 billion in cash to ETC in exchange for 19 percent of ETC stock to be distributed to Williams’ stockholders in exchange for their Williams stock. Step two would involve the transfer of the Williams assets to ETC in exchange for newly issued ETE Class E partnership units. The number of Class E units transferred and ETC shares issued would be the same number and the two were expected to be similar in value.

Condition. The merger was conditioned upon the issuance of an opinion by ETE’s tax counsel, Latham & Watkins LLP (Latham), that the second step of the transaction, the transfer of Williams’ assets to ETE in exchange for the Class E partnership units, “should” be a tax-free exchange of a partnership interest for assets under Section 721(a) of the Internal Revenue Code 2 (the “721 opinion”). The agreement also contained provisions that required the parties to use “commercially reasonable efforts” to obtain the 721 opinion and to use “reasonable best efforts” to consummate the transaction.

A severe market decline, however, led to a significant loss in the value of assets of the type held by Williams and ETE, causing the transaction to become financially undesirable to ETE and raising the specter of possibility that the IRS might view a portion of the over $6 billion not as payment only for the ETC stock, but as payment in part for the Williams assets, thus rendering the second step of the merger taxable. That issue led to Latham being unwilling to issue the 721 opinion and as a condition of the transaction, ETE indicated it would not proceed with the merger.

Court of Chancery. Williams sought to enjoin ETE from terminating the merger, arguing that ETE breached the agreement by failing to “use commercially reasonable efforts” to obtain the 721 opinion and “reasonable best efforts” to consummate the transaction. Williams had also argued that ETE was estopped from terminating the agreement by a representation it made in the agreement that it knew of no facts that would prevent the second step of the transaction from being treated as tax-free at the time the parties entered into the agreement.

The court, however, took the position that Latham’s determination that it could not issue the 721 opinion was a good faith determination made by it independent of any conduct, or lack of conduct, by ETE and that ETE was not estopped from terminating the agreement.

Supreme Court majority. The majority agreed with the Court of Chancery and explained that a footnote in the lower court’s opinion, when analyzed, demonstrated that ETE met its burden by showing that the record was barren of any indication that the action or inaction of the partnership, other than simply drawing Latham’s attention to the tax issue, contributed materially to Latham’s inability to issue the 721 opinion.

As to the estoppel argument, the court explained that there was “nothing to indicate that ETE knew of this potentially problematic theory of tax liability at the time it made its representations and chose not to disclose it to Williams.”

Dissent. Chief Justice Strine, in dissenting, explained that while his friends in the majority affirmed the outcome of the Chancery Court’s decision, they did so by focusing on the wrong issue. The issue was not whether the Latham Tax Lawyer was honest when he said he could not give the required tax opinion but, rather, the question was why the Latham Tax Lawyer did not give the required opinion.

The affirmative covenant in the merger agreement imposed the specific duty on ETE in connection with the 721 opinion in which it use “commercially reasonable” efforts to obtain the opinion and “instead of determining whether ETE in fact used commercially reasonable efforts to obtain the 721 opinion, the Court of Chancery focused on whether ETE had somehow prevented the Latham tax lawyer from giving the 721 opinion and concluded that, although ETE had certainly not desired the 721 opinion because it wished to get out of the deal, ETE had not coerced or misled Latham to prevent the issuance of that opinion.”

The Chief Justice reasoned that “the Court of Chancery’s sympathy toward the Latham Tax Lawyer had the effect of ignoring the covenant-breaching behavior that put the Latham Tax Lawyer under undue professional pressure in the first place.” He continued, explaining that the “multiple forms of behavior that breached ETE’s affirmative obligation are exactly the kind of conduct that compromised the ability of the Latham Tax Lawyer to find a way to yes, and that foreclosed any meaningful consideration of economically immaterial adjustments to the transaction that might have solved any genuine tax concern.”

The Chief Justice concluded, saying that he would remand and require a new trial “at which ETE would be required to prove that its breach did not materially contribute to the failure of the Latham Tax Lawyer to deliver the 721 opinion.”

The case is No. 330, 2016.

Friday, March 24, 2017

SEC chief accountant highlights revenue recognition, internal control topics

By Amanda Maine, J.D.

SEC Chief Accountant Wesley Bricker recently addressed the Annual Life Sciences Accounting and Reporting Congress in Philadelphia, where he discussed the progress of companies transitioning to FASB’s new revenue recognition standard. He also touched on the importance of effective internal controls over financial reporting in transitioning to the new standard.

Revenue recognition. Bricker praised issuers that have made use of the transition guidance for the new revenue recognition standard on contracts with customers, which was issued by FASB and the IASB in May 2014 and will be effective for all issuers for the annual reporting periods beginning after December 15, 2018. However, he noted that some companies are lagging behind and need to make significant progress this year in their implementation of the standard. According to Bricker, eight percent of respondents in an October 2016 survey of public companies had not started an initial assessment of the new standard, and an “overwhelming majority” of the other respondents were still assessing its impact.

Bricker noted that none of the 108 submissions to FASB’s Transition Resource Group (TRG) remain open and that TRG discussions have been published by FASB as a resource for preparers and auditors to understand the application of the new standard’s core principles and their application. The AICPA and other industry groups have also published guidance, and the SEC’s own Office of the Chief Accountant has received consultation requests from registrants about the new standard, with the issue of whether a registrant is a principal or an agent in a revenue transaction being among the most common, he said.

Guidance on revenue recognition has also changed, Bricker said. The current recognition guidance is primarily a risk and rewards-based model; however, the new standard is focused on control, Bricker advised. Additional judgments may be needed in applying the new standard, Bricker said, and OCA staff will continue to respect well-reasoned, practical judgments when they are grounded in the principles of the new standard. Still, he emphasized the need for preparers to understand the underlying transaction behind the judgment, including the registrant’s specific facts and circumstances and contractual terms.

In addition, Bricker explained that if a company does not know the expected financial impact of the new standard, that fact should be disclosed. The SEC staff will expect such disclosures to include a qualitative description of the effect of the new accounting policies and a comparison to the company’s current accounting, Bricker said.

Internal controls. According to Bricker, “it is hard to think of an area more important than ICFR.” When implementing the new standard, companies should do a “refresh” of components of ICFR such as professional competence, he said. “Having resources with sufficient training and competence is fundamental to the effectiveness of a company’s overall control environment,” Bricker declared.

He also stressed the importance of setting the right “tone at the top” and expectations for responsible conduct throughout the company. Taking a fresh look at a company’s IT and communication ICFR components should be part of implementing the new standard, Bricker advised.

In addition, Bricker implored companies to keep in mind that the effectiveness of changes to internal controls are predicated on the comprehensive and timely assessment of risks that might arise in the wake of the new standard. These risks may exist in different areas of the company, and management and employees from the accounting and financial reporting function should be involved in assessing these risks, according to Bricker.

Thursday, March 23, 2017

Sham loan doesn’t defeat relief defendant jurisdiction

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

Addressing an issue of first impression, the Ninth Circuit ruled that putative relief defendants in an SEC disgorgement proceeding could not divest a court of jurisdiction over them simply by asserting a facially colorable claim to the disputed funds. The panel held that the district court properly asserted jurisdiction to determine the legal and factual legitimacy of the appellants’ claim that they received the $5 million at issue as a loan. The district court also did not err in finding that the loan was a sham and that the funds transferred to the appellants were ill gotten as a matter of law (SEC v. World Capital Market, Inc., March 21, 2017, Tallman, R.).

“Loan” agreement. The SEC had filed a motion for an order of disgorgement against the appellants, alleging they had received $5 million of the approximately $57 million of dollars unlawfully raised by Phil Ming Xu and his related entities in an international Ponzi scheme. One of the appellants, who provided legal advice to Xu regarding tax, corporate, and immigration matters, was aware by the fall of 2013 that Xu and his entities were under investigation by the SEC for securities law violations.

When the appellant learned in February 2014 that Xu’s outside securities law counsel had recommended settling with the SEC for $64 million, he texted Xu and advised him to “drop” his outside counsel because the settlement sum was “ridiculous.” He also wrote: “Perhaps the new counsel can delay the negotiations so that your assets seem less.” Three weeks later, Xu transferred $5 million from the bank account of one of his entities to the appellant’s attorney-client trust account.

Although Xu asked the appellant to hold the funds for future business endeavors, the appellant responded that he would not simply hold the funds. Instead, on the day after the transfer, the appellant prepared and executed a document he later characterized as a “loan agreement.” The appellant further testified that the loan was in furtherance of previously discussed proposals to set up a fund for future investments in Africa, and that the “no recourse” language in the agreement meant that he could do whatever he wanted with the money in terms of investment ventures. The appellant later wired almost $1 million of the funds to a company retained by Xu to help establish a political action committee and for which the appellant acted as general counsel.

In May 2014, the SEC amended its complaint against Xu to add the individual appellant and the company as relief defendants. Although the appellants argued that they were not proper relief defendants because they had a legitimate claim to the $5 million they received from Xu, the district court ruled that the appellants had no legitimate claim to the funds because the loan agreement with Xu was a sham.

Question of legitimacy. On appeal, the appellants contended that once they advanced a facially colorable claim to the disputed funds as loan proceeds, the district court was immediately divested of jurisdiction to adjudicate the legitimacy of their claim and proceed any further against them as relief defendants. Instead, they insisted that they would have to be named as defendants either in the SEC’s underlying civil enforcement action against Xu or in a stand-alone lawsuit, with all of the rights attending a civil action.

The Ninth Circuit panel disagreed, however, rejecting the individual appellant’s argument that the receiver could not proceed against him as a relief defendant because the putative loan agreement gave him “presumptive title” to the money. This position begged the question, according to the appellate court, because it necessarily assumed that the loan was not a sham—the very issue the district court resolved in deciding whether to allow the proceedings to continue.

Accordingly, the panel joined the Fourth Circuit in holding that relief defendants cannot defeat jurisdiction simply by asserting an ownership interest in the disputed funds. Rather, they must assert an interest both “recognized in law” and “valid in fact.” Otherwise, any third party with a custodial claim to the proceeds of securities violations committed by others would be able to defeat relief defendant jurisdiction “simply by stating a claim of ownership, however specious,” the court reasoned.

Sham loan. The appellate panel next held that there was no clear error in the district court’s finding that the $5 million transfer as a loan was a sham. In concluding the loan agreement was a ruse designed to keep $5 million of Xu’s money out of the reach of the SEC, the district court relied not only on its rejection of the individual appellant’s "incredible" testimony, but also on impeaching evidence such as: the appellant's text message to Xu advising him to delay the SEC negotiations so that they could make his assets “seem less;” Xu’s transfer of the $5 million less than three weeks later, before any discussion of a potential loan, along with a contemporaneous request to “hold” the money; the cursory agreement prepared by the appellant after the transfer, which lacked the normal provisions of a valid loan agreement; the appellant's testimony that he had no personal legal obligation to repay the $5 million; and a request by Xu to return the $5 million just nine days after the transfer. Accordingly, the Ninth Circuit affirmed the ruling of the lower court.

The case is No. 15-55325.

Wednesday, March 22, 2017

CAQ publishes report on addressing complex accounting challenges

By Jacquelyn Lumb

The Center for Audit Quality has released a report on the challenges of highly subjective and complex accounting areas which provides recommendations for deterring fraud and enhancing financial reporting. The report was prepared by the Anti-Fraud Collaboration, which includes CAQ, Financial Executives International, the National Association of Corporate Directors, and the Institute of Internal Auditors, whose goal is to promote the deterrence and detection of financial reporting fraud. The report is the result of two workshops that were held after an analysis of the SEC’s accounting and audit enforcement releases (AAERs) that identified failures in internal control over financial reporting.

Workshops. The workshops focused primarily on revenue recognition, loan impairment, and valuation based on the earlier analysis of the SEC’s AAERs. These areas involve significant judgment and estimates, and were areas of stress during the financial crisis. Following their discussions of the accounting policies relating to these subject areas and the related internal controls, the work shop developed a number of recommendations.

First, the accounting policies must adhere to technical accounting guidance. The policies must be understandable to non-accountants. They must be reviewed on a regular basis and the review process should enable companies to identify and monitor changes in activities that may have an impact on accounting. The group recommended that policies be tested in the field prior to implementation, and then be monitored for compliance once they are implemented.

Revenue recognition. Revenue recognition was a particular area of focus. The group concluded that revenue recognition policies should be very detailed given that even small differences in interpretation can have a major impact. Contract terms should be standardized where possible, and should reflect how transactions at the contract level relate to the requirements of GAAP.

Companies should establish clear lines of responsibility and communication among legal, business, and finance. The group found this recommendation to be particularly important in implementing the new revenue recognition standard which goes into effect January 1, 2018, for calendar year-end companies.

ICFR. During the group’s consideration of ICFR, tone at the top emerged as an essential component. The group also recommends a risk-based evaluation to achieve optimum effectiveness and efficiency. The group found that internal controls over unusual and non-routine transactions may be overlooked or given less attention when developing the ICFR regime.

The group concluded that companies must have both preventative and detective controls. A single control at the end of a process cannot typically be relied upon to deter fraud. The group also determined that smaller companies may be at the greatest risk for ICFR deficiencies due to a lack of resources.

Regulators’ focus. Representatives of the SEC’s fraud group, Office of the Chief Accountant, and the PCAOB’s Division of Enforcement and Investigations briefed the workshop members about their activities, including their close cooperation and the benefits of self-reporting possible securities law violations.

During the regulators’ presentations to the group, a PCAOB representative advised that one of its areas of focus is the quality of cross-border audits, particularly those that involve non-U.S. affiliates of the global accounting networks. The PCAOB is concerned that affiliates in some countries do not follow the auditing standards. The quality control procedures at the U.S. firm do not necessarily translate to certain of their foreign affiliates, even at the biggest affiliates of some of the biggest firms.

Another issue on which the PCAOB is focused is the improper alteration of documents. The staff has warned that any alterations in connection with PCAOB inspections or investigations are a mistake, with the sanction for this activity often being worse that a failure to document something in the audit. An SEC staffer added that while SEC investigations are civil in nature, any destruction or alteration of documents could result in a criminal referral to the Justice Department.

Audit committees. The group also had recommendations for audit committees. There should be open lines of communication or ethics hotlines directed to the audit committee. Audit committees should look beyond the routine materials they receive at meetings. For those in industries with highly specialized accounting, audit committees may benefit from external industry specialists. The group also noted that committee refreshment may revitalize members’ engagement in the accounting issues. Enforcement actions against audit committees are uncommon, but the report points out that they are not unprecedented, citing the MusclePharm case in which the committee chair did not take any action although he had reason to know about certain undisclosed perquisite compensation.

Tuesday, March 21, 2017

High court won’t resolve circuit split on SEC whistleblowing

By Anne Sherry, J.D.

The Supreme Court declined to resolve a circuit split regarding whether Dodd-Frank protects whistleblowers who do not report misconduct to the SEC. The case came to the Court on an unusual posture, seeking to appeal a Sixth Circuit decision that sidestepped the SEC-reporting question entirely. The first question presented in the petition for certiorari was whether the Sixth Circuit erred by avoiding the issue; next, the petitioner asked the Court to settle the circuit split (Verble v. Morgan Stanley Smith Barney, LLC, cert denied March 20, 2017).

The petitioner alleged that he was fired by Morgan Stanley after acting as a confidential source to the FBI. The district court acknowledged a split between the Fifth Circuit (holding in Asadi that Dodd-Frank protects only whistleblowers who report misconduct to the SEC) and the Second (holding in Berman that Dodd-Frank is ambiguous and deferring to the SEC’s rule under Chevron). The district court sided with Asadi and dismissed the petitioner’s Dodd-Frank claims. But rather than enter the fray, the Sixth Circuit affirmed the dismissal on the basis that the complaint suffered from a “fundamental defect” of pleading.

While the petition for certiorari was pending, the Ninth Circuit became the third court of appeals to rule on the central question, holding that whistleblowers need not report to the SEC to be protected. Unlike Berman, the Ninth Circuit decision does not rely on Chevron deference. Rather, the court held that the Dodd-Frank provision “unambiguously protects from retaliation all those who report to the SEC and who report internally.”

The question will likely come up before the Supreme Court again, perhaps on a cleaner record (the defendants in Berman contemplated seeking certiorari, but opted not to). Supreme Court nominee Neil Gorsuch has been an outspoken critic of Chevron.

The case is No. 16-946.

Monday, March 20, 2017

EU Parliament approves conflict minerals proposal

By Amy Leisinger, J.D.

By a 558-17 vote, the European Parliament approved a proposal to stop trade in conflict minerals to ensure that European industries source minerals responsibly. According to the European Commission, the changes will stop financing of armed groups in developing countries and curb human rights abuses through trade in conflict areas.

“I'm very glad we now have an ambitious, workable solution to eliminate conflict minerals from supply chains,” said Commissioner for Trade Cecilia Malmström after the vote.

“We cannot turn a blind eye to the harm we cause in other parts of the world,” added Parliament International Trade Committee Chair Bernd Lange.

The regulation will require all but the smallest importers of tin, tungsten, tantalum, gold and their ores to do “due diligence” checks on suppliers to ensure responsible sourcing of the materials. Large manufacturers will also need to disclose the methods by which they will monitor resources. The regulation requires responsible sourcing in connection with the extraction and refining of minerals used by importers and manufacturers and allows companies to be listed by the Commission as responsible importers by declaring in writing to authorities in their respective member states that they follow the obligations set forth in the regulation. Authorities in EU member states will be responsible for ensuring compliance and enforcing penalties, and the Commission will provide guidance for importers. Recycled metals, existing EU stocks, and by-products are also excluded from the regulation. The Commission will review and report on the effectiveness of the changes on an ongoing basis.

Concurrently, the EU will put in place measures to support small and medium-sized importers and reach out to other governments to encourage responsible sourcing and elimination of alternative conflict minerals markets. More than 95 percent of all EU imports of tin, tantalum, tungsten and gold will be covered by due diligence provisions by January 1, 2021.

The regulation is still subject to formal adoption by the Council.

Friday, March 17, 2017

Rise of the machines: industry mulls automated trading and ‘robo-regulators’

By Lene Powell, J.D.

At a derivatives industry conference, a panel of market participants and a CFTC official discussed concerns arising from the intersection of regulation and technology. Notably, a CFTC proposal for regulatory access to trading firms’ proprietary source code may be in partial retreat with the recent nomination of Acting Chairman J. Christopher Giancarlo for the CFTC chairmanship. The panel, which took place at the annual FIA conference in Boca Raton, Florida, also explored the CFTC’s consideration of the use of artificial intelligence for market surveillance.

Reg AT and source code. With the comment period for proposed Regulation AT now extended to May 1, the CFTC is “reconsidering all aspects” of the proposal, and public comments will continue to drive the agency’s thinking, said Daniel Bucsa, a deputy director in the Division of Market Oversight. The CFTC is looking to leverage risk controls already in place at exchanges and market participants, and wants to avoid installing duplicative new requirements, he said.

“Everybody wants a well-functioning market,” said Bucsa.

On the controversial proposal of requiring automated trading firms to make their source code available to the CFTC upon a books and records request, Bucsa said that Acting Chairman Giancarlo is “highly sensitive” to industry concerns about privacy and safety, and to the issue of intellectual property as a whole. The CFTC understands the need to protect this confidential information and the “immeasurable damage” it could do to a firm if it were to get out. The CFTC has been collecting confidential information for a long time, said Bucsa, and has processes and procedures in place to protect such information. He added that one possible approach is that instead of source code being provided to the CFTC, agency officials could go to the firm’s location and view the software on site.

Bill Harts, CEO of the advocacy group Modern Markets Initiative, said that because Acting Chairman Giancarlo has been very supportive of the industry position that source code should only be accessible via a subpoena, market participants are hoping the proposal for books-and-records access will “go away.” However, even with the restriction of a subpoena, trading firms remain concerned about the safety of source code in the control of regulators. Harts acknowledged that the CFTC has experience in handling confidential information, but observed that there has been a lot of hacking of government databases, even at the CIA and NSA. The CFTC’s expertise is in “futures, not firewalls,” said Harts.

Harts also pointed to an incident in which an SEC employee downloaded market participant data to his own personal laptop. Further, when government agencies use consultants, it adds yet another source of potential breach.

“With the amount of hacking that we see of government databases, of government information, the potential for firms’ ‘secret sauce’ or what drives trading at any particular firm, to be stolen by hackers from a foreign country or I won’t even begin to say where, is so scary to a lot of market participants,” said Harts. “It really deserves a lot of thought by the CFTC.”

Steve Grob, director of group strategy at Fidessa, agreed, pointing out that the more copies of software there are, the more potential there is for things to go wrong. He questioned the need for regulators to have access to source code and asked how it would help keep markets safe. It might possibly be useful to look at algorithms after an event to reconstruct what went wrong, said Grob, but it’s not clear that having source code beforehand would prevent disruptive events.

“Robo-regulator.” Turning to the issue of surveillance, Woods referred to a recent news article that reported that the CFTC is looking at using artificial intelligence for market surveillance. Especially with Commissioner Giancarlo’s announcement that some surveillance functions in the Division of Market Oversight will be transferred to the Division of Enforcement, asked Woods, is there a danger of moving into an era of “robo-regulatory enforcement,” in which the system generates alerts that are then acted on automatically by enforcement?

Harts asked what “artificial intelligence” meant in this context, whether it referred to surveillance software that already exists or to some new capability. Woods clarified that it meant an evolution of surveillance software from case-based or rules-based programs to software that could spot patterns of conduct that could be interpreted as manipulative, for example. This development of surveillance technology is necessary because the volume of market data is now too large to be monitored only by humans, Woods said.

Bucsa said the value of having “robo-regulator” capabilities is that it adds another tool to spot anomalies. The information can then be analyzed by human staff, who have knowledge of products and markets and who use human judgment and discretion. The human element is crucial to well-regulated markets, he said.

Woods agreed that there needs to be human involvement in order to dig deeper on a qualitative level, and in particular to determine intent. Harts concurred, and noted a concern that these types of tools could be used to generate “traffic tickets,” which wouldn’t really make the markets better or safer. If the CFTC or other regulators use their budget to invest in technology, it should be with the purpose of finding larger problems throughout the system, said Harts.

Thursday, March 16, 2017

Chamber urges additional one-year delay of DOL fiduciary rule

By Anne Sherry, J.D.

Calling the Department of Labor’s original 12-month implementation period for its fiduciary rule an “unrealistic deadline,” the Chamber of Commerce supported the agency’s proposal to delay applicability for 60 days and urged the DOL to tack on another year. The pool of advisers willing to work with smaller retirement investors is already shrinking, the chamber submits, and this situation will worsen as more advisers announce their compliance plans.

The DOL’s proposal would delay the fiduciary rule’s applicability date by 60 days, until June 9, to facilitate a review of the rule directed by a presidential memorandum. The DOL also issued a non-enforcement policy to cover the gap between the current applicability date (April 10) and such time as a delay is issued, as well as a 30-day cure period should no delay be issued. The chamber asked the department to work with Treasury on a non-enforcement policy regarding IRAs.

The complexity of the fiduciary rule and uncertainty about what compliance entails are already increasing costs and reducing access to investment advice, the chamber writes. In the 10 months since the final regulation was published, new information and real-world compliance experience have become available to the department. It should take this information into account as part of its review.

The chamber also focuses on the Best Interest Contract Exemption. This is the only way transactions involving fixed index annuities can get around a prohibition on commissions, and it is only available to banks, registered investment advisers, insurance carriers, and broker-dealers. This directly harms retirement savers, who will be unable to receive advice and some investment products from their insurance agents.

The DOL erred by assuming in its cost-benefit analysis that no saver would lose access to expert investment advice, the chamber continues. In 2011, the department estimated as part of a rulemaking that improved access to investment advice would yield benefits of between $7 billion and $18 billion annually. Conversely, the chamber argues, the department could have estimated the monetary cost to savers who may lose access to advice as a result of the fiduciary rule. The opportunity to correct this error, which may have led to a wrong rulemaking decision, is ample reason to postpone the rule’s applicability date. The chamber submits that the DOL also erred by presuming that the full benefits of the rule would begin to accrue immediately and continue to accrue uniformly.

Wednesday, March 15, 2017

PLI panelists address hot topics in corporate governance

By Jacquelyn Lumb

Panelists at the Practising Law Institute’s recent conference on corporate governance listed among the current hot topics as board compensation, climate change, the rise of proxy access, board refreshment, and risk management. Alan Beller, a co-chair of the program and former director of the SEC’s Division of Corporation Finance, asked the panelists about directors’ responsibilities in addressing these issues.

Board refreshment. Michael Garland, the assistant comptroller for corporate governance and responsible investment with the New York City Office of the Comptroller, noted that directors do not like to tell other directors when it is time to go, so they tend to rely on tenure and age limits. Assessments of directors are important and boards need to act, he advised. Achieving the “right board” is the responsibility of all directors. Garland added that he likes to see a mix of tenures on the board and is not concerned about one or two long-term directors.

Both Steven Haas of Hunton & Williams and Rachel Gonzalez of Sabre Corporation emphasized the importance of board evaluations. Haas said boards should move away from a check-the-box approach in favor of more substantial engagement with directors. Gonzalez said boards are not well-served by bright lines around tenure.

Meredith Cross, also a co-chair of the program and a former director of the Division of Corporation Finance, agreed with Garland that it is not easy to get boards to decide that someone should not be on the board anymore, so tenure restrictions are not the worst thing. Since the restrictions are automatic, they ensure board turnover will happen, she noted.

Cybersecurity. Beller said that boards need to think more broadly to achieve a company’s objective and must consider whether the board has the skill set to respond to an event at a moment’s notice. Gonzalez gave the example of cybersecurity, where the board may not have the expertise but it may have an expert on speed dial. Beller agreed that most boards do not have a director who is a cyber expert, but cybersecurity is a huge issue. Companies must prioritize what to protect because the costs of covering everything are so prohibitive.

Climate change. With respect to climate change disclosure, Beller said companies must think strategically. Do not call it a material event on your website without a word to that effect in your SEC filings, he warned. Garland said that investors need metrics in order to identify the risks and to benchmark performance over time. The Sustainability Accounting Standards Board’s standards would provide a floor, he suggested, with additional information provided in companies’ sustainability reports. Virtually every company has some climate change risk, he added.

Cross noted that when she was at the SEC, the staff issued a climate change release that resulted in a firestorm. Then-Chair Mary Schapiro explained that it merely provided guidance to help ensure that the disclosure rules were consistently applied. It did not opine on whether the climate is changing, at what pace, or due to what causes, she said. The guidance was issued just after the mid-term elections which resulted in a split government, Cross added. The staff was accused of being a bunch of tree huggers.

Government regulation of climate change disclosure is not going to happen, in Cross’s view, but she supports disclosure policies and procedures around sustainability reporting. Beller called it investors’ rock to push up the hill. Garland pointed out that a lot of institutional investors are focused on climate change, and they are permanent investors.

Tuesday, March 14, 2017

SEC launches ‘POSITIER’ investor research initiative at evidence summit

By Amanda Maine, J.D.

The SEC recently held a day-long “Evidence Summit” to mark the start of its new investor research initiative, dubbed “Policy Oriented Stakeholder and Investor Testing for Innovative and Effective Regulation,” or “POSITIER.” The purpose of the summit was to discuss strategies for raising retail investors’ understanding of key investment characteristics such as fees, risks, returns, and conflicts of interest. According to the SEC, POSITIER seeks to inform the rulemaking process with evidence obtained from surveys and specific testing projects. Those speaking at the summit included academics specializing in economics, psychology, law, and marketing, as well as government officials.

Commissioner Kara Stein called POSITIER an exciting initiative and said she looked forward to the public-private partnership under the initiative. She noted that the American investor is an individual, and a “one-size-fits-all” approach will not serve the informational needs of all investors. Stein said that with data and analysis, the SEC can design new tools and methods that make the most of the information provided to investors, be it in the form of data, visualization, or narrative. Technology can also be used to provide “just in time” information and comparison shopping across fund groups, she observed.

Keynote. The summit’s keynote address was delivered by George Loewenstein, a professor of economics and psychology at Carnegie Mellon University. According to Loewenstein, disclosures rarely help much because most are not read, and when they are read, they are not understood. In addition, disclosure usually benefits people who need the least help—the experts. In addition, Loewenstein observed, disclosure can have perverse effects by acting as a substitute for regulatory interventions that are more effective, thereby letting policymakers off the hook.

However, there are ways to improve disclosure, Loewenstein said. Disclosures should be presented in terms people can understand. Products should also be compared rather than being presented one at a time, he advised. In addition, disclosures should be designed by those who will be using the information (or their advocates) rather than those that are providing it. Doing otherwise reveals the “curse of knowledge,” he said, offering as an example health care disclosures that health care professionals may not find complicated, but the average person would.

The effectiveness of simple disclosure depends on the simplicity of the product, according to Lowenstein. Studies have shown that the most important types of regulations that influence effectiveness of disclosure are those that mandate simplification of products. However, describing complex products in simple terms risks sweeping complexities under the table, Loewenstein warned.

Loewenstein advocated the use of modern technology to improve disclosure, moving beyond pencils and paper to computers and tablets. Interactive technologies in particular can have benefits and can enhance the value of interactions with human investment advisers. He also explained that there is a virtual consensus that to be effective, assessments must be “frequent, early, and informative.”

Effective disclosure. One panel discussed how the SEC’s disclosure regime can facilitate disclosure in the most effective manner for a wide variety of users. Rick Larrick, a professor of business administration and Duke University, outlined four core principles of disclosure to provide better information for consumer. The first principle involves doing the calculations for the consumer, such as in a MPG chart or a plan to pay off credit card debt. The second principle is translating the information to personal objectives, such as translating the number of calories consumed to the amount of exercise needed to burn those calories.

The third principle is providing relative comparisons. To illustrate this principle, Larrick gave the example of comparing one’s energy use to one’s neighbors, which can create a sense of competition. The last principle—expanding scales to increase importance—would recommend, for example, disclosures of gallons per 1000 miles compared to gallons per 100 miles.

Ginger Jin of the Federal Trade Commission outlined three types of disclosure: disclosed, hidden, and non-disclosed. Disclosed information includes regulations requiring restaurants to post a letter grade for food hygiene, which research has shown to be effective in catching people’s attention. “Hidden” disclosures include things like ticket transaction fees. According to Jin, consumers are more likely to buy more tickets and pay higher prices if the transaction fees are disclosed at the back-end instead of up front.

Tom Lin, a law professor at Temple University Beasley School of Law, explained that the heart of the SEC’s disclosure regime, the reasonable investor, is a “convenient fiction.” Designing regulations for the “idealized” reasonable investor is not difficult, he said, but the idea of a reasonable investor puts day traders, hedge fund managers, and retirees all in the same category of “reasonable investor,” despite having asymmetrical information. Disclosure reform efforts should recognize diverse investors, including enhancing disclosure by using new media technology such as interactive interfaces like the SEC’s new rule requiring reports filed with the SEC to include hyperlinks to exhibits.

Disclosure of discrete items. In a panel discussion regarding how the SEC can improve the disclosure of discrete items like fees, strategies/risks, and performance, Brain Scholl, the principal economic advisor in the SEC’s Office of the Investor Advocate, echoed other participants’ views that a one-size-fits-all disclosure regime does not benefit all investors, particularly retail investors, which his office has colloquially referred to as “Aunt Millie.” Like others, he also emphasized the importance of comparison shopping. If he tells Aunt Millie that she is paying 2.5 percent on her funds without comparison, she only has that information in a vacuum, he explained.

Division of Investment Management Assistant Director Michael Spatt continued the common themes of comparison and technology in improving the SEC’s disclosure regime. To facilitate comparison, fund disclosure should make use of things like graphs and charts. They should also harness the use of technology by using structured data in filings.

Ahmed Taha, a professor at Pepperdine University School of Law, discussed mutual fund advertisements and “the cost of chasing past returns.” According to Taha, mutual fund investors tend to be financially unsophisticated and pay too little attention to fund risks and expenses and too much attention to past performance, despite little evidence of past performance being indicative of future performance.

Mutual fund advertisements are required under Rule 482 to include a disclaimer that enshrines this principle; however, Taha believes the current disclaimer is ineffective. While it could say to the investor that past performance is a poor predictor of future performance, it could also convey that returns may vary, or that past performance is a good predictor of future performance but does not guarantee it.

Taha proposed a stronger disclaimer for mutual fund advertisements, and possibly the prospectus, that reads:
Do not expect the fund’s quoted past performance to continue in the future. Studies show that mutual funds that have outperformed their peers in the past generally do not outperform them in the future. Strong past performance is often a matter of chance.
Taha also described the possible benefits of outright prohibiting performance advertisements. According to Taha, disclaimers about past performance might not even be read; a stronger effective disclaimer might end such performance advertisements anyway; they could prevent selective timing of performance advertisements; and may benefit low-cost funds.

Monday, March 13, 2017

Snap IPO has Investor Advisory Committee debating no-vote offerings

By Anne Sherry, J.D.

In the shadow of Snap Inc.’s enormous and controversial IPO, the SEC Investor Advisory Committee heard representatives from the industry and academia about the relative merits and pitfalls of unequal voting rights. Snap’s dual-class structure, which lacks a sunset provision, effectively gives the company’s twentysomething founders control of the company until both die. Some panelists cautioned about the risks and disenfranchisement that such a structure entails, while one suggested it is a correction to a “corporate governance misalignment” that panders to short-term shareholder interests.

Snaps are ephemeral; founders’ control is near-permanent. Jill Fisch (University of Pennsylvania Law School) explained that Snap’s three-tier share structure means that the founders will retain control of the company as long as they live, unless they sell 70 percent of their class C shares. The founders could sell all of their A and B shares, and a majority of their class C shares, and still retain control. Some have defended dual-class structures for giving founders a defined period of time to review their objectives and take risks, Fisch observed, but that justification is absent because unlike a number of dual-class IPOs, Snap does not have a compelling transition plan.

Disclosure and state law implications. Fisch also said that the issue does not end at voting rights. A number of SEC disclosure requirements are keyed to voting stock. Snap, which does not have to prepare a proxy statement, has indicated that it intends to provide disclosures voluntarily, but it is unclear what that means. The issue also implicates state law, Fisch noted: Delaware, for example, has given shareholders the power to cleanse transactions or affect transaction form through the vote. Will nonvoting shares obtain the right to vote in a conflict-of-interest transaction, which is likely to come up for Snap? Fisch concluded by cautioning against outright prohibition of no-vote structures because companies may simply opt to stay private.

Do investors have a choice? Several of the panelists raised the quandary that investment advisers, particularly passive managers, are facing. Rakhi Kumar (State Street Global Advisors) pointed out that passive managers have a mandate to replicate indices. If S&P, MSCI, or Russell puts non-voting or unequal shares into the index, State Street’s index funds has to buy them. Kumar said that 31 of S&P 500 companies—representing 12 percent of the index—have unequal share structures. This goes beyond tech companies; Berkshire Hathaway, Ford, and Nike are other examples. Fisch also mentioned that this issue goes beyond passive management. If enough companies in the tech sector adopt unequal share classes, active managers will not be able to opt out and still represent that they are offering tech funds.

Corporate governance misalignment. David Berger (Wilson Sonsini Goodrich & Rosati) disagreed with the notion that there is no such thing as good corporate governance in Silicon Valley. Instead, he believes it’s time to rethink what is considered good governance. Why are some of the most innovative and successful companies so heavily criticized for their corporate governance structures? Berger chalks this up to corporate governance misalignment: an overwhelming focus on the needs of stockholders and short-term results. This misalignment has caused companies to adopt other structures so their boards can explore longer-term strategies.

Listing standards should be tightened. Ken Bertsch (Council of Institutional Investors) allowed that it is important to pay attention to other stakeholders, not just shareholders. Ultimately, though, he said that this is a power question. At Snap, the two founders have all the power and are making all the decisions with no accountability. Bertsch reminded the committee corporations are led by human beings who do not always see their own mistakes and limitations. “One share, one vote” has been a bedrock principle of CII since shortly after its founding in 1985.

Snap CEO Evan Spiegel said that it will take five years to educate the markets as to the value of the company. If that is true, Bertsch asked, why did Snap not sunset the share structure in five years? He cited recent problems at Viacom, controlled by ninetysomething Sumner Redstone by virtue of dual-class shares, as an example of the long-term pitfalls of multi-class stock companies.

Bertsch called on the SEC and exchanges to revisit the rules on new offerings of multi-class structures. CII members “have watched with rising alarm for the last 30 years as global stock exchanges have engaged in a listing standards race to the bottom,” which may have been reached with the Snap no-vote offering.

Friday, March 10, 2017

FINRA’s streamlined exam proposal eases entry into securities business

By Jay Fishman, J.D.

The Financial Industry Regulatory Authority (FINRA) has filed with the SEC a proposal to streamline the competency exam requirement so that individuals may more easily enter and re-enter the securities industry. The proposal would additionally adopt as FINRA rules in the consolidated FINRA rulebook the NASD and Incorporated NYSE qualification and registration requirements. Lastly, the proposal would amend the continuing education requirements. The comment period remains open for 21 days following the proposal’s publication in the Federal Register.

Streamlining competency exams. The main thrust of the competency exam proposal would be to eliminate duplicative testing and make it easier for individuals with no prior securities experience to enter the industry. Currently, individuals must already be working for a FINRA-regulated firm to take the competency exams. As proposed, persons not working in the securities industry such as investors, college graduates or professionals seeking a second career could take a newly created Securities Industry Essentials (SIE) exam to demonstrate general securities knowledge. Thereafter, these persons wishing to enter the industry would need to be associated with, or sponsored by, a firm to take and pass a second exam evidencing their knowledge of the securities specialty they wish to engage in.

The proposal would also change the reinstatement period for individuals in good standing. Currently, if a registered individual transfers to a financial services affiliate for two or more years, the individual’s qualification expires and he or she must re-take the applicable exam(s) to be re-qualified to return. As proposed, individuals in good standing who transfer to a firm’s financial services affiliate can return within seven years without re-taking qualification exams, provided they complete securities industry continuing education and are not subject to disclosable adverse events.

Robert W. Cook, FINRA’s President and CEO, said that “this new approach would give individuals seeking to enter the securities industry the opportunity to demonstrate a fundamental knowledge of regulatory requirements prior to joining a firm, potentially providing firms a larger pool of qualified candidates. It would also provide enhanced flexibility and efficiency in our qualification programs, while maintaining important standards and investor protections.”

Thursday, March 09, 2017

NASAA urges tolling of repose period with regard to class actions

By Amy Leisinger, J.D.

The North American Securities Administrators Association, Inc. has filed an amicus brief urging the Supreme Court to overturn the Second Circuit’s decision that the tolling rule set forth in American Pipe & Construction Co. v. Utah does not apply to the three-year statute of repose contained in Securities Act Section 13 and that the filing of a class action does not protect putative class member claims from the repose period. According to the group, requiring investors to quickly decide whether to proceed with a class or pursue an independent claim to avoid the statute of repose undermines the viability of class actions and the ability of the courts and state regulators to evaluate the superiority of class actions and the reasonableness of potential settlements (California Public Employees’ Retirement System v. Anz Securities, Inc., March 6, 2017).

In its brief, the NASAA noted that American Pipe “does not involve ‘tolling’ at all,” but instead defines what it means to “bring” an action by treating absent class members as parties to the original action. Once a class action has been filed, the purposes of the limitations period have been satisfied—the defendants know the subject matter and potential size of the litigation. Further, the group argued, by holding that a class action filing does not protect putative class member claims from the three-year repose period, the Second Circuit undermined the viability of class actions in securities litigation, placed significant burdens on institutional investors and the courts, and left retail investors with reduced protections.

Requiring investors to decide early on whether to proceed with a class or opt out for an independent claim in order to avoid the running of the statute of repose would deprive investors of justice, according to the NASAA. In addition, rejection of the American Pipe rule in these circumstances will result in duplicative, unnecessary litigation and substantial burdens on the judicial system, the NASAA explained. It is generally not practical for individual investors to opt out of a potential settlement, and they need to be able to pursue their interests together with institutional investors in order to leverage those companies’ often-greater financial interests and oversight capabilities. While rejection of the rule might incentivize sophisticated investors to file duplicative litigation, small investors will be left without recourse, the NASAA stated.

The NASAA opined that class action litigation provides critical remedies and compensation for harmed investors and promotes confidence in the markets by enforcing disclosure standards. Without litigation, a great deal of securities fraud would go unpunished because the number of violations is too large to be addressed by federal and state regulators, the NASAA stated. Resource constraints “prevent them from being able to fill an American Pipe sized hole in the securities enforcement structure,” according to the group.

Finally, Rule 23’s provisions become useless if individual class members’ claims are time-barred, the NASAA continued, as an individual would be very unlikely to exercise an opt-out right if the alternative is to try to litigate an untimely claim alone. In addition, if the statute of repose has run, the class action will always be “superior” to individual actions. These kinds of changes could negatively affect the integrity of the markets and the remediation of securities fraud, the NASAA concluded.

The case is No. 16-373.

Wednesday, March 08, 2017

Banks may not omit shareholder proposals on divestiture of non-bank business segments

By Jacquelyn Lumb

Bank of America Corporation and Wells Fargo & Company may not omit shareholder proposals asking their boards to consider whether divestiture of all non-core banking business segments would enhance shareholder value and whether they should divide into a number of independent firms. Bank of America sought to omit the proposal in reliance on Rules 14a-8(c) on the basis that it constituted more than one proposal, 14a-8(i)(3) on the basis that it was vague and indefinite, and 14a-8(i)(10) on the basis that it had substantially implemented the proposal. Wells Fargo also sought to omit the proposal under Rule 14a-8(i)(3) and under Rule 14a-8(i)(7) as constituting ordinary business operations. Both proposals were submitted by Bartlett Naylor.

Study on bank divestitures. The proposals ask the boards to conduct a series of study sessions, ideally led by an independent director, and to report their findings about a potential divestiture of non-core banking business segments. The boards should consider retaining independent legal, investment banking, and third party advisers as appropriate to assist in the valuation, under the proposals. In each proposal, Bartlett Naylor defines non-core banking operations to mean those that are conducted by affiliates other than Bank of America, N.A. and Wells Fargo Bank N.A., respectively.

Bartlett Naylor cited the financial crisis of 2008 in support of its proposal, which it said highlighted the significant weaknesses in the practices of large inter-connected financial institutions. The crisis revealed that some banks were too big to fail, too big to jail, and too big to manage, according to the proponent. The proposal is not intended to be prescriptive, Bartlett Naylor added. The study is meant to determine whether a trimmer organizational structure would be more beneficial.

Arguments for omission. Bank of America argued that the submission included two different proposals—whether to divest of non-core banking business segments and whether it should divide into a number of independent firms. Each would require a separate and distinct analysis, according to the firm. The firm also argued that the proposal was vague because it would not enable shareholders to determine which operations constituted non-core banking business segments.

Bank of America also noted that it has divested non-core operations and simplified its operations since the financial crisis, and it is not too big to manage today, as asserted by the proponent. Throughout this decade, Bank of America said it has engaged annually in a review of its operations and business strategy, which includes consideration of whether to divest non-core business lines with a focus on enhancing shareholder value. For example, in 2010 the firm divested a total of more than $74 billion in non-core operations and assets.

Wells Fargo also argued that the proposal was vague and indefinite with respect to what constituted non-core banking operations and said it is subject to multiple interpretations, each of which would require different actions. In addition, the firm said the proposal relates to non-extraordinary transactions involving ordinary business operations. The non-core banking operations are relatively small business segments, the firm explained, and shareholder approval would not be required to divest them under Delaware law or under the firm’s governing documents. Given that the divestiture would constitute non-extraordinary transactions, Wells Fargo said the proposal could be omitted under the ordinary business exclusion.

Staff response. In its response to Bank of America’s no-action request, the staff did not concur with the view that the proponent had submitted more than one proposal or that the proposal was vague and indefinite. The staff added that, based on the information provided, the firm’s policies, practices, and procedures did not appear to compare favorably with the guidelines in the proposal and the proposal could not be omitted in reliance on Rule 14a-8(i)(10).

In its response to Wells Fargo, in addition to its finding that the proposal was not vague or indefinite, the staff concluded that the proposal focused on an extraordinary business transaction and could not be omitted in reliance on Rule 14a-8(i)(7).

Tuesday, March 07, 2017

Ironridge amicus brief tells judges to overrule Landry, find SEC in-house judges unconstitutional

By Mark S. Nelson, J.D.

Ironridge Global Partners, LLC wasted little time in urging the full D.C. Circuit to find the SEC’s administrative law judges are unconstitutionally appointed in the wake of last month’s blockbuster announcement that the full court will rehear (on the same day in May) two earlier panel decisions, one in Lucia upholding the SEC’s ALJs, and another faulting the director-led structure of the Consumer Financial Protection Bureau. As part of its friend of the court brief, Ironridge picked up on the court’s invitation to Raymond J. Lucia Companies, Inc. and the SEC to explain the validity of the court’s Landry decision in which a panel majority said the Federal Deposit Insurance Corporation’s ALJs were employees, not inferior officers, for purposes of the U.S. Constitution’s Appointments Clause (Raymond J. Lucia Companies, Inc. v. SEC, March 2, 2017).

The D.C. Circuit’s now vacated Lucia decision had provided the initial impetus for a developing circuit split. A divided Tenth Circuit panel concluded in Bandimere that the SEC ALJ in that case was an inferior officer and, thus, unconstitutionally appointed. The full D.C. Circuit’s Lucia decision will be closely watched both for its impact on the SEC’s in-house courts, but also for its influence on the full court’s decision in the CFPB case. Ironridge had fought its own battle against the SEC until its hopes were dashed by an Eleventh Circuit decision in another case that held the district court lacked jurisdiction to halt SEC administrative proceedings. By contrast, Lucia and Bandimere more squarely present the constitutional issue.

Overrule Landry? The D.C. Circuit’s order granting en banc rehearing in Lucia specifically asked the parties in the case to address whether Landry should be overruled. The Landry panel upheld an associational bar imposed by an FDIC ALJ against a bank executive, although one judge concurred in order to emphasize that while he found the decision resulted in no prejudice to the bank executive, he disagreed with the panel majority’s handling of the Supreme Court’s Freytag opinion.

In Freytag, the Supreme Court found that Internal Revenue Service Special Trial Judges were inferior officers under the Appointments Clause. The concurring judge in Landry read Freytag as being less demanding on the issue of finality than did the Landry majority. The Landry majority, and the unanimous panel in Lucia, found that decisional finality was the dividing line between inferior officers and employees. The Landry majority had relied on at least one of the several formulations of this dividing line; another often quoted version from the Supreme Court’s Buckley v. Valeo opinion posits that an officer of the U.S. is someone who wields “significant authority.”

Like the concurring judge in Landry, Ironridge would have the full D.C. Circuit either overrule Landry or, alternatively, cabin Landry’s reach by finding the SEC’s ALJs are constitutionally infirm despite existing circuit law. Ironridge further argued that the government’s winning view in the Supreme Court’s Edmunds opinion, which involved military officers, drew a clearer line in the sand regarding finality: in this approach, finality has less to do with the divide between inferior officers and employees than it does in distinguishing principal officers from inferior officers.

Ironridge also noted what it considers to be inconsistencies in the SEC’s position before the courts. For one, Ironridge suggested that the SEC conceded that Freytag did not turn on finality. This conclusion derived from Ironridge’s reading of an earlier SEC panel brief in Lucia. Ironridge similarly noted a discrepancy between the SEC’s website, which touts its ALJs as “independent adjudicators,” and the SEC’s arguments in Lucia asserting that its ALJs are “employees who are wholly subordinate to the Commission.”

What about Tucker? According to Ironridge, the D.C. Circuit may have presaged the eventual outcome in Lucia in a decision five years ago. The case, Tucker v. Commissioner, involved a day trader’s unpaid tax bill and the IRS’s refusal to accept the taxpayer’s offer-in-compromise made at a collection due process hearing as a substitute for the IRS’s partial installment plan.

Circuit Judge Williams, writing for a unanimous panel in Tucker, and also the author of the majority opinion in Landry, concluded that the IRS’s “Appeals employees” (comprising team managers, settlement officers, and appeals officers) were employees because they lacked sufficient discretion to be inferior officers. The Tucker panel noted the murkiness of the line between inferior officers and employees but suggested that “significance” of matters handled, “discretion,” and “finality” are the “main criteria” for making this distinction. The panel sidestepped Landry-driven issues about whether the IRS positions at issue were “established by law” under the Appointments Clause.

Ironridge characterized Tucker as a “step away” from the finality-centric Landry decision. Specifically, Ironridge focused on the implications of one paragraph in Tucker which, after beginning with a brief recitation of Freytag, said:
If the tasks assigned a position allowed the holder no choice, obviously, it would be pointless to classify him as an “Officer” even though the consequences of his ministerial decisions were both vital and final. And in this case, in fact, we conclude that the lack of discretion is determinative, offsetting the effective finality of Appeals employees’ decisions within the executive branch.
According to Ironridge, this passage “implied” that the Tucker panel applied a “sliding scale” that treated “effective finality” in a way that could allow the full court to view finality in a more flexible manner than did the Landry majority. As a result, Ironridge suggested that Tucker might offer a way to bring the SEC’s ALJs within the Appointments Clause without overruling Landry.

The case is No. 15-1345.

Monday, March 06, 2017

Industry, watchdog groups criticize CFTC position limits proposal from opposite sides

By Lene Powell, J.D.

Several financial services industry associations and public interest groups have submitted comments on CFTC position limits rules proposed in December 2016, for which the comment period recently closed.

Position limits proposals. In 2011, the CFTC issued proposed and final rules to implement provisions of the Dodd-Frank Act on position limits and the bona fide hedge definition. Most of these rules were vacated in 2012 by the D.C. district court on the basis that the CFTC did not adequately find that position limits were necessary. The CFTC proposed new rules for position limits and aggregation of positions in late 2013, followed by a supplemental proposal in June 2016. The CFTC then issued a reproposal in December 2016.

The reproposal would establish speculative position limits for 25 exempt and agricultural commodity futures and option contracts, and physical commodity swaps "economically equivalent" to such contracts, as defined. Among other provisions, the reproposal would also update definitions; revise exemptions, including for bona fide hedging; extend and update certain reporting requirements; and establish processes for exchanges to recognize positions as hedges and provide exemptions subject to CFTC review. Comments on the reproposal were due on February 28, 2017.

Financial services associations. According to the Futures Industry Association (FIA), the position limits and exemptions as proposed are too restrictive and would impede bona fide hedging by end-users like farmers, manufacturers, and construction companies. Rather than attempting to prevent any speculation, threatening the ability of commercial business to carry out critical risk management activities, the CFTC needs to define when speculation becomes “excessive” and demonstrate that this speculation has an undue effect on prices. Among other suggestions, the FIA recommended that the rule include more enumerated bona fide hedges and allow more flexibility for hedging activities generally, provide for a phase-in with spot-month limits first, and establish accountability levels in lieu of hard limits on non-spot-month contracts.

A group of associations including the Managed Funds Association (MFA), the Asset Management Group of the Securities Industry and Financial Markets Association (SIFMA AMG), and the Alternative Investment Management Association (AIMA) emphasized that before attempting to regulate in this area, the CFTC must first find that excessive speculation exists, and that position limits are necessary in each of the core referenced futures contracts. The associations also think the reproposal uses an overly simplistic one-size-fits-all approach based on a generic percentage of deliverable supply and open interest. The associations believe the CFTC should make more specific findings, delegate more authority to exchanges, and exclude economically equivalent contracts, at least at this time.

Public interest groups. Taking a mostly opposite view, Better Markets and Americans for Financial Reform believe that the reproposal falls short in reining in excessive speculation, failing to protect consumers and physical commodity producers. According to Better Markets, by setting very high, narrowly applied limits and delegating some of the CFTC’s paramount duties and authorities to for-profit exchanges, the proposed rules would fail to meaningfully prevent or reduce excessive speculation except for the most egregious cases of manipulation. The rules would also fail to capture particularly harmful types of speculation like commodity index trading, said the group.

The group recommends a number of revisions including lowering the limits, subjecting commodity index funds to limits, removing the delegation of authority to exchanges, and requiring that bona fide hedges be linked to demonstrable physical positions.

Americans for Financial Reform (AFR) backed the views of Better Markets, saying the rules will not protect the public from commodity price manipulation by speculators. By simply accepting and authorizing current market practices, said AFR, the CFTC leaves the door open to wild swings in commodity prices, unjustified by fundamentals and harmful to real economy businesses and consumers. The group pointed to an apparent conflict in having exchanges set limits and grant exemptions, saying it is in the interest of exchanges to set high limits because they have a profit motive to increase trading volume.

“We urge the Commission to turn away from its current course of the repeated delay and weakening of commodity position limits,” wrote the group. “Instead, the Commission must act on the Congressional mandate to control the greatly increased level of speculation in vital CFTC-regulated commodity markets.”

Friday, March 03, 2017

New York AG seeks to deflect House subpoena over Exxon climate enforcement matter

By Mark S. Nelson, J.D.

New York Attorney General Eric Schneiderman said his office plans to dispute the validity of a subpoena issued by the House Committee on Science, Space, and Technology seeking information about New York’s investigation into whether ExxonMobil Corp. may have broken state securities and other laws regarding disclosures the company allegedly made about climate change. This is the second time in a year that Schneiderman’s office has objected to a subpoena from the House committee, while also fending off related litigation by Exxon.

In the latest response, counsel for Schneiderman’s office told committee Chairman Lamar Smith (R-Tex) not to expect a reply to what the office said was an even broader subpoena than the one issued by the committee last summer. “I write to inform you that the NYOAG cannot and will not comply with the Subpoena as presently composed,” said counsel Leslie Dubeck. Still, the New York attorney general’s letter held open the possibility of resolving the subpoena dispute without further litigation.

According to New York, the subpoena violates the Tenth Amendment, which serves as a check on Congressional power. New York cited a Congressional Research Service report that found no precedent for a Congressional committee issuing a subpoena to a state attorney general. New York also cited concerns voiced by several federalism scholars who argued that this type of subpoena can put state sovereignty at risk, and it may disrupt an ongoing enforcement matter.

Separately, Maryland Attorney General Brian Frosh announced that 15 state attorneys general sent a letter to Chairman Smith urging him to withdraw subpoena requests made to New York and Massachusetts. According to the letter, the subpoenas are actually an effort by Exxon to obtain records it could not get by other means.

The attorneys general also cited the Supreme Court’s decision in Younger v. Harris, which established the Younger abstention doctrine barring federal courts from interfering with pending state criminal or quasi-criminal proceedings and with some state court orders, for the proposition that the House subpoena would upset long-held principles of federal-state comity.

Thursday, March 02, 2017

Squeezed-out shareholder lost standing to sue for books and records

By Anne Sherry, J.D.

In a case of first impression, the Delaware Court of Chancery held that Section 220 of the Delaware General Corporation Law only allows plaintiffs to sue for books and records if they are still shareholders at the time of suit. The plaintiff was a shareholder of Monster Worldwide when he made his Section 220 inspection demand, but got squeezed out in a merger before filing a complaint (Weingarten v. Monster Worldwide, Inc., February 27, 2017, Glasscock, S.).

A few months after Monster entered into a merger agreement with Randstad Holding nv and its subsidiary, and about two weeks before the transaction closed, the plaintiff sent an inspection demand to Monster’s board. While the parties were negotiating the scope of the inspection, the plaintiff said that he would abstain from filing a complaint but asked Monster to notify him by a certain deadline if it would not waive a standing argument should the merger close before a complaint was filed.

Monster did not respond to that email by the deadline, but the plaintiff did not file a complaint. On the Friday before the merger, Monster told the plaintiff that it would not give up any defense should a complaint be filed. The plaintiff filed a complaint to compel inspection a few weeks after closing.

The chancery court granted Monster’s motion to dismiss based on the plaintiff’s lack of standing, holding that Section 220 requires that a plaintiff own stock at the time the complaint is filed. The statute requires a plaintiff to establish that he “is a stockholder” and “has complied” with the presuit demand requirement. This language is plain and ambiguous: it requires both past-tense compliance with the demand requirement and present-tense ownership of shares.

The court also rejected the plaintiff’s argument that Monster should be estopped from challenging standing because it did not respond to the plaintiff’s waiver request in time for him to file a complaint. Equitable estoppel requires some conduct on which the misled party reasonably relied. Here, there was no “conduct” by Monster, and to the extent the plaintiff relied on Monster’s silence, that reliance was not reasonable.

The case is No. 12931-VCG.

Wednesday, March 01, 2017

Golfers’ friendship passed ‘personal benefit’ test

By Anne Sherry, J.D.

A golfer convicted of trading on a tip passed to him by a fellow country-club member lost his appeal to the First Circuit. The men’s friendship and the tipper’s testimony provided sufficient evidence of a personal benefit. Furthermore, while the trial court clearly erred in instructing the jury on state of mind, the error did not “seriously impair” the integrity of the proceedings (U.S. v. Bray, February 24, 2017, Stahl, N.).

The stock tip. Both tipper and tippee were members of the Oakley Country Club in Watertown, Massachusetts, making this the third insider trading case from that club to come before the First Circuit in the last year. The defendant, a real-estate developer, was friendly with the tipper, an executive in the due-diligence team at Eastern Bank. In 2010, the defendant asked for “bank stock tips.” The Eastern Bank executive wrote the word “Wainwright” on a napkin and passed it to the defendant.

The next day, the defendant placed an order for 25,000 shares of Wainwright Bank & Trust stock, which had an average trading volume of around 1000 to 2000 shares per day. He liquidated much of his portfolio to buy more shares over the next two weeks. Eastern Bank then publicly announced its agreement to acquire Wainwright for $19 per share, nearly double the previous day’s closing price. The defendant then offered the tipper an investment opportunity. The defendant netted about $300,000 when he sold his shares pursuant to the acquisition agreement.

Sufficiency of evidence. The defendant challenged the conviction under the government’s misappropriation theory. Under Dirks and, more recently, Salman, a tippee can be liable for trading on misappropriated information where the tipper personally benefits from sharing the information. The defendant admitted that he traded based on material, nonpublic information and that the tipper breached his duty of loyalty and confidentiality. The defendant argued, though, that there was insufficient evidence that the tipper expected a personal benefit or that the defendant had knowledge of such an expectation or breach of fiduciary duty.

The court determined that there was sufficient evidence of the men’s friendship from which to infer a personal benefit. The defendant argued that the men were only casual rather than close friends, falling short of the Dirks standard. The Second Circuit in U.S. v. Newman held that it could not infer a personal benefit in the absence of proof of a meaningfully close personal relationship. The Supreme Court abrogated part of the Newman holding in Salman, but did not discuss the “meaningfully close personal relationship” language.

The First Circuit likewise did not need to go that far, instead holding narrowly that the record evidence and testimony provided a sufficient basis for a reasonable jury to conclude that the tipper acted in expectation of a personal benefit. The tipper testified that he and the defendant had known each other for 15 years and often socialized together. The defendant also bonded with the tipper’s son. The tipper also testified that he “figured the tip would enhance” his reputation with the defendant, from which a reasonable jury could infer that he expected a benefit down the road.

Such a jury could also have inferred that the defendant knew the tipper expected to benefit personally from sharing the information and knew that the tipper had breached a duty of confidentiality. Until the Wainwright tip, the executive had only given the defendant investing advice based on publicly available information. Only after the defendant expressly requested a tip on which he could make a “big score” did the tipper provide the Wainwright tip, and the defendant did not comment or ask questions.

Jury instructions. The defendant also argued that the trial court clearly erred by instructing the jury that it could convict if he “should have known” that the tipper had an obligation to keep the Wainwright information confidential. He also claimed that the trial court wrongly equated the concept of “willful blindness” with negligence. The appeals court agreed that there was plain error on both these points. However, to establish reversible plain error, the defendant must show not only that a clear or obvious error occurred, but that the error affected his substantial rights and seriously impaired the fairness, integrity, or public reputation of the judicial proceedings.

The defendant could not satisfy the last prong of this test. Unlike a First Circuit case finding “serious impairment,” here the government’s case was sufficiently strong that it was unlikely a properly instructed jury would have acquitted. The district court also emphasized to the jury that the government had to prove the defendant acted willfully, knowingly, and with the intent to defraud—hardly rendering state of mind an inconsequential afterthought.

The case is No. 16-1579.