Friday, January 30, 2015

MSRB Again Calls for Better Debt Disclosure by Bond Issuers

[This story previously appeared in Securities Regulation Daily.]

By John Filar Atwood

The Municipal Securities Rulemaking Board (MSRB) has issued another call to municipal bond issuers to make more information about their bank loans and other undisclosed debt available to the public. The MSRB first urged state and local governments back in 2012 to provide more information about their bank loans through the Electronic Municipal Market Access (EMMA) system, but fewer than 100 bank loan documents have been submitted since the initial request.

Unaware of impact. The MSRB said that it is concerned that investors are often unaware of the potential impact of bank loans and other debt-like obligations on the seniority status of existing bondholders and the credit or liquidity profile of an issuer. In a press release, MSRB executive director Lynette Kelly said that the MSRB is worried that as issuers increasingly turn to bank loans to finance infrastructure projects, current disclosure requirements may not provide a full picture of an issuer’s indebtedness.

The MSRB’s advisory emphasizes the importance of bank loan disclosure for the transparency and efficiency of the municipal securities market. It also provides best practices to support voluntary disclosure of bank loan information through EMMA. In the advisory, the MSRB provides examples of steps issuers and their financial professionals can take to ensure investors have a full understanding of the terms of a bank loan and its implications for existing debt.

Partner with SEC. The advisory comes on the heels of the MSRB’s request earlier this month that the SEC consider requiring bank loan disclosure as part of an extensive review of the federal municipal market disclosure regime established by 1934 Act Rule 15c2-12. As discussed in a January 21 Securities Regulation Daily story, the MSRB expressed its willingness to partner with the SEC to conduct a re-examination of Rule 15c2-12, and to consider possible changes to reflect current market practices.

Thursday, January 29, 2015

Savings Statute Cannot Rescue Claim of Improper Demand Refusal

[This story previously appeared in Securities Regulation Daily.]

By Amy Leisinger, J.D.

The Delaware District Court has dismissed an action against certain investment advisers, funds, and a number of directors alleging, among other things, breaches of fiduciary duty, negligence, and waste. According to the court, the Delaware savings statute’s exceptions to the applicable statute of limitations for procedural matters could not save an untimely claim challenging demand refusal. In any case, the court continued, the plaintiffs failed to show that the demand investigation was unreasonable or that the board’s refusal of the demand was made in bad faith (Hartsel v. The Vanguard Group, Inc., January 26, 2015, Robinson, S.).

Background. Two investors filed claims against the funds in which they invested, as well their investment advisers (including The Vanguard Group, Inc.) and the directors of those entities, alleging that the defendants purchased shares of illegal internet gambling businesses for the funds in violation of their fiduciary duties. In 2009, the court dismissed the plaintiffs’ initial action alleging RICO and other derivative and class claims, finding that the complaint failed to establish causation and refusing to exercise supplemental jurisdiction over the other claims. The Second Circuit affirmed, and the U.S. Supreme Court denied certiorari.

In 2010, the plaintiffs brought a second action in the Delaware Court of Chancery alleging claims based on the same conduct, as well as demand futility. The court found the claims without merit and additionally determined that the plaintiffs failed to articulate sufficient evidence of a lack independence or a substantial likelihood of liability so as to excuse demand.

On July 25, 2012, the plaintiffs made a demand on the board, which appointed a committee in October to review the demand. On June 24, 2013, plaintiffs filed another action, given the impending end of the limitations period, alleging that the board and the committee purposefully postponed a decision to cause the claims to become time-barred. The committee and the board thereafter determined to reject the demand.

Savings statute. In opposing dismissal of the action as time-barred, the plaintiffs argued that their claims are protected by Delaware’s savings statute, which “provides exceptions to the applicable statute of limitations in certain instances where the plaintiff has filed a timely lawsuit, but is procedurally barred from obtaining a resolution on the merits.” According to the plaintiffs, the dismissal of the previous case for failure to make a demand involved dismissal on a “matter of form” protected by the statute.

The court rejected this argument, noting that, in the earlier action, the Court of Chancery found that the plaintiffs failed to plead demand excusal, which involved a substantive determination instead of the procedural issues addressed in the savings statute’s exceptions. “Having chosen to argue demand futility on the facts, plaintiffs cannot now characterize the analysis of such a decision as a ‘matter of form’ in order to proceed,” and the savings statute cannot protect the action from being dismissed as time-barred, the court concluded.

Demand refusal. The court also noted that, even if the action could be deemed timely, the plaintiffs have offered no facts to support a finding that the board failed to carry out its fiduciary duties or to conduct a reasonable investigation so as to demonstrate improper demand refusal. Noting that the business judgment rule protects managerial and board decisions in the absence of evidence of violations of duty, the court declined “to find that the mere passage of time, without more, is sufficient indicia of bad faith.”

The case is No. 13-1128-SLR.

Wednesday, January 28, 2015

Government Asks Full Court to Rehear Newman Insider Trading Appeal

[This story previously appeared in Securities Regulation Daily.]

By Anne Sherry, J.D.

Criticizing last month’s opinion by a Second Circuit panel overturning two insider trading convictions based on a lack of personal benefit to the tippers, the government is asking for rehearing and rehearing en banc. The government’s petition argues that the opinion is counter to Supreme Court precedent and absolves “deliberate, corrupt, and formerly criminal insider trading” (U.S. v. Newman, January 23, 2015).

The Second Circuit last month vacated the convictions of two hedge fund portfolio managers in the absence of evidence that they knew they were trading on insider information or that the insiders received a personal benefit in exchange for the tips. But the government was denied an opportunity to retry its case under the “newly announced knowledge requirement,” the petition argues. The government maintains that the panel’s personal benefit definition conflicts with prior decisions, including by the Supreme Court, and that its evidence was sufficient to establish a personal benefit and knowledge or conscious avoidance of that benefit.

Narrow benefit requirement. The Second Circuit, following the Supreme Court’s opinion in Dirks v. SEC, previously defined personal benefit broadly to include “not only pecuniary gain, but also the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend.” The panel qualified this line of reasoning, stating that prior precedent did “not suggest that the Government may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature.” Instead, the panel held, the benefit received in exchange for confidential information must be of some consequence. Furthermore, the government also needed to prove that the defendants knew that such a personal benefit had been conferred on an insider.

According to the petition, the panel replaced part of the Dirks benefit test with a new test, none of whose components, such as a “meaningfully close” personal relationship, have a familiar meaning in this or any analogous area of law. “To the extent the Panel sought to set clear guidelines for Wall Street professionals and prosecutors, the test it adopted will do just the opposite,” the government maintains.

Threat to securities markets. That the case was wrongly decided, in the government’s position, is especially problematic considering it is one of the most significant developments in insider trading law in a generation. The Second Circuit’s “preeminence in the field of securities regulation, and its jurisdiction over the financial capital of the world, serve to underline the opinion’s importance nationally and, consequently, magnify the harm that will result from its errors.” These harms include, the petition maintains, a perception by individuals that “cozy relationships” allow insiders and elite traders to exploit nonpublic information for personal gain. This outcome contravenes the basic objective of the securities laws to ensure honest markets and promote investor confidence, the government concludes.

The case is No. 13-1837.

Tuesday, January 27, 2015

With Judicial Challenge Looming, FSOC Will Be Under Scrutiny from House Panel

Against the backdrop of a judicial challenge to the Financial Stability Oversight Council’s (FSOC) designation of Met Life, Inc. as a systemically important financial institution (SIFI) under the Dodd-Frank Act, the House Financial Services Committee said that it would conduct significant oversight of the FSOC this year to assess its effectiveness in carrying out its statutory responsibility to make financial markets more stable and resilient and to ensure that it conducts its deliberations with an appropriate level of transparency.

Similarly, the Committee’s oversight plan indicated that the Committee will conduct oversight of the Office of Financial Research, which supports FSOC, to ensure that the OFR is transparent and accountable, that it makes progress towards fulfilling its statutory duties, that its requests for data are not unduly burdensome or costly, and that the confidentiality of the data that it collects is strictly maintained.

FSOC determined that the occurrence of material financial distress at MetLife could pose a threat to U.S. financial stability, hastening to add that this does not constitute a determination that the company is currently experiencing, or is likely to experience, material financial distress. MetLife has challenged the SIFI designation in federal court.

House Panel Signals Strong Oversight of Dodd-Frank Derivatives Regulations

The House Agriculture Committee will conduct intense oversight of the regulatory implementation of the Dodd-Frank Act derivatives provisions. An oversight plan approved by the Committee, which is chaired by Rep. K. Michael Conaway (R-TX), said that the Ag Committee will continue to ensure that the CFTC and SEC rulemaking process is transparent and that meaningful comment is accepted and appropriately reviewed; and that the CFTC performs an adequate cost-benefit analysis for each proposed or finalized rule. Importantly, the Committee will insist that the CFTC and SEC properly coordinate with both domestic and international financial regulators so as to avoid regulatory arbitrage in the area of derivatives regulation. In that spirit, the Committee will examine the level of coordination between U.S. and international regulators for potential effects on U.S. financial institutions compared to their foreign counterparts.

More broadly, the Committee will look at how Dodd-Frank Title VII rulemakings have affected U.S. market structure. It will examine the developing effect of CFTC, SEC, and Prudential Regulator regulations, such as the imposition of new margin and capital requirements, and how they affect the ability of many end-users to utilize swaps to hedge against legitimate business risks.

Monday, January 26, 2015

NAM Backs Wal-Mart's ‘Ordinary Business’ Argument

[This story previously appeared in Securities Regulation Daily.]

By Rodney F. Tonkovic, J.D.

The National Association of Manufacturers (NAM) has filed an amicus brief in support of Wal-Mart Stores, Inc.'s appeal regarding a shareholder proposal on gun sales. Wal-Mart has appealed a district court decision holding that a shareholder proposal concerning the sale of certain guns should have been included in Wal-Mart's proxy materials for its 2014 annual shareholders meeting and should not be excluded in 2015. NAM posits that a proposal attempting to influence the types of products a retailer may sell clearly relates to an "ordinary business" matter (Trinity Wall Street v. Wal-Mart Stores, Inc., January 21, 2015).

Background. Trinity Wall Street submitted a shareholder proposal requesting that Wal-Mart's board amend its charters to provide for policies to determine whether Wal-Mart should sell products that: (1) are especially dangerous to the public; (2) pose a substantial risk to the company’s reputation; and (3) would be considered offensive to the values integral to Wal-Mart’s brand. The proposal encompasses the sale of firearms equipped with magazines holding more than ten rounds of ammunition. The proposal, with the SEC's no-action blessing, was excluded from Wal-Mart's 2014 proxy materials.

In November 2014, the District Court for the District of Delaware found that the proposal dealt with matters that were not related to Wal-Mart's ordinary business operations and also rejected Wal-Mart's argument that the proposal was "vague and indefinite" under Rule 14a-8(i)(3). The court concluded that the proposal was improperly excluded from the 2014 proxy materials and that an identical proposal should not be excluded in 2015. Wal-Mart appealed to the Third Circuit, arguing that the district court ignored or misconstrued longstanding SEC guidance on the ordinary business exclusion. Wal-Mart seeks a declaration that the proposal was excludable in 2014 and that an injunction requiring the inclusion of the proposal in 2015 be vacated.

NAM's brief. In its brief, NAM argues that the Trinity proposal clearly relates to an "ordinary business" matter. Citing Trinity's claims that the products at issue could have the potential to impair Wal-Mart's reputation or be offensive to community values, NAM contends that this subject matter is "inherently subjective and open-ended." Where retailers sell a wide variety of products to an array of consumers, many products could offend someone, somewhere. The shareholder proposal rules are not meant to be a referendum on how a retailer selects its inventory, NAM says, and "[i]f the mix of products a retailer chooses to stock and sell is not subject to the ordinary business exception, that exception is rendered a nullity."

NAM maintains that the district court's holding improperly narrows the ordinary business exception. The brief expresses NAM's concern that the shareholder proposal process is "increasingly dominated by activists advancing social or policy concerns that are divorced from increasing shareholder value." NAM was thus troubled by the district court's determination that that the proposal implicates significant policy issues, noting that any lawful product could potentially draw some social objection from someone. If the Third Circuit rules that Trinity's proposal is not excludable, NAM asserts, shareholders will be emboldened to submit an "endless supply" of previously-excludable proposals concerning retailers' inventories.

Next, NAM maintains that the district court also erred in concluding that because the proposal was directed to Wal-Mart's board, it did not relate to an ordinary business matter. This analysis, NAM says places form over substance, an approach that the Commission has rejected. Finally, NAM states that reversing the district court's decision will not silence Trinity, which has a right under Delaware law to present proposals from the floor at the annual meeting, as well as the financial wherewithal to fund its own proxy solicitation if it chooses to do so.

The case is No. 14-4764.

Friday, January 23, 2015

FSOC Considers Greater Transparency in Nonbank Designation Process

[This story previously appeared in Securities Regulation Daily.]

By Jacquelyn Lumb

SEC Chair Mary Jo White signaled her support for enhancing the transparency of the Financial Stability Oversight Council’s process for considering nonbank financial companies for potential designation as systemically important. At today’s FSOC meeting, the staff reported that, based on wide ranging discussions with numerous parties, including three companies under consideration for designation, three main themes were apparent. Companies want to know sooner if they are being considered for designation as systemically important. They want more information about FSOC’s designation process, and they would like more details about the annual reviews and to be given the opportunity to meet and discuss developments during the reviews.

The staff recommended that if a company publicly announces that it is under consideration by FSOC for a systemically important designation, FSOC should confirm it. Once designated, companies should have an opportunity for more interaction with FSOC during the annual reviews. If a company is considered for designation but then not advanced, the staff recommended that it be notified in writing. If the designation process advances to the final stage, FSOC should grant any request for an oral argument. FSOC should let companies know as quickly as possible where they stand.

During the annual reviews of designated companies, FSOC should let the companies discuss the scope of the review and any relevant changes. A company should be able to contest its designation every five years before the full Council. FSOC would then vote and notify the company of its decision.

Treasury Secretary Jacob Lew noted that FSOC is a young organization. He said it is important that FSOC be nimble and adjust its processes as the organization grows and matures. He strongly supports the staff recommendations and said he would move expeditiously to bring them to a final decision.

Thursday, January 22, 2015

Chairman Massad Praises Progress by U.S., Japan on Cross-Border Issues

[This story previously appeared in Securities Regulation Daily.]

By Lene Powell, J.D.

In an address to the Futures Industry Association in Tokyo, CFTC Chairman Timothy Massad talked about the interconnectedness of the global derivatives markets and the need for regulatory coordination on G-20 commitments. He announced the approval of the application of the Tokyo Commodities Exchange (TOCOM) for registration as a foreign board of trade (FBOT). The chairman also reviewed progress on derivatives oversight in Japan, Asia, and Europe.

TOCOM registration. The CFTC generally doesn’t regulate futures trading by U.S. persons on offshore exchanges, Massad explained. In the past, the CFTC has given relief from registration requirements for foreign futures exchanges to provide direct electronic access to people in the U.S. Now, the process has been formalized and foreign exchanges can register with the CFTC as FBOTs.

TOCOM said its regulatory regime under the Japanese Ministry of Economy, Trade, and Industry and Ministry of Agriculture, Forestry, and Fisheries satisfies CFTC requirements for registration. Under the order, TOCOM can give members or other participants in the U.S. direct access to its electronic order entry and trade matching system to trade futures contracts on metals, fuels, rubber, and agricultural commodities, and futures and option contracts on gold. The approval shows that the CFTC is committed to a coordinated regulatory approach that relies on foreign supervisory authorities and ongoing cooperation, said Massad.

In a statement, Commissioner Mark Wetjen applauded TOCOM’s registration, saying a cross-border approach to trading platform oversight incentivizes higher standards globally because foreign entities that want access to U.S. market participants must be subject to comparable supervision in their own jurisdictions. Wetjen said these same incentives apply to swap execution facilities (SEFs), and the CFTC should formalize a regulatory regime for foreign SEFs.

G-20 commitments for derivatives oversight. Observing that Japan has had rice futures for over 300 years, Massad said Japan has made good progress on the G-20 commitments for derivatives oversight, which were adopted in 2009 following the global financial crisis. One G-20 goal is increased clearing of swaps transactions. Globally, the percentage of swaps transactions that are centrally cleared is now about half, and has increased in the U.S. from 15 percent before the crisis to 75 percent today. Japan has had a clearing mandate in place for certain interest rate and credit default swaps since 2013.

As more clearing is required, clearinghouse supervision is a top priority, said Massad. A small number of clearinghouses have become single points of risk internationally, and regulators must work closely together on clearinghouse standards and strength, including margining standards, stress testing, recovery and resolution, and cybersecurity. Japan Securities Clearing Corporation has handled clearing for U.S. participants on a limited basis under temporary arrangement with the CFTC, and has now applied for registration.

Regarding oversight of swap dealers, Massad noted that the CFTC has recognized Japan’s regulations under substituted compliance determinations. A big task is to set margin requirements for uncleared swaps because not all swaps will be required to be cleared and margin requirements will help to mitigate the risk of uncleared positions. The U.S., Japan, and Europe have all proposed rules on margin for uncleared swaps. The rules are substantially similar, but have some differences that Massad hopes can be minimized.

Cybersecurity. The CFTC is “very focused” on cyber security because it is possibly the most significant new risk to financial stability, Massad said. Because of the interconnectedness of financial institutions and markets, a breach at one institution can have significant repercussions for the system as a whole. The CFTC is focusing on this issue in examinations, said Massad, and boards of directors and top management should be making it a priority.

Tuesday, January 20, 2015

Massachusetts Adopts Emergency Crowdfunding Exemption

[This story previously appeared in Securities Regulation Daily.]

By Jay Fishman, J.D.

The Massachusetts Securities Division adopted an emergency intrastate crowdfunding exemption, permitting job growth by helping Massachusetts small and early-stage businesses find investors and gain greater access to capital with fewer restrictions.

Benefits. The exemption, available to Massachusetts-based corporations, LLPs and LLCs, allows the issuers to: (1) offer both equity and debt securities on the Internet; and (2) raise up to $1 million in a 12-month period, and up to $2 million if they have audited financial statements. The exemption allows investors to purchase an amount of securities either greater than $2,000 or 5 percent of their annual income or net worth if both the income and net worth are less than $100,000. Investors may, alternatively, buy an amount of securities up to 10 percent of their income or net worth if the income or net worth is $100,000 or more, subject to an investment limit of $100,000.

Qualifications and disqualifications. Issuers, to be eligible for the exemption, must be Massachusetts-formed entities authorized to do business in the state with their principal place of business in the state. Issuers must ensure that their transactions comply with Securities Act Section 3(a)(11) and SEC Rule 147.

Issuers whose officers, directors or majority shareholders are subject to specified “bad boy” provisions, such as securities fraud or misrepresentation, are disqualified from the exemption. The exemption is also prohibited for blind pool and blank check offerings, investment companies, hedge funds, commodity pools, and oil, gas or mining exploration industries.

Restrictions. The following restrictions apply:
  • Securities may be offered and sold only to Massachusetts residents.
  • Commissions (or other remuneration) may not be paid to any person for soliciting prospective purchasers, unless the person is a Massachusetts-registered broker-dealer or agent.
Requirements. The following requirements apply:

  • Issuers must file a prescribed notice with the Secretary no later than 15 days after the first Massachusetts sale of a security under the exemption.
  • Issuers must disclose all material facts pertaining to the company and offering, along with the fact that the offering is not registered under federal or state law.
  • Issuers must set a minimum amount to be raised under the exemption.
  • Issuers must place all funds received from investors in an escrow account at a Massachusetts-authorized insured bank or depository institution. Investor funds must remain at this institution until the minimum offering amount is reached.

Sunday, January 18, 2015

Dodd-Frank Corrections Bill Heads to Uncertain Future in the Senate

Having passed the House , the Promoting Job Creation and Reducing Small Business Burdens Act, H.R. 37, a bipartisan piece of legislation containing a number of Dodd-Frank corrections and job creation measures, heads to the Senate where it faces an uncertain future. The vote in the House was 271 to 154, with 29 Democrats voting for the measure. However, there was strong opposition to the bill, especially a provision giving Volcker Rule relief to certain debt securities of collateralized loan obligations (CLOs). Joseph Lynyak II, a partner at the international law firm Dorsey and Whitney ( in its Finance & Restructuring Group, described H.R. 37 as a quintessential technical corrections bill.

Title VIII of the Act, which is the Restoring Proven Financing for American Employers Act, which provides Volcker Rule relief for certain debt securities of collateralized loan obligations (CLOs), has become something of a lightning rod for opposition to the entire bill. It was prominently mentioned in the President’s veto message on H.R. 37 and in remarks on the House floor by Rep. Maxine Waters (D-CA), the Ranking Member of the House Financial Services Committee. This opposition comes against the backdrop of the strong bi-partisan support that this provision received as a stand alone bill in the 113th Congress. That bill, H.R. 4167, was favorably reported out of the Financial Services Committee by a vote of 53 to 3.and later passed the full House on a voice vote.

Mr. Lynyak described opposition to the Volcker Rule provisions as more political than policy-based. He agrees with the House floor statement of Rep. Andy Barr (R-KY), the author of the provision, that the CLO provision represents a small and commonsense solution, not a rollback of Dodd-Frank by any means. It keeps the Volcker rule completely intact and simply provides phased-in compliance to banks of all sizes that made sound investment decisions, allowing for a finite universe of well-performing legacy CLOs to be sold or paid off.

Senator Richard Shelby (R-Ala), incoming Chair of the Banking Committee, has not issued a statement on H,R. 37, but he is known to favor Dodd-Frank technical corrections. In the 113th Congress, Senator Shelby introduced two legislative proposals aimed at clarifying and streamlining the implementation of the Dodd-Frank Act. But Senator Elizabeth Warren (D-MA), a key member of the Banking Committee, is likely to rally opposition to Dodd-Frank changes, particularly any changes in the Volcker Rule.

Friday, January 16, 2015

NASAA Proposes Model M&A Broker Exemption

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

NASAA’s Broker-Dealer Section has requested public comment on a proposed uniform model rule that would exempt certain merger and acquisition brokers from state registration requirements. The proposal follows federal legislation that was introduced in the 113th Congress that would exempt merger and acquisition brokers from some of the registration requirements in the federal securities laws.

Merger and acquisition broker. The proposed model rule defines the term “merger and acquisition broker” to include any broker or associated person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership of an “eligible privately held company,“ provided that certain conditions are met. The broker must reasonably believe that: (1) any person acquiring securities or assets of the eligible privately held company will control the company and will be active in management or conducting the company’s business; and (2) any person who is offered securities in exchange for securities or assets of the company will receive the issuer’s most recent fiscal year-end financial statements, a balance sheet, and certain other information pertaining to the management, business, and results of operations.

The proposed model rule defines an “eligible privately held company” to mean a company that does not have any class of securities registered, or required to be registered, with the SEC under Exchange Act Section 12. The company must also have either EBITDA of less than $25 million or gross revenues of less than $250 million, or both, for the fiscal year ending immediately before the fiscal year in which the services of the merger and acquisition broker are initially engaged with respect to the securities transaction.

Excluded activities. The proposed rule does not exempt, however, any merger and acquisition broker that engages in certain excluded activities. In order to qualify for the exemption, the broker must not: (1) hold, transmit, or have custody of the funds or securities to be exchanged by the parties to the transaction; (2) engage on behalf of an issuer in a public offering of any class of securities required to be registered with the SEC under Exchange Act Section 12; or (3) engage on behalf of any party in a transaction involving a public shell company, as defined by the rule.

Request for comments. In particular, the Broker-Dealer Section has requested comments on a number of specific questions. Among them, the Section has asked whether the proposed model rule should specify how long the buyers must control and actively operate the acquired company in the transaction. The Section has also asked whether the proposed model rule should specifically address and disallow fee splitting between a merger and acquisition broker and an unregistered or non-exempt party, and whether a private equity firm or a private fund should be permitted to qualify for exemption under the rule.

Public comment period. Comments are due by February 16, 2015. NASAA encourages comments to be sent by email, if possible, to Bryan Lantagne, Chair of NASAA’s Broker-Dealer Section; Carolyn Mendelson, Chair of the Market Regulatory Project Group; and Christopher Staley of the NASAA Corporate Office.

Thursday, January 15, 2015

SunTrust May Not Omit Proposal to Disclose Incentive Compensation Recoupments from Proxy

[This story previously appeared in Securities Regulation Daily.]

By Jacquelyn Lumb

The staff of the SEC’s Division of Corporation Finance has advised SunTrust Banks, Inc. that it may not omit a shareholder proposal seeking annual disclosure of any recoupments or forfeitures of senior executives’ incentive compensation under the bank’s recoupment policy. SunTrust sought to omit the proposal on the basis that it was too vague or that it related to the bank’s ordinary business, but the staff disagreed on both counts. The proposal was submitted to SunTrust by the UAW Retiree Medical Benefits Trust and the Nathan Cummings Foundation.

Past abuses. In their supporting statement that accompanied the proposal, UAW and the Foundation noted that in the last two years, SunTrust settled federal and state charges over abuses related to securitized home loans, settled federal claims with respect to its mismanagement of the Home Affordable Modification Program, settled a whistleblower case alleging that the bank defrauded veterans and the government, and settled a federal action for racially discriminatory lending. SunTrust has not made any proxy statement disclosure about its application of the recoupment policy in response to the conduct in any of those claims.

SunTrust has administered a recoupment policy since 2002. The proponents wrote that the disclosure of the use of SunTrust’s recoupment provisions would reinforce behavioral expectations and communicate concrete consequences for misconduct.

Definition of senior executives. In discussions with the proponents about the proposal, SunTrust explained that the proposal’s reference to senior executives could potentially cover a large number of persons, and the bank explained that it would prefer not to provide disclosure for such a broad group since the proxy statement’s focus is on the compensation of named executive officers.

In seeking to omit the proposal from its proxy material, SunTrust wrote to the SEC that the lack of a definition of senior executive rendered the proposal so vague that it should be omitted. SunTrust added that the proposal sought to micromanage the bank’s business by regulating compensation matters that applied to a broad group of employees. The proponents responded that SunTrust’s argument runs counter to over 20 years of staff no-action determinations, not one of which found the term “senior executive” to be too vague.

Privacy concern. SunTrust also maintained that it could not implement the proposal without violating employees’ privacy. The proponents responded that their proposal seeks disclosure of the general circumstances of a recoupment and does not specify the disclosure of an individual’s name. The proponents also took issue with SunTrust’s characterization of the proposal as relating to ordinary business since it could relate to the compensation of several thousand employees. The proponents said the proposal applies only to senior executives, the very group whose compensation has consistently been found to transcend ordinary business.

Staff’s view. The staff did not concur with SunTrust’s view that the proposal was so inherently vague or indefinite that neither the shareholders voting on the proposal, nor the company in implementing it, would be able to determine with reasonable certainty what actions were required to be taken. Accordingly, the proposal could not be omitted under Rule 14a-8(i)(3).

The staff also was unable to concur with SunTrust’s view that the proposal could be omitted under Rule 14a-8(i)(7). The staff noted that the proposal focuses on the significant policy issue of senior executive compensation and does not seek to micromanage the company to such a degree that its exclusion would be appropriate.

Wednesday, January 14, 2015

MD&A Omission Can Serve as Basis for Fraud Claim

[This story previously appeared in Securities Regulation Daily.]

By Matthew Garza, J.D.

The management's discussion and analysis (MD&A) requirement of Regulation S-K Item 303 creates an affirmative duty to disclose that can serve as the basis for an Exchange Act 10(b) fraud claim, the Second Circuit held Monday in a matter of first impression. The ruling came in a suit filed by pension fund investors against Morgan Stanley stemming from crisis-era trading in residential mortgage-backed securities (RMBS). The court nonetheless found that fraud allegations against the bank fell short because scienter and loss causation pleadings were lacking. (Stratte-McClure v. Morgan Stanley, January 12, 2015, Livingston, D.).

Background. A trade structured in a way that is familiar to those that followed the implosion of the residential mortgage-backed securities (RMBS) market was behind the suit. In December 2006, Morgan Stanley’s Proprietary Trading Group sold CDOs to take a $13.5 million long position in a portfolio of subprime RMBS, while simultaneously purchasing credit default swaps to establish a $2 billion short position. The long position was in the lower risk RMBS, for which the bank received premium payments that it used to fund the short position. Morgan Stanley lost billions on the trade when the housing market began a precipitous decline in mid-2006. The complaint filed by the pension funds alleged that Morgan committed fraud by misrepresenting its exposure to credit risks related to the long position, and misrepresenting the bank’s consequently inflated stock price.

Officer statements. Six of Morgan Stanley’s officers were accused of making misrepresentations or omissions to conceal the bank’s exposure to the subprime mortgage market. One said on a June 20, 2007, analyst call that “concerns earlier in the quarter about whether issues in the sub-prime market were going to spread dissipated,” and that in fact the bank benefited from market conditions. Another officer in September stated that the bank “remained exposed” to the subprime market, but did not specify the extent of the exposure. A month later, investors complained, the same officer said in an interview that he did not anticipate further write-downs related to the trade.

Disclosures. The investors also alleged that the bank’s 10-Q filings were deficient because Item 303 of Regulation S-K requires companies to disclose on their 10-Q filings known trends, or uncertainties that have had, or might reasonably be expected to have a negative material effect on the company’s revenue. In another claim, the pension funds alleged that Morgan Stanley overstated its third quarter 2007 income by failing to sufficiently write down the value of the long position. The investors pointed out that the ABX Index, which tracks RMBS, declined 32.8 percent in the third quarter of 2007. A loss calculated with that indicator would have amounted to a $4.4 billion loss, investors claimed, but the bank wrote down only $1.9 billion after relying on internal models. The bank later increased the amount of the write down. The Southern District of New York dismissed the plaintiffs complaint on April 4, 2011, finding that it did not specify why the bank’s statements about the risk to its trading positions were false or misleading, that the bank had no obligation of disclose the long position, and that the funds failed to plead loss causation.

Known trends. Obligatory Item 303 disclosures “give investors an opportunity to look at the registrant through the eyes of management by providing a historical and prospective analysis of the registrant’s financial condition and results of operations,” the court said, quoting Exchange Act Release No. 6835. A reasonable investor would interpret the absence of a disclosure to imply the nonexistence of such “known trends.” It follows, said the court, that Item 303 imposes the type of duty to speak that can give rise to liability under 10(b). However, all the other requirements attendant in a 10(b) action still apply, the court pointed out, including materiality under Basic, Inc. v. Levinson.

Circuit Split. The court noted that the decision is contrary to the conclusion reached in the Ninth Circuit in In re NVIDIA Corp. Securities Litigation, which relied on a Third Circuit opinion written by then-Judge Alito that concluded that Item 303’s disclosure duty is not actionable under 10(b) and 10b-5. The Second Circuit took a narrower view on Oran, saying that “Contrary to the Ninth Circuit’s implication that Oran compels a conclusion that Item 303 violations are never actionable under 10b‐5, Oran actually suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material 10b‐5 omission.”

The court went on to hold that investors did sufficiently allege that Morgan Stanley breached its duty under Reg S-K Item 303 to disclose the fact that the bank faced a deteriorating subprime mortgage market that was likely to materially affect its financial condition, but dismissed the case for failure to plead a strong inference of scienter.

Tandem order. A summary order issued in tandem with the opinion decided that Morgan’s affirmative statements about its exposure to the mortgage securities market during the relevant time period were not misleading, but the “most cogent inference” from the allegations was that the bank delayed releasing information on its Form 10‐Qs in the second and third quarters of 2007 in a manner that was “at worst negligent” as to the effect the delay would have on investors. The order affirmed the dismissal of the valuation claim for failure to plead loss causation.

The case is No. 13-0627-cv.

Tuesday, January 13, 2015

House to Bring Up Dodd-Frank Corrections Bill Under a Rule

The House, having failed to pass bipartisan legislation containing a number of Dodd-Frank corrections and job creation measures on a fast track, is bringing the Promoting Job Creation and Reducing Small Business Burdens Act, H.R. 37, under a rule this week. The measure contains a number of Dodd-Frank Act corrections, as well as corrections and enhancements to the JOBS Act. The bill was brought up under a suspension of the rules last week, which meant that it had to pass by a 2/3 super majority. While 35 Democrats did vote for the bill, the final vote of 276 to 146 came up short of the two-thirds needed to pass it,

Registration of Thrifts. Title III of the Act is the Holding Company Registration Threshold Equalization Act, which amends the JOBS Act to extend shareholder thresholds for SEC registration and deregistration to savings and loan institutions. The measure corrects the inadvertent omission of thrifts from the new shareholder thresholds contained in the JOBS Act and thereby effects congressional intent.

Currently, JOBS Act Sec. 601 raises the number of shareholders permitted to invest in a community bank before triggering SEC reporting and registration from 499 to 1999. It also requires termination of a security registration in the case of a bank or bank holding company if the number of holders of a class of security drops below 1200. The bill would extend these shareholder thresholds to savings and loan associations.

Representative Ann Wagner (R-Mo.), a co-sponsor of the legislation, noted that these JOBS Act provisions lift outdated burdens off small lenders and help increase capital raising. She noted that many community banks have already taken advantage of the new shareholder threshold provisions. Thrifts were intended to be included in the new thresholds, Rep. Wagner said, because they are regulated like banks and are subject to the same reporting requirements.

Brokers in Mergers. Title IV of the Act is the Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act, which amends the Exchange Act to reform and to scale the regulation of M&A brokers. Representative Bill Huizenga (R-Mich.), sponsor of the measure, noted that current federal law treats the sale of a small, privately held business as if it were a Wall Street investment firm selling securities of a public company. The legislation establishes a streamlined and commonsense approach that allows for the sale of small- and mid-size businesses while maintaining the necessary safeguards.

The legislation provides for a notice-filing registration procedure for brokers performing services in connection with the transfer of ownership of smaller privately held companies and provides for regulation appropriate to the limited scope of the activities of such brokers. H.R. 2274 is designed to scale federal regulation of securities broker-dealers with respect to privately negotiated business sales, mergers, and acquisitions.

At a hearing last year on capital formation conducted by the House Capital Markets Subcommittee, Rep. Huizenga noted that an SEC working group studied this issue, but the SEC has not moved with recommendations. Thus, Rep. Huizenga concluded that a legislative tool is needed.

Specifically, the measure would add a new subsection to Exchange Act Sec. 15, which governs broker-dealer registration, to reduce the regulatory costs incurred by sellers and buyers of small- and mid-sized privately held companies for professional business brokerage services, while enhancing their protection through well defined, appropriately scaled, and cost-effective federal securities regulation. The legislation would direct the SEC to create a simplified system of registration through a public notice filing, publicly available on the SEC’s website, and would require appropriate client disclosures pertaining to M&A brokers and their associates. The legislation would also direct the SEC to tailor its rules governing M&A brokers in light of the limited scope of their activities, the nature of privately negotiated M&A transactions, and the active involvement of buyers and sellers in those transactions.

A properly completed electronic notice of registration would become effective immediately upon receipt by the SEC, except that SEC approval of such notice would be required if the M&A broker or an associated person were subject to suspension or revocation of registration, a statutory disqualification, or a disqualification under SEC rules pursuant to the Dodd-Frank Act.

Remove international barrier to swap data reporting. Title V of the Act is the Swap Data Repository and Clearinghouse Indemnification Correction Act. As a condition of obtaining access to swap data repositories, Dodd-Frank required foreign regulators to indemnify repositories and the CFTC and SEC for any litigation expenses that may arise from sharing information. This requirement would be removed by this provision.

The bill was necessary because according to a joint CFTC-SEC report, international entities objected to the indemnification requirement and were unwilling to register or recognize swap data repositories without access to data.

According to Rep. Gwen Moore (D-Wis), the bill was non-controversial and the SEC has said outright that it supports the bill. In addition, three of five CFTC commissioners support the bill, she said.

Exempt interaffiliate swaps. Title II of the bill would exempt interaffiliate swap transactions from the Dodd-Frank Act’s margin, clearing, and reporting requirements. Interaffiliate swaps are swaps executed between entities under common corporate ownership.

According to Rep. Steve Stivers (R-Ohio), the federal government shouldn’t penalize businesses for how they choose to do business. Rules on interaffiliate swaps don’t consider increased costs on business. Interaffiliate swaps are simply an accounting method used to assign transactions and centralize and aggregate risk. They don’t create systemic risk, he said.

Emerging Growth Companies. Title VI of the Act is the Improving Access to Capital for Emerging Growth Companies Act. This was a bi-partisan piece of legislation introduced by Rep. Stephen Fincher (R-Tenn.) and Rep. John Delaney (D-Md.) in the 113th Congress that would build on and expand the JOBS Act of 2012 by making improvements to the IPO process for emerging growth companies. It would reduce the number of days that emerging growth companies must have a confidential registration statement on file with the SEC from 21 days to 15 days before they can conduct a road show. It would also allow a one-year grace period for an issuer that began the IPO process as an emerging growth company to complete its IPO as an emerging growth company.

Representative Fincher described the reforms as simple, technical improvements to the JOBS Act that improve the IPO process and allow emerging growth companies to continue growing and providing jobs. He noted that more than 200 companies have registered with the SEC as emerging growth companies since the passage of the JOBS Act in April 2012. The JOBS Act established the emerging growth company category in Title I. At the one-year anniversary of the JOBS Act, he noted, a study by Ernst & Young showed that approximately 78 percent of all publicly filed IPO registration statements and approximately 83 percent of the IPOs that went effective since April 2012 were filed by emerging growth companies (see Cong. Record, November 22, 2013, p. E1756).

During the mark-up, Rep. Delaney said that the bill creates a more streamlined IPO process without sacrificing investor protection. He added that for an emerging growth company doing an IPO is a difficult moment, which can be costly, time consuming, and cumbersome. But, at the same time, said Rep. Delaney, investor protection is at its highest during the IPO process. The SEC does a full review of the filing, he noted, and this is when the audit firms establish all the important accounting policies for the company and the underwriters conduct due diligence. In addition, most of the offerings are usually sold to institutional investors, who engage in significant diligence.

With respect to an emerging growth company, the measure directs that within 30 days of enactment, the SEC must revise its general instructions on Form S-1 to indicate that a registration statement filed or submitted for confidential review by an issuer prior to an initial public offering may omit financial information for historical periods otherwise required by Reg. S-X as of the time of filing or confidential submission of the registration statement, provided that the omitted financial information relates to a historical period that the issuer reasonably believes will not be required to be included in the Form S-1 at the time of the contemplated offering. Another proviso is that prior to the issuer distributing a preliminary prospectus to investors, the registration statement is amended to include all financial information required by Regulation S-X at the date of the amendment.

XBRL relief. Title VII of the Act is the Small Company Disclosure Simplification Act, which would exempt smaller public companies from requirements relating to the use of Extensible Business Reporting Language (XBRL) for periodic reporting to the SEC. The measure was introduced by Rep. Robert Hurt (R-Va.), who believes that the legislation would streamline regulations for small public companies and remove a disincentive for companies to access capital in the public markets.

Public companies are required to provide their financial statements in an interactive data format using XBRL. XBRL tags certain data points in issuers’ reports and exports them in a standardized format. XBRL is reported in a unique computing language, one that requires specific expertise outside the bounds of traditional financial or accounting training.

Representative Hurt noted that a glaring example of a regulation where costs currently outweigh potential benefits is related to the use of XBRL. The bill offers a commonsense solution to this problem, ensuring that regulations are not hampering the success of smaller companies. Currently, he continued, in order to comply with the XBRL regulation, small companies must expend tens of thousands of dollars on average. However, evidence suggests that less than 10 percent of investors actually use XBRL.

In line with the JOBS Act, the measure would remove duplicative regulations for small companies from submitting interactive data filings with XBRL. Public companies would still be required to file mandatory information with the SEC.

The legislation would create a two-tier exemption from reporting in XBRL for smaller public companies. First, emerging-growth companies would be exempt from using XBRL for financial statements and other periodic reporting required by the SEC, although such companies can elect to use XBRL. Second, an exemption from reporting in XBRL is provided for other smaller companies, specifically those with total gross revenue under $250 million. These companies can also elect to use XBRL. But, the bill provides that the exemption for companies with revenue below $250 million must continue in effect for five years after enactment or two years after an SEC determination that the benefits of using XBRL reporting outweigh the costs to the company.

In making this determination, the SEC must use an analysis spelled out in the legislation. The analysis must include an assessment by the Commission of how such costs and benefits may differ from the costs and benefits identified by the SEC in the order relating to interactive data to improve financial reporting of January 30, 2009, 74 F.R. 6776, because of the size of such companies. The analysis must also assess the effects on efficiency, competition, capital formation, and financing, as well as on analyst coverage of such issuers, including any such effects resulting from the use of XBRL by investors.

The analysis must further include the cost to the company of submitting data to the SEC in XBRL, posting it on the company’s website in XBRL, as well as the cost of the software to do all this. The analysis must then assess the benefits of XBRL to the SEC in terms of the improved ability to monitor the securities markets and to assess the potential outcomes of regulatory alternatives. Importantly, the SEC analysis must also assess the effectiveness of U.S. standards for interactive filing data relative to the standards of international counterparts.

The legislation requires the SEC to submit a report to Congress, within one year, on the progress in implementing XBRL reporting and the use of XBRL data by SEC officials and by investors.

Volcker Rule relief. Title VIII of the Act is the Restoring Proven Financing for American Employers Act, which would clarify that nothing in the Volcker Rule should be construed to require the divestiture, prior to July 21, 2017, of any debt securities of collateralized loan obligations (CLOs), if such debt securities were issued before January 31, 2014. Introduced by Rep. Andy Barr (R-Ky.), the measure amend the Volcker Rule to exclude certain debt securities of CLOs from the prohibition against acquiring or retaining an ownership interest in a hedge fund or private equity fund.

Rep. Barr said that the legacy debt securities of CLOs must be protected from the medicine that the Volcker Rule prescribes. In his view, this medicine would be far more damaging to the credit markets than the perceived illness of suffering losses from CLO paper. Congress must grandfather existing CLO investments.

The legislation would also clarify that a financial institution would not be considered to have an ownership interest in a CLO if there is no indicia of ownership other than the right of the firm to fire or remove for cause, or to participate in the selection or removal of, a general partner, managing member, member of the board of directors, investment manager, investment adviser, or commodity trading advisor of the fund provided that the CLO is predominantly backed by loans.

The measure also provides that an investment manager or investment adviser must be deemed to be removed for cause if the manager or adviser is removed as a result of a breach of a material term of the management or advisory agreement or the agreement governing the CLO; the inability of the investment manager or adviser to continue to perform its contractual obligations; or any other action or inaction by the investment manager or investment adviser that has, or could reasonably be expected to have, a materially adverse effect on the CLO if the manager or adviser fails to cure or take reasonable steps to cure such effect within a reasonable time.

The legislation represents a bipartisan compromise that balances the goal of preserving a proven financing mechanism with concerns against watering down the Volcker Rule.

According to Rep. Murphy, the Volcker Rule is not intended to capture debt. Debt is an everyday tool of plain vanilla financial institutions. The Volcker Rule is about equity ownership. Congress does not want banks owning hedge funds and private equity funds, but still wants lending. The legislation would provide narrow relief to existing CLO securities as long as they qualify as debt under the bill. For CLOs that are not debt securities under the bill, banks will get an additional two years to divest, which will prevent a disruptive fire sale of these securities.

Rep. Murphy added that the legislation also clarifies that the right to vote to remove a CLO manager in traditional, creditor-protective circumstances, such as a material breach of contract, does not, by itself, convert a debt security into an equity security under the Volcker Rule. (Cong. Record, Apr 29, 2013, pH3258).

Relief for advisers to venture capital funds. Title IX of the Act is the SBIC Advisers Relief Act, H.R. 4200, introduced by Rep. Blaine Luetkemeyer (R-Mo), would would amend the Investment Advisers Act to reduce unnecessary regulatory costs and eliminate duplicative regulation of investment advisers to small business investment companies. Specifically, the measure would allow advisers to venture capital funds to continue to be exempt reporting advisers if they also advise a small business investment company fund. The measure would also prevent the inclusion of the assets of a small business investment company fund in the SEC registration calculation of assets under management for those advisers that advise private funds in addition to small business investment company funds.

Currently, an adviser to a venture capital fund is exempt from SEC registration and an adviser to a small business investment company is exempt from registration. But, an adviser to both a venture capital fund and a small business investment company is not exempt. The legislation would exempt from SEC registration an investment adviser that advises both a venture capital fund and a small business investment company. A co-sponsor of the measure, Rep. Carolyn Maloney (D-NY), said that the measure restores the access of small businesses to broad investment advice and capital without compromising investor protection.

Simplifying Form 10-K. Title X of the Act is the Disclosure Modernization and Simplification Act, introduced by Rep. Scott Garrett (R-NJ), chair of the Capital Markets Subcommittee, which would direct the SEC to permit issuers to submit, on Form 10-K annual reports, a summary page to make annual disclosures easier to understand for current and prospective investors. Chairman Garrett noted that the summary page would have cross-references to the annual report to aid investors in navigating what can be lengthy annual reports. The bill would also direct the SEC, within 180 days of enactment, to tailor Regulation S-K’s disclosure rules as they apply to emerging growth companies and smaller issuers and to eliminate other duplicative, outdated, or unnecessary disclosure rules as they apply to these smaller issuers. It would also direct the SEC to identify and implement additional reforms to Reg. S-K to simplify and modernize SEC disclosure rules. The measure would require the SEC to consult with the Investor Advisory Committee when studying Regulation S-K.

Encouraging employee stock ownership. Title XI of the Act is the Encouraging Employee Ownership Act, introduced by Rep. Randy Hultgren (R-Ill.), which would amend SEC Rule 701, originally adopted in 1988 under Sec. 3(b) of the Securities Act and last updated in 1998. Under current law, if an issuer sells, in the aggregate, more than $5 million of securities in any consecutive 12-month period, the issuer is required to provide additional disclosures to investors, such as risk factors, the plans under which offerings are made, and certain financial statements. The legislation would require the SEC to increase that threshold to $20 million. Rep. Hultgren noted that support for this effort to expand the utility of Rule 701 can be found in the SEC’s Government-Business Forum on Small Business Capital Formation Final Reports for 2001, 2004-2005 and 2013.

The legislation aims to encourage the idea of letting employees own a stake in company they are part of. Ownership is a great incentive, noted the sponsor. Rule 701 mandates disclosure. The SEC arbitrarily set the threshold at $5 million, noted Rep. Hultgren. It is costly to prepare disclosures just so a company can offer stock to employees, said Rep. Hultgren. The bill, in addition to raising the threshold from 5 to 20 years, would also adjust it for inflation every five years.

Monday, January 12, 2015

CII Criticizes Whole Foods for Unworkable Proxy Access Threshold

[This story previously appeared in Securities Regulation Daily.]

By John Filar Atwood

Whole Foods Markets has drawn the ire of the Council of Institutional Investors (CII) by proposing a proxy access ownership threshold that is far above the norm. The company initially proposed to require a nominating shareholder to hold 9 nine percent stake, but subsequently reduced it to 5 percent. CII called both numbers “unreasonably high” and beyond what U.S. shareholders want.

Not workable. CII executive director Ann Yerger has written to Whole Foods to ask its board to revise the proposed proxy access bylaw to be consistent with prevailing U.S. shareowner views for a viable ownership threshold. She noted that the initial proposal of holding a nine percent stake for five years would not have been workable for any current Whole Foods shareholder.

Yerger said that the revised proposal—a nominating shareholder would have to have owned 5 percent of company stock for at least five years—is still “wildly at odds” with the approach to proxy access currently supported by U.S. shareholders. That approach, she noted, is requiring a nominating shareholder or group to have owned 3 percent of the voting shares for at least three years.

Three percent approach. The 3 percent method has already been adopted by a number of companies, including Chesapeake Energy Corp., Western Union Co. and Verizon Communications Inc., according to Yerger. She also noted that in 2014, proxy access proposals won majority shareholder support at annual meetings of six U.S. companies and all of them endorsed the 3 percent for three years approach. Members of CII, many of whom are Whole Foods shareholders, favor a 3 percent for two years model, she added.

Yerger urged the Whole Foods board to revise the proposed binding access bylaw, asking that the company respect what U.S. shareholders increasingly view as the norm.

Friday, January 09, 2015

Gallagher’s Promise to Rework Harvard SRP Paper Inflames Critics

[This story previously appeared in Securities Regulation Daily.]

By Anne Sherry, J.D.

The announcement that SEC Commissioner Daniel Gallagher and Stanford professor Joseph Grundfest will revise their argument that the Harvard Shareholder Rights Project (SRP) has violated federal securities laws has only further provoked their critics. Yale law professor Jonathan R. Macey called the authors’ plans to develop arguments that they had previously dismissed “a rather desperate attempt to salvage assertions of illegality that the authors ought to drop,” while Boston University law professor Tamar Frankel posited that Gallagher’s continued accusations may violate the SEC Canon of Ethics.

Previous dialogue. Professor Macey’s first response to the Gallagher-Grundfest paper maintained that the SRP’s shareholder proposals to declassify boards of directors did not contain material omissions in violation of the securities laws. He also questioned the policy rationale for threatening proponents with securities litigation and noted that there was no precedent for an enforcement action over a shareholder proposal that failed to cite research contrary to its argument. In his own response posted to Harvard’s corporate governance blog on Monday, Professor Grundfest expressed gratitude for Professor Macey’s post “suggest[ing] strategies to strengthen the coming revision” of the Gallagher-Grundfest paper.

Contrary to Professor Macey’s arguments, Professor Grundfest states, the current and former SEC commissioners are not limiting their criticism to just seven shareholder proposals; instead, they maintain that every instance in which the Harvard proposal appears in a proxy statement violates Rule 14a-9. Among his other rebuttals, Professor Grundfest also concedes that there is no precedent for the type of enforcement action or private suit discussed in his paper, but states that the lack of precedent for the litigation theory “makes it novel, not incorrect.”

“The dramatic flip-flop.” Now, in his second response, posted to the same blog on Tuesday, Professor Macey characterizes the Grundfest post as a “dramatic shift of allegations” as well as a failure to address the deficiencies he identified via his first response. Gallagher and Grundfest’s plan to revise their paper is “troubling,” in the Yale professor’s view, in that the authors mean to develop four arguments that they had mentioned in passing in their original paper but expressly declined to rely upon. “Making up new spurious claims when earlier ones are discredited is unworthy of a sitting SEC Commissioner,” Macey writes.

Ethical issues. Professor Frankel expressed agreement with the Macey view, but her own response, posted on Wednesday, focuses less on the substantive merits of the debate and more on the propriety of Commissioner Gallagher’s actions. She writes, “There is a big difference between discussing general policy problems, which SEC Commissioners should be doing, and attacking or urging actions against particular individuals and organizations, which SEC Commissioners should not be doing.”

Specifically, Professor Frankel cites Section 200.66 of the SEC Canon of Ethics, which provides that “no public pronouncement of the pendency of such an investigation should be made in the absence of reasonable evidence that the law has been violated and that the public welfare demand it.” In her view, either Commissioner Gallagher expected the SEC to investigate the SRP proposals—in which case he was bound by the Canon of Ethics not to make pronouncements about such a case—or he publicly issued a paper urging enforcement action that he knew or assumed would not occur. The latter scenario might also violate Section 200.66, which bars SEC staff from “suggest[ing] … an investigation aimed at a particular individual for reasons of animus, prejudice or vindictiveness,” the professor reasons.

Thursday, January 08, 2015

Maine Adopts Crowdfunding Registration Rule

[This story previously appeared in Securities Regulation Daily.]

By Jay Fishman, J.D.

This short-form seed capital registration rule, authorized by a Maine Uniform Securities Act short-form qualification registration provision, may be used only by issuers meeting the requirements of both the Maine statutory provision and federal Regulation D, Rule 504. Furthermore, the short-form registration is unavailable for issuers who, themselves, or whose affiliates are subject to specified “bad boy” disqualification provisions.

But qualified issuers may register their securities by sending the Maine Securities Administrator a Form FND-ME, Fund-ME Offering Circular Form, along with a prescribed subscription agreement and $300 fee for each type or class of security offered. Following registration, issuers must deliver to each purchaser a complete Form FND-ME, together with the subscription agreement. Issuers also must follow specified steps to place all invested funds in escrow.

Wednesday, January 07, 2015

Feds Announce Five Accounting Fraud Arrests

[This story previously appeared in Securities Regulation Daily.]

By Amanda Maine, J.D.

The Manhattan U.S. Attorney and the FBI announced that former executives and employees of an unnamed New Jersey-based company (the Company) were arrested on federal bank fraud, wire fraud, and conspiracy charges for their roles in an accounting fraud scheme. Principals of the Company, which provided in-store displays for retailers, made false and misleading statements about its financial condition and sales to secure millions of dollars in loans. These statements included phony invoices and purchase orders to two unnamed customers, Customer-1 (a New York-based sports apparel and footwear retailer) and Company-2 (an Oregon-based multinational designer and manufacturer of athletic footwear, clothing, and accessories).

Accounting fraud. According to the indictment, the defendants created fictitious and falsely inflated purchase orders purporting to reflect sales in order to create the false impression of sales. Customer-1 was also tricked by the defendants into paying falsely inflated invoices. The defendants provided cash payments, personal vacations, home renovations, and other kickbacks to an employee of Customer-1 for helping perpetuate the scheme. That employee, who was also arrested and charged, verified to the Company’s lenders false information about the Company and caused Customer-1 to pay invoices from the Company she knew were inflated.

Fake emails. One method the defendants used to prevent the Company’s lenders and auditors from discovering the fraud was the use of fake emails belonging to Customer-1 and Customer-2 employees, according to the Government. The fake email accounts, which used domain names that were similar to the Customers’ actual domain names, were used by the defendants to pretend to be actual employees of the Customers. Using the fake emails, the defendants would verify false information about the Company’s financial condition to its lenders and outside auditors.

Shell companies and false documents. The defendants also used shell companies to keep their scheme afloat. Through the shell companies, the defendants engaged in “round-trip” transactions to create the appearance that customers were paying the Company’s outstanding phony receivables. One of the defendants used his graphic design skills to create documents such as fake invoices and purchase orders to support the false representations about the Company’s financial condition.

Misappropriation. The indictment alleged that three management defendants misappropriated nearly $3 million of the loan proceeds which were falsely secured though the accounting fraud. They used this money to pay for homes, luxury cars, private school tuition, and personal credit card bills. Some of the misappropriated funds were also used to pay the kickbacks to the Customer-1 employee for her assistance in the scheme.

Charges. The five defendants were charged with various criminal violations, including bank fraud, wire fraud, and conspiracy to commit fraud or money laundering. According to the U.S. Attorney’s press release, each count carries a potential sentence of between 20 to 30 years in prison.

The case is No. 14 CRIM 845.

Tuesday, January 06, 2015

High Court Asked to Find ’40 Act Breach of Duty, Private Right of Action

[This story previously appeared in Securities Regulation Daily.]

By Amy Leisinger, J.D.

Two pension funds have petitioned the Supreme Court to determine whether an investment adviser may avoid liability under Investment Company Act Section 36(b) for overcompensation by conducting securities-lending activities through an affiliate and whether fund investors have a private right of action against the fund’s investment adviser, as well as the fund directors, for violations of Section 36(a). Specifically, the petitioners ask the court resolve the circuit split created by the Sixth Circuit in determining that Section 36(b) will not support an action when an adviser structures transactions through an affiliate and refusing to find an implied private right of action under Section 36(a) (Laborers’ Local 265 Pension Fund v. iShares Trust, December 29, 2014).

Background. Two pension funds were shareholders in exchange-traded funds issued by iShares, Inc. and iShares Trust (iShares), whose revenue came largely from lending its securities holdings to various borrowers. BlackRock Fund Advisors (BFA) managed and advised the iShares funds with respect to their investment activities, and BlackRock Institutional Trust Company, N.A. (BTC), the corporate parent of BFA, provided securities-lending services to the iShares investment companies and other funds. BTC received a 35-percent fee of all securities-lending net revenue, and BFA managed the funds’ portfolio for a separate, additional fee.

The shareholders’ filed a complaint against iShares, BFA, and BTC, contending that BTC and BFA violated Sections 36(a) and (b) by charging an excessive lending fee that bore no relationship to the actual services rendered. The district court dismissed the action (covered in the Securities Regulation Daily Wrap Up for August 29, 2013) based on the defendants’ arguments that the Section 36(b) claim was barred by the language of the section in relation to a previous SEC exemption order and that Section 36(a) does not provide for an implied private right of action.

On appeal to the Sixth Circuit, the shareholders contended that Section 36(b) permitted a lawsuit against BFA for excessive compensation despite the SEC’s approval of the operations and that BTC’s 35-percent fee should be aggregated with BFA’s separate advisory fee to show excessiveness. The appellate court disagreed, finding that the shareholders forfeited their “aggregation argument” because they did not object to the advisory fee and, in any case, the two fees were for entirely different services (see the Securities Regulation Daily Wrap Up for September 30, 2014). If the fees for each service viewed separately were not excessive for the particular service rendered, then the two fees combined were also permissible, the court reasoned. In considering the shareholders’ arguments in support of a private right of action under Section 36(b), the appellate court concluded that the text of Section 36(a) does not contain any “rights-creating language” and, instead, focuses on the “person(s) regulated rather than on the individuals protected.”

Cert petition. By its decision, the petitioners state, the Sixth Circuit has exacerbated an existing circuit split by refusing to recognize an implied private right of action under Section 36(a). Several circuits have found implied rights of action under the Act and reiterated this position in later actions, and the Court should step in to resolve the division, according to the petitioners.

In addition, the petitioners contend that the Sixth Circuit created a circuit split regarding the correct interpretation of Section 36(b). According to the petitioners, the Sixth Circuit’s dismissal based on BlackRock’s use of an affiliated securities-lending agent and Section 36(b)(4)’s notation that the subsection does not apply to payments made in connection with affiliate transactions subject to Section 17 conflicts with the First Circuit’s interpretation of these provisions as mutually exclusive. The First Circuit has held that overcompensation of an adviser’s affiliate is actionable by individual investors unless actionable under Section 17, the petitioners stress, and, in the form of releases, the SEC has provided support for the proposition that overcompensation of an adviser-affiliate remains actionable against an adviser under Section 36(b). By its determination, the petitioners explain, the Sixth Circuit has provided undue protection for overcompensation received by the structuring actions through affiliates.

“The overcompensation of BlackRock’s investment advisers and their affiliates through BlackRock’s short-sale operation is exactly the problem the Congress intended to remedy,” the petitioners emphasize.

The case is No. 14-771.

Monday, January 05, 2015

NASAA Advocates Credit Check Exclusion for FINRA

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

NASAA has expressed concern regarding pending state and municipal legislation that would prohibit certain employers from conducting credit checks on prospective employees. NASAA fears that unless these bills provide for an explicit exclusion for FINRA, there may remain ambiguity surrounding FINRA’s authority to conduct background checks on agents applying for securities licenses. NASAA’s comments came in separate letters to the National Conference of State Legislatures and the United States Conference of Mayors.

NASAA noted that 11 states have enacted laws regulating credit reports used by employers for employment purposes since 2007, and that 16 other states plus the District of Columbia and New York City are currently considering such legislation. In addition, the City of Chicago enacted a law on May 1, 2012, prohibiting employers from using credit history as a basis for making employment decisions.

Role of Form U4. NASAA emphasized the importance of Form U4 (Uniform Application for Industry Registration and Transfer) to both state regulators and FINRA in carrying out their regulatory responsibilities. State securities regulators and FINRA rely on the information disclosed by applicants on Form U4 in order to administer the broker-dealer agent registration process in a uniform and efficient manner.

NASAA stated that the disclosures required from prospective agents concerning bankruptcies and outstanding judgments or liens are not designed to present a barrier to entering the industry, but rather to provide firms, regulators, and investors with relevant and accurate information on each broker-dealer agent. Accordingly, NASAA stressed the importance of explicitly referring to FINRA in an exclusion in any legislation that prohibits employers from requesting credit history information from prospective employees.