Wednesday, October 18, 2017

TICs are securities under North Carolina law, NASAA argues

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

NASAA has urged the North Carolina Court of Appeals to uphold a trial court’s ruling that tenancy in common (TIC) interests were securities under North Carolina law. Although disclaiming any interest in the outcome of the claims underlying the dispute, NASAA filed a joint amicus brief with the North Carolina Secretary of State, arguing that the case’s foundational jurisdiction issues directly implicate the Secretary of State’s ability to enforce the North Carolina Securities Act (NNN Durham Office Portfolio 1, LLC v. Grubb & Ellis Co., October 16, 2017).

TICs are securities. The trial court had held that the exercise of control over the enterprise by the tenants-in-common after the collapse of the defendants’ business plan did not prevent the investment from qualifying as a securities transaction. Although agreeing with this conclusion, the amici urged the North Carolina Court of Appeals to go further and reach the ultimate question left open by the trial court, namely, whether the TICs at issue fell within the definition of a security under North Carolina law.

The amici observed that the Secretary of State has adopted by rule a definition of the term "investment contract" that closely parallels the U.S. Supreme Court’s widely-followed Howey test. The TICs offered by the defendants were securities, the amici argued, because they constituted an investment in a common real estate enterprise with an expectation of profit to be derived from the defendants’ management of that enterprise. Other courts considering this question have also agreed that TICs are securities, and construing the North Carolina Securities Act in a similar fashion would promote uniformity with other jurisdictions and advance the legislature’s policy goals of protecting investors and the state’s capital markets, the amici stated.

Standing under the North Carolina Securities Act. The amici also urged the appeals court to reverse the trial court’s ruling that only those plaintiffs who actually received or accepted an offer in North Carolina could bring claims under the North Carolina Securities Act. The amici noted that North Carolina is one of 33 states that have adopted language from the Uniform Securities Act of 1956 providing for territorial jurisdiction when an offer to sell securities "originates from" the state. Although few courts have construed the "originates from" language, three precedents have been established:
  1. the Newsome test, which holds that an out-of-state offer "originates from" the state if "any portion of the selling process" occurred in-state (Newsome v. Diamond Oil Producers, Okla. Dist. 1983);
  2. the Lintz test, which holds that an out-of-state offer originates from a state if there is a "territorial nexus" between the extraterritorial offer or sale and the originating state (Lintz v. Carey Manor Ltd., W.D. Va. 1985); and
  3. the Lundberg test recently adopted by the Kansas Court of Appeals, which unifies these two approaches (State v. Lundberg, Kan. App. 2017).
The amici contend that the trial court erred by failing to consider any of these relevant precedents. The amici posited that the hybrid Lundberg test provides the appropriate test to apply when assessing territorial jurisdiction because this standard will keep North Carolina law uniform with the law of all other jurisdictions that have considered this question. If the trial court’s ruling were to stand on this point, the amici fear, the legislature’s intent of safeguarding the integrity of North Carolina’s securities markets would be subverted and the enforcement efforts of the Secretary of State and other state securities regulators could be impeded.

The case is No. COA17-607.

Tuesday, October 17, 2017

Justices asked to reject government petition in ALJ case

By Mark S. Nelson, J.D.

David Bandimere filed an opposition to the government’s bid to persuade the Supreme Court to decide the question of whether the SEC’s administrative law judges are appointed consistent with the U.S. Constitution’s Appointments Clause. A divided Tenth Circuit had granted Bandimere’s petition for review of a Commission decision upholding sanctions against him for securities law violations. According to Bandimere’s lawyers, the government’s certiorari petition should either be denied or granted, but not held pending the outcome of a similar case the justices have been asked to hear. Bandimere also said that if the Court declines to order an “outright” denial of certiorari, he would not disagree with a grant of certiorari in his case (SEC v. Bandimere, October 10, 2017).

The government had made a semi-cryptic argument in its petition for certiorari in Bandimere in favor of the justices instead taking a case from the D.C. Circuit that raises the same question, in which the government said it would soon provide a more fulsome reply (currently due October 25). But the government also hedged its position by asking the Court to hold Bandimere’s petition if it granted certiorari in the D.C. Circuit case, while alternatively urging the court to deny certiorari in Bandimere’s case if it were to decline certiorari in the D.C. Circuit case. Still, it is plausible that the justices may be waiting for a case from the Fifth Circuit regarding the Federal Deposit Insurance Corporation, or yet another case challenging the SEC’s ALJs, as the vehicle to address the Appointments Clause.

Bandimere and Lucia. Bandimere’s lawyers told the justices that Lucia may not be the better case to deal with the Appointments Clause question, as the government had previously suggested, because Lucia has limited precedential value. The Lucia petition for certiorari arrived at the Supreme Court after the three-judge panel’s opinion upholding the SEC’s ALJs had been vacated pending en banc review. An equally divided full D.C. Circuit later issued a brief order denying the petition for review in Lucia. According to Bandimere, Lucia is laden with vehicle issues that do not exist in his case.

The Lucia (rehearing denied) and Bandimere (rehearing denied) cases both arose from SEC administrative proceedings that were then appealed under the securities laws to federal courts of appeal. The D.C. circuit in Lucia upheld the SEC’s ALJs on the ground that they do not issue final opinions. That decision depended on circuit precedent (Landry v. FDIC) that had reached the same conclusion regarding the FDIC ‘s ALJs.

By contrast, the Tenth Circuit held that the SEC’s ALJs were not appointed in a manner consistent with the U.S. Constitution’s Appointments Clause and, in so holding, rejected the D.C. Circuit’s Landry opinion as unpersuasive. Although the Landry court was unanimous regarding the outcome in that case, one judge concurred to emphasize that the Supreme Court’s prior foray into the Appointments Clause arena (Freytag) could be read to find that government officials are inferior officers, rather than employees, even if they do not issue final orders. The Landry concurrence and many respondents in SEC proceedings have emphasized the “significant authority” touchstone in the Supreme Court’s precedents for deciding if a government official is an inferior officer as compared to an employee (See, e.g., Buckley v. Valeo).

Monday, October 16, 2017

CFTC chairman, EC VP agree to common approach on trading venue, margin requirement equivalence

By Brad Rosen, J.D.

In a significant development towards cross border harmonization with the European Commission, CFTC Chairman J. Christopher Giancarlo announced that the CFTC has agreed to a common approach with the European Commission regarding equivalence and comparability for derivatives trading platforms as well as a margin framework for uncleared derivatives. The chairman made the announcement at a joint press conferencein Washington, D.C. with his counterpart, EC Vice President Valdis Dombrovskis.

Under the contemplated derivatives platform equivalence arrangement, both European and U.S. firms will have assurances that they can trade on each other’s registered derivatives platforms. Additionally, the European Commission has adopted an equivalence decision for the CFTC’s margin framework for uncleared derivatives. At the same time, the CFTC has issued a decision today concluding that the EU margin rules are comparable to the CFTC rules. As a result, EU firms may rely on substituted compliance with EU margin rules to meet CFTC requirements.

In his remarks about these collaborative achievements, Chairman Giancarlo noted, "[t]oday marks a significant milestone in cross-border harmonization between the European Commission and the CFTC…These cross-border measures will provide certainty to market participants and also ensure that our global markets are not stifled by fragmentation, inefficiencies, and higher costs. Indeed these measures are critical to maintaining the integrity of our swaps markets," he added.

Common approach regarding derivatives trading venues. Under the common approach, Vice President Dombrovskis intends to propose that the EC adopt an equivalence decision covering CFTC-authorized SEFs and DCMs that are notified to it by the CFTC, provided that the requirements of the Markets in Financial Instruments Regulation (MiFIR), the Markets in Financial Instruments Directive (MiFID II), and the Market Abuse Regulation (MAR) are met.

At the same time, CFTC staff intends to propose an exemption from SEF registration requirements for trading venues that have been authorized in accordance with MiFID II/MiFIR requirements and that have been identified to the CFTC by the EC, as long as they satisfy the standard set forth in Commodity Exchange Act (CEA) Section 5h(g). Chairman Giancarlo indicated he will support this exemption.

Margin comparability and equivalence determinations. CFTC commissioners have unanimously approved a comparability determination finding the margin requirements for uncleared swaps under the laws and regulations of the EU comparable in outcome to those under the CEA and CFTC regulations. This determination is effective immediately.

Pursuant to this comparability determination, a swap dealer or major swap participant that is subject to the both CFTC and EC margin rules with respect to an uncleared swap may rely on substituted compliance wherever available under the CFTC’s margin rules. Any such swap dealer or major swap participant that complies with the EU’s margin rules would be deemed to be in compliance with the CFTC’s margin rules, but would remain subject to the CFTC’s examination and enforcement authority.

Likewise, the EC has recently announced its own equivalence decision which similarly finds that the CFTC’s uncleared swap margin rules are comparable in outcome to the EU’s corresponding margin requirements for uncleared OTC derivatives.

Commissioner comments. Commissioner Rostin Behnam observed, "[a]s important financial reforms are phased in across the globe, effective cross-border harmonization must be a top priority for all regulators." According to Behnam, "[t]oday's substituted compliance determination is a step towards harmonization." His fellow commissioner Brian Quintenz added, "this is a significant accomplishment that will help prevent fragmentation of the global derivatives market."

Chairman Giancarlo took a realistic but optimistic view in his closing comments at the press conference, observing, "I think what we've achieved today speaks very well for what we'll be able to achieve in the future. Invariably there will be additional issues come up. There are issues today, there will be issues in the future. What's important, though, is that we have a path to resolution of them. We have a methodology, we have staff-to-staff relationships all the way down the chain, and I think that bodes very well for the other issues that invariably will be ahead of us. But I think we have a path to success, and we've shown that today."

Friday, October 13, 2017

SEC committee considers promises and pitfalls of distributed ledger technologies

By Anne Sherry, J.D.

A morning session of the SEC’s Investor Advisory Committee tackled cryptocurrencies and distributed ledger technology (DLT) and the implications of these emerging technologies on the securities markets. A group of industry professionals and academics converged around the concept of these emerging technologies as tools that industry participants and regulators can use to shape or refine the way markets operate. But not all committee members were satisfied with the lack of a clear answer as to where they fit in the legal landscape.

An ex-regulator’s perspective. Jeff Bandman (Bandman Advisors) discussed the challenges regulators face and the potential that DLT offers. Bandman, a former FinTech Advisor at the CFTC, observed that regulators do not regulate technologies themselves, but rather their application. Regulators must remain neutral, not just between competing companies, but also competing technologies. He added that blockchain tends to be developed in the open, so it is more visible to regulators than some other technologies. It offers the potential to see events as they unfold—through the windshield—rather than through the rear-view mirror a day or two later.

Bandman also lamented well-intentioned rules that have unintended consequences for regulators. Procurement and ethics rules can stand in the way of progress, he said, giving the example of innovators offering nascent technology at below fair market value, which could constitute a gift that government officials are unable to accept. Officials may also be unable to become members in technology groups: if they get in free, it’s a gift; if they pay, it’s a procurement. CFTC Commissioner Quintenz has responded by promoting technology prizes and hackathons, but this is a workaround, not a solution, Bandman emphasized. Just as innovators have sandboxes in which to develop new technologies, Congress should give regulators a sandbox for applying them.

The SEC’s July report concluding that DAO tokens were securities is the agency’s digital Marbury v. Madison, Bandman concluded. Just like that seminal Supreme Court case, the report is a landmark declaration of the agency’s jurisdiction in the digital space. He praised the report for putting the market on notice that these tokens can be securities while avoiding a blanket, one-size-fits-all approach.

Four years of exploration at Nasdaq. Fredrik Voss (Nasdaq) described some of the half-dozen or so DLT implementations that Nasdaq has publicized since it started its blockchain initiative in 2013. Nasdaq focuses its work on the securities markets, the relationship between the issuer and investor, and enhancing societal awareness of what is happening in the capital markets. With one project, Nasdaq leveraged Chain’s blockchain protocol to enable peer-to-peer transfers. The firm also worked on a voting application whereby a company can digitize votes and submit tokens to investors on a blockchain network. This allows tracing, which is good not just for investors, but also intermediaries because they can indisputably prove they followed voting instructions, he said.

Cryptocurrencies distinguished. Chain’s cofounder and CEO, Adam Ludwin, offered an overview of the technology itself. Ludwin said that it is important to define the terms involved and avoid conflating distinct concepts. In particular, he emphasized that cryptocurrency like bitcoin is an asset class in service of something broader, just as securities are in service of the corporate form of organization. In a decentralized system, he explained, you need to create an incentive for entities to contribute resources to make the service possible. Bitcoin as an asset class (he believes “currency” is a misnomer) is a secondary market, he said. Its primary function is to compensate the computers and entities processing transactions on the market, also known as miners.

On virtually every dimension, Ludwin said, centralized services are superior to decentralized ones. They are faster, lower cost, more scalable, secure, and have a better user experience with less drama. The one advantage of decentralized services is their resistance to censorship. There are two groups for whom this advantage outweighs the disadvantages: people who are off the grid, such as in developing countries—and people who want to be off the grid.

Committee responses. The panel’s sometime reluctance to delve into the technology’s implications for the securities markets frustrated committee member Damon Silvers (AFL-CIO), who tried to pin panelists down as to whether the purchase of cryptocurrency is a contract and, if so, who is answerable if anything goes wrong. Silvers referred to Ludwin’s description of coin mining and said that cryptocurrency looks a lot like the definition of an investment contract—investing money with the expectation of earning profits from the efforts of third parties. Nancy Liao (Yale Law School) allowed that an investor may be able to sue the creator of the code, if that person can be found. Ludwin extended the mining hypothetical, asking, if you mine gold, “Do you have a contract with the Earth?” “I’m interested in the law,” Silvers retorted, “and you haven’t said a single thing that is legally relevant.”

The SEC’s Investor Advocate, Rick Fleming, asked specifically how the securities markets would change under distributed ledger technology. He posited that street name would go away, as would proxy overvoting and failures to deliver on short sales. Instead of a T+2 settlement, the market would be headed to T+0. He asked the panelists if they agreed with this list and whether they would add anything to it. Voss remarked that these questions are answered by the people who organize the markets; the underlying technology is just a tool. He also pointed out that T+0 is already supported today and is in use in some markets in the Middle East. Bodson concurred, adding that DTCC sometimes settles orders on a same-day basis, it just is not the market convention for the bulk of transactions.

Thursday, October 12, 2017

IOSCO provides insight into non-traditional products offered by credit rating agencies

By John Filar Atwood

The International Organization of Securities Commissions (IOSCO) has published a report on the non-traditional products offered by credit rating agencies (CRAs) that was begun after a 2015 inquiry into possible revisions to the CRA code of conduct. During that consultation, IOSCO received numerous questions about CRA products and was convinced that it should prepare a report to provide a better understanding of other CRA services.

The report covers non-traditional products such as private ratings, confidential ratings, expected ratings, indicative ratings, provisional ratings, preliminary ratings, one-time ratings, regional ratings, national ratings, and point-in-time ratings. It also covers scoring, credit default swap spreads, bond indexes, portfolio assessment tools, credit assessments, fund ratings, data feeds, and research, IOSCO said in a news release.

IOSCO noted that although other CRA products (OCPs) and services are distinct from commonly identified issuer-paid or subscriber-paid traditional credit ratings, they may be used by market participants to make investment and other credit-related decisions. They can also be used by issuers and obligors to make decisions about whether to obtain a traditional credit rating from a particular CRA.

The report describes six groups of OCPs and their current status, as well as business practices and trends within the CRA industry. IOSCO concludes that OCPs should be responsive to the spirit of the four high-level objectives set forth in the Principles Regarding the Activities of Credit Rating Agencies. The principles relate to the quality and integrity of the rating process, independence and conflicts of interest, transparency and timeliness of ratings disclosure, and confidential information.

The report observes that some OCPs share similar processes and features as traditional credit ratings. CRAs develop a number of OCP using the same credit rating analysts who determine traditional credit ratings, and CRAs may also apply methodologies and follow similar rating processes to determine OCPs.

OCPs may be subject to similar regulatory- and compliance-driven policies and procedures as traditional credit ratings, the report notes, and may be expressed by CRAs and identified by the market using similar symbols, scales, and definitions as traditional credit ratings. The OCPs may or may not be described by CRAs as a type of credit rating, and CRAs whose activities are subject to the oversight of regulatory or other government authorities may not treat them as credit ratings subject to the same regulatory oversight as traditional credit ratings.

The report also concludes that CRAs tend to create separate structures or business line organizations. Some CRAs have organized themselves according to a bifurcated legal and/or corporate structure, while others separate all the activities that are subject to regulation, including traditional credit ratings, into regulated entities or business units. The report states that the legal and/or corporate organizational structures chosen by CRAs to engage in an activity or offer a service or product are not indicative of whether they are subject to the code of conduct.

The report notes that common features can be identified among OCPs, which can be categorized into six primary groups. Like traditional credit ratings, OCPs may be used by market participants as part of the process of assessing the creditworthiness of an entity or obligation, while some OCPs may be used by market participants as part of their internal risk assessment analysis.

However, some OCPs differ from traditional credit ratings, according to the report, in that they may emphasize only one aspect of a traditional credit rating. For example, OCPs may focus only on quantitative analysis or qualitative considerations, as compared with a traditional credit rating, which is typically understood to reflect both quantitative and qualitative analysis.

Wednesday, October 11, 2017

REIT merger challenge dismissed again for lack of presuit demand

By Anne Sherry, J.D.

For the second time, the Delaware chancery court has dismissed a lawsuit alleging that a REIT overpaid for assets. The New Residential Corp. stockholder failed to establish that demand on the board was futile, either by casting doubt on the directors’ disinterestedness or independence or by challenging their exercise of business judgment in approving the merger (Chester County Employees’ Retirement Fund v. New Residential Investment Corp., October 6, 2017, Montgomery-Reeves, T.).

The New Residential Corp. stockholder alleged that the board, along with other entities, caused the REIT to overpay for the assets of Home Loan Servicing Solutions, Ltd., in order to advantage commonly owned real estate assets and maximize fees. Last October, the chancery court dismissed the original complaint with leave to amend, reasoning that the dual-natured derivative and direct action should be treated as derivative for purposes of the demand requirement. While the plaintiff did plead that at least half of the New Residential directors were beholden to the REIT’s controller, Fortress, it did not establish that Fortress had a material interest in the challenged transactions. The complaint also failed to adequately allege how the New Residential directors were incentivized to overpay for the assets.

Aronson analysis. After the court denied the plaintiff’s motion for reargument, the plaintiff filed the second amended complaint, again without first making demand on the board. The court again concluded that demand was not excused. Under Aronson v. Lewis, demand is futile if the plaintiff alleges particularized facts to raise a reasonable doubt either that the directors are disinterested and independent or that the challenged transaction was otherwise the product of a valid exercise of business judgment. Demand was not excused under the first prong because the plaintiff failed to create a reasonable doubt as to the independence of four of the seven New Residential directors.

For example, a director’s receipt of indemnification and exculpation rights did not cast doubt on his independence and disinterestedness; Delaware law holds as much because indemnification has become commonplace in corporate affairs and does not increase a director’s wealth. The plaintiff alleged that another director had “several years of social connections” with two individuals with key positions at Fortress, but failed to plead particularized facts from which the court could infer the director and Fortress officials had a close personal friendship. Finally, the court would not rule that another director’s board compensation was material simply because he was retired; this would amount to a blanket determination that all retired board members lack independence.

Demand was also not excused under Aronson’s second prong. Demand is not futile even if Fortress is a controlling stockholder of New Residential and was interested in the challenged transactions. Although entire fairness would potentially apply if that were the case, the argument that demand is thus futile is inconsistent with Delaware case law. The focus of the demand futility analysis is whether the plaintiff’s allegations raise a reasonable doubt as to the impartiality of a majority of the board. Nor could the plaintiff rest demand futility on its “Monday morning quarterbacking” of the board’s business decision. This was not one of the rare cases in which a transaction is so egregious on its face that board approval cannot meet the test of business judgment.

The case is No. 11058-VCMR.

Tuesday, October 10, 2017

Virginia proposes federal regulation crowdfunding, agent fee increases

By Jay Fishman, J.D.

The Virginia Division of Securities and Retail Franchising has proposed adding a federal regulation crowdfunding rule; a fee increase for broker-dealer agents, issuer-agents, and investment adviser representatives; an adoption of certain policy statements of the North American Securities Administrators Association (NASAA); and the repeal of a rule under federal Regulation D’s Rule 505.

Interested persons may comment or request a hearing on the proposed rules by writing to Joel H. Peck, Clerk, State Corporation Commission, c/o Document Control Center, P.O. Box 2118, Richmond, Virginia 23218. All correspondence must reference Case No. SEC-2017-00034.

Federal regulation crowdfunding. A rule exemption would apply to offerings made under federal Regulation Crowdfunding 17 C.F.R. Section 227 and Securities Act Sections 4(a)(6) and 18(b)(4)(C).

Initial filing. Issuers with either a Virginia principal place of business or issuers that sell at least 50 percent of the aggregate offering amount to Virginia residents may claim the federal regulation crowdfunding exemption by sending the Virginia Corporation Commission: (1) a complete Uniform Notice of Federal Crowdfunding Offering Form or copies of all SEC-filed documents; and (2) a Form U-2, Uniform Consent to Service of Process (if the consent is not filed on the Uniform Notice of Federal Crowdfunding Offering Form).

The initial filing would be submitted to the Commission when the issuer makes its initial Form C filing for the SEC offering if the issuer’s principal place of business is located in Virginia. If the issuer’s principal place of business is located outside Virginia but Virginia residents have purchased at least 50 percent of the aggregate offering amount, the filing must be submitted to the Commission when the issuer becomes aware that the purchases have met this threshold, but in no event later than 30 days from the offering’s completion date.

Effectiveness and annual renewal. The notice would take effect for 12 months from the date it is filed with the Commission. To renew the same offering for an additional 12 months, an issuer would file a complete Uniform Notice of Federal Crowdfunding Offering Form marked “renewal” and/or a cover letter or other document requesting renewal on or before the date the current notice expires.

Amendment. To increase the amount of securities offered in Virginia, an issuer would submit either a complete Uniform Notice of Federal Crowdfunding Offering Form marked “amendment” or another document describing the transaction.

Fee increase for agents and investment adviser representatives. The initial and renewal registration fee for broker-dealer agents (including Canadian broker-dealer agents), issuer-agents, and investment adviser representatives would increase from $30 to $40.

NASAA statements of policy. The following four NASAA statements of policy would be adopted by reference: (1) Promotional Shares; (2) Loans and Other Material Transactions; (3) Impoundment of Proceeds; and (4) Electronic Offering Documents and Electronic Signatures.

Rule 505 repealed. Virginia’s Regulation D, Rule 505 rule would be repealed in light of the SEC’s repeal of this exemption.

Monday, October 09, 2017

SEC roasts reggae coffee company schemer for $58 million

By Rodney F. Tonkovic, J.D.

An SEC enforcement action against Marley Coffee has ground to a halt with a $58 million final judgment. Wayne Weaver was pressed for participating in multimillion-dollar international pump-and-dump scheme involving the stock of Jammin' Java Corp., a company using the trademarks of reggae artist Bob Marley for licensed coffee products. Weaver, of the U.K. and Canada, is the last defendant in this action against whom a judgment has been obtained (SEC v. Jammin' Java Corp., October 3, 2017).

The scheme brews up. According to the complaint, the scheme began to percolate in 2008, when former CEO Shane Whittle orchestrated a reverse merger to form the company and through which he secretly gained control of millions of Jammin' shares that had been issued to foreign nominees. In 2010, Whittle spread a portion of his stock through a complex network of offshore entities controlled by Weaver, among others. Weaver and the other offshore defendants then orchestrated a sham financing arrangement designed to create the false appearance of legitimate third-party interest and investment in Jammin'. The public announcement of this arrangement in December 2010 caused Jammin's share price to soar.

In early 2011, entities under the defendants' control or coordination took advantage of the elevated prices and sold over 45 million shares in unregistered transactions, generating at least $78 million in profits. Weaver also took part in funneling a portion of the profits back to Jammin' under the guise of the sham financing arrangement. In May 2011, however, the share price collapsed after Jammin' disclosed that it had learned of various unauthorized internet stock promotions. The price dropped even more after Jammin' released disappointing results in a Form 10-K.

Roasted. The final judgment permanently enjoins Weaver from violations of the registration, antifraud, and beneficial ownership disclosure provisions of the securities laws. Weaver is permanently barred from participating in penny stock offerings and was ordered to disgorgement of $26,371,585, prejudgment interest of $5,221,809, and a civil penalty of $26,371,585. He has filed a notice of appeal.

The last drop. The Commission has previously obtained consent judgments against all of the other defendants named in the action. These judgments have ordered the payment of over $8 million in disgorgement, interest, and penalties.

The case is No. 15-cv-08921.

Friday, October 06, 2017

International FCPA coordination is spiking, but so are potential pitfalls, PLI panelists report

By Lene Powell, J.D.

International coordination in anti-corruption cases just keeps getting better and better, and settlements are getting bigger and bigger, said panelists in a PLI program on FCPA enforcement. But cutting against that trend, strong privacy and labor protections can impede investigations, particularly in Europe, where enhanced privacy restrictions will take effect in May 2018. These cross-currents create complexity for multinational companies trying to comply with conflicting demands.

The panel, “FCPA Investigations and Enforcement: Developments and Updates,” was part of PLI’s White Collar Crime 2017 program and was moderated by F. Joseph Warin, chair of the litigation department of Gibson Dunn’s Washington, D.C. office.

Authorities are working together. Increasing international coordination between enforcement authorities has been a big-picture trend over the past few years, said Charles Cain, acting chief of the SEC FCPA unit. Calling it “the wave of the future,” he expects to see this trend to continue and to result in more coordinated resolutions. The SEC participates in many international efforts, including the Working Group on Bribery, which is part of the Organisation for Economic Co-operation and Development (OECD). Belonging to this group, which includes representatives from the Department of Justice, Department of Commerce, and State Department, allows members to strengthen peer-to-peer relationships and facilitate cross-border coordination, Cain said.

One recent big multinational success is In the Matter of Telia Company AB, a $965 million settlement announced in late September that was one of the largest criminal corporate bribery and corruption resolutions in U.S. history. The case involved a Swedish company’s payment of bribes government to officials in Uzbekistan, as well as money laundering. Cain observed that the structure of the settlement was a little unusual because the SEC, DOJ, and Dutch authorities reached a resolution that allowed for the possibility of a Swedish resolution, and the next day, Swedish authorities filed charges against three individuals. In all, over a dozen different jurisdictions assisted in the investigation. Cain pointed out that even though the company delisted, this does not extinguish jurisdiction.

Process can vary. How multinational investigations and prosecutions begin is very case-specific, said Alixandra Smith, of the U.S. Attorney’s Office for the Eastern District of New York. Sometimes the foreign country has already begun an investigation, and the question is how far along the investigation is and what resources can each country bring. Sometimes the U.S. starts first, and in the course of assisting, the other jurisdiction will decide to bring its own investigation, or the U.S. can actively encourage this.

As the case proceeds, the U.S. can obtain records and service of process via Mutual Legal Assistance Treaties (MLATs), which the U.S. has with most countries, said Smith. For example, to serve a subpoena for records in the U.K., a package is put together and submitted to the DOJ’s Office of International Affairs, which sends the request to and receives the records back from the U.K. authorities. The process is certified, so the records can be used in court in the U.S. Smith explained that although this is the formal process, obtaining records through informal law enforcement contacts can sometimes move more quickly.

According to Matthew Cohen, director of global anti-corruption at Hewlett Packard Enterprise, over the last five years the number of outgoing requests through the OIA has increased 75 percent over the last five years, and incoming requests have increased 150 percent.

Thursday, October 05, 2017

Commissioner Quintenz supports tech innovation, but critical of prior administration’s regulatory initiatives

By Brad Rosen, J.D.

CFTC Commissioner Brian Quintenz, in delivering his first major address since being sworn in to the commission in August of this year, announced his strong support to advance and promote innovation in financial marketplaces, but also offered harsh criticism for certain regulatory initiatives set in motion under the prior administration.

Reg AT. In remarks before the Symphony Innovate 2017 conference held in New York City, Quintenz railed against Reg AT (Regulation Automated Trading) noting, “[t]he agency’s process on this rule development was so confused, the regulation is titled Regulation Automated Trading but the entities it would require to register were classified as Algorithmic Trading Persons.” He further described Reg AT as a “lame-duck re-proposal” that reflects “poorly-crafted and flawed public policy.” Additionally, Quintenz described the controversial “source code repository” component of Reg AT as “massively over-reaching and highly concerning” and declared that “proposal is D-E-A-D.”

Role with Technology Advisory Committee. Quintenz will likely play a key role in connection with the commission’s embrace of technological innovation. He has been named as sponsor to the commission’s Technology Advisory Committee which is composed of outside professionals and structured to provide the CFTC with formal guidance on existing or emerging technological advances and associated potential regulatory issues.

Quintenz sees the financial markets and services sectors as now being primed to benefit from advancements made possible by the internet, as well as the exponential growth of computing power. He noted that new types of companies are now expanding into financial services, motivated by confidence in proprietary technological advancements. In order to realize the potential benefits offered by new technologies, Quintenz views two key elements that need to be in place. First, the commission requires leadership which prioritizes a consistent and engaging dialogue with the FinTech community, and secondly, it must fully utilize existing avenues and create new structures to empower those conversations.

LabCFTC. Quintenz noted that the CFTC’s LabCFTC initiative, which was launched in May of this year, as a pathway through which the CFTC can develop and foster dialogue with the FinTech community. LabCFTC is designed to make the CFTC more accessible to FinTech innovators, and serves as a platform to inform the Commission's understanding of emerging technologies and how they square with current rules. Additionally, LabCFTC is an information source for the Commission and the CFTC staff on market-enhancing innovation that may influence policy development. LabCFTC will enable the CFTC to be proactive as FinTech applications continue to develop, and to help identify related regulatory opportunities, challenges, and risks.

Bitcoin. Quintenz noted that prior to his arrival to the CFTC, through successive enforcement cases, determined that Bitcoin is a commodity and that trading in the cryptocurrencies represents trading in a commodity interest. As a result, the commission will be presented with many challenging issues surrounding features unique to cryptocurrencies will need to provide “regulatory consistency with other commodities….as well as regulatory certainty within which a more constructive trading environment may develop.”

Cybersecurity. Quintenz sees Cyberspace as the 21st century battlefield for those wanting to harm our country and threaten our way of life. He believes that recent public and private sector attacks have shown we also need to focus on mitigation and recovery. Moreover, he noted, “[w]e owe it to our registrants, who send us highly sensitive and proprietary information, to make a realistic assessment of our vulnerabilities and ensure that all data submitted is rationalized and completely necessary.”

In his concluding remarks, Quintenz noted that “innovation won’t wait for us,” adding, “[t]he world is changing, and we as regulators must now change. A 21st century economy demands 21st century regulation.” Time will tell what precise form 21st century regulation will take.

Wednesday, October 04, 2017

Rulemaking petition on human capital management disclosure gains support

By Jacquelyn Lumb

A rulemaking petition submitted to the SEC by the Human Capital Management Coalition, which seeks better disclosure about human capital management policies, practices, and performance, has received about a dozen letters of support, including one last month by the AFL-CIO. The AFL-CIO noted that it has submitted comments in the past about the importance of clear, consistent, and comprehensive disclosures to investors and the markets. Human capital management is a key driver of corporate performance and an essential indicator of value creation strategy and long-term viability, according to the AFL-CIO, and it urged the SEC to begin the rulemaking process immediately.

Public Citizen. Public Citizen noted that the petition builds on a robust body of research that shows the importance of human capital management in determining the value of a firm. Firms with superior human capital management enhance company performance and share value, according to Public Citizen. The group cited a number of studies that found a correlation with superior investment outcomes, but noted that the SEC’s Regulation S-K only requires disclosure of the number of persons employed. The disclosure is “woefully inadequate,” in Public Citizen’s view, especially given that firms often state that their employees are their most valuable asset.

Public Citizen expressed support for the nine subjects that the Coalition enumerated in its petition that should be disclosed, which include workforce demographics; stability; composition; skills; culture; health and safety; productivity; and compensation and incentives. Public Citizen said the disclosure also should include information about violations, fines, and work stoppages, and added that it supports a petition signed by 1.2 million investors calling for political spending disclosure. The SEC’s leadership seems to lean more toward reducing disclosure than providing the information that investors want, the organization said.

Jon Lukomnik. Jon Lukomnik, the executive director of Investor Responsibility Research Center, wrote in his personal capacity of his fear that financial reporting is facing what he called a slow-moving, but existential crisis. Today’s markets increasingly depend on information that is not required by GAAP, he explained, and the non-GAAP information should be improved in terms of quality and consistency. He encouraged the SEC to begin considering how its disclosure regime can evolve to provide the information that investors need while balancing the cost to issuers, and suggested that the chairman make this issue a hallmark of his tenure since it would improve both investor protection and capital formation.

ValueEdge Advisors. ValueEdge Advisors, a consulting firm that specializes in corporate governance matters, noted that GAAP was developed in an era when companies’ primary worth was based on real property, equipment, and their inventories of tangible products. Today, many companies’ primary assets and liabilities are human capital—the abilities, knowledge, and relationships of their employees. ValueEdge strongly endorsed the Coalition’s rulemaking petition and said the disclosure it seeks is achievable at a low cost while providing tremendous value to investors, analysts, and issuers. The firm urged the SEC to schedule hearings in pursuit of what it sees as an essential area for agency action.

Walden Asset Management. Walden Asset Management wrote that it tries to strengthen environmental, social, and governance policies of its portfolio companies through shareholder engagement and public policy advocacy. Walden agrees with the Coalition that the current disclosure requirements related to human capital management are unsatisfactory. More robust disclosures would support investors’ long-term objectives, stabilize markets, and encourage employers to invest in their employees, Walden advised.

British Columbia’s Municipal Pension Board of Trustees. British Columbia’s Municipal Pension Board of Trustees also wrote in support of further discussion about the importance of human capital metrics and disclosures. As long-term investors, the board said it understands the importance of measuring and reporting non-financial information, and said human capital management metrics are “a critical and missing piece of the puzzle for investors.” The board called for further research, discussion, and consideration of the importance of human capital management metrics.

Tuesday, October 03, 2017

High Court drops two SLUSA cases, but will hear another this term

By Rodney F. Tonkovic, J.D.

The Supreme Court has issued its first order list for the October Term 2017. In this list, the Court has denied certiorari for two securities-related cases asking the court to consider the application of the Securities Litigation Uniform Standards Act to state law contract and breach of fiduciary duty claims. Looking ahead to the first full term with Justice Gorsuch, the court will hear three securities cases involving Regulation S-K disclosures, Dodd-Frank's whistleblower provisions, and the SLUSA.

Cert denied. On September 25, 2017, the court held its first conference after its summer recess. In a voluminous order list, the court denied certiorari in two securities-related cases from the Seventh Circuit: Holtz v. JPMorgan Chase Bank, N.A. and Goldberg v. Bank of America N.A.

In Holtz (16-1536), the petitioner asked the court to address when a party is properly held to be "alleging" a "misrepresentation or omission of a material fact" within the meaning of 15 U.S.C. § 78bb(f)(1)(A). In this case, investors claimed that they were led to believe that a bank was acting in their best interests, but it failed to disclose a bias toward recommending its own funds. Seeking to avoid invoking federal law, the investors framed their claims under state contract and fiduciary principles. The district court threw the case out under the SLUSA, concluding that the class action claims rested on the "omission of a material fact." A Seventh Circuit panel agreed.

The petition argued that the issue of whether a party has alleged a misrepresentation or omission under the SLUSA has led to at least a three-way circuit split. The majority approach, as applied in the Second, Third, and Ninth Circuits, asks whether plaintiffs can prevail without proving that the defendants engaged in deceptive misrepresentations or omissions. In contrast, the petition asserts, the Seventh Circuit stands alone in holding that a suit is barred whenever an omission is even implicitly alleged and when it is likely that a fraud issue will arise in the course of the litigation. This position effectively eliminates most contract and fiduciary duty claims, "regardless of what the complaint actually alleges."

In Goldberg (16-1541), decided on the same day as Holtz, a divided Seventh Circuit panel sided with the lower court and Bank of America in holding that certain banking fees charged, but not disclosed, amounted to an omission of material fact. As a consequence, Goldberg's state law claims for breach of contract and fiduciary duty were preempted by the SLUSA and must be brought in federal court. Here, the Seventh Circuit affirmed the district court's dismissal, concluding that the complaint depended on the omission of a material fact in connection with a covered security.

The petition asked the court to address whether the SLUSA requires dismissing with prejudice a class action complaint for breach of contract and breach of fiduciary duty under state law when the plaintiff's claims are not predicated on a misrepresentation or omission of material fact. According to the petition, the Seventh Circuit's interpretation of the SLUSA places serious restrictions on the enforcement of state laws governing contractual and fiduciary relationships, effectively nullifying Illinois contract law in situations in which a federal fraud claim "could be imagined." As in Holtz, the decision conflicts with holdings of the Second, Third, and Ninth Circuits focusing on whether a plaintiff's claim is predicated on a misrepresentation or omission.

Monday, October 02, 2017

Government says Justice Gorsuch is one reason to prefer D.C. Circuit case to mull SEC’s law judges

By Mark S. Nelson, J.D.

The government filed its long-awaited petition for certiorari in a case originating in the Tenth Circuit that challenges the constitutionality of the SEC’s administrative law judges. A divided Tenth Circuit had granted SEC respondent David Bandimere’s petition for review and held that the mode of appointing the ALJ in Bandimere’s in-house proceeding violated the U.S. Constitution’s Appointments Clause. The government’s petition urged the Supreme Court to eventually consider the question presented by Bandimere’s case but instead to select a case from the D.C. Circuit that presents fewer vehicle issues (Bandimere v. SEC, September 29, 2017)

Among the reasons the government cited for waiting was the presence of Justice Gorsuch as a circuit judge on the Tenth Circuit at the time of the government’s request that that court review Bandimere’s case en banc. The Tenth Circuit denied the government’s request for the full court to rehear the case, although several judges dissented from the denial of a rehearing.

Both the Tenth Circuit (rehearing denied) case and the D.C. Circuit case (Lucia v. SEC; petition for review denied by equally divided court) turned on interpretations of the Supreme Court’s Freytag opinion, which held that Tax Court special trial judges are inferior officers. Previously, the D.C. Circuit in Landry upheld the FDIC’s ALJs because it found their decisions were not final. One judge concurred in Landry to emphasize his view that Freytag did not turn on finality and that ALJs exercising less than final powers could fall within the meaning of inferior officer because of the significance of those duties. The Tenth Circuit majority substantially adopted the concurring view in Landry.

The government’s Bandimere petition summed up its view: “We therefore respectfully request that the Court hold this petition pending its consideration of the petition in Lucia. If the Court grants the petition in Lucia, the government suggests that the Court hold the petition in this case pending the final disposition of Lucia. If the Court denies the petition in Lucia, it should deny the petition in this case as well.”

The government also promised a more fulsome explanation of why the court should decide the ALJ question when it replies to the Lucia petition in late October. The question of whether ALJs are inferior officers was a remnant of the Supreme Court’s Free Enterprise opinion regarding the PCAOB, in which the court said in a footnote that it was not yet ready to consider the issue while noting that the D.C. Circuit’s Landry opinion was disputed.

The case is No. 17-475.

Friday, September 29, 2017

ALJ says Enforcement Division case against Tilton unproven

By Mark S. Nelson, J.D.

An SEC administrative law judge has dismissed the Enforcement Division’s in-house case against Lynn Tilton. The agency had alleged that Tilton and her firm Patriarch Partners, LLC ran afoul of the Investment Advisers Act’s antifraud provisions as a result of disclosure issues and accounting irregularities regarding collateralized loan obligations (CLOs). But the ALJ concluded after a lengthy hearing that the Division’s allegations were unproven (In the Matter of Lynn Tilton, Release No. ID-1182, September 27, 2017).

Tilton and Patriarch had set up a series of entities that were either investment advisers or relying investment advisers to act as collateral managers for three funds designated Zohar I, II, and III. The funds consisted of CLOs and issued notes to investors whose funds were then used to buy or to make loans to a portfolio of distressed companies. Investors included large institutions known as qualified institutional buyers or qualified purchasers, entities the ALJ would refer to as "...not, in the words of Commission Chairman Jay Clayton, ‘Mr. and Ms. 401(k)’" (referring to a speech Clayton gave outlining his principles of securities regulation).

Unique approach and star witness. During the 14-day hearing nearly a year ago, the ALJ heard testimony from nine experts: three for the Division and six for Tilton and Patriarch. The Division’s experts collectively opined that Tilton and Patriarch received $208 million in improper fees for a variety of reasons, including providing financials that were hard for investors grasp, employing a method of categorizing loans contrary to fund governing documents, and by deviating from GAAP accounting principles.

Three of Tilton’s and Patriarch’s experts focused on one Division expert’s opinion that Tilton did not "amend" loans when she accepted interest amounts below what was due under contract. Tilton’s and Patriarch’s experts said Tilton and her firm possessed wide discretion to modify loans to avoid defaults. One of these experts included a legal analyst for the Zohar II and III funds, who was accepted by the ALJ as an expert on interpretation of the Zohar indentures.

But Tilton and Patriarch also brought out the star power. R. Glenn Hubbard, Dean of Columbia University’s Graduate School of Business and former chairman of the President’s Council of Economic Advisers during the second Bush Administration, and who is often mentioned as a candidate for Fed chairman if Janet Yellen is not re-nominated, offered a set of four conclusions about the Zohar funds.

Hubbard agreed with another Tilton/Patriarch expert that the Zohar funds were atypical CLOs (the other expert had said the Zohar funds should be viewed through the lens of funds with Zohar-like characteristics, not a "typical CLO manager"). Hubbard also noted Tilton’s unique approach to investing in distressed properties and disputed a Division expert’s conclusions that some metrics were hard to replicate from fund valuation reports. Hubbard also disputed the completeness of calculations performed by a Division expert because they did not consider future periods.

Based on the testimony, the ALJ first concluded that items allegedly not disclosed to investors were disclosed and that Tilton and Patriarch had amended loan agreements. As a result, there was no material misrepresentation or omission of a material fact. The ALJ also found the Division’s GAAP allegations similarly unproven. For one, the facts did not support charges regarding impairment. Moreover, GAAP violations by themselves cannot establish securities fraud (the ALJ noted that even if Tilton and Patriarch violated GAAP, there was no material misrepresentation).

With respect to accounting standards for fair value, the ALJ observed that the types of assets Tilton and Patriarch dealt with were Level 3 assets because of the lack of observable inputs. Still, the ALJ concluded that the fund’s financial statements disclosed the variable nature of the fair value techniques employed by the funds.

Appointments clause. For a time, Tilton became one of the more prominent targets of SEC probes to challenge the constitutionality of in-house proceedings before the SEC’s ALJs. These cases were brought in multiple district courts around the U.S. and achieved some initial traction in a few court rooms only to falter in a series of appellate decisions denying access to the federal district courts to respondents seeking to halt the SEC’s proceedings. Tilton pursued her case until the Supreme Court declined to hear it.

But the Appointments Clause issue that Tilton and others had raised may yet find its way to the Supreme Court in one or more cases that followed the statutory scheme of the federal securities laws and, thus, present fewer vehicle issues than did the earlier district court cases. Currently, there is a split of authority between the D.C. Circuit (upholding the SEC’s ALJs and later producing a per curiamorder denying the respondent’s petition for review by an equally divided en banc court) and the Tenth Circuit (rehearing denied), which found the agency’s ALJs were appointed in violation of the Appointments Clause.

The respondent in the D.C. Circuit case petitioned the Supreme Court to decide whether prior circuit law correctly interpreted the Court’s Freytag decision, which had prompted a concurrence the circuit’s seminal Landry opinion upholding the FDIC’s ALJs against constitutional challenge. That petition is still pending. The Tenth Circuit case also could reach the Supreme Court if the government opts to appeal. As of publication, the government had received two extensions of time to file a certiorari petition, the most recent until September 29.

Alleged Division misconduct. The ALJ’s initial decision also rejected assorted claims by Tilton that the Division had engaged in prosecutorial misconduct. Tilton’s claims focused on the Division’s use of experts during the pre-OIP period before the agency brought formal charges against her, alleged failures to disclose information to Tilton, a concurrent engagement with Tilton’s only accounting firm in another matter, and alleged collusion between the Division and one of the fund’s investors in a related matter brought by the investor against Tilton.

The release is No. ID-1182.

Thursday, September 28, 2017

CFTC’s chief enforcer underscores benefits of self-reporting and cooperation in NYU address

By Brad Rosen, J.D.

CFTC Enforcement Director James McDonald reiterated and clarified the benefits that can accrue to commission registrants who elect to self-report violations and offer substantial cooperation in connection with regulatory investigations in an address he made before NYU’s Institute for Corporate Governance and Finance.

In his remarks, McDonald noted, "we at the CFTC are committed to working together with the companies and individuals we regulate to identify and prosecute wrongdoing that has occurred, and to stop future wrongdoing before it starts. In particular, we’re committed to giving companies and individuals the right incentives to voluntarily comply with the law in the first place—and to look for misconduct and report it to us when they see it." He continued, "[w]e know the vast majority of businesses and market participants want to obey the law. We know they work hard to do the right thing—not because they’re afraid of getting caught. But because they want to run their businesses the right way. These businesses know that misconduct within a company diminishes confidence in management. It undermines the company’s culture.

According to Gary DeWaal, special counsel in Katten Muchin Rosenman’s financial services group and long-time industry observer, the framework articulated by McDonald is a welcome development. "For many years, it has been the perception across the industry that there has been no reward for coming clean and bringing a problem to the attention of the agency. McDonald has made it clear there will be benefits for doing so," he noted.

However, DeWaal cautioned that industry participants must be mindful that self-reporting and cooperation may result in benefits with the CFTC, but exposures and liabilities relative to exchanges, foreign regulators, and the U.S. attorney may remain. Notwithstanding, DeWaal observed, "the CFTC has limited resources combined with an expanded mandate. This is a practical response to economic realities, and it is the right thing to do." To be sure, the CFTC has been encouraging registrants to embrace notions of cooperation and self-reporting for some time, even prior to McDonald’s appointment in March of this year. In January, the agency issued two advisories on cooperation that noted factors considered in providing cooperation credit to companies and individuals. In June, trader David Liew was able to completely avoid a civil monetary penalty for spoofing and manipulation in the gold and silver futures markets by providing "substantial assistance" to the enforcement division. Later that month, the CFTC entered into its first-ever Non-Prosecution Agreements (NPAs) with three former Citigroup traders who provided "timely and substantial cooperation" relating to their spoofing misconduct.

In August, McDonald noted that a $600,000 penalty imposed against The Bank of Tokyo-Mitsubishi for spoofing was a "substantially reduced penalty" in exchange for self-reporting and other cooperation. Later that month, McDonald was a guest on CFTC Talks, the recently introduced podcast hosted by Chief Market Intelligence Officer Andy Busch, where he touted the substantial benefits of self-reporting.

In his remarks, McDonald articulated specific details regarding the cooperation and self-reporting framework envisioned by the division and the benefits that could be expected including:
  • Disclosure must be truly voluntary. Cooperation must occur before an imminent threat of disclosure or of a government investigation and it must be made independent of any other legal obligation. A disclosure must also be made in a clear and prominent manner.
  • Disclosure must be made within a reasonable period of time. A company must make its disclosure in a reasonably prompt time after becoming aware of a problem and all relevant facts known at the time must be disclosed.
  • Cooperation must be complete and continue during the course of the investigation. The company must disclose all facts relevant to the misconduct as the company becomes aware of them during its own investigation—including facts related to the involvement of any individuals.
  • Cooperation must be proactive, not reactive. It’s not enough just to be responsive to Division staff during the course of an investigation. Full cooperation requires an active effort to find all related wrongdoing and not taking a squinty-eyed view of the facts to minimize the misconduct or avoid disclosures.
  • Remediation is required to ensure the misconduct doesn’t happen again. This means the company must work to fix the flaws in its compliance and internal controls programs that allowed the misconduct in the first place. The Division indicated it will work in tandem with companies to achieve remediation solutions.
  • Division of Enforcement commitments. The Division indicated it will clearly communicate with the registrant—at the outset—its expectations regarding self-reporting, cooperation, and remediation. The division noted that its self-reporting program is not going to be a game of gotcha—where only once you’re at the settlement table do you learn there’s been one slip up in the process that takes you out of the self-reporting lane.
  • Expected benefits to registrants. A registrant can expect concrete benefits in return for its self-reporting, cooperation, and remediation. If a company does those three things, the Division of Enforcement will recommend a substantial reduction in the penalty that otherwise would be applicable. In truly extraordinary circumstances, the Division may even recommend declining to prosecute a case.
In his conclusion, Director McDonald asserted that the self-reporting and cooperation program outlined should shift the incentive structure in favor of self-reporting and cooperation. If so, he believes great strides will have been made toward stopping misconduct in the markets.

Wednesday, September 27, 2017

Petition asks: Does American Pipe tolling also apply to class actions?

By Rodney F. Tonkovic, J.D.

A petition for certiorari askes the Supreme Court to address whether American Pipe tolls not just individual actions, but also class actions. The Ninth Circuit construed American Pipe to toll the limitations period for class action plaintiffs who were unnamed class members in previously uncertified classes. Unlike the Ninth Circuit, at least six others have held that American Pipe applies only to individual actions. A new class action brought by previously absent class members would have been dismissed as untimely in these circuits, the petition asserts (China Agritech, Inc. v. Resh, September 21, 2017).

Tolling permitted? This petition involves the third identical securities fraud class action brought by shareholders of the petitioner, China Agritech, Inc. Class certification for both previous actions was denied, and the respondents did not seek to participate as named plaintiffs or appear in those actions. The underlying action was filed in June 2014, seventeen months after the applicable two-year statute of limitations had lapsed. The district court dismissed the new complaint as time-barred. The judge, who also presided over the two earlier class actions, held that American Pipe tolling permitted the filing of new individual claims, but not an entirely new class action based on a substantially identical class.

On appeal, the Ninth Circuit reversed and held that the statute of limitations was tolled during the pendency of two prior class actions. Permitting unnamed class members in previously uncertified classes to avail themselves of American Pipe tolling "would advance the policy objectives that led the Supreme Court to permit tolling in the first place," the panel concluded. Further, the pendency of the prior actions would alert defendants to the substantive claims, so there would be no unfair surprise, and the rule promotes economy of litigation. The court acknowledged the possibility of abuse, but said that plaintiffs and attorneys would not risk bringing successive nonviable suits and that the ordinary principles of preclusion and comity would further reduce incentives to re-litigate frivolous or already dismissed class claims. The appellate court subsequently denied both rehearing and rehearing en banc.

The petition. The petition asks whether the American Pipe rule tolls statutes of limitations to permit a previously absent class member to bring a subsequent class action outside the applicable limitations period. The petition asserts that up to now, appellate courts have uniformly rejected attempts to extend American Pipe to permit absent class members to bring claims on behalf of a class. According to the petitioner, the First, Second, Third, Fifth, Eight, and Eleventh Circuits have held that American Pipe tolling does not apply to serial class actions, particularly when an attempt to certify a materially identical class has already been rejected. The Sixth, Seventh, and now the Ninth Circuits, however, have adopted rules that would extend the statute of limitations for class actions indefinitely, the petition says.

The petition explains that the First, Second, Fifth, and Eleventh Circuits flatly reject extending American Pipe tolling to otherwise untimely class actions. In these circuits, tolling only applies to the individual claims of absent class members. In some circumstances, the Third and Eight Circuits allow tolling for successive class actions, but not when class certification has previously been denied on the basis of the lead plaintiffs' deficiencies as class representatives.

The Sixth, Seventh, and Ninth Circuits, on the other hand, permit "endless relitigation" of class certification determinations, the petition claims. According to the petition, while the Sixth and Seventh Circuits generally extended American Pipe tolling to class actions, neither applied the rule in a case where certification of an identical class had already been denied. In this case, the Ninth Circuit has applied American Pipe where certification was denied, leaving "no limit to a plaintiff's ability to stack class actions" and inviting "endless, vexatious litigation" of the sort Congress intended to prevent in enacting statutes of limitations.

The petition concludes by arguing that the Ninth Circuit's decision is an ideal vehicle for resolving this recurring question of national importance. The Court's review is needed to eradicate opportunities for forum shopping and to establish uniformity. Moreover, the Ninth Circuit's decision is at odds with Supreme Court precedent holding that American Pipe applies to individual claims. Finally, there are adverse policy consequences to the Ninth Circuit's holding such as an essentially indefinite extension of the statute of limitations that would also make it much more difficult to timely settle disputes.

The petition is No. 17-432.

Tuesday, September 26, 2017

Deputy chief accountant urges registrants to ramp up efforts to implement new standards

By Jacquelyn Lumb

SEC Deputy Chief Accountant Sagar Teotia shared some of the staff’s observations regarding the implementation of the new GAAP standards at an event in San Diego. He said a significant amount of work remains, but also cited a great deal of progress and credited the collaborative efforts of preparers, auditors, audit committees, standard setters, and regulators.

Revenue recognition. Teotia urged registrants that are in the process of implementing the revenue recognition standard to “finish strong.” For companies in the early stages of implementation, he encouraged them to ramp up their efforts in order to be successful. Teotia added that it may be easier and more efficient if all of the new standards are implemented concurrently, or partially concurrently, where system enhancements will be needed.

The new standards are likely to impact registrants’ internal control over financial reporting which will take time to implement, according to Teotia, so it is important to resolve implementation and application issues as they arise.

SAB 74 disclosure. As the effective dates near for the new standards, Teotia said the staff expects the disclosures under Staff Accounting Bulletin 74 regarding their likely impact to become more informative. The disclosure should discuss the status of registrants’ implementation efforts. For companies that have not made sufficient progress, Teotia said the disclosure will give audit committees, auditors, and investors the opportunity to hold management accountable.

The staff will accept reasonable judgments in the application of the new standards, Teotia advised, but well-reasoned judgments require time to gather facts, consider accounting alternatives, and come to a sound conclusion. This is why having enough time to implement the standards is so crucial, he explained. With the application of the new standard on revenue recognition just a few months away, Teotia said the time to ask question is now in order to avoid a massive backlog at the end of the year.

Leases. The new standard on leases is effective beginning in 2019, but can be adopted earlier. As with revenue recognition, Teotia encouraged companies to assess the status of their implementation plans and their ability to achieve the standard’s financial reporting objectives. The steps that are required to adopt the lease standard may be time-consuming, he warned, so getting started early is a best practice.

Unlike the new revenue recognition and credit impairment standards, Teotia noted that FASB did not appoint a transition resource group to help in the implementation of the new lease standard. He said it is important to raise accounting questions as soon as possible and urged a dialogue with the staff as questions arise. The questions that the Office of the Chief Accountant has received so far mostly relate to scoping and transition matters, he advised.

Credit losses. The staff has spent significant time evaluating the requirements of the new standard on credit losses. Teotia reported that the staff is actively monitoring the implementation efforts that are underway. Based on its monitoring activities, Teotia said the staff has seen the importance of coordination among all stakeholders, including preparers and auditors in implementing the standard. The transition resource group is assisting stakeholders as they work through the implementation issues that have arisen. Just as with revenue recognition and leases, Teotia said the staff will accept well-reasoned judgments in the application of the new credit loss standard.

Monday, September 25, 2017

EC issues plan to revise EU financial industry supervision, give more power to ESMA

By John Filar Atwood

In an effort to further the transition to a capital markets union with integrated financial supervision, the European Commission has issued plans to reform the European Union’s financial industry supervisory structure. Among other things, the proposals would give the European Securities Markets Authority (ESMA) direct supervisory authority over several aspects of the capital markets such as benchmarks, market entry and market abuse cases.

The EU overhauled its financial system after the global financial crisis by introducing a single rulebook for financial regulation in Europe and creating the European Supervisory Authorities (ESAs) and the European Systemic Risk Board (ESRB). The new proposals would further the reform effort by enhancing regulatory and supervisory convergence within the single market.

To ensure the uniform application of EU rules and promote a capital markets union, the EC proposed to give ESMA direct supervisory power in specific financial sectors that are highly integrated, have important cross-border activities and which are regulated by directly-applicable EU law. The EC is not proposing to change the responsibilities of national authorities to supervise other areas such as central depositories, money market funds, trading venues, UCITS or alternative investment funds.

ESMA’s role. Under the reform plan, ESMA will authorize and supervise the EU’s critical benchmarks and endorse non-EU benchmarks for use in the EU. In addition, ESMA will be in charge of approving certain EU prospectuses and all non-EU prospectuses drawn up under EU rules.

The EC proposed to have ESMA authorize and supervise certain investment funds with an EU label with the aim of creating a genuine single market for the funds. They include European Venture Capital Funds, European Social Entrepreneurship Funds and European Long-Term Investment Funds.

Finally, ESMA will be given a greater role in coordinating market abuse investigations. It will have the right to act where certain orders, transactions or behaviors give rise to suspicion and have cross-border implications or effects for the integrity of financial markets or financial stability in the EU.

Stronger coordination. A primary objective of the reform proposals is to strengthen coordination of supervision across the EU. The ESAs will set EU-wide supervisory priorities, check the consistency of the work programs of individual supervisory authorities with EU priorities and review their implementation. They also will monitor regulators’ practices in allowing market participants such as banks, fund managers and investment firms to delegate and outsource business functions to non-EU countries, to ensure that rules are followed and risks are properly managed. The functioning of the ESRB will be made more efficient in order to strengthen its oversight of risks for the financial system as a whole.

The plan provides that ESAs will make decisions more independently from national interests. Under the new governance system, newly-created executive boards with permanent members will lead to quicker EU-oriented decisions. In addition, interested parties will be able to ask the EC to intervene if the majority consider that the ESAs have exceeded their competences when issuing guidelines or recommendations.

The EC also proposed to make the funding of the ESAs independent from national regulators to improve the autonomy and independence of the ESAs. The EU would continue to contribute a share of the ESAs’ funding, but the rest would be funded by contributions from the financial sector.

Fintech and sustainability. The reform proposals also include steps to foster the development of financial technologies (fintech), and to ensure that sustainability considerations are taken into account in supervisory practices at the European level. The EC’s vice president for financial stability, financial services and capital markets union said in a news release that the reform package will make it easier for EU companies to operate across borders, and to take advantage of new opportunities in fintech and sustainable and green finance.

Friday, September 22, 2017

CFTC pursues its first action against alleged Bitcoin Ponzi operator

By Brad Rosen, J.D.

The CFTC has filed a civil enforcement action in the U.S. District Court in the Southern District of New York against defendants Nicholas Gelfman of Brooklyn, New York, and his company, Gelfman Blueprint, Inc. (GBI), a New York corporation. The complaint charges them with fraud, misappropriation, and issuing false account statements in connection with soliciting investments in the cryptocurrency Bitcoin (CFTC v. Gelfman, September 21, 2017).

The CFTC alleges that from approximately January 2014 through approximately January 2016, Gelfman and GBI, a company where Gelfman served as chief executive officer and head trader, operated a Bitcoin Ponzi scheme in which they fraudulently solicited more than $600,000 from approximately 80 persons. Virtually all of the fraudulently solicited funds were misappropriated by the defendants.

The Commission claims that the defendants induced customers to invest in a pooled commodity fund that purported to employ a high-frequency, algorithmic trading strategy, executed by a computer trading program called “Jigsaw.” The CFTC charges, in reality, the strategy was fake, the purported performance reports provided to investors were false, and, as is the case in all Ponzi schemes, payouts of supposed profits to GBI customers in actuality consisted of other customers’ misappropriated funds.

Misrepresentations. The CFTC’s complaint specifically alleges that the defendants made the following misrepresentations in their solicitation materials, asset and performance reports, and other collateral:
  1. that GBI Customers averaged a 7-9 percent monthly increase in their Bitcoin balances net of all fees through Defendants’ risk-protected strategy, when in fact they did not; 
  2. provided individualized performance and balance reports showing that GBI Customers owned specific amounts of Bitcoin, when in fact those customers did not; and
  3. that GBI’s assets and performance were audited by a certified public accountant (“CPA”), when in fact they were not.
The CFTC also asserts that Gelfman staged a fake computer “hack” designed to further conceal trading losses and misappropriation.

Director’s comments. The CFTC’s Director of Enforcement, James McDonald, commented, “[a]s alleged, the Defendants here preyed on customers interested in virtual currency, promising them the opportunity to invest in Bitcoin when in reality they only bought into the Defendants’ Ponzi scheme. We will continue to work hard to identify and remove bad actors from these markets.” He also noted, “the CFTC has demonstrated its continued commitment to facilitating market-enhancing FinTech innovation. Part of that commitment includes acting aggressively and assertively to root out fraud and bad actors in these areas.”

Relief sought. In its continuing litigation, the CFTC seeks, among other relief, restitution to defrauded pool participants, disgorgement of benefits from violations of the Commodity Exchange Act and CFTC Regulations, civil monetary penalties, trading bans, and a permanent injunction against future violations of federal commodities laws, as charged. While separate criminal charges have not been instituted against the defendants, in its release the CFTC expressed its appreciation for the cooperation and assistance it received from the New York County District Attorney’s Office in this matter.

The case is No. 17-7181.

Thursday, September 21, 2017

New C&DIs target Regulation D and Rule 147

By Mark S. Nelson, J.D.

The SEC’s Division of Corporation Finance issued a set of new and revised Compliance & Disclosure Interpretations covering various aspects of Regulation D and Securities Act Rule 147. Regulation D had been significantly updated by provisions in the Jumpstart Our Business Startups (JOBS) Act and by the Commission’s implementing rules release. The Commission more recently adopted changes to Rule 147. The new C&DIs include eight substantive revisions or additions plus 22 revisions the Division characterized as non-substantive.

Rule 506. Securities Act Rules Question 257.08 has been updated to reflect the policy choice made by Congress in JOBS Act Section 201 with respect to Rule 506 of Regulation D. The prior version of this C&DI, issued in 2009, provided that an offering would not lose its “covered security” status if a notice of an exempt offering was not filed with the SEC. The staff then opined that such a filing was not a condition of satisfying the Securities Act Section 4(a)(2) exemption with respect to Rule 506. Similarly, the revised C&DI states that the filing of Form D is not a condition that must be met under Rule 506.

When Congress enacted the JOBS Act, Section 201 required the Commission to adopt rules to allow general advertising and general solicitation in a new type of offering, which the Commission provided for in Rule 506(c). Section 201 also included language characterizing Rule 506:
Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)).
The JOBS Act separately amended Section 4(2) to add the “(a)” in “4(a)(2),” the current locus of the exemption.

Rule 504. The Division clarified that Rule 504 of Regulation D may not be available to private funds in some circumstances. Revised Securities Act Rules Question 258.03 observed that Rule 504 offerings can be either public or non-public. Public offerings by a private fund would bring the fund within the ambit of the Investment Company Act and, thus, the fund would be unable to invoke Rule 504. Prior Question 258.03 had concluded that Rule 504 was unavailable to investment companies.

The staff also noted the differences between offerings under Rule 504 and Rule 506(c), the latter having been deemed not to be “public offerings” by JOBS Act Section 201(b)(2). Specifically, the JOBS Act provision said Rule 506 offerings would not be public offerings “as a result of general advertising or general solicitation.”

A second change involved the staff withdrawing Question 258.04, which previously dealt with the calculation of the aggregate offering price. But the staff added Question 258.05 regarding whether an instruction in Rule 504 concerning the calculation of the aggregate sales price also would imply that offerings must be integrated. The staff said “No.”

Lastly, the Division’s new Question 258.06 reiterated that Rule 504 would be unavailable to an issuer subject to a bad actor disqualification on or after January 20, 2017. After this date, an issuer must consider its bad actor status any time it relies on Rule 504.

Rule 147. Securities Act Rules Question 541.02 has been withdrawn. That C&DI had concluded that a family trust located in the state where a Rule 147 offering was to occur could not be offered securities or purchase securities where the trust had a non-resident beneficiary that held a 50 percent interest in the trust. However, the staff added Question 541.03, reflecting the Commission’s latest rulemaking in this area, which posits a somewhat similar scenario and concludes that a family trust could be offered securities or purchase securities under Rule 147. Specifically, a Rule 147 offering could take place where a family trust (not a separate legal entity) has two trustees of whom one is a non-resident of the state where the offering takes place.

Rule 505 C&DIs withdrawn. The Division also withdrew C&DIs regarding Rule 505 of Regulation D, which had been contained in Securities Act Rules Questions 259.01 to 259.05. The withdrawal was prompted by changes the Commission made to Rule 504 to raise the aggregate amount of securities that can be offered and sold from $1 million to $5 million, thus eliminating the need for Rule 505, which the Commission has repealed. The Division also withdrew the related Question 659.01 regarding censure of an issuer that was a broker-dealer.