Thursday, December 14, 2017

Katten webinar surveys the vast legal and compliance landscape for cryptocurrencies

By Brad Rosen, J.D.

In a webinar titled Trading Bitcoin: Legal and Compliance Considerations for Trading and Facilitating Transactions in Bitcoin, a team of Katten Muchin Rosenman attorneys explored the vast, murky and ever-expanding terrain surrounding cryptocurrencies and CFTC, SEC, FinCen, and NY Department of Financial Services regulation. The Katten team also explored emerging litigation issues, as well as providing practical insights and advice to industry players dealing with these issues. Below are some highlights from the webinar:

Three types of cryptocurrencies. The webinar kicked off with a discussion of the three basic types of cryptocurrencies. First, there are those that serve as a medium of exchange and store of value, like Bitcoin. Second, there are those that reflect an interest in an enterprise that is generally be deemed to be a security and might be offered as part of an initial coin offering (ICO). Third there are utility tokens that are associated with the rights to use a product or service. These can also be deemed to be securities. A particular cryptocurrency may possess more than one of these qualities and can morph from one function to another during its lifetime.

CFTC regulation and potential manipulation. Gary DeWaal led the discussion regarding CFTC-regulated exchanges and the recently launched futures products related to Bitcoin at the CBOE Futures Exchange on December 10, as well as the CME product, which will launch on December 17. Two other futures exchanges also have Bitcoin related products in the pipeline. Two swap execution facilities (SEFs) currently host Bitcoin related swap products, although retail customers do not have access to the SEFs.

In response to a question about the potential for manipulating the settlement price for the Bitcoin futures contracts, DeWaal noted that both sets of exchange traded futures contracts were cash settled and that the underlying Bitcoin exchanges were not subject to functional regulation. He explained that these exchanges do not have trade practice requirements, nor is there an obligation to monitor for manipulation by those exchanges. He observed, though, that these exchanges might be subject to some forms of prudential regulation which would include anti-money laundering, capital, and cyber security requirements.

Practical concerns related to Bitcoin futures trading. DeWaal raised a number of practical considerations for firms trading in or facilitating trading in Bitcoin futures, including:
  • How adequate are the firm's disclosures related to unusual characteristics of Bitcoin futures? (For example, a customer’s margin requirements may routinely increase when a customer's long positions increase in value) 
  • Do the firm's disclosures adequately describe unusual conditions the firm may have imposed on customers trading Bitcoin futures? (For example, naked short positions may not be allowed, no give-in trades be permitted, or a premium to exchange-minimum margin may be required). 
  • Has the firm considered highlighting exchanges' authority, if applicable, to set market prices unrelated to market activity under extraordinary circumstances? 
  • Is the firm's customer agreement adequately drafted to authorize the firm to take actions it may deem warranted should Bitcoin futures experience extraordinary volatility?
  • How should an account be liquidated when a client defaults in a margin payment related to positions in Bitcoin futures or under other circumstances? 
SEC regulation. In contrast with the CFTC’s approach regarding the unregulated underlying Bitcoin markets, the SEC has taken a hard line with respect to approving Bitcoin-related products. As one of the presenters noted, in March 2017, the SEC denied the application of the Bats BZX Exchange for it to list and trade shares of the Winklevoss Bitcoin Trust. The SEC cited that the exchange must have surveillance sharing agreements with the significant markets where the underlying Bitcoin was transacted. The SEC concluded there was not sufficient visibility in connection with the underlying markets.

Similarly, in October 2017, the SEC encouraged two sponsors of exchange traded funds (ETFs) tied to Bitcoin to withdraw their applications. The webinar presenters noted, however, the SEC may be revisiting the Winklevoss Trust and other potential ETF Bitcoin related products sometime in the coming year.

Litigation. One of the webinar presenters observed that, while there has been some litigation related to cryptocurrencies, the activity has not been substantial. Looking ahead, he foresees much of the litigation will mirror regulatory enforcement actions. Additionally, significant market losses will also likely trigger an increase in litigation activity. Other particular areas he saw that will likely be subject of litigation might be related to the resale of unregistered securities, forced liquidations, trading and delivery issues, as well IPO related fraud and Ponzi related actions where investor funds have seemingly disappeared.

Wednesday, December 13, 2017

Clayton cautions both investors and market professionals about ICOs

By Jacquelyn Lumb

Jay Clayton has emphasized that his focus as SEC chairman will be on capital raising and the protection of retail investors. Following a recent enforcement action against Munchee Inc. for an offering of digital tokens that constituted an illegal unregistered securities offering, Clayton released a statement in which he outlined his general views on cryptocurrency and the ICO markets. The SEC is committed to promoting capital formation, he said, and investors should be open to these opportunities, but they must ask good questions, demand clear answers and apply common sense.

For Main Street investors, Clayton advised that there is much less investor protection in the cryptocurrency and ICO markets than traditional markets, which creates more opportunities for fraud and manipulation. No ICOs have been registered with the SEC, and no cryptocurrency type products have been approved for listing and trading, he advised. In addition, the SEC has not approved for listing any exchange-traded products that hold cryptocurrencies or other assets related to cryptocurrencies.

In a footnote to his statement, Clayton noted that the CFTC has designated bitcoin as a commodity. He said that fraud and manipulation involving bitcoin which is traded in interstate commerce is appropriately within the purview of the CFTC, as is the regulation of commodity futures tied directly to bitcoin. However, products that are linked to the value of underlying digital assets, including bitcoin and other cryptocurrencies, may be structured as securities products subject to registration under the Securities Act or the Investment Company Act.

He urged investors to read the investor alerts, bulletins, and statements issued by the SEC regarding the marketing of these offerings. Because these instruments may trade on systems and platforms outside the U.S., Clayton said it heightens the risk that the SEC and other regulators may not be able to recover any lost funds.

For market professionals, including securities lawyers, accountants, and consultants, Clayton urged them to read the SEC’s Section 21(a) investigative report on The DAO that was issued on July 25, 2017. The report describes how the SEC applied longstanding securities law principles to demonstrate that a token was an investment contract, and therefore a security under the federal securities laws. Clayton said that offerings which incorporate features and marketing efforts that promote the potential for profits based on the efforts of others contain the hallmarks of a security. Market professionals should be guided by the intent of the SEC’s registration, offering process, and disclosure requirements, he said, which includes the protection of Main Street investors.

Before launching a cryptocurrency or a product with its value tied to cryptocurrencies, Clayton said that promoters must be able to demonstrate that the product is not a security or they must comply with the applicable registration and other requirements of the federal securities laws. Broker-dealers and other market participants that allow payments in cryptocurrencies, allow customers to purchase cryptocurrencies on margin, or otherwise use cryptocurrencies in securities transactions should exercise caution to ensure that they are not undermining their anti-money laundering or know-your-customer obligations, he added.

Clayton’s statement closed with a list of questions that investors may wish to consider before engaging in a cryptocurrency or an ICO investment opportunity. He has asked the Division of Enforcement to focus on this area and to bring enforcement actions when they find ICOs that violate the federal securities laws.

Tuesday, December 12, 2017

Oral agreement to settle proxy contest is enforceable

By Amy Leisinger, J.D.

The Delaware Chancery Court has ordered specific performance of an oral agreement between shareholder funds and a company to settle a proxy contest by expanding the company’s board and appointing two of the shareholder nominees. According to the court, the shareholder funds demonstrated that the oral settlement agreement constituted a binding contract regardless of documentation, and the individual negotiating on behalf of the company had actual and apparent authority to bind the firm (Sarissa Capital Domestic Fund LP v. Innoviva, Inc., December 8, 2017, Slights, J.).

Proxy contest and settlement. Dissident shareholders of Innoviva, Inc. mounted a proxy contest in February 2017 to elect three nominees to the company’s seven-member board of directors. The shareholder funds’ proxy materials contended that Innoviva’s incumbent directors were overpaid in comparison to performance and failed to properly execute their oversight responsibilities and that the company was not being run for the benefit of shareholders. Three proxy advisory firms recommended votes in favor of the shareholders’ nominees.

When these recommendations came out, the parties began discussing a potential settlement of the proxy contest. During several calls, the founder of the shareholder funds and the vice chairman of Innoviva’s board negotiated terms, which were discussed with and approved by Innoviva’s board throughout the process. Upon learning of the likelihood that large Innoviva shareholders would vote in favor of the funds’ nominees, Innoviva agreed to expand its board from seven members to nine members, to appoint two of the shareholder funds’ nominees to the board, and to forgo a standstill in exchange for dismissal of the shareholders’ pending action and discontinuation of the proxy contest. The parties also agreed to issue a conciliatory joint press release announcing the settlement. The vice chairman and the funds’ founder confirmed they “had a deal” and would leave the paperwork to others.

As the parties were working to finalize the written agreement and the press release, Innoviva learned that BlackRock had voted in favor of the board’s slate of directors and backed out of the deal.

The shareholder funds filed an action seeking declaration that the parties entered into a binding settlement agreement during the telephone call and asked for specific performance of the contract. Innoviva argued that the parties never reached a meeting of the minds on material terms and understood that any contract would have to be memorialized in an executed written agreement. In addition, Innoviva contended that the vice chairman did not have actual or apparent authority to bind the company to the alleged oral contract.

Actual and apparent authority. The court found that Innoviva’s vice chairman had authority to bind the company to an oral settlement agreement. Innoviva’s board had appointed him to act as its “lead negotiator” in settlement discussions, and he agreed to do so, creating a specific agency relationship and actual authority, the court stated. Moreover, if the board thought it needed to “reapprove” the agreed-upon terms, it would have done so quickly (before learning about BlackRock’s decisive vote) to protect the company from losing face with regard to the proxy contest, the court noted. “The board well understood that the deal had been struck,” the court stated.

The evidence also clearly demonstrated that the vice chairman had apparent authority to bind Innoviva because the shareholders’ principal reasonably believed that he was speaking on behalf of Innoviva’s board and thus was authorized to enter into a settlement agreement, the court found. This reasonable belief was traceable to Innoviva’s own manifestations, particularly with regard to its appointment of the vice chairman as the “lead negotiator,” according to the court.

Valid contract. The court noted that a valid contract exists when the parties have made a bargain with “sufficiently definite” terms and manifested mutual assent to be bound and found that the parties’ representatives formed a binding contract during their phone call. During the call, they reached agreement on the essential terms of the settlement and confirmed that they “had a deal,” the court stated. Neither party indicated that the settlement was contingent upon the execution of a written agreement or the finalization of the press release, the court explained.

Concluding that the shareholder funds lack an adequate legal remedy, the court decreed specific performance, ordering Innoviva to perform its obligations under the settlement agreement, and declared the two shareholder nominees rightful members of Innoviva’s board.

The case is No. 2017-0309-JRS.

Monday, December 11, 2017

FIA warns on risks of cryptocurrency derivatives, calls for more CFTC oversight

By Lene Powell, J.D.

Given the extreme volatility of bitcoin and a lack of historical data, the CFTC should not have given the go-ahead to several exchanges to list bitcoin futures contracts and binary options through the expedited self-certification process, FIA CEO Walter Lukken said in an open letter to the CFTC. Without a robust public discussion of the risks, FIA is concerned that important issues may not have been fully considered, including whether there should be a separate guarantee fund for the unproven products.

“While we greatly appreciate the CFTC’s efforts to receive additional assurances from these exchanges, we remain apprehensive with the lack of transparency and regulation of the underlying reference products on which these futures contracts are based and whether exchanges have the proper oversight to ensure the reference products are not susceptible to manipulation, fraud, and operational risk,” Lukken wrote.

Products self-certified by exchanges. On December 1, 2017, the CFTC announced that the Chicago Mercantile Exchange Inc. (CME) and the CBOE Futures Exchange (CFE) had self-certified new contracts for bitcoin futures products, and the Cantor Exchange (Cantor) had self-certified a new contract for bitcoin binary options.

Under the self-certification process, a designated contract market (DCM) must determine that the new product complies with the Commodity Exchange Act (CEA) and CFTC regulations, including that the contract is not readily susceptible to manipulation. If the Commission does not find that the product would violate the CEA or regulations, the DCM may then list the new product one full business day later. Completion of this process does not constitute Commission approval, nor endorsement of the use or value of the products.

According to the CFTC, the “vast majority” of new products are brought to market through this process, and CFTC staff held “rigorous discussions” with the exchanges for weeks and months before the self-certifications. CFTC Chairman J. Christopher Giancarlo noted that the exchanges agreed to changes requested by staff on contract design and settlement, as well as to information-sharing and surveillance commitments. The CFTC said that after the products are launched, the agency will monitor risks, conduct reviews of designated contract markets, derivatives clearing organizations (DCOs), clearing firms and individual traders, and will also work closely with the National Futures Association (NFA).

FIA concerns. The price of bitcoin, the underlying reference product, has shot up over the past year. According to Coindesk, an information services provider for the digital asset industry, the price of one bitcoin passed $1,000 for the first time on January 1, 2017, and reached $16,601 on December 1, 2017. In addition, prices can swing wildly intraday and sometimes diverge significantly between bitcoin exchanges.

Given the extreme volatility of the underlying reference product and the novel, untested nature of the self-certified derivatives products, FIA is concerned that clearing firms bear the brunt of the risk through guarantee fund contributions and assessment obligations, rather than the exchanges and clearinghouses who list them. According to FIA, the one-day self-certification process did not allow for proper public transparency and input.

In particular, FIA believes the CFTC should have had public discussion on whether a separate guarantee fund for the products was appropriate or whether exchanges put additional capital in front of the clearing member guarantee fund. In addition, not all risk committees of the relevant exchanges were consulted before the certifications, per FIA’s understanding. FIA said that CPMI-IOSCO guidance and good governance would suggest that this should have happened.

FIA said it looks forward to a “healthy public discussion” on how to improve the self-certification process in the future, as well as the CFTC’s continued oversight of the emerging instruments.

Friday, December 08, 2017

Tennessee proposes exempt employee benefit plan rule amendments

By Jay Fishman, J.D.

The Tennessee Securities Division has proposed amendments to its exempt employee benefit plan rule. The anticipated effective date of the rule is February 28, 2018 if no hearing is requested.

As proposed, issuers wishing to offer securities from, in or into Tennessee under the Tennessee Securities Act’s employee benefit plan exemption would file with the Tennessee Securities Commissioner no later than 15 days after the first sale: 
  1. a complete, properly executed Form IN-1461, Notice of Sale of Securities Pursuant to Employee Stock Purchase/Option Plan Exemption
  2. a complete, properly executed Form U-2, Uniform Consent to Service of Process (or another Division-approved form);
  3. a complete, properly executed Form U-2A, Uniform Form of Corporate Resolution, if the issuer is a corporation; 
  4. a $500 fee; and 
  5. a statement specifying the date of the first sale, if any, of securities from, in or into Tennessee.

Thursday, December 07, 2017

E.U. recognizes U.S. derivatives trading venues for purposes of MiFID II/MIFIR

By Lene Powell, J.D.

Heading off possible fragmentation of E.U. and U.S. derivatives markets, the European Commission announced that it will recognize CFTC-authorized Designated Contract Markets (DCMs) and Swap Execution Facilities (SEFs) as eligible for compliance with EU derivatives trading requirements under MiFID II/MIFIR. The decision ensures that E.U. counterparties can trade derivatives instruments subject to the requirements, including interest rate swaps and index-based CDS, on U.S. trading venues after the new framework goes into effect as of January 3, 2018.

In a joint statement, Valdis Dombrovskis, European Commission Vice-President in charge of Financial Stability, Financial Services, and Capital Markets Union said, “Today's decision on equivalence, together with the CFTC staff's recommendation for an exemption order, confirms how global cooperation can bring tangible benefits to market operators on both sides of the Atlantic.”

CFTC Chairman J. Christopher Giancarlo encouraged his fellow commissioners to approve a pending staff recommendation for exemption from the CFTC’s SEF registration requirement for multilateral trading facilities (MTFs) and organized trading facilities (OTFs) authorized in the E.U.

MiFID II/MiFIR and equivalence. Under the new MiFID II and MiFIR framework, as of January 3, 2018, EU financial and non-financial counterparties must execute derivatives transactions subject to the trading obligation on E.U. trading venues or third-country trading venues recognized by the European Commission as “equivalent.” Derivatives that have been designated by E.U. regulators as subject to the E.U. trading obligation include euro, dollar, and pound interest rate swaps in the most common benchmark tenors, as well as index-based CDS.

On October 13, 2017, the CFTC and European Commission agreed to a “Common Approach” framework allowing for mutual recognition of derivatives trading facilities in the U.S. and E.U. Under the Common Approach, the two jurisdictions agreed that:
  1. The European Commission intended to adopt an equivalence decision covering CFTC authorized SEFs and DCMs that are notified to it by the CFTC, provided 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. 
  2. The CFTC intended to propose, and the chairman would support, the CFTC's exemption from the SEF registration requirement, through a single exemption order, of the trading venues authorized in accordance with the MiFID II/MiFIR requirements that have been identified to the CFTC by the EC, provided they satisfy the standard in Commodity Exchange Act Section 5h(g).
The European Commission’s equivalence decision and annex on December 5, 2017 provide further details and list the specific DCMs and SEFs that have been deemed equivalent.

Pending CFTC exemption. According to the joint statement, the exemption recommendation for EU-authorized MTFs and OTFs, currently pending before the CFTC, is the first time the CFTC has adjudicated an exemption from the SEF registration requirement.

“I thank Vice President Dombrovskis and his staff for all of their work in reaching this positive result. I also welcome and support the CFTC staff recommendation to the Commission for an exemption order applicable to EU trading venues and encourage my fellow Commissioners to act expeditiously in approving the order,” said Giancarlo.

Wednesday, December 06, 2017

AICPA conference panelists discuss SEC comment letter process

By Amanda Maine, J.D.

Current and former officials from the SEC’s Division of Corporation Finance offered their views on the SEC’s comment letters on issuer filings at the AICPA’s Annual Conference on Current SEC and PCAOB Developments. Former Corp Fin director Brian Lane, now with Gibson Dunn, noted that the makeup of the staff has changed since he left in 1999. During his tenure, the vast majority of the staff consisted of attorneys, but there has been a big shift to accountants since then, he observed.

Review of outside information. Christine Davine of Deloitte & Touche, who moderated the panel, noted that more comment letters have been referring to information in company press releases or on a company website and inquired as to how the staff considers that information in the review process. Associate Director Kyle Moffatt, who will take over the role of acting chief accountant when the Division’s current chief accountant, Mark Kronforst, departs in January, says that the Division takes a number of things into account, including company websites, investor slides, what analysts are saying, and what goes on in the industry itself. If necessary, he said, the staff will request more details or insight on items to be considered for disclosure.

Lane said that some of his clients have received comments where the SEC staff had reviewed an investor presentation. These clients might try to tell him that the information in the investor presentation isn’t important, but he noted that during the presentation itself, the client “made it sound like the second coming.” He urged issuers to be very mindful of these investor presentations because they are fertile ground for SEC staff to review.

Process. Lori Locke, who served at CorpFin and is currently VP and corporate controller at Gannett, was asked what happens when her company receives an SEC comment letter. Locke explained that they will assemble a working group who will assess the time it will take to complete the review, look at the nature of the comment, and put together a schedule. She warned that formulating a response to a comment letter takes longer than one might think, but she also advised that if an extension is needed, the company can contact the SEC staff. A one or two week extension is fine, she said, but a month extension is probably too long. She also recommended pulling together contemporaneous documentation to make it easier and faster to respond to the SEC’s comments.

When asked why the average number of comment letters received and the number of comments per review have gone down, Lane said that experience is a good teacher. There have been fewer IPOs recently, resulting in a more mature collection of public companies that have gone through the process and know what to do, he said.

Communicating with staff. Locke said that when it comes to communicating with SEC staff, the first time to reach out is to seek clarification. Issuers should also contact the staff if they want to provide additional context to the filings that were reviewed. Locke advised that anything told to the staff over the phone should be put in writing as well.

Davine inquired when a client should request a face-to-face meeting with the SEC rather than communicating over the phone. Lane said that there are practical reasons that the staff prefers phone calls, such as bringing in people who work remotely. However, in-person conferences may be useful for situations such as a pre-IPO or if it is something really important, such as discussing a new segment.

Moffatt assured that the staff is always willing to listen. Counsel should let the staff know if they feel they’re not being heard, or if they want to appeal, or if they want others involved, he said.

Non-GAAP and MD&A. Davine noted that management discussion and analysis (MD&A) has historically been the top area for SEC comments, but it has been supplanted by comments on non-GAAP measures this year. According to Moffatt, companies have been doing a good job of complying with the revised Compliance & Disclosure Interpretations (C&DIs) on non-GAAP financial measures issued in May 2016, so for the most part, these staff comments are in clean-up mode. However, the staff will continue to monitor these kinds of disclosures, he advised, noting that the staff does look outside the filings to statements like earnings releases.

When asked about what kinds of issues registrants should focus on in MD&A, Lane pointed to the recent efforts to reform the tax code. Issuers should take into account how taxes might affect business and if the impact of any legislation should be disclosed in the company’s risk factors.

Tuesday, December 05, 2017

Corporation Finance staff is working on update to cybersecurity disclosure guidance

By John Filar Atwood

The staff of the Division of Corporation Finance is developing new guidance for companies’ handling of cybersecurity disclosure. Division Director Bill Hinman said at Practising Law Institute’s securities regulation conference that when Chairman Jay Clayton first asked him if the existing guidance needed to be refreshed, he did not think so. After reviewing the disclosure on more recent cyber events, Hinman changed his mind.

The existing cybersecurity guidance on disclosure is principles-based and was developed in 2011. Hinman said the 2011 guidance is still relevant, but the staff is working on updates in certain areas. The staff will look carefully at what companies are disclosing about their preparation for an attack and how they handled the event itself.

Among other things, the new guidance will ask companies to look at their disclosure controls in the area of cybersecurity, he said. The staff believes that a hallmark of good controls is a procedure that ensures that the IT department and management are talking to each other when a cyber event happens, he noted. The staff wants to see that when a breach occurs, the event is being reviewed by the proper levels of management, he added.

The new guidance also will include a reminder that with escalation procedures in place, a breach could rise to the level of a “material” event, Hinman said. As a result, companies would be wise to review their insider trading policies, and to re-emphasize the restrictions on insider trading, he noted.

Non-GAAP disclosure. Hinman was joined in a panel discussion on Corporation Finance hot topics by the Division’s director of disclosure operations, Shelley Parratt. She said that after much activity in the area of non-GAAP disclosure, she believes the staff is moving into a period where it will largely leave the issue alone. There will still be comments provided on non-GAAP financial measures that the staff finds troubling, she noted, but it will not be as prominent an issue as in the recent past.

Personally identifiable information. Parratt also discussed the October 11 FAST Act-related proposals, particularly the proposal dealing with personally identifiable information (PII). The proposed rule changes would create efficiencies in the process to seek confidential treatment for commercially sensitive or confidential information, including PII. The proposals would permit registrants to omit from material contract exhibits confidential information that is not material and would cause competitive harm if publicly disclosed, without having to request confidential treatment from the Commission.

Companies would be permitted to omit PII in all cases without submitting a confidential treatment request. Under the proposals, exhibits would continue to be subject to review, and the staff would assess whether redactions appear to be appropriate.

Parratt said that the proposal seeks to codify what has already been staff practice. The staff wants companies to redact the exhibit information for which they otherwise would ask for confidential treatment, and to eliminate the long explanation process otherwise associated with the confidential treatment request, she said.

According to Parratt, the proposal is designed to lessen the compliance burden on companies, and to lessen the information protection burden on the staff. The staff has protocols in place to maintain confidential information, and uses very rigorous procedures to protect the information, she said. Not having that information in-house will make it easier on the staff, she noted. She cautioned that if the proposals are adopted, the staff will monitor their use to ensure that companies are “not getting greedy with their redactions.”

Resource extraction. Hinman also briefly touched on the issue of resource extraction disclosure, noting that the staff is working on a proposal in this area. The existing rule was disapproved under the Congressional Review Act in February, giving the SEC one year to develop a new rule. Hinman said that the staff has met with interested groups, and is working to come up with a proposed new approach to resource extraction disclosure by February 14.

Monday, December 04, 2017

REIT controllers owed fiduciary duties to public stockholders

By Joanne Cursinella, J.D.

Claims that certain defendants in a convoluted REIT scheme violated their fiduciary duties to stockholders survived a motion to dismiss. The court found that the plaintiff sufficiently alleged that the defendants set up a structure whereby they profited at the expense of the stockholders, maximizing the profits at the first entity they created to the detriment of the non-controlling stockholders of another entity they created and took public (RCS Creditor Trust v. Schorsch, November 30, 2017, Glasscock, S.).

Ownership structure exploited. The essence of the plaintiff’s claim is that, pursuing a convoluted scheme, certain of the defendants created an entity, AR Capital LLC, to develop and manage REITs. They formed another entity, RCS Capital Corporation (RCAP), which, through subsidiaries, was responsible for marketing and distributing, and providing other services, in connection with AR Capital investment products. These defendants owned 100 percent of AR Capital, but took RCAP public, retaining only a minority interest in RCAP.

Through retention of a single share of super-voting common stock, however, they ensured that they retained control of RCAP. Thereafter, they structured operation of the entities in a way that maximized profits at AR Capital, and that assigned expenses to RCAP, to the detriment of the non-controlling stockholders of that entity. The plaintiff claimed that the defendants owed fiduciary duties to the non-controlling stockholders of RCAP, which they breached, aided and abetted by an entity they controlled and an officer of one of RCAP’s subsidiaries.

Present action. The complaint contains three counts. Count I was brought against some of the defendants alleging that they breached their duties of care and loyalty in connection with the conduct outlined above. The second count, against these same defendants alleged that they are at least liable for aiding and abetting breaches of fiduciary duty by other defendants. Count III was brought against other defendants, and it alleged that each of these defendants was unjustly enriched by the conduct described above, and that such conduct warrants the imposition of a constructive trust.

Core claim remains viable. This complaint focused primarily on a series of allegedly self-dealing transactions in which the certain defendants caused RCAP, which they collectively controlled but in which they held only a 25 percent economic stake, to serve as a cost center for AR Capital, in which they (along with a non-party) retained a 100 percent ownership interest. These allegations adequately stated a claim for breach of the duty of loyalty against those defendants the court said, since the plaintiff also adequately alleged that the defendants owed fiduciary duties to RCAP. Further, these duties were breached by the defendants by their actions and the core claim, the allegation that these defendants used their control over RCAP to cause it to enter into off-market arrangements with AR Capital, which they wholly owned, remained viable despite the defendants’ objections.

Other claims. A proxy claim against these defendants was dismissed because the allegations that they received an ancillary benefit not shared by all stockholders required pleading that the benefit received was sufficiently material to overcome fiduciary duties, and here it was not, the court said. The decisions made, therefore, receive the protection of the business judgment rule, so any fiduciary duty claim premised on them was dismissed. However, the court reserved decision on the arguments for dismissing unjust enrichment and aiding and abetting claims, pending supplemental briefing, given that the core fiduciary duty claim remains.

The case is No. 2017-0178-SG.

Friday, December 01, 2017

Commissioner Quintenz focuses on the promise of transformative technologies at ISDA gathering in London

By Brad Rosen, J.D.

CFTC Commissioner Brian Quintenz shared an optimistic vision for the future, and the power of technology to transform the financial markets, in a keynote address before the ISDA Technology & Standards: Unlocking Value in Derivatives Markets conference in London, United Kingdom. Quintenz’s remarks, which were tempered by a measure of caution and skepticism, spanned a wide range of tech-related topics including block chain technology, LabCFTC, the British regulatory sandbox, and the challenge of international coordination in an increasingly complicated world.

Blockchain technology in the derivatives context. Quintenz observed that rapid and widespread acceptance and adoption of distributed ledger technology (DLT) in the financial setting promises to transform a range of business operations in the derivatives industry. This includes how firms handle trade execution, processing, and reporting and recordkeeping of derivatives.

Quintenz noted these innovations are already starting to take shape, and pointed to the example of the Depository Trust Clearing Corporation (DTCC) which recently announced that it is transferring records for more than $11 trillion of cleared and bilateral credit derivatives transactions to its own DLT platform.The platform will provide market participants with real-time access to a single recordkeeping system for their swap transactions. It is expected to go live in early 2018.

According to Quintenz, "the further actualization of DLT in the derivatives space will depend on the ability of market participants to digitize all aspects of their financial transactions. Once the terms of a swap can be reduced to a completely digital, industry-accepted standard, then automatic trade reporting, centralized recordkeeping, and, ultimately, smart contracts become possible." "ISDA’s common domain model, which aims to capture all post-execution trade lifecycle events in a digital format, is an indispensable step toward the fulfillment of blockchain’s full potential," he continued.

LabCFTC and the British regulatory sandbox. Quintenz discussed the CFTC’s LabCFTC initiative which was launched in May of this year as a pathway by which the CFTC can develop and foster dialogue with the FinTech community. He noted that LabCFTC plans to host a series of prize competitions in 2018, and that these competitions are meant to encourage the development of beneficial technologies within the private sector. Quintenz described the prize competitions, in conjunction with the CFTC’s ability to provide no-action relief when necessary, as two powerful tools at the agency disposal to promote innovation.

Quintenz also took the opportunity to laud the British for their approach to promoting FinTech through their regulatory sandbox initiatives. In particular, he pointed to the Financial Conduct Authority’s (FCA) "Project Innovate," which was established in 2014, and the Bank of England’s "FinTech Accelerator" launched last year. Quintenz noted that the FCA’s sandbox initiative, in its first year, reduced the time and cost of getting innovative ideas to market. Specifically, 75 percent of firms that participated in the sandbox successfully completed testing, and 90 percent of those firms are preparing for a wider market launch.

Bitcoin related instruments. Commissioner Quintenz stated that "[p]erhaps one of the most prominent ideas associated with FinTech are digital currencies, led by bitcoin." He described the new bitcoin futures products being proposed by the Chicago Mercantile Exchange Inc. (CME) and the CBOE Futures Exchange (CFE), and how these instruments will provide a new platform to gain or hedge exposure to bitcoin’s volatility. However, his comments on this score were neutral and agnostic. He noted "the Commission does not endorse any particular futures contract, including bitcoin."

Quintenz also described the market oversight roles to be played by both the exchanges and the commission. He noted, "exchanges have a duty to monitor market activity on an ongoing basis to detect and prevent manipulation, price distortions, and, where possible, disruptions in the cash-settlement process." Moreover, he added, "the Commission staff will engage in a variety of oversight activities. These activities include monitoring and analyzing open interest, initial margin, and variation payments, as well as stress testing positions. Commission staff also will conduct reviews of exchanges, clearing firms, and individual traders involved in the trading and clearing of bitcoin futures."

International coordination. Quintenz also highlighted the importance of the CFTC’s coordination with other international regulators, not just on novel FinTech issues, but more generally on the myriad of issues that impact global derivatives markets. He recognizes that progress has been made regarding comparability and equivalence determinations relative to trading venues, as well as harmonizing data standards for swaps trade reporting. However, Quintenz believes more work and discussions are necessary, especially around governance issues. Moreover, the supervision of cross-border CCPs is of paramount importance to both the EU and the CFTC, according to the commissioner.

In his final remarks, Quintenz concluded, "[w]ith the right outlook, we can help guide advancement…promote it...and capture it. The opportunities, as well as the challenges, ahead of us are immense. But, through gatherings like this, on-going dialogue, partnerships, and trust, we will find the wisdom, commitment, and vision to benefit innovators, consumers, and the markets with thoughtful and appropriate regulation."

Thursday, November 30, 2017

Corporation Finance director provides clarification on Staff Legal Bulletin 14I

By John Filar Atwood

Staff Legal Bulletin 14I (the SLB) encourages, but does not require, a company’s board to provide analysis on shareholder proposals under paragraphs (i)(5) and (i)(7) of Rule 14a-8, according to Bill Hinman, director of the SEC’s Division of Corporation Finance. At Practising Law Institute’s securities regulation conference, he said that the staff would like to see a board’s analysis of whether a proposal is of transcending importance, but not all companies have to provide it.

The SLB includes guidance on the application of paragraph (i)(7), which is the ordinary business exclusion, and paragraph (i)(5), which permits exclusion of a proposal based upon its economic relevance to the company. For both provisions, the SLB requests that companies provide a discussion that reflects the board’s analysis of the particular policy issue raised in a shareholder proposal and its significance.

Hinman said that judgment calls about whether a proposal is so significant to a company’s business that it should not be excluded from the proxy are difficult for the staff to make. The SLB is designed to provide the staff with more information to improve its decision-making process.

Board analysis. Hinman encouraged boards to provide the requested analysis for proposals that fall under paragraphs (i)(5) and (i)(7) and assured that it would be carefully considered by the staff. Asked how much detail the staff would like to see in the board’s analysis, Hinman said that companies can decide for themselves how much information they feel is compelling. Companies should analyze the issue with their specific shareholder base in mind, he advised.

He believes that much of the board’s analysis will take place at the nominating committee and governance committee level. The staff would like to see if these committees have considered the issue in the proposal, and whether a company has met with the affected shareholders, he said. The analysis process may result in more companies working out issues with shareholders before they reach the proposal stage, in his opinion.

Ronald Mueller, a partner at Gibson, Dunn & Crutcher, said that he was initially surprised by the SLB’s request for board input on the shareholder proposal issues. However, he acknowledged that when deciding whether a proposal rises to the level of significance under (i)(7), no one is more qualified to weigh in than the board of directors.

Michele Anderson, a deputy director in the Division of Corporation Finance, reiterated Hinman’s advice that the board analysis is welcome, but not required. A company may be able to argue its point and persuade the staff without the board analysis, she noted. Mueller said that since the board analysis is not required, it should not be seen as an additional burden, but rather as an additional avenue to make the case that a proposal qualifies as ordinary business.

Anderson believes that the SLB breathes new life into paragraphs (i)(5) and (i)(7). She noted that paragraph (i)(5) was adopted in 1983, but has only rarely been used since 1985. In her view, the SLB will enable (i)(5) to be used as it was intended.

Proposals by proxy. On the issue of proposals by proxy, Hinman said that the staff has heard that issuers were not sure who they were dealing with when proposals are submitted by proxy. The SLB outlines four elements that would be useful in providing a more complete record in determining who the proponent is. The proposal will not necessarily be excludable if a company does not hit on all four elements, he said.

Hinman told Wolters Kluwer that the SLB was not issued as a response to the CHOICE Act, which calls for a prohibition on proposals by proxy. The staff was mindful of the CHOICE Act, he noted, but included the proposal-by-proxy guidance in the SLB simply to make more information available on who is submitting the proposal. He emphasized that the staff believes that proposals by proxy are acceptable.

Wednesday, November 29, 2017

SCOTUS whistleblower debate focuses on plain language, Chevron deference

By Anne Sherry, J.D.

The Supreme Court held oral argument on whether Dodd-Frank protects an employee against retaliation even if the employee does not report misconduct to the SEC. The employer, who petitioned the Court, argues that the statute’s definition of “whistleblower” as requiring SEC reporting applies equally to the award and anti-retaliation provisions. Some Justices seemed skeptical of the employee’s counterarguments that the definition plainly does not apply to the retaliation portion or, if the law is ambiguous, that the SEC’s rule is entitled to deference (Digital Realty Trust, Inc. v. Somers, November 28, 2017).

Statutory definition. Exchange Act Section 21F, added by Dodd-Frank, bars employers from discriminating against “a whistleblower” for providing information to the SEC; being involved in an investigation or action based on the information; or (in the controversial subsection (iii)) making disclosures required or protected under the securities laws. That third category of protected disclosures includes certain categories of internal reporting and other reports that are not necessarily made to the SEC. But “whistleblower” is defined elsewhere in Section 21F as “any individual who provides … information relating to a violation of the securities laws to the Commission, in a manner established, by rule or regulation, by the Commission.” In light of this apparent tension, many employees argue that the statute is ambiguous, warranting Chevron deference to the SEC’s rule, which does not require reporting to the agency.

Circuit split. The Court granted certiorari to review the Ninth Circuit holding that internal whistleblowers are protected from employment retaliation, which deepened a circuit split. The Ninth Circuit agreed with the district court that the SEC’s rule aligned with Congress’s overall purpose to protect whistleblowers, whether they report violations internally or to the government. The language of subsection (iii) illuminates Congress’s intent to protect certain professionals, namely auditors and attorneys, who are required to report violations internally before they can do so externally. The fact that the statute describes whistleblowers as employees who report to the SEC did not dispose of the employee’s argument because terms can operate differently in different contexts, as the Supreme Court reasoned in upholding most of the Affordable Care Act (King v. Burwell (U.S. 2015)). One judge on the panel dissented on the grounds that this case should be “quarantined” to its specific facts.

Supreme Court contends with definition. The Justices focused much of their questioning on the operation of this whistleblower definition. In the view of the whistleblower/respondent and government (as amicus curiae in support of the respondent), the definition applies only to the award section of the statute. When used in the anti-retaliation provision, the word “whistleblower” carries its ordinary meaning. Respondent’s counsel also emphasized that the statutory definition does not say the report has to go to the Commission, but that it be made “in a manner established by rule or regulation by the Commission.” It makes sense for Congress to contemplate that the whistleblower award process be carried out in a particular way, to make it easy to track who is eligible for an award after an enforcement action is announced. But Congress did not need to limit the anti-retaliation section to a particular form of reporting to accomplish the core objective of the whistleblower legislation.

The employer/petitioner, however, asserted that the definition is clear and that its application to the anti-retaliation provision is consistent with the history, structure, and objectives of the whistleblower provisions. In this view, anyone who has reported to the SEC is protected from retaliation for any reason. The petitioner’s counsel said that subsection (iii) thus “reaches a situation in which an employee … reports to the SEC but is retaliated against because of an internal report or perhaps a report to another governmental entity.”

Tuesday, November 28, 2017

IOSCO issues report on hedge fund statistics, trends

By Amy Leisinger, J.D.

The International Organization of Securities Commissions (IOSCO) has published its biannual report on the global hedge fund marketplace, key regulatory changes, and the potential systemic risks posed by the industry. IOSCO’s survey assembles information from national authorities on hedge fund activities and is designed to enable regulators to share information and observe trends regarding exposure, leverage, liquidity management, funding, and trading activities in the hedge fund industry.

Using data as of September 30, 2016, IOSCO’s report notes that, in the span of two years, the global assets under management of 1,971 surveyed hedge funds increased by 24 percent to $3.2 trillion, likely as a result of enhanced reporting requirements, market performance, consolidation of smaller funds, and/or growth through net new investment. To avoid double counting, IOSCO scaled down data sets of other jurisdictions where hedge funds were likely also to have reported to the SEC on Form PF, but the data implies that 76 percent of the global total is held with primarily U.S.-based hedge fund managers, the organization reports. According to IOSCO, the Cayman Islands remains the domicile of choice for hedge funds, with 53 percent of the global total by NAV, and the portion of funds domiciled in Europe and Asia continues to be very limited.

IOSCO found that values for interest rate derivatives dominate as to gross exposures per asset class. After derivatives, equities represented the next highest total in both long and short exposure. Equity long/short was the most widely used investment strategy, followed by global macro and fixed income arbitrage, both of which might be expected to make extensive use of government bonds, according to the report.

Across the sample funds, IOSCO found total gross notional exposure to all asset classes (adding short positions to long positions) was $22.7 trillion, which, divided by the $3.2 trillion global NAV, shows a gross leverage of 7.1x—an increase from 5.1x in 2014. However, the report notes that one of the factors affecting the calculation is the inclusion of notional values of interest rate and FX derivatives, which may exaggerate the level of exposure. Recalculating to exclude those categories results in a gross exposure of $9.8 trillion and a more modest gross leverage of 3.1x, IOSCO explains. The amount of leverage used by hedge funds may vary widely depending on investment strategy, but the data show prime brokers still represent the largest source of financial leverage for hedge funds with an increased reliance on repo markets, according to the report.

Further, IOSCO found that, in the aggregate, hedge funds maintain liquidity buffers and portfolio liquidity exceeds investor liquidity by a wide margin across different time periods, suggesting that funds should be able to meet investor redemptions through orderly liquidation. In addition, 3.8 percent of hedge fund assets involve liquidity management tools, such as gates, suspensions, or side pockets, the report states.

IOSCO found that hedge funds across the sample posted total collateral of more than $2.7 trillion, with the amount posted in the form of cash and equivalents falling slightly. In the realm of trading and clearance, the portions of cash securities traded on exchange versus over-the-counter were relatively equal, except with respect to derivatives, which traded higher OTC, the report concludes.

Monday, November 27, 2017

Petition asks high court to curb SEC's dodging of statutes of limitations

By Rodney F. Tonkovic, J.D.

A petition for certiorari has been filed asking the Court to reign in a tactic used by the SEC to avoid statutes of limitations. The petitioner maintains that the Commission frequently takes portions of a continuous course of action in a way that allows it to commence an action after the limitations period has expired. The petition also raises a series of challenges to what it argues were erroneous factual findings and misapplications of properly-stated rules of law (Knight v. SEC, November 7, 2017).

From late 1999 through the summer of 2000, Internet start-up iShopNoMarkup.com disseminated a private placement offering. The Commission filed an action in 2004, claiming that iShop Chairman Anthony M. Knight and others conducted a fraudulent and unregistered securities offering scheme that defrauded over 350 investors who invested approximately $2.3 million. In 2014, the matter came before a jury, which returned a verdict in favor of the Commission, finding that Knight violated the antifraud provisions of the securities laws and the securities registration provisions of the Securities Act.

No miscarriage of justice. In September 2015, Knight sought judgment as a matter of law or a new trial asserting, among other arguments, that the Commission engaged in misconduct, witnesses were not credible, and that others besides Knight made the alleged misrepresentations. In denying Knight's motion, the court said that his submission generally consisted of unsubstantiated attacks and Knight's "own, self-serving, interpretation of the facts." The court then found that the jury's finding was neither the result of surmise nor a miscarriage of justice. Knight was then permanently enjoined from violations of the registration and antifraud provisions. He was also ordered to disgorge $2.3 million and to pay a civil monetary penalty of $330,000.

On appeal, Knight (proceeding pro se) challenged the jury's findings and the remedies imposed by the district court. Knight first claimed that the Commission's allegations were time-barred, but the court disagreed, stating that the claims did not accrue until the earliest alleged violation in September 1999. The Commission filed its action in September 2004, so its claims were not barred under the five-year limitations period in 28 U.S.C. § 2462.

Knight also raised a number of challenges to the jury's findings, all of which were rejected by the panel. Among its conclusions, the court stated that the general disclosures contained in iShop's offering memoranda could not overcome proof that the description of the security was materially inaccurate. The court also rejected Knight's defense that he reasonable relied on the advice of counsel because the jury could reasonable have found that he failed to make a complete disclosure to counsel. Knight also argued under Janus that he was not the "maker" of the statements in the offering memoranda, but there was sufficient evidence, the court said, that he was. The panel found no error in the district court’s choice of remedies and affirmed the judgment.

Cert petition. The petition for certiorari first asks the Court to consider whether the SEC can choose, piecemeal, alleged actions in a continuous course of action so as to avoid prosecution being time-barred pursuant to 28 U.S.C. Code § 2462. According to Knight, the appellate court failed to consider that iShop's actions were part of an alleged course of conduct that began before the five-year statutory period and that the Commission commenced its action after the limitations period had passed. This, the petition, states, is a frequent tactic employed by the SEC to escape statutes of limitations, with dire consequences for Knight and "countless others."

The petition then asks the Court to assess whether a series of eight judicial errors merits a reversal. Knight concedes that certiorari is rarely granted when the asserted error consists of erroneous factual findings of the misapplication of a properly-stated rule of law. But, he requests consideration due to the "sheer enormity of the erroneous factual findings and misapplications of properly stated rules of law in conjunction with an important federal question." The district court departed from the accepted and usual course of judicial proceedings, Knight says, and the appellate court sanctioned this departure. This case, Knight concludes, presents a change to review the SEC's conduct and is important to every pro se litigant targeted by the Commission.

The petition is No. 17-734.

Friday, November 24, 2017

Kokesh fails to save adviser from disgorging ill-gotten gains

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

A former hedge fund adviser has been ordered to pay almost $2 million in disgorgement and penalties for fraudulently spending investors’ funds on luxuries and paying off investors from a prior scheme. The federal district court in Dallas summarily rejected the defendant’s contention that the Supreme Court’s decision in Kokesh v. SEC would make disgorgement an unlawful penalty in his case. The court also rejected the argument that a New Mexico court’s award of restitution against the defendant for his role in the prior scheme precluded an order of disgorgement in the present case (SEC v. Sample, November 20, 2017, Boyle, J.).

Lobo Fund scheme. The defendant, Matthew D. Sample, had raised $982,000 from investors in his hedge fund, Lobo Volatility Fund, LLC. The SEC charged Sample with using the invested funds for personal expenses while supporting his con by creating false IRS forms showing positive account balances and investment returns. In April 2014, Sample agreed to disgorge his ill-gotten gains, pay prejudgment interest on those gains, and pay a civil penalty. In a parallel criminal proceeding, a federal district court in New Mexico subsequently sentenced Sample to five years of probation and ordered him to pay approximately $1.1 million in restitution to the victims of the Lobo Fund scheme and a prior fraudulent scheme.

Kokesh unavailing. Although Sample had previously agreed to disgorge his ill-gotten gains, he responded to the SEC's motion for monetary remedies by arguing that the Supreme Court's June decision in Kokesh v. SEC would make ordering him to disgorge an unlawful penalty. Specifically, Sample’s argument hinged on footnote three of Kokesh, where the high court stated that nothing in its decision should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings.

The district court, however, flatly rejected Sample’s argument, noting that Kokesh had no effect on how courts apply disgorgement principles. Rather, Kokesh merely held that disgorgement claims are subject to 28 U.S.C. § 2462’s five-year statute of limitations. Moreover, the restitution ordered in Sample’s criminal proceeding did not prevent an order of disgorgement in his civil case. Accordingly, the court ordered Sample to disgorge an amount equal to $919,875 less what he pays the Lobo Fund victims in restitution.

Civil penalty. The court also granted the SEC's request for a third-tier civil penalty against Sample. Among other things, the court noted that Sample: (1) had misappropriated substantial amounts of his clients’ money for his personal use; (2) knew his conduct was illegal; (3) lied to his clients about losses he was incurring and created fake account statements; (4) was aware of the federal securities laws as a veteran of the securities industry; and (5) made Ponzi payments to pay alleged returns to an existing investor. Given the egregiousness of Sample’s scheme and the losses he caused his victims, the court imposed a civil penalty of $919,875.

The case is No. 3:14-CV-1218-B.

Wednesday, November 22, 2017

Oregon’s proposed crowdfunding amendments will enhance capital formation

By Jay Fishman, J.D.

The Oregon Finance and Securities Regulation Division has proposed amendments to its crowdfunding rules to better align them with federal requirements, and to capture changes providing small businesses with more leeway to raise capital from permitted investors without lessening investor protections.

Public comments. Interested persons may submit written comments about the rule proposals to Karen Winkel at the Department of Consumer and Business Services, Finance and Securities Regulation Division, Labor and Industries Building, 350 Winter St NE, Salem, Oregon 97301. Alternatively, comments may be emailed to karen.j.winkel@oregon.gov. Comments must be received by 5:00 pm on December 11, 2017.

Proposed crowdfunding rule changes. Highlights of the proposed rule amendments would include the following:

Exemption from registration. The “Oregon Intrastate Offering Exemption” (OIO) would provide Oregon businesses with an exemption from securities registration to facilitate investment by Oregon residents while simultaneously protecting investors. To be exempt:
  • the sale would be made by an issuer comprising an existing Oregon business that complies with all Oregon Secretary of State requirements for doing business in Oregon; 
  • the offer and sale would be conducted in accordance with SEC Rule 147A; note that issuers having properly filed an OIO offering before July 7, 2017 under federal Securities Act, Section 3(a)(11) and SEC Rule 147 would notify the Director that the continued offer and sale will comply with this subsection (2) [SEC Rule 147(A)]; 
  • OIO securities would be offered or sold only to natural persons who the issuer, salesperson, or broker-dealer reasonably believes are Oregon residents (and otherwise qualify under the OIO rules); and 
  • the issuer, salesperson or broker-dealer, before any sale under the OIO exemption occurs, would obtain reasonable documentary evidence that the prospective purchaser’s principal residence is in Oregon (reasonable documentary evidence proving Oregon residency could include a current Oregon-issued driver’s license or personal identification card, or a current voter registration, or evidence of Oregon principal residence ownership or occupancy, or official business mail from a state or federal agency); note that a signed statement without additional evidence does not sufficiently create a reasonable belief in a purchaser’s Oregon residency.
Aggregate offering amounts. An issuer could engage in multiple OIOs subject to integration, but the total amount raised in any 12-month offering period (or 24-month period if the issuer applies to extend the offering) would not exceed $250,000. The OIO could be used to raise a maximum aggregate amount of $500,000.

Single investor limit. The amount the issuer could accept from any individual investor would not exceed $2,500 unless the following alternative maximum investment (AMI) applies: A person whose income exceeded $100,000 for the two consecutive years and who reasonably expects their income to exceed $100,000 for the current year, and who has a $200,000 net worth, excluding their principal residence, may invest up to $10,000. For AMI purposes, an issuer, salesperson or broker-dealer must have formed a reasonable belief based on document review and the prospective purchaser’s signed declarations that the prospective purchaser meets the income and net worth thresholds. An issuer that sells a security under the AMI would be permitted to engage only in a single transaction at the AMI limit per spousal unit. The AMI-subject securities could be held jointly or individually.

Securities limitation. OIO securities would be limited to notes, stocks and/or debentures.

Notification of first sale. An issuer would notify the Director within five days of the first sale of an OIO security.

Duration of offering. An OIO offering would not exceed 12 months from the date the security is first sold under the OIO exemption. An OIO offering could be extended for one additional, consecutive 12-month period, but an offering period would not exceed 24 months from the date of the initial sale. An issuer could apply to extend the offering by submitting to the Director an amended filing on a Director-approved form that conforms with the OIO rules.

Offering proceeds. OIO sale proceeds would be used in accordance with both the issuer’s representations made to investors and with OIO rule disclosures.

Issuers must meet with business technical service provider. Issuers, before advertising, offering or selling OIO securities, would need to have reviewed their business plan in person with a business technical service provider.

Notice filing. Issuers would send the Director a written notice of the OIO offering not less than 15 days before any advertising, offer or sale of an OIO security occurs, whichever of the three events comes first. The notice filing requirement could be met by an issuer submitting either a Director-approved form or all the above-required numbered items individually.

The notice, accompanied by a $200 fee payable to the Department of Consumer and Business Service, would contain:
  1. the issuer’s name and address, as well as the names and addresses of the directors’, officers’ principals’, managing members’, and shareholders’ having a 20 percent (or more) interest in the Oregon business; 
  2. a copy of the proposed advertising template (including a URL if a website will be used for the offering) and the name of the third party platform provider (if applicable); 
  3. a brief description of the business and specific project comprising the offering; 
  4. the minimum amount needed to release funds to the issuer, and the maximum *offer amount; 
  5. a copy of the offering documents and a sample of the certificate or other evidence of the security; and 
  6. a Director-approved form verifying the issuer’s in-person meeting with a business technical service provider to review the issuer’s business plan, or an approved waiver. The filing would be signed by the issuer or by the issuer’s duly authorized representative verifying the filing’s material accuracy and completeness. 
* “Offer” would include every attempt to dispose of an OIO security for value. The publication of any information and statements, and publicity efforts—including any advertising materials—in advance or in connection with an OIO that contributes to the conditioning of the public mind or arousing public interest in the issuer or is intended to arouse public interest investing in the issuer or purchasing its securities—even though it does not contain an express offer—is an offer of OIO securities for purposes of this OIO exemption.

Tuesday, November 21, 2017

SCOTUS offered three competing interpretations of SLUSA jurisdiction

By Anne Sherry, J.D.

What effect did the Securities Litigation Uniform Standards Act have on state-court jurisdiction? Cyan, Inc., which successfully petitioned the Supreme Court for certiorari, argues that the statute withdraws, rather than continues, state courts’ concurrent jurisdiction over Securities Act class actions. The respondents counter that SLUSA does not strip state courts of concurrent jurisdiction. And the government, in an amicus brief, submits that defendants are authorized to remove Securities Act covered class actions involving covered securities to federal court (Cyan, Inc. v. Beaver County Employees Retirement Fund, November 13, 2017).

Cyan shareholders sued the company over weaker-than-expected results following its IPO. The complaint was brought as a class action to pursue strict-liability remedies under the Securities Act. It was brought in California state court, but alleged no state-law claims. Bound by California decisions holding that SLUSA continued state-court jurisdiction over class actions under the Securities Act, the state court denied Cyan’s motion for judgment on the pleadings.

SLUSA amended Securities Act Section 22 to close a loophole in the Private Securities Litigation Reform Act that many feared could lead to abusive litigation. The statute now provides that state courts have concurrent jurisdiction of Securities Act suits, “except as provided in [Section 16] with respect to covered class actions.” The parties and amici disagree on how this “except clause” operates.

Cyan’s take: excepting Securities Act claims. Cyan argues that its interpretation is the only one that gives effect to the “except” language of the statute. The clause must except some set of Securities Act claims from the concurrent jurisdiction of state courts, and its text makes clear that these excepted claims are Securities Act claims in “covered class actions,” as provided in Section 16. While Congress sometimes uses the words “as provided in” to refer to a self-operative limit from another statute, as the respondents and government argue, this is not always the case. Cyan presents a hypothetical parking sign that reads “No parking, except as provided in 5 U.S.C. §6103 with respect to legal public holidays.” That code section lists legal public holidays; it has nothing to do with parking, but a reader would understand that the sign bars parking except on the statutory holidays.

To the respondents’ argument that it would have been bizarre for Congress to prescribe different kinds of treatment for state-law class actions, mixed class actions, and Securities Act class actions, Cyan posits that the scheme works “just about as efficiently as possible.” State-law class actions, which are exempt from the PSLRA, are precluded entirely. Securities Act class actions must be filed directly in federal court, where the PSLRA applies. And a hybrid approach for mixed class actions authorizes defendants to remove the suits to federal court, where the state-law claims can be dismissed and the federal claims allowed to proceed subject to the PSLRA.

The less bad alternative: removal. If the Supreme Court does reject Cyan’s reading, Cyan urges it to adopt the government’s interpretation. Unlike Cyan, the government submits that the “except as provided in” language is naturally understood to mean that the cross-referenced provision provides the exception to the general principle. But nothing in Section 16 provides an exception to the general rule of concurrent state-court jurisdiction of a suit asserting only federal-law claims. Rather, Section 16(c) authorizes defendants to remove Securities Act covered class actions involving covered securities to federal court.

The government maintains that its interpretation is consistent with the text of Section 16(c), which does not turn on the source of law under which the removed claims arise. It is also consistent with the structure and purpose of SLUSA, through which Congress authorized removal of state-law actions because it was unwilling to leave preclusion decisions under Section 16(b) to state courts alone. Cyan disagrees, but concedes that while the government’s reading “is not as faithful to SLUSA’s text, structure, and purpose” as its own, it is closer than the respondents’ reading. It would ensure that Securities Act class actions could be heard in a federal forum and prevent circumvention of the PSLRA.

The case is No. 15-1439.

Monday, November 20, 2017

House FSC approves Dodd-Frank repeals plus capital formation, Fed bills

By Mark S. Nelson, J.D.

The House Financial Services Committee engaged in a two-day markup session of nearly two dozen securities and banking bills spanning a range of topics, including Dodd-Frank Act repeals, hedge funds and private equity, business development and closed-end companies, capital formation, proxy advisers, non-bank financial institutions, Fed oversight, and Iran disclosures. The markup and approval of all 23 bills followed a prior House FSC hearing that considered many of the same bills (See vote scorecard).

Dodd-Frank Act repeals. A trio of bills would repeal two of the specialized securities disclosure obligations imposed by the Dodd-Frank Act plus the settlement title of the reform bill. The provisions to be repealed would include:
  • Conflict minerals—Repeal of Dodd-Frank Act Section 1502 (H.R. 4248). 
  • Mine safety—Repeal of Dodd-Frank Act Section 1503 (H.R. 4289). 
  • Restoring Financial Market Freedom Act of 2017 (H.R. 4247)—Repeal of Dodd-Frank Act Title VIII regarding payment, clearing, and settlement. 
By comparison, the Financial CHOICE Act (H.R. 10) would repeal the entirety of the specialized disclosure provisions, including the authority for the SEC’s resource extraction issuer’s rule (Congress disapproved the SEC’s resource extraction issuers rule earlier this year via the Congressional Review Act), plus required studies of inspectors general and of core and brokered deposits. The Treasury Department's report on capital markets, published as part of a review of financial regulations in light of core principles announced by the Trump Administration, recommended repeal of provisions on conflict minerals, mine safety, and resource extraction issuers, and that related SEC rules be withdrawn. The report also urged Congress to transfer the subject matter of these provisions to other agencies if lawmakers were to continue the specialized disclosure regime.

With respect to conflict minerals, the SEC’s recent guidance rolling back the due diligence requirement did not otherwise eliminate the need for U.S. companies to comply with the conflict minerals rule and many firms continued to make the same level of disclosure in 2017 as they had in prior filings. Similar European regulations will come online in January 2021 and will impact European Union importers whose conflict minerals imports are above specified volume thresholds.

Hedge funds and private equity. The Investor Clarity and Bank Parity Act (H.R. 3093) would amend the Bank Holding Company Act to permit hedge funds and private equity funds to use the same name or a variation of a name that the fund has in common with a banking entity that is an investment adviser to the fund if the fund meets certain requirements, which include that the investment adviser not be an insured depository institution, share a name with such institution, or use “bank” in the fund’s name. Currently, BHCA Section 13 (12 U.S.C. §1851) provides that federal regulators can permit banking entities to engage in certain activities despite the Volcker rule ban on many forms of proprietary trading, including organizing or offering a private equity or hedge fund if, among other things, the fund does not share the banking entity’s name.

Friday, November 17, 2017

CFTC Commissioner Behnam reflects and inflects in Georgetown

By Brad Rosen, J.D.

“The CFTC is at an inflection point, where strategic regulatory decisions are critically important to determine the future of market transparency, resiliency, and systemic risk”, declared Commissioner Rostin Behnam, the newest member of the Commodity Futures Trading Commission in his first official speech as a commissioner. Behnam made his long- awaited remarks on November 14 before the Georgetown Center for Financial Markets and Policy at George University, Behnam’s undergraduate alma mater. Behnam was sworn in as a commissioner on September 6, 2017.

In the speech, titled The Dodd-Frank Inflection Point: Building on Derivatives Reform, Behnam provided a sweeping foundational survey of the history of futures regulation in the U.S., starting with the Futures Trading Act of 1921 through the current day, with stops along the way that included the passage of the Commodity Exchange Act in 1936, the establishment of the CFTC in 1974, as well as the 2009 G20 Pittsburgh Summit, which laid the framework for regulating the over-the counter-derivatives markets and the passage of the Dodd-Frank Act in 2010.

Behnam noted that the 2008 financial crisis and weaknesses in the global regulatory system it revealed led to Congress enacting the Dodd-Frank Act, which largely incorporated the international financial reform initiatives for over-the-counter derivatives laid out at the G20 Pittsburgh Summit. These initiatives included: (i) moving standardized contracts to exchanges or electronic trading platform (when appropriate); (ii) mandatory clearing for most bilateral contracts through central counterparties (“CCPs”); (iii) reporting executed trades to trade repositories; and (iv) instituting higher capital requirements for non-centrally cleared contracts.

Behnam argued that it is critical for the CFTC to continue supporting key Dodd-Frank reforms in a manner that is both reflective and forward looking. By this he means it is important to reflect on both the success and failures of policy changes that have been made to date and to keep a vigilant eye on new challenges, innovations, and threats to the financial markets. Behnam asserted, “[o]ur mission is to protect the market and the public from fraud, abuse, and systemic risk”, and recalled, “[w]e cannot forget that millions of jobs were lost and homes foreclosed upon before we were authorized to take action.”

With respect to the further implementation of Dodd-Frank reforms, Behnam identified four areas where the commission needs to make further progress as follows.

Mandatory clearing of standard swaps. Following the implementation of the CFTC clearing mandate in 2013, more than 80 percent of interest rate derivatives and credit default swaps are now centrally cleared. However, mandatory clearing has raised new challenges and concerns with regard to the role and size of the global portfolio of cleared derivatives. Accordingly, aggressive efforts to monitor and consider the potential systemic repercussions of the clearing mandate need to be analyzed and pursued by commission staff.

Exchange trading of standardized swaps. The trading of standardized swaps on CFTC-regulated exchanges (designated contract markets or “DCMs”) or on multi-participant trading systems or platforms first established in the Dodd-Frank Act (swap execution facilities or “SEFs”) is another key area of reform. The main policy goal of the exchange trading requirement is to further transparency in the OTC markets. Like the clearing mandate, the exchange trading policy initiative is sound and the market has moved swiftly to adapt to the regulatory changes.

Swap data reporting. Before Dodd-Frank, there simply was little, if any, relevant market data regarding the size, complexity, and potential risks underlying over-the-counter derivatives. Through robust data collection, market risks and unexpected events can be better assessed and possibly predicted. However, given the CFTC’s limited resources and technology capabilities, the Commission does not have the bandwidth to seek to collect or maintain data that does not serve a proven purpose of protecting markets, market participants, and customers. Nonetheless, the CFTC must prioritize building on the current data requirements established in Dodd-Frank in a way that sets clear parameters for what data must be collected and submitted, when it must be submitted; and, equally important, what form the data must take.

Capital and margin requirements for non-centrally cleared swaps. Capital serves as a loss absorbency mechanism in times of extreme market stress. The CFTC has completed its margin rules, but has yet to finalize capital requirements for the swap dealers who are not prudentially regulated. Regulators must continually monitor market ecosystems to ensure that regulations, including capital and margin requirements, are properly set to ensure market resiliency, safety, and liquidity in times of market stress.

Key priorities. Behnam also stated two of his key priorities and objectives that he will focus on during his early days as a Commissioner. The first is his sponsorship of the CFTC’s Market Risk Advisory Committee (MRAC), the Commission’s open forum to examine risk across broad swaths of the markets. The second, and following in the footsteps of Chairman Giancarlo, Commissioner Behnam will embark on a listening tour across the country and meet with market participants, such as commercial manufacturers, financial institutions, and farmers and ranchers. The stated goal of this undertaking is to get a better understanding of the risk management challenges that these various end users encounter.

Thursday, November 16, 2017

BakerHostetler hosts webinar on preparing for the 2018 proxy season

By Jacquelyn Lumb

National law firm BakerHostetler hosted a webinar on preparing for the 2018 proxy season during which panelists talked about the role of proxy advisers, SEC rulemaking, and emerging issues. The panelists agreed that, while many subscribe to a proxy advisory firm’s services, they do not necessarily follow its recommendations. Companies should engage with proxy advisory firms before the proxy season is underway and before their preliminary proxy has been filed.

Proxy advisory firms. Institutional Shareholder Services reports that it holds 61 percent of the market share with 1,700 clients. Glass Lewis has 1,200 clients. Egan Jones has a smaller shop and is the least influential of the three, but one panelist noted that its guidelines are much stricter. For example, in Egan Jones’ view, a director who has served for 10 years is an affiliated outsider who is no longer fully independent. The firm also has stricter guidelines on auditor ratification and over-boarding.

Shareholder proposals. Shareholder proposals seeking proxy access are in decline and by the end of the upcoming proxy season over 80 percent of the S&P 500 companies are expected to have a proxy access policy. Other hot topics include board refreshment, diversity, and the board’s skill matrix; environmental, social, and governance issues; and shareholder engagement. The panelists said they had the most success in negotiating the withdrawal of proposals relating to board diversity after providing assurances that the companies would look to a diverse pool of candidates with every new opening on the board. However, these companies now must follow their assurances with action.

Withhold recommendations. The panelists said that among the issues that may result in a withhold recommendation by a proxy advisory firm in the election of directors is where a director has attended less than 75 percent of the board meetings, where the director serves on too many boards, where the board has failed to take action on a shareholder proposal that gained majority support, and where the board either adopts or retains what is considered an anti-shareholder rights provision.

Say on pay. With respect to say on pay, both ISS and GL pay attention to pay for performance, the structure of the compensation program, problematic pay practices, and the compensation committee’s communications and responsiveness.

Pay ratio disclosure. 2018 will be the first year for the mandatory pay ratio disclosure. Advisory firms are not expected to react the first year, but one panelist predicted that the media will have a field day. Another panelist said that after the election, he thought the pay ratio rule would be revoked, and another wondered if the SEC would come up with a regulatory maneuver to delay the mandate. Instead, the SEC and the staff issued guidance on how to comply with the requirement.

Hedging and clawbacks. Two other Dodd-Frank Act rules that were proposed by the SEC but not yet adopted relate to hedging and clawbacks. One of the panelists said the hedging proposal was a bit more palatable but the clawback proposal was pretty prescriptive. Neither is likely to be adopted any time soon, in one panelist’s view, although some companies have adopted policies in those areas. If the SEC ultimately adopts a clawback provision, companies may have to amend existing policies to reflect the new rule.