Friday, December 14, 2018

CFTC seeks public input on Ether virtual currency

By Lene Powell, J.D.

In a new Request for Information, the CFTC is requesting public feedback on the virtual currency Ether and the Ethereum network that produces it. In seeking to understand Ether, one of the top three virtual currencies by market capitalization, the CFTC asked 25 specific questions about purpose and functionality, technology, governance, markets oversight and regulation, and cybersecurity and custody. The CFTC also seeks input on similarities and differences between Ether and Bitcoin.

What are Ether and Ethereum? Launched in 2015, Ether is the virtual currency that powers the Ethereum network. Like Bitcoin’s blockchain, Ethereum is a distributed ledger that uses a “proof of work” consensus mechanism in which “miners” are compensated for processing transactions and validating the ledger. The Ethereum Foundation plans to switch to a “proof of stake” mechanism in the future to increase efficiency. The network can run decentralized applications and smart contracts, and the Ethereum website specifically mentions futures contracts as a type of smart contract that may develop. (See the CFTC’s recent primer on smart contracts.)

In June 2018, Bill Hinman, the SEC director of the Division of Corporation Finance, gave a speech in which he stated his personal view that, based on his understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.

Questions for the public. The CFTC asked questions on the following topics:
  • Purpose and functionality. Among other questions, the CFTC asked what use cases are anticipated and how many confirmations on the Ethereum blockchain are sufficient to wait to ensure that the transaction will not end up on an invalid block.
  • Technology. Questions relate to comparisons to Bitcoin, scalability, transition to a proof of stake consensus model, and capability to support smart contacts. The CFTC noted reports of disagreements in the Ether community over the proposed transition to a proof of stake model, and asked if this might result in a fragmented or diminished Ether market if the disagreements are not resolved.
  • Governance. The CFTC asked how Ethereum’s governance compares to governance of the Bitcoin network and whether there are potential issues that could make Ether’s underlying blockchain vulnerable to future hard forks or splintering.
  • Markets, oversight and regulation. Questions include the potential for disruption, impediments, or risks in the conversion of Ether to legal tender and how the introduction of derivative contracts on Ether could impact the network.
  • Cyber security and custody. The CFTC asked about any security issues peculiar to Ethereum or Ethereum-supported smart contracts, and best practices for Ethereum wallets and independent audit of Ether deposits.
In considering the relation of Ether to Bitcoin, the CFTC briefly discussed its 2017 Primer on Virtual Currencies and Bitcoin’s characteristics as a virtual currency. Futures contracts and options on Bitcoin first emerged in December 2017 via a self-certification process by several exchanges, including the Chicago Mercantile Exchange (CME). Some including the FIA and CFTC Commissioner Rostin Behnam have criticized that process, saying it did not allow for sufficient public comment.

Comment period. The comment period will be open for 60 days after publication in the Federal Register.

Thursday, December 13, 2018

Proskauer Rose attorneys warn of collateral consequences in parallel proceedings

Securities cases often are interconnected and difficult to maneuver, and attorneys should not step into parallel proceedings without considering how their choices in one case can filter into other matters, according to Ralph Ferrara, Ann Ashton and Corey Rogoff of Proskauer Rose LLP. In their view, boundaries separating cases appear fuzziest when it comes to shareholder derivative suits. They examine shareholder derivative issues and their unclear link to other securities actions if they address issues such as sequencing parallel proceedings, defending or maintaining objectivity, and managing discovery.

To read the entire article, click here.

Wednesday, December 12, 2018

Senior SEC accounting officials talk recent policy initiatives

By Amanda Maine, J.D.

Deputy accountants in the SEC’s Office of the Chief Accountant (OCA) engaged in a panel discussion about recent policy initiatives at OCA, the SEC, and the PCAOB, including the auditor’s reporting model, the implementation of new accounting standards, audit committees, and international issues. The officials spoke at the AIPCA’s recent conference on SEC and PCAOB developments in Washington, D.C.

CAMs. While the first phase of the PCAOB’s new standard on the auditor’s reporting model, including disclosure of auditor tenure, has already become effective, the more challenging part has yet to be implemented, said SEC Deputy Chief Accountant Marc Panucci. That phase is, of course, the disclosure in the audit report of critical audit matters (CAMs), which are matters that have been communicated to the audit committee, are related to accounts or disclosures that are material to the financial statements, and involved especially challenging, subjective, or complex auditor judgment. Communication of CAMs for audits of large accelerated filers will be required in audits of financial statements for fiscal years ending on or after June 30, 2019.

According to Panucci, there is a lot of momentum and effort behind “dry runs” in anticipation of CAMs. The staff is hearing that the dry runs have been successful and that audit committees and engagement teams are seeing benefits from these dry runs. Panucci said that the dry runs are helpful in taking the disclosure of CAMs from a theoretical debate to how it actually affects an individual engagement.

Panucci also remarked that the dry runs have not revealed pervasive issues about auditors disclosing original information about the company, which both the PCAOB final release and the SEC’s order of approval had warned against. Panucci explained that an auditor can disclose original information about the company regarding why a certain issue was a CAM, but original information should not be pervasive in the audit report.

Panucci mentioned some specific areas of interest raised by stakeholders regarding CAMs, including the interaction between CAMs and the new accounting standards for revenue, leases, current expected credit loss (CECL). According to Panucci, auditing firms are examining this interaction at multiple levels, from implementation to execution of the new polices.

Stakeholders are also studying the interaction between CAMs and “key audit matters” (KAMs), the international version of CAMs which predated the PCAOB’s standard. Panucci noted that there are similarities between CAMs and KAMs, but it is unknown how pervasive those differences will be. He requested that interested parties give feedback on the disclosure of CAMs and KAMs.

New accounting standards. Deputy Chief Accountant Sagar Teotia discussed the new FASB standards and progress regarding their implementation. Sagar praised the work on the new standard on revenue recognition, which became effective last year. Looking back 12 to 15 months ago, the profession has made a significant step forward in implementing the new standard, he said. He praised the commitment made by the profession to get the standard right and singled out in particular the time and effort that preparers and audit committees have expended in implementing the new standard.

The SEC and the FASB will monitor what is actually in the financial statements with regard to the new revenue recognition standard, but he noted that between the revenue recognition Transition Resource Group (TRG), industry groups, and SEC consultations, there has been progress.

The new standard on leases has also been a priority, Teotia said. Because there was no TRG on the leasing standard, the profession has to find other ways to flush these issues out, and he highlighted in particular the work of auditors and preparers. He also praised the FASB for its role in answering questions about implementing the leasing standard.

As for the SEC, Teotia remarked that earlier this year, he gave a speech delving into the new leasing standard and that the SEC has been vocal and mindful about what needs to be done. He encouraged people to ask the SEC questions about the new standard because it will help the agency become a better regulator.

International issues. Jenifer Minke-Gerard, interim deputy chief accountant in OCA’s international group, discussed the role of audit committees, in particular the work of the International Organization of Securities Commissions (IOSCO). Minke-Gerard described a recent IOSCO project tackling the issue of audit quality from the perspective of the audit committee. Under this project, IOSCO hopes to produce a report on good practices for audit committees and issued a consultation paper earlier this year.

Minke-Gerard advised that there are different practices in different jurisdictions when it comes to audit committees, including in their structure and the way they operate, which should be taken into consideration. For example, the audit committee of a subsidiary in another country may operate differently from the audit committee of the parent company, she explained. She recommended that audit committee members take a look at the “tone at the top” and the culture emanating from the subsidiary and examine how it impacts the external auditors.

Tuesday, December 11, 2018

Justices take case bearing on agency deference

By Anne Sherry, J.D.

The Supreme Court granted certiorari to decide whether to overrule two decisions directing courts to defer to an agency’s reasonable interpretation of its own regulation. The Auer and Seminole Rock cases are cousins to Chevron, which applies to agency interpretations of a statute. Although the petitioner in the case before the Court challenges an adverse ruling by the Department of Veterans Affairs, the Supreme Court’s ultimate decision could affect federal regulators more broadly, including the SEC and CFTC (Kisor v. Wilkie, December 10, 2018).

The Court’s grant of certiorari is limited to the first question presented: “Whether the Court should overrule Auer and Seminole Rock.” The Court will not take up the second question: whether, in the alternative, Auer deference should yield to a substantive canon of construction.

The petitioner is a military veteran who in 1982 filed a claim with the VA for disability benefits. The VA denied the claim, and in 2006 the petitioner sought review of this denial, identifying materials that existed at the time of the denial but had not been associated with his file. Of the two principal mechanisms by which a previously denied claim can be reviewed, the VA granted relief under the provision that does not provide for retroactive benefits, finding that the materials the petitioner had identified did not qualify as “relevant” within the meaning of the other provision.

When the case came before the Federal Circuit, it concluded that both parties offered reasonable constructions of the term “relevant,” indicating that the VA’s regulation was ambiguous on its face. Therefore, it applied Auer deference and affirmed the VA’s application of the regulation because its interpretation was not “plainly erroneous or inconsistent” with the agency’s regulatory framework.

The petitioner urges the Court to overrule Auer because criticism of the doctrine by Supreme Court Justices has caused confusion in the lower courts. Furthermore, he argues, Auer deference is incompatible with due process because it allows agencies a way around the Administrative Procedure Act’s notice-and-comment procedures, and with separation of powers because it transfers judicial power to the Executive Branch. The Chamber of Commerce agreed in its brief as amicus curiae. In opposing certiorari, the Secretary of Veterans Affairs argued that the case would be an unsuitable vehicle on which to consider overruling Auer and Seminole Rock because the outcome of the case would be the same whether or not the agency’s decision was entitled to deference; that determination reflected the best reading of the regulation’s text and purpose.

The case is No. 18-15.

Monday, December 10, 2018

Chairman Giancarlo speaks out as Brexit zero-hour approaches

By Brad Rosen, J.D.

CFTC Chairman J. Christopher Giancarlo issued a statement expressing his serious concerns with regard to the U.K.’s exit from the European Union. Giancarlo noted the uncertainty surrounding Brexit and its effect on the U.K. and the EU member states (EU27) financial markets, as well as the substantial impact it is already having on entities and markets regulated by the CFTC.

The Chairman called on the U.K. and EU27 to settle "the terms of Brexit in a manner that provides sufficient legal and regulatory certainty to market participants." He went on to warn that if the Brexit-related uncertainties are not dispelled, global derivative markets may become destabilized.

Further assurances and clarifications are needed. Giancarlo noted that derivatives market participants need to have greater detail and clarity from European authorities with respect to the following matters:
  • specifying the timing of when the proposed equivalence decision for the U.K. and recognition decision for U.K. CCPs will be made;
  • whether the equivalence and recognition decisions will apply to all cleared products or only to derivatives; and
  • whether the equivalence and recognition decisions will apply to both new and existing cleared transactions.
Chairman Giancarlo further advocated that relevant legal and regulatory decisions made by European authorities should be for a reasonable duration and with limited conditions. He noted that this additional clarity and certainty are necessary to limit substantial operational and market risks that will result from the sudden transfer of potentially trillions of euros in swap exposures in the remaining weeks before a possible no-deal Brexit scenario.

Some recent statements from European authorities are welcome. Notwithstanding his concerns, the chairman is encouraged by recent statements from various European bodies, including the European Commission (EC) and the European Securities and Market Authority (ESMA), that they will act to ensure EU market participants can continue to clear through U.K. central clearinghouses (CCPs) after March 29, 2019, in the case of a no-deal Brexit.

Giancarlo also characterized the EC’s decision to allow a "temporary and conditional" equivalence regime for U.K. CCPs, along with ESMA’s call for U.K. CCPs to apply for recognition as a responsible first step in limiting the risk of market disruption. He observed such actions send the message that European authorities do not wish for the political discussions over Brexit to threaten the integrity and continued operation of markets for derivatives and other financial products.

Regulatory and legal certainty are paramount. Giancarlo also indicated that the CFTC stands ready to consider all necessary actions including use of no action relief to provide certainty and clarity to participants in European derivatives markets. He concluded by calling on relevant U.K. and European authorities to take immediate and fully effective action to provide market participants with the necessary legal and regulatory certainty to manage their operations and activities after Brexit.

A view from London—the zero-hour rapidly approaches. Nathaniel Lalone, a financial services partner in Katten Muchin Rosenman’s London office, had this to say about the chairman’s cautionary statement: "Chairman Giancarlo is saying publicly what many are thinking privately: we are rapidly approaching zero-hour for implementing hard Brexit contingency plans. The only way to avoid the worst fallout is for the European authorities to publish, clearly and unambiguously, detailed legislation that provides the means of avoiding potentially significant financial stability concerns."

The UK is currently scheduled to leave the EU on Friday, March 29, 2019, at 11 p.m. U.K. time. It can be extended if all EU members agree, but at the moment all concerned parties are focusing on March 29 as being the key one.

Friday, December 07, 2018

SEC officials, panelists confer on muni disclosures in atmosphere of partial regulation

By Anne Sherry, J.D.

With Dodd-Frank’s requirement that municipal advisors register with the SEC—but municipal securities themselves occupying a middle ground that subjects them only to the SEC’s antifraud enforcement authority—panelists at a one-day SEC conference pondered issues of disclosure, enforcement, and guidance in the evolving municipal securities markets. SEC Chairman Jay Clayton emphasized the need for timely financial disclosures in his opening remarks, while panelists described some of the obstacles, including liability fears, that could be hindering disclosure of some types of information.

Clayton’s focus on financial disclosures. In his introductory remarks, Clayton emphasized the importance of timely and accurate financial information to investors and analysts. Nevertheless, some municipal issuers release their financial information long after the end of the relevant fiscal period. Clayton said that he would put it this way to the Main Street investor: the audited financial information you’re receiving could be out of date by 18 months or more.

Clayton also stressed that Congress intentionally chose not to create a federal regulatory registration regime governing municipal issuers through the Tower Amendment, which expressly limits the authority of the SEC and MSRB to require municipal issuers to file documents prior to selling securities. The SEC’s investor protection efforts focus on regulating broker-dealers and municipal advisors, enforcing the antifraud provisions, and overseeing the MSRB. Clayton said that he has asked the Office of Municipal Securities to work with the MSRB to explore ways in which broker-dealers can increase transparency regarding financial information and to examine whether there is a role in MSRB’s version of EDGAR, EMMA, to facilitate transparency.

Stein’s remarks on transparency. Addressing the conference before it broke for lunch, Commissioner Kara Stein also spoke on transparency. Stein asked the audience to consider why municipal offerings are important: they allow investors to raise money for schools, infrastructure, fire and police departments, and other tangible benefits to their communities. These benefits only accrue where there is trust, and the foundation of trust is transparency, Stein said. Citing some of the key changes in the last decade, such as municipal advisor registration and disclosure, Stein noted that they were each meant to reinforce integrity and trust in the municipal markets. The commissioner also noted that regulation needs to be able to evolve and change, including keeping up with technological changes and the development of new products such as green bonds.

Enforcement and guidance. Clayton’s comments on the boundaries of the SEC’s jurisdiction over municipal offerings echoed throughout the four conference panel discussions. The SEC’s LeeAnn Gaunt, chief of the Public Finance Abuse Unit in the Division of Enforcement, led a discussion on enforcement issues by reiterating that the ’33 and ’34 Acts provide broad exemptions for municipal securities. With exemptions from registration, the SEC cannot review offering materials prior to sale, and investors do not receive 10-K or 10-Q-style disclosures. One area where issuers are not exempt is antifraud, she said.

John McNally, a partner at Hawkins Delafield & Wood LLP, said that enforcement actions addressing material misstatements and omissions are not particularly important to municipal securities practice. More helpful is when the SEC enforcement action provides guidance, although he would prefer interpretive guidance to an enforcement action. McNally cited the concept of selective disclosure as an area that particularly could use clarification. The SEC should make clear that this is a regulatory matter through FD, not an antifraud matter, and therefore does not directly apply to the municipal market. The guidance could note the distinction between selective disclosure and insider trading, but this would insure that municipal issuers have the freedom to talk to rating agencies and analysts.

Several panelists asked for safe harbors in certain areas. Jim Spiotto, managing director at Chapman Strategic Advisors LLC, noted that in a distress situation, people want timely and accurate information. But distress amounts to dynamic uncertainty, he said. There should be assurances that if you honestly and fairly present information, you won’t be liable if circumstances change down the road. Kenton Tsoodle, Assistant Finance Director for Oklahoma City, also suggested that issuers would be more likely to provide interim financial statements if they had a safe harbor. It is virtually impossible to supply audited interim statements because of all the steps it takes to get a clean opinion, he said.

Peg Henry, deputy general counsel at Stifel Financial Corp., agreed from the underwriter’s perspective. Issuers are tempted to include unaudited financials because their audited information may be stale, but to what extent are underwriters expected to conduct diligence on these numbers, and how? Furthermore, what should be disclosed once the underwriter has completed its due diligence, especially with respect to continuing disclosure failures? It is unclear how underwriters can satisfy the requirement that they reasonably believe the issuer will comply with the continuing disclosure agreement.

Disclosure now and in the future. The last panels of the day centered around disclosure technology and future trends. MSRB COO Mark Kim said that the board’s website has been fully designed and is ready to go for those signing in on February 27, the compliance date of the amendments to the Municipal Securities Disclosure Rule. Through EMMA, issuers can make any disclosures required under those amendments.

Ernesto Lanza, senior counsel at Clark Hill PLC, discussed technological advancements, specifically XBRL reporting. Lanza said that whether or not the market is excited about changes like big data, AI, and machine learning, it is happening. XBRL permits the aggregation of data, which facilitates comparability—of a particular issuer over the years, for example, or multiple issuers within a year. Lanza did caution that people are experiencing tagging issues in XBRL where multiple tags exist for concepts or defined terms that are the same or similar.

Returning to the theme of financial disclosures, Amy Johonnett, research analyst with Fidelity Investments, said that the buy side likes to see prompt and public sharing of material information. Issuers are surely tracking their financial benchmarks on a monthly basis, she said, so they should be disseminating this information to the public on an unaudited basis. She would also like to see issuers place the information they share with the agencies on their websites. Dee Wisor, a partner at Butler Snow LLP, said that issuers should not be required to repeat information in amendments to continuing disclosure agreements that is no longer relevant to the marketplace.

Thursday, December 06, 2018

Final MRAC meeting of 2018 focuses on clearinghouse and vendor risk management matters

By Brad Rosen, J.D.

In its third and final meeting of 2018, the CFTC’s Market Risk Advisory Committee (MRAC) recently convened and focused on a variety of clearinghouse risk and vendor risk management issues. The day’s ambitious agenda included panels on (1) clearinghouse governance structures and risk management; (2) non-default losses in recovery and resolution; (3) a discussion of recent reports and developments relative to CCP resolution, leverage rations, and incentives to clear; and (4) oversight of third-party service providers and vendor risk management.

Commissioner Rostin Behnam, MRAC’s sponsor, noted in his opening remarks, “As market infrastructure continues to evolve, the issues examined within the MRAC will continue to evolve with it.” He elaborated, “One of the major changes since the financial crisis and Wall Street Reform has been the growth of central clearing, which has played a significant role in reducing systemic risk throughout the global financial ecosystem; however, given this growth, market participants and regulators must continually have fresh discussions about current risk management and governance policies of central counterparties.”

Newly-formed Interest Rate Benchmark Reform subcommittee comes out of the gate. Interest Rate Benchmark Reform Subcommittee Chairman Thomas Wipf told the MRAC that there is a wide variety of where parties are in the transition away from LIBOR to its replacement, the Secured Overnight Financing Rate (SOFR). He noted that some users are far along in the process, but other, infrequent users and issuers have a way to go.

Commissioner Behnam also took the occasion of the meeting to announce the appointment of members to the subcommittee that has been charged with providing reports and recommendations to the MRAC regarding ongoing efforts to transition U.S. dollar derivatives and related contracts from LIBOR to a risk-free rate (RFR), and the impact of such transition on the derivatives markets. The appointed members of the subcommittee are noted here.

Clearinghouse risk management—tensions between CCP’s and clearing members. The day’s first panel, facilitated by Robert Steigerwald from the Federal Reserve Bank of Chicago, featured an overview of current risk management and governance issues with a focus on the balancing of interests and incentives between the clearinghouse and its members. Alice Crighton, speaking on behalf the FIA, which represented clearing member perspectives, underscored the need to have CCP incentives aligned with that of clearing members. She observed this was not always the case and asserted that the CCPs need to have skin in the game to the same extent of its clearing members.

Lee Betsill, director and Chief Risk Officer at the CME Clearinghouse, took issue with Crighton’s assertion that there was a misalignment between CCPs and their members. He noted that the CME, like most clearinghouses, took clearing member views into consideration, and added CCPs have no incentive to shortcut risk management concerns because their revenue base is dependent on sound risk management practices.

Commissioner Quintenz expresses concerns from overseas over leverage ratios. Commissioner Brian Quintenz took the opportunity to advance his view regarding the role of leverage ratios in the risk management mix as he weighed in from his overseas travels. He characterized the leverage ratio, which constrains a bank’s capital as “a true and remote backstop metric [and] a blunt regulatory instrument” that creates many perverse outcomes and is a poor regulatory construct.

He further observed that “we are currently seeing with the leverage ratio’s outsized negative impact on clearing and custody services that are the heart of the futures and swaps markets.” He further noted, “Unless the treatment of client margin changes, I fear we will see FCMs continue to exit the clearing business and the worrisome trend of FCM consolidation will continue” and further indicated that as of 2017, the top five swaps clearing members controlled up to 75 percent of the business.

Oversight of third-party service providers and vendor risk management. The day’s final panel examined the oversight of third-party service providers and vendor risk management, an area that has seen dramatic growth in light the proliferation of fintech-related services. Behnam noted that exchanges, clearinghouses, intermediaries, commission registrants, and their customers are increasingly employing a wide-array of vendors that provide a multitude of different services, and each relationship carries its own risks.

Salman Banaei, executive director of IHS Markit, a public company fintech service provider, laid out five core principles for third-party risk management in his presentation, which focused on documentation, non-discrimination/equal treatment for providers, open dialogue, responsiveness, and proportionality between the extent of reliance and market benefits.

In his remarks, Commissioner Behnam noted, “all of these entities continue to increase the number and complexity of relationships with vendors through the outsourcing of business and regulatory compliance functions, registrants must ensure that they have appropriate management and control functions to address the associated risks.” He added, “At the heart of those relationships is the ability of market participants to know with whom they are doing business, both directly and indirectly, and what risks may arise from third-party service providers.”

Behnam concluded that this panel will be the start of a longer conversation by MRAC and potentially a subcommittee with the ultimate goal of providing the CFTC with surgical recommendations – as needed – to ensure market safety, transparency, and resiliency.

Wednesday, December 05, 2018

SEC finalizes rules aimed at promoting research reports on investment funds

By Amanda Maine, J.D.

The SEC has adopted amendments to implement the Fair Access to Investment Research Act of 2017 (FAIR Act). The new rules and amendments are intended to promote research on mutual funds, exchange‑traded funds, registered closed-end funds, business development companies, and similar covered investment funds by reducing obstacles to providing research on these kinds of funds. Under the new rules, a broker or dealer can publish or distribute research reports under certain conditions similar those that exist under safe harbor for research reports about public companies.

Rule 139b. New Rule 139b is modeled on Securities Act Rule 139, which provides a safe harbor for the publication or distribution of research reports concerning one or more issuers by a broker or dealer participating in a registered offering of one of the covered issuers’ securities. The affiliate exclusion prohibits two separate categories of research reports from being deemed to be “covered investment fund research reports” under Rule 139b’s safe harbor. The first category covers research reports published or distributed by the covered investment fund or any affiliate of the covered investment fund. This exclusion prevents such persons from indirectly using the safe harbor to avoid the applicability of the Securities Act prospectus requirements and other provisions applicable to written offers by such persons. The second category covers research reports published or distributed by any broker-dealer that is an investment adviser (or an affiliated person of an investment adviser) for the covered investment fund. Rule 139b does not preclude a broker-dealer from relying on existing Rule 139 if applicable.

Conditions. The final rule release outlines several conditions for the safe harbor to apply. A covered investment fund that publishes or distributes issuer-specific reports must have been subject to the relevant requirements under the Investment Company Act and/or the Exchange Act to file certain periodic reports for at least 12 calendar months prior to a broker-dealer’s reliance on Rule 139b and must have filed these reports in a timely manner. A covered investment fund that is the subject of an issuer-specific report must satisfy a minimum public market value threshold at the date of reliance on the new rule (the “float requirement”).

Regarding industry research reports, to be eligible for the safe harbor the report either must include similar information about a substantial number of covered investment fund issuers of the same type or investment focus (the “industry representation requirement”) or contain a comprehensive list of covered investment fund securities currently recommended by the broker-dealer (the “comprehensive list requirement”). The rule also states that analysis of any covered investment fund issuer or its securities included in an industry research report cannot be given materially greater space or prominence in the publication than that given to any other covered investment fund issuer or its securities.

Change from proposal. The proposed rule would not have required a standardized performance presentation for covered investment fund research reports. However, the final rule states that if fund performance information is included in a research report, it must be presented in accordance with certain standardized presentation requirements dependent on the type of covered investment fund.

Rule 24b-4. Under new Rule 24b-4, a covered investment fund research report about a registered investment company will not be subject to Investment Company Act Section 24(b) except to the extent the research report is otherwise not subject to the content standards in self-regulatory organizations’ rules related to research reports, including those contained in the rules governing communications with the public regarding investment companies or substantially similar standards. Covered investment fund research reports under Rule 139b that otherwise would be subject to the filing requirements of investment company sales literature under Section 24(b) would not be subject to that section so long as they remain subject to the general content standards of FINRA Rule 2210(d)(1), the release states.

The release is No. 33-10580.

Tuesday, December 04, 2018

Failure to show artificial price dooms CFTC manipulation action against DRW

By Lene Powell, J.D.

Calling the conclusions of a CFTC expert witness “absurd,” “near religious,” and “circular,” the Southern District of New York dismissed the CFTC’s market manipulation case against proprietary trading firm DRW and its founder, Don Wilson. The court concluded that the defendants had merely savvily capitalized on a legitimate trading opportunity, not manipulated the market, because the CFTC did not show that the defendants created an artificial price (CFTC v. Wilson, November 30, 2018, Sullivan, R.).

Noting that the case involved the CFTC’s pre-Dodd Frank legal authority, CFTC Chairman J. Christopher Giancarlo said the agency was analyzing the decision and considering next steps.

Alleged manipulation. In 2010, DRW began to trade the IDEX USO Three-Month Interest Rate Swap Futures Contract, based on Wilson’s belief that the contract was mispriced in relation to the over-the-counter (OTC) swap rate. DRW submitted a large percentage of its bids during the settlement window, knowing that this trading practice would result in a higher settlement price, particularly since the market for the contract was highly illiquid. In August 2011, DRW placed its final bid on the contract and unwound all its open positions for approximately $20 million. As the CEO of Jeffries, LLC, one of DRW’s counterparties, stated in an email to Wilson, “You won big. We lost big.”

The CFTC alleged that the defendants had violated Sections 6(c) and 9(a)(2) of the Commodity Exchange Act, which prohibit market manipulation and attempted manipulation. The CFTC argued that the defendants’ trading practice in placing most bids during the settlement window was a type of disruptive trading practice called “banging the close.” Both sides moved for summary judgment, which the court denied and declined to reconsider.

No artificial price equals no manipulation. After a bench trial, the court concluded that the defendants had not engaged in market manipulation. Although the CFTC did establish the first element of price manipulation, that the defendants had the ability to influence the settlement price, the CFTC failed to show the second element, that the defendants had created an artificial price.

According to the court, the CFTC offered no evidence or explanation demonstrating that the contract settlement prices were artificially high. The court dismissed the testimony of the CFTC’s expert witness, who gave the opinion that the prices did not reflect the forces of supply and demand, as “conclusory and circular” and not based on evidence or settled economic principles. The defendants offered an “overwhelming” basis for concluding that the natural or fair market price for the contract was “well north” of the corresponding rates and also higher than DRW's bids.

The court also rejected the CFTC’s fallback argument that any price influenced by the defendants' bids was illegitimate and artificial because the defendants understood and intended that the bids would have an effect on the settlement prices. This was tautological and lacked any basis in law, said the court. Taken to its logical conclusion, this logic would effectively bar market participants with open positions from ever making additional bids to pursue future transactions.

In reaching its conclusion, the court found the following facts significant:
  • There was no evidence that DRW ever made a bid it thought might be unprofitable.
  • There was no credible evidence that DRW ever made a bid it thought could not be accepted by a counterparty.
  • The CFTC provided no credible evidence as to what the fair value of the contract actually was at the time DRW was making its bids.
  • There was no credible evidence that DRW's bidding practices ever scared off would-be market participants.
  • There was no evidence that DRW ever made a bid that violated any rule of the exchange.
Not a violation to be savvy. In dismissing the CFTC’s claims, the court concluded that Wilson’s trading strategy did not manipulate the market, but merely comprehended the true value of the contract better than else and capitalized on that knowledge.

“It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product,” stated the court. “It is only the CFTC's Enforcement Division that has persisted in its cry of market manipulation, based on little more than an ‘earth is flat’-style conviction that such manipulation must have happened because the market remained illiquid. Clearly, that is not enough to prove market manipulation or attempted market manipulation, and the CFTC has simply failed to meet its burden on any cause of action.”

The case is No. 13 Civ. 7884 (RJS).

Monday, December 03, 2018

Lucia v. SEC 2.0 presses removal question left unanswered by Supreme Court

By Mark S. Nelson, J.D.

Raymond Lucia, whose win earlier this year in the Supreme Court netted him the right to a new SEC administrative proceeding before either the Commission itself or before a new administrative law judge, is moving forward with round two in his battle to avoid having to appear before an ALJ he still believes is unconstitutionally appointed. In June, the Supreme Court agreed with Lucia that SEC ALJs are inferior officers of the United States and, thus, must be appointed in conformance with the Appointments Clause of the U.S. Constitution. Lucia now argues that the SEC’s compliance with this decision removes only part of the constitutional infirmity surrounding the agency’s ALJs because they still enjoy too many layers of tenure protection (Lucia v. SEC, November 28, 2018).

The removal question. The Commission in 2015 found that Lucia aided and abetted Advisers Act violations by his eponymous company by failing to make full disclosures about back testing data used to explain Lucia’s “Buckets of Money” investment strategy to attendees at seminars. The Commission imposed second-tier penalties of $50,000 on Lucia and $250,000 on Lucia’s company. Lucia also was barred by the Commission from associating with any investment adviser or broker-dealer. Lucia’s previous appeal made it to the Supreme Court via the statutorily prescribed route when he filed a petition for review in a federal circuit court.

In his new complaint, filed in federal court in Southern California, Lucia claims that the despite his administrative matter being assigned to a new ALJ post-Lucia, the proceeding against him still violates Article II of the U.S. Constitution because of the multiple ways in which good cause removal provisions in federal law protect ALJs from being removed from their positions; Lucia claims that these tenure protections involve both the SEC and the Merit Systems Protection Board (MSPB). According to Lucia: the MSPB can remove an ALJ only for good cause; MSPB members are removable by the president, but only for good cause; and SEC commissioners can only be removed for good cause. In Free Enterprise, the Supreme Court determined that the Public Company Accounting Oversight Board’s dual for cause removal protection was unconstitutional, although the PCAOB as an institution could continue because the justices were able to sever the offending provisions from the Sarbanes-Oxley Act.

Lucia’s complaint also recites the many ways in which he believes SEC in-house proceedings are inherently unfair. Lucia further emphasizes that the several deadlines imposed by SEC rules of practice for administrative proceedings have long since lapsed in his matter. Meanwhile, Lucia asserts that he has lost his profession and reputation without having had a hearing before a properly appointed ALJ and a resulting, valid merits decision. Lucia seeks a preliminary injunction and other declaratory relief from the SEC and from Chairman Jay Clayton and Acting U.S. Attorney General Matthew Whitaker, both of whom were sued in their official capacities.

In Lucia’s Supreme Court case, the government eventually confessed error on the Appointments Clause question following the most recent change of Administration. The government also tried to persuade the court to take up the removal question then. But, as the first footnote in the Supreme Court’s Lucia opinion explained, the court declined to take the removal question because it wanted lower courts to opine on the matter first. Justice Breyer, who concurred and dissented in Lucia, would have preferred that the court decide Lucia on statutory grounds because, in his view, the answer to the constitutional question the court decided depended partly on how the court would have answered the question about statutory for cause removal protections enjoyed by ALJs. Justice Breyer had previously voiced concerns in his Free Enterprise dissent about the potential consequences that may flow if courts upend the administrative process at agencies across the federal government that use numerous ALJs.

Possible hurdle? One potential initial hurdle for Lucia’s new suit will be whether the district court can exercise jurisdiction over it. When numerous other pre-Lucia SEC respondents filed similar suits in federal district court, many of those courts determined that they lacked jurisdiction because the applicable securities laws spelled out the appeals process, which contemplates that a respondent who endures an adverse ruling by the Commission will appeal to a federal circuit court.

Free Enterprise and three other cases (Elgin, McNary, and Thunder Basin) decided by the Supreme Court developed a rubric for evaluating when a federal district court can hear claims related to an administrative proceeding where the agency’s governing statute requires a final agency decision to be appealed to a federal appellate court (i.e., it is “fairly discernible” Congress intended the claim to follow the statutory scheme). Thunder Basin, for example, suggested three factors that could justify taking a case out of the statutory scheme: (1) the potential for no meaningful judicial review; (2) claims that are wholly collateral to the administrative charges; and (3) claims that are outside the agency’s expertise. Such cases typically involve a plaintiff who must figuratively and literally “bet-the-farm” to get judicial review of their claims. Lucia’s complaint repeatedly emphasizes that without action by the district court, he will be unable to obtain meaningful judicial review.

The case is No. 18-cv-02692.

Friday, November 30, 2018

PCAOB advisory group members advocate greater communication between Board and stakeholders

By Amanda Maine, J.D.

Members of the PCAOB’s Standing Advisory Group (SAG) echoed sentiments expressed in a recent PCAOB survey about improving the Board’s communication with auditors, investors, audit committees, and other stakeholders. Several members urged the Board to disseminate more information relating to the inspections process, while others would like to see more communications between the PCAOB and audit committees.

Survey results. Barbara Vanich, acting director of the Office of the Chief Auditor, presented the results of a PCAOB survey on communications to the SAG. Respondents were surveyed about the types of PCAOB communications they use. Coming in first was the staff’s Audit Practice Alerts at 79 percent. According to the survey, 71 percent used implementation guidance, 63 percent used inspection observations, 50 percent used inspection briefs, and 46 percent used PCAOB Q&As on rules and forms. In addition, 58 percent cited communications with audit committees.

The survey also reported that almost all respondents desire more communication from the PCAOB regarding standards. Some respondents expressed concerns about the risk of using guidance to impose “de facto” requirements beyond the auditing standards, and in particular regarding parties not regulated by the PCAOB such as issuers and preparers. Too much reliance on guidance might inhibit innovation by auditing firms, according to some survey respondents.

A majority of respondents to the PCAOB’s survey want the PCAOB to engage all constituencies, including registered firms, audit committees, investors, and preparers. However, they feel that communication should be targeted to each group separately to describe what the standard means to them.

Regarding timing, there was a general preference that the PCAOB should communicate about new auditing standards before they become effective. However, some were concerned that issuing guidance too close to the effective date could cause confusion or disruption.

When asked to rank attributes in the order of importance about communicating PCAOB standards, the final tally was: (1) timely; (2) responsive to specific questions raised by stakeholders; (3) comprehensive; (4) detailed technical explanations; and (5) plain English that can be understood by non-accountants.

Audit committees. A number of SAG members expressed support for more Board communication with audit committees. Former SEC CorpFin Director John White, now at Cravath, Swaine & Moore, brought up the PCAOB’s project on developing audit quality indicators (AQIs), which has languished in the concept release and discussion stage since it was first pondered in 2013. According to White, there is a lot of information available regarding AQIs that could be useful to audit committees in understanding and identifying the mechanisms that accompany an effective audit.

Guy Jubb of the University of Edinburgh called the communication between audit committees and investors one of the weakest links in the chain. While he acknowledged that this area may fall more under the SEC’s jurisdiction, he stressed that there is a need to integrate what audit committees are doing into the investor relationship.

Former IAASB Chair Sir David Tweedie said there is a deeper problem in the system itself with respect to audit committees. For audit firms, the tension between being professional and skeptical and keeping their clients is very difficult. An auditing firm that says, hire us because we’re the toughest, most mean-spirited firm in town is not going to get the job, but that is exactly what investors are saying they want, he lamented. Citing cuts in audit fees, he wondered if an audit committee represents management or the investors, because lowered fees pressure the auditor to get the job done cheaper and to cut corners.

Sandra Peters of the CFA Institute agreed with Tweedie, stating that when she has been on audit committees, she cringes when there is talk about lowering audit fees. “You get what you pay for,” she said.

Communicating about inspections. Peters was one of several SAG members who voiced support for more communications about the results from the PCAOB’s inspections. She noted that while the top responses to the PCAOB’s survey indicated a desire for more communication regarding auditing standards, most of the respondents were auditors. Investors are more interested in inspections findings than the standards themselves, she said.

Liz Murrall of The Investment Association also encouraged the PCAOB to increase the transparency of its inspections findings and communicating them. She observed that in the U.K., the Financial Reporting Council (FRC) issues both thematic reports and individual firm reports where the audited entities are not identified. However, the confidential reports on the audited entity are sent to audit committee chairs and the audit committee is required to state in its report whether or not its audit has been subject to an inspection and what they’ve done in relation to those inspection findings. Investors have found this to be very helpful, Murrall said.

Other methods of communication. PCAOB Member Jay Brown asked if SAG members were interested in other mechanisms the PCAOB could use to communicate with stakeholders. He mentioned as an example the SEC’s “Dear CFO” letters sent by the Division of Corporation Finance. He observed that entities do read and study these letters and that they do have an impact.

Drawing on his experience as CorpFin director, White compared PCAOB inspection reports to comment letters that are issued by the Division and sent out one by one and after the fact. In contrast, when Dear CFO letters and Compliance & Disclosure Interpretations are issued prior to the 10-K season, “you can affect the entire universe of public companies,” which is a much more effective method of guidance, according to White. Robert Knetchel of the University of Florida agreed with White, advising that using this kind of constructive, proactive intervention can be more effective than “naming and shaming.”

Thursday, November 29, 2018

FSB says G20 regulatory reforms are in place, calls for more rigorous implementation

By John Filar Atwood

The Financial Stability Board (FSB) has determined that the main financial reforms called for by the G20 after the financial crisis are in place, but that implementation remains uneven. In its fourth annual report, prepared for the upcoming G20 summit in Buenos Aires, the FSB asks for the support of G20 leaders in implementing the reforms and reinforcing global regulatory cooperation.

Ten years after the crisis, reforms are in place that make the financial system more resilient, and reduce the likelihood and severity of future crises, according to the FSB. Large banks are better capitalized, less leveraged, and more liquid, the report states, and implementation of too-big-to-fail reforms is advancing. In addition, over-the-counter (OTC) derivatives markets are simpler and more transparent, the use of central clearing has increased, and collateralization is more widespread, the FSB said.

Implementation efforts. The FSB said that it is now turning its attention toward implementation of the G20 reforms, which remains incomplete. This will include work to implement the final Basel III reforms and to operationalize resolution plans for cross-border banks, the FSB stated. It also entails building effective resolution regimes for insurers and central counterparties and making OTC derivatives trade reporting more effective. The report notes that the FSB also hopes to strengthen the oversight and regulation of non-bank financial intermediation.

The FSB has begun to evaluate the impact of G20 reforms on infrastructure finance and incentives to centrally clear OTC derivatives. The evaluation framework is working as intended, according to the FSB, and is identifying and delivering adjustments where appropriate, without compromising financial resilience.

The report acknowledges that the global financial system has continued to grow, but there are no signs that the reforms have led to a shortage in the supply of financing. In addition, the supply of financial services has become more diversified, including through the growth in non-bank financial intermediation, the report states. Overall, the trend toward greater global financial integration has continued, with some divergent trends within market segments, the FSB said.

Next steps. Looking ahead, the FSB determined that although the financial system is stronger, risks keep evolving and financial institutions and markets may not be sufficiently prepared for potential risks from adverse market developments. In the FSB’s opinion, high sovereign and corporate debt levels in many parts of the world could expose the financial system to significant risk. Sharply rising yields could trigger swings in cross-border capital flows, which could impact local equity, bond, and foreign exchange markets, the FSB said. Moreover, the increasing role of investment funds could amplify any market shocks, the report states.

The FSB advised that it will continue to assess the resilience of evolving market structures and the impact of technological innovation. This includes the resilience of financial markets in stress, and the growth of non-bank financial intermediation and cyber risks, the FSB said.

In the report, the FSB recommends that the world’s regulators lead by example in promoting the timely implementation of remaining reforms to Basel III, resolution regimes, OTC derivatives, and non-bank financial intermediation. Frameworks for cross-border regulatory cooperation should allow for the sharing of information and support an open and integrated global financial system, in the FSB’s view.

The FSB called on regulators to evaluate whether the G20 reforms are achieving their intended outcomes, to identify any material unintended consequences, and to address them without compromising the objectives of the reforms. The FSB also asked financial stability authorities to continue to contribute to the FSB’s monitoring of emerging risks, and to be ready to act if the risks materialize.

Wednesday, November 28, 2018

Nebraska amends BD agent exam requirement and crowdfunding exemption

By Jay Fishman, J.D.

The Nebraska Department of Banking and Finance has amended its broker-dealer agent written exam requirement, along with its intrastate crowdfunding, domestic issuer, agriculture cooperative and exchange listed exemptions. The changes took effect November 25, 2018.

Broker-Dealer Agents.

Broker-dealer agent written examinations. Broker-dealer agents need to take and pass the Uniform Securities Agent State Law Examination (Series 63), along with FINRA Rule 1220-required exams. The Uniform Combined State Law Examination (Series 66) may be taken instead of the Series 63 by an agent who also takes and passes the General Securities Representative Examination (Series 7). The Series 6, 22, and 79 were eliminated from the list of possible exams to take.

Exempt Securities.

Exchange listed exemption. Stock exchanges approved for Nebraska’s exchange listed exemption are securities exchanges specified by federal Securities Act, Section 18(b)(1) and SEC Rule 230.146, as well as the Chicago Stock Exchange. The “notice filing” and “cure order” provisions were eliminated.

Exempt Transactions.

Cooperative exemption. An agricultural cooperative transaction exemption was re-titled to broaden its coverage to cooperatives and cooperatives under the Limited Cooperative Association.

Domestic issuer exemption. Information rule requirements. Previously, a Nebraska issuer could claim the statutory exemption at Section 8-1111(23) for a nonpublic offering made exclusively to Nebraska residents, provided: (1) the issuer’s total sale proceeds in any two-year period does not exceed $250,000 [now $750,000], and at least 80 percent of those proceeds are used in Nebraska; (2) no commissions or other remuneration are paid directly or indirectly to any person for soliciting prospective purchasers, except if paid to a Nebraska registered broker-dealer or agent; (3) the issuer or its affiliates are not subject to the statutory exemption’s disqualification provisions; (4) the issuer files a notice with the Department of Banking and Finance no later than 15 business days before any sales are made under this exemption; (5) the issuer sends the Director a statement showing the number of investors, total dollar amount raised and use of proceeds, within 30 days after the offering completes; and (6) the offering complies with SEC Rule 147 [ and as amended: or SEC Rule 147A].

Effectiveness. Previously, a filed exemption notice remains effective until the earliest of the following events to occur: (1) $250,000 [now $750,000] in proceeds is raised; (2) two years from the first sale date; or (3) the issuer sends the Director a statement showing the number of investors, total dollar amount raised and use of proceeds, within 30 days after the offering completes.

Intrastate crowdfunding exemption. Advertising. Previously, for the statutory intrastate crowdfunding exemption at Section 8-1111(24), an issuer’s or funding portal’s general announcement about the issuer’s offering being made under the exemption will not be considered a securities offer, provided the following are included with the general announcement: (1) a statement that the issuer is conducting an offering, the name of the portal operator conducting the offering and a link directing potential investors to the funding portal; (2) the maximum offering amount; and (3) factual information about the issuer’s legal identity and business location, limited to the issuer’s name and address, and a brief description of its business. Additionally, any general announcement about the issuer’s offering must contain a statement clearly declaring that the offering is directed only to Nebraska residents [now deleted: and may only be distributed within Nebraska. An issuer may post this general announcement on its website provided the issuer obtains an affirmative representation that a person is a Nebraska resident before allowing that person to view the general announcement].

Tuesday, November 27, 2018

NFA Annual Review summarizes past year highlights and looks forward to coming attractions

By Brad Rosen, J.D.

The National Futures Association issued its 2018 Annual Review with a focus on the organization’s significant initiatives for the past year as well as a preview for coming attractions. The Annual Review, which covers the NFA’s fiscal year ending June 30, 2018, was released with little fanfare, apparently the day after Thanksgiving. It summarized enforcement activities as well as initiatives regarding the association’s emerging role as a swaps overseer. The review also looked to a number of other undertakings that are part and parcel of NFA’s regulatory mission.

A self-regulator’s year in enforcement. According to the Annual Review, NFA’s enforcement activities in fiscal year 2018 yielded the following results:
  • NFA’s Business Conduct Committee issued 17 complaints against 27 respondents. This compares to 14 complaints brought against 24 respondents in fiscal year 2017.
  • NFA’s disciplinary panels issued 16 decisions, and ordered six expulsions and five suspensions. In comparison, in fiscal year 2017, disciplinary panels issued 21 decisions, and ordered 15 expulsions and 3 suspensions.
  • NFA collected nearly $550,000 in fines in 2018 compared to nearly $700,000 in fines collected in 2017. 
An emerging swaps proficiency requirements program. NFA’s executive committee and board of directors approved the development of swaps proficiency requirements for associated persons (APs) engaging in swaps transactions. These requirements take the form of an online learning program with embedded test questions. The requirements will be applicable to all APs engaging in swaps activities, including those who are designated as swap APs at futures commission merchant (FCMs), introducing brokers (IBs), commodity pool operators (CPOs) and commodity trading advisors (CTAs), and those individuals who act as APs at swap dealers (SDs). The NFA already has proficiency requirements for all APs.

To begin this project, the board approved the formation of a Swaps Proficiency Requirements Advisory Committee composed of industry experts from the various membership categories that will be impacted by these requirements. The advisory committee is currently consulting with and assisting staff regarding the development and implementation of the requirements. The NFA is also working closely with the CFTC, the board, NFA members, and relevant trade associations with regard to the undertaking. According to the Annual Review, it is anticipated that this program will be launched in early 2020.

Evolving swap dealer oversight activities. The NFA’s swap dealer oversight program has continued to evolve in an effort to enhance NFA’s monitoring of all SDs, including non-U.S. SDs. Staff has also stepped up its program for risk-based SD exams tailored to the specific regulatory concerns of each SD by enhancing its SD risk profiling system. The system is used to identify SDs that pose heightened regulatory risk and allocate NFA’s regulatory resources accordingly. The system also utilizes information from a number of sources including policies and procedures reviews, prior exam findings, risk exposure reports, and other monitoring activities.

NFA’s board has also approved the collection of standardized swap valuation (SVP) dispute information and SD monthly market and credit risk data. These additional data inputs enable NFA to gain further insights into an SD’s activities. This additional data, along with other quantitative and qualitative factors, is now being used to prioritize SD exams and help determine a particular exam’s scope. NFA will look to further enhance its SD profiling system to ensure that it is functioning as designed and accomplishing regulatory objectives.

Other regulatory activities. The Annual Review also identified a number of other activities conducted by the NFA and their related statistics as noted: 
  • In fiscal year 2018, NFA’s Registration Department processed nearly 500 firm registrations and approximately 8,400 individual registrations.
  • NFA’s Information Center—a service NFA offers to Members and the investing public—received more than 24,000 calls and responded to over 3,000 emails.
  • NFA’s restitution program disbursed more than $10 million to nearly 2,500 harmed investors during the fiscal years. Most of the victims served by this program were harmed by had dealings with non-NFA members.
  • NFA’s Fitness Investigations Group opened approximately 1,300 cases. These fitness investigation cases are due to fingerprint card results, answers to disciplinary history questions on the application, or regulatory information obtained during NFA’s background checks. 
Looking forward. In a letter accompanying the Annual Review, NFA Chairman of the Board Michael C. Dawley looked to the future and pointed to regulatory topics that are awaiting CFTC action such as the CFTC’s swap dealer capital rules and the SEF market reform that was discussed in CFTC Chairman Giancarlo’s White Papers. Dawley also noted that in his White Papers, Chairman Giancarlo has expressed his desire to raise the professional standards of individuals engaging in swaps-related activity. As a result, the NFA will be focused on the development of proficiency requirements for individuals engaged in swaps activities. Dawley also observed that flexibility and nimbleness are critical as the NFA adapts to changing regulatory and industry landscapes.

Monday, November 26, 2018

Roundtable panelists offer contrasting views on the use of shareholder proposals to improve engagement

By Amanda Maine, J.D.

Participants at the SEC’s recent roundtable on the U.S. proxy system clashed over reforming the shareholder proposal process as a means to improve company engagement with shareholders. Representatives from industry groups expressed support for raising the thresholds for the submission of proposals, while investor advocates praised the current system as a low-cost method of engaging with issuers.

Threshold issue. Under Rule 14a-8, a shareholder who has held $2,000 or 1 percent of a company’s stock for one year may submit a proposal to be included in the company’s proxy statement for a vote by all shareholders. The threshold was last raised in 1998, from $1,000. Maria Ghazal of Business Roundtable said that the $2,000 threshold is too low and should be increased. Ideas that could be considered by the Commission include tying ownership to the length of the holding period and allowing for a reduced threshold for long-term holders, tiering ownership thresholds based on the size of the company, and requiring a filing fee for shareholder proposals, Ghazal suggested.

Tom Quaadman of the Chamber of Commerce’s Center for Capital Markets Competitiveness advised that the decline in the number of public companies from 20 years ago is evidence that the public company system is not working, and the shareholder proposal process may have contributed to this decline. Quaadman advocated revisiting the thresholds for submitting reproposals to cut down on the number of “zombie proposals”—proposals that have been submitted multiple times without ever reaching a majority vote—that clog up communication channels between the company and shareholders and impose a cost on the company and investors. “At some point in time, we have to realize that is why companies are deciding not to go public,” Quaadman said.

Brandon Rees of the AFL-CLO said that the idea that companies are not going public because of shareholder proposals is “preposterous.” According to Rees, the average publicly listed company can expect a shareholder proposal about once every 7.7 years. Rees said that the shareholder proposal rules are in place to democratize the process so it is accessible to small investors. Large shareholders do not need to submit a shareholder proposal to get the company’s attention, he said.

Jonas Kron of Trillium Asset Management agreed with Rees, stating that the quality of one’s idea doesn’t depend on the size of one’s ownership. The ownership threshold is meant to demonstrate a shareholder’s “skin in the game,” and for some investors, $2,000 is skin in the game. According to Kron, shareholder proposals make up less than 2 percent of proxy ballot items, less than 4 percent were filed with companies with under $1 billion in market capitalization, and less than 9 percent of Russell 3000 companies that have had an IPO since 2004 have received a shareholder proposal. It is a very well-functioning system, and so-called zombies are not “clogging it up,” Kron said.

Aeisha Mastagni of CalSTRS also questioned whether the discussion involved creating a solution to a problem that does not exist. The current system works and has appropriate balances for both issuers and investors, according to Mastagni. Noting that the SEC has finite resources, she wondered if they would be better spent on improving the mechanics of the proxy voting system instead.

ESG issues. Some participants raised the issue of using the shareholder proposal process to advocate for social change, or ESG (environmental, social, governance) issues. According to Dannette Smith, senior deputy general counsel at UnitedHealth Group, in many instances the shareholder process has turned into voting on social issues raised by a shareholder with no long-term interest in the company, and the board does not understand why they are forced to spend time on these issues. Quaadman agreed, stating that social proposals now make up about 50 percent of shareholder proposals, and they never pass. However, Rees said that mainstream investors are increasingly recognizing that environmental and social issues are important drivers of value creation because they matter to company performance.

Wednesday, November 21, 2018

KISS leads to a final uncleared swap margin rule

By Brad Rosen, J.D.

The CFTC has approved a final rule to amend its uncleared swap margin requirements (CFTC Margin Rule) to clarify that master netting agreements are not excluded from the definition of “eligible master netting agreement,” thereby harmonizing CFTC requirements with those of other regulatory bodies as well as providing further regulatory certainty to market participants.

Alignment with Prudential Regulators. The final rule, which grew out of the Commission’s Project KISS initiative, is aligned with certain rules related to qualified financial contracts (QFC Rules) adopted by the Board of Governors of the Federal Reserve System (FRS), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC). As a result of the Project KISS initiative, the Commission received suggestions to harmonize its uncleared swap margin rule with that of the aforementioned Prudential Regulators, as well as the Farm Credit Administration and Federal Housing Finance Agency.

Master netting agreements will not be excluded under the margin rule. According to the CFTC’s release, the rule amendments ensure that master netting agreements are not excluded from the definition of “eligible master netting agreement” under the CFTC Margin Rule based solely on such agreements’ compliance with the QFC Rules. They also ensure that any legacy uncleared swap that is not subject to the CFTC Margin Rule would not become so subject if it is amended solely to comply with the QFC Rules.

CFTC role and authority. The CFTC is required to establish margin requirements for uncleared swaps for all CFTC registered swap dealers (SD) and major swap participants (MSP) for which there is not a Prudential Regulator. A Prudential Regulator imposes similar margin requirements on SDs and MSPs for which there is a Prudential Regulator with respect to its prudential margin rule.

The CFTC Margin Rule was issued in January 2016 and establishes minimum requirements for SDs and MSPs to collect and post initial and variation margin for certain swaps that are not cleared by a registered derivatives clearing organization or a derivatives clearing organization that the CFTC has exempted from registration. The CFTC Margin Rule is designed to help ensure the safety and soundness of SDs and MSPs while being appropriate for the risk associated with the uncleared swaps.

Chairman Giancarlo weighs in. Chairman J. Christopher Giancarlo had this to say about the final rule: “Through the Commission’s Project KISS initiative, the Commission received suggestions to harmonize its uncleared swap margin rule with that of the Prudential Regulators. In response, this final rule does so and provides market certainty, specifically with respect to amending the CFTC’s definition of “eligible master netting agreement” and amending the CFTC Margin Rule.”

The final rule amendments will be effective 30 days after publication in the Federal Register.

Tuesday, November 20, 2018

Proxy voting mechanics and technology examined at SEC roundtable

By Amanda Maine, J.D.

In the first of three panel discussions on the U.S. proxy process, representatives from industry and investor groups shared ideas on how to improve the accuracy, transparency, and efficiency of the proxy voting and solicitation system and how technological advances might be used to enhance the voting process. The SEC hosted the proxy roundtable, which also featured discussions on improving shareholder engagement and the role of proxy advisory firms.

Corporation Finance Director William Hinman welcomed the panelists, advising that private market solutions can be faster, more flexible, and less intrusive than regulatory solutions, so the SEC benefits greatly from industry feedback. He also drew attention to a concept release published by the Commission on the proxy process in 2010, noting that many of the issues raised in the concept release still exist today.

Advisory committee input. Professor John Coates of Harvard Law School acknowledged that of the three topics to be discussed by the roundtable, this topic was the “most boring,” but he also said that it was the least partisan and the most important. He outlined some of the main themes gleaned from a recent meeting of the Commission’s Investor Advisory Committee (IAC), which had discussed the proxy process at length. There is a general concern that retail participation in proxies is down, even in contested elections where voting can play a pivotal role, he said. One reason for this is the OBO/NOBO system that creates differences in communications with retail investors. Non-objecting beneficial owners (NOBOs) allow intermediaries to release their names and addresses to the issuer, while OBOs are shareholders who do not allow their identities to be disclosed. Coates suggested that the SEC conduct a survey to determine why some shareholders do not choose to be NOBOs and then think about how the industry can respond.

Members of the IAC had also emphasized that shareholders want to know that their votes were actually counted, Coates said. He noted that there are solutions that currently exist, and urged Broadridge Financial Solutions, which provides proxy voting services, to think how it can make its system simpler. In addition, the IAC observed that the many layers of intermediation can produce mismatches in information, which can lead to the disqualification of votes, Coates said.

Systemic change needed, but short-term fixes are available. Nudges from regulators alone will not be sufficient to improve the system, according to Ken Bertsch, executive director of the Council of Institutional Investors. In CII’s view, it is time for a fundamental rethink of the proxy voting system. In terms of regulation versus market forces, the SEC should lead the thought process to find out what makes sense, Bertsch said. While the technology is available that can be used in this area, a fundamental change will take time, and the Commission should look at short-term fixes.

In the near-term, the SEC should, through rulemaking or guidance, require all intermediaries to take steps to transmit all the necessary information to provide routine and reliable vote confirmation, Bertsch advised. The Commission should also issue guidance that leads to pre-reconciliation of discrepancies between broker-dealer and DTC positions to minimize differences.

OBO/NOBO issues. Katie Sevcik, executive vice president and COO of transfer agent EQ, suggested that many shareholders who are currently OBOs actually would prefer to be NOBOs. Even issuers that do have access to shareholders who are NOBOs find it expensive to gain access to the shareholder list, noting that one issuer recently paid $70 per name. She also observed that NOBO lists do not use email addresses, meaning issuers can only reach out to these shareholders via postal mail.

Lawrence Conover, vice president at Fidelity Investments, pointed out that the largest percentage of OBOs are institutional investors. For them, it is a privacy issue, he said, and they will do anything to protect their privacy. Comparatively, most retail investors are NOBOs, he added.

Blockchain. Several roundtable participants expressed support for using blockchain or other distributed ledger technology to reform the proxy voting system. Robert Schifellite, president of investor communications at Broadridge, said that his company is making very significant investments in blockchain, including a pilot program with Bank Santander as well as blockchain pilots in the U.S. with five issuers and a couple of custodians. He highlighted Broadridge’s platform and invited those interested to come see how it works, the controls that have been implemented, and audits that take place to ensure that the process is accurate and reliable.

Alexander Lebow of A Say Inc. was more cautious to embrace blockchain, although he acknowledged that the technology holds great promise with regards to proxies. According to Lebow, there is a spectrum of approaches to blockchain, with one end being the complete reconstruction of the equity markets with distributed ledger technology and the other end involving certain layers of blockchain on top of a pre-existing system. In his view, the more you move away from an all-in reconstruction of the system towards “layers of veneer,” the fewer the benefits will be and the less clear the advantages are over existing database technologies. “If you’re going to do it, you need to go all-in on blockchain,” he advised.

Chairman Jay Clayton praised the roundtable’s participants and said he was heartened to hear about technology and stressed that the technology should not drive the structure; rather, we should outline our goals and then find the technology that can help address these goals.

Monday, November 19, 2018

Cyber, Brexit are among SEC disclosure review priorities in coming filings season

By John Filar Atwood

In the upcoming filings season, the staff of the SEC’s Division of Corporation Finance will be looking closely at disclosure on the degree to which the board oversees the management of the company’s cybersecurity risks. At Practising Law Institute’s conference on securities regulation, both Deputy Director Shelley Parratt and Associate Director Cicely LaMothe emphasized that the staff expects this year’s cyber disclosure to adhere to the 2018 staff guidance in this area.

LaMothe said the staff will expect to see disclosure on the cyber risks a company faces and the board’s oversight of managing that risk. She noted that the staff reads press reports, and if it sees a cyber incident mentioned, it will look for a discussion of the incident in the company’s disclosure documents. The information disclosed must make sense in terms of what is going on with a company, she added.

Parratt agreed, and opined that cyber disclosure is improving overall. She advised companies to be sure to discuss their internal controls surrounding cybersecurity and their policies to prevent insider trading before an incident is made public. Northrop Grumman’s Jennifer McGarey said that her company puts certain employees on a no-trade list so that if a cyber breach occurs, the company can act quickly. At Northrop Grumman, cybersecurity is a board-level disclosure, she noted.

Sidley & Austin’s Thomas Kim remarked at how the Commission’s 2011 cyber guidance was a little tentative, but the 2018 has a very different tone. After reading the 2018 guidance, companies should conclude that cybersecurity and data management must be treated as a material risk by all entities, he said.

Yahoo! case. Former CorpFin Director Meredith Cross, a partner at WilmerHale, advised companies to learn some lessons from the 2018 cyber disclosure case against Yahoo! The Commission found that the company’s risk factor disclosure was materially misleading for failure to disclose a massive data breach in 2014.

Importantly, Cross said, the SEC criticized Yahoo! for not consulting with outside auditors and experts on the matter. She wondered whether prior to the Yahoo! case corporate counsel would have thought of outside consulting as part of the controls and procedures process. She advised companies to be mindful going forward of the Commission’s critique of Yahoo!.

Brexit. Another area of focus for the CorpFin staff in upcoming filings will be Brexit disclosure, according to Parratt. As the March 2019 deadline nears, she noted, the staff is monitoring the disclosure on the topic. So far the quality of reporting is wide ranging, she said, with some companies covering very thoroughly supply chain and personnel issues, and whether Brexit will cause them to have to relocate. Division Director William Hinman added that if a company is still providing generic Brexit disclosure, it should think about whether its shareholders will be surprised about it after it happens.

The LIBOR phase-out could have a significant impact on some companies, Parratt said, so the staff will want to see adequate disclosure if it is a material issue for a company. She added that the staff expects LIBOR-related reporting to improve as more information becomes available on the transition to other reference rates.

LaMothe said that the top areas on which the staff comments remain consistent from year to year. This year the staff issued numerous comments on revenue recognition, fair value disclosure, and MD&A. She advised that when the staff is drafting comments, it tries to understand what a company’s accounting method is and then examines how the company has applied the relevant staff guidance.

Staff reviews are not limited to the filings themselves, LaMothe said. The staff also looks at analyst reports, news stories, and web sites. The staff’s objective to understand the story of a company, she noted, and then to make sure the company’s MD&A coveys that.

Fewer comment letters. Cross said that overall it seems the staff is issuing fewer comment letter, but that they are harder and more well-informed. LaMothe agreed that there are fewer letters issued, noting that the staff is moving away from sending out generic comments. In addition, the staff is being more proactive in the comment process by calling companies to discuss its questions, she said.

In her opinion, companies also engage in a lot of self-correction. They take into account the comments the staff has issued and adjust their disclosure accordingly, which cuts down on the need for comment letters, LaMothe said.

She emphasized that the staff does not always require an amendment when it has questions about a company’s filing. She advised companies to call the staff for clarification. The staff can hopefully help a company target its responses to the staff’s questions, she added, and avoid having to prepare an amended filing.

Friday, November 16, 2018

SEC enforcement co-directors discuss approach to crypto assets, impact of Supreme Court decisions

By John Filar Atwood

The SEC’s Division of Enforcement has tried to take a measured approach to enforcement in the crypto asset space in order to address violations without stifling innovation, according to co-directors Stephanie Avakian and Steven Peikin. The division’s cyber unit is closely watching the space, and looking for situations where investors do not have adequate disclosure about crypto products, they said at Practising Law Institute’s conference on securities regulation.

Peikin said the crypto cases generally involve outright fraud, where entities do not have the product they claimed to have, or trading suspensions because there was not enough information about the product in the marketplace. The staff also is beginning to bring actions for regulatory violations such as a failure to register, such as the December 2017 case against Munchee Inc., which was selling digital tokens through unregistered offers and sales.

More recently, the division has started cracking down on the operation of unregistered digital exchanges, Peikin said. He cited the first unregistered exchange case brought last week against an individual that operated EtherDelta, an online platform that had executed more than 3.6 million orders for tokens over an 18-month period.

Given the uncertainty surrounding regulation of the digital asset space, Peikin was asked if the Enforcement Division is engaging in regulation by enforcement. He said the staff is sensitive to that concern, but argued that the division’s work in this area has been incremental and has progressed logically. As evidence, he cited the decision to issue a Section 21(a) report in the DAO investigation instead of bringing an enforcement action, and the decision not to impose penalties on Munchee because it quickly and fully cooperated and gave all of the money back. Those were responsible approaches to the two cases, in his opinion.

Supreme Court decisions. Avakian and Peikin also discussed the impact on enforcement of the Supreme Court decisions in Kokesh v. SEC and Lucia v. SEC. In Kokesh, the Supreme Court ruled that the SEC’s imposition of disgorgement constitutes a penalty and, as a result, is subject to a five-year statute of limitations. In Lucia, the Court determined that administrative law judges are officers of the U.S. and so must be appointed by the full Commission.

Peikin said that Kokesh has had a dramatic impact on the division, noting that it has had to forego about $900 million in disgorgement. The staff is more thoughtful about case selection because of Kokesh, he added, and looks at the age of a case before deciding whether to proceed.

Avakian agreed, saying that if misconduct in a pending case is four years old, the enforcement staff may bypass it. However, if the fraud in the case is ongoing, then the division will certainly take action, she stated. If the agency is only going to get an injunction and no remedies at the end of a case, it is hard to decide it is worth the resources, she said. The staff is not at a loss for cases, she added, noting that it received 20,000 tips and referrals last year, and so must choose where to put its resources.

Lucia also has had a measurable impact on the SEC’s enforcement program, according to Avakian, who noted that more than 200 cases came back to the division because of the ruling. She said the staff will work through those cases over the coming year, and may have to use a significant amount of litigation resources to retry some of them. She believes that the backlog caused by Lucia should clear out it about a year.

2018 annual report. The Enforcement Division released its fiscal 2018 annual report recently, and Avakian said observers should not read too much into the decrease in the number of financial fraud cases during the past year. Fraud cases remain a high priority for the staff, she insisted, citing the litigation in significant cases such as those against Theranos and Rio Tinto.

Peikin emphasized the importance of the share class selection disclosure initiative that the staff implemented last February. Under the program, the staff agreed to recommend favorable settlement terms for investment advisers that self-reported their failure to make required disclosures relating to their selection of mutual fund share classes that paid the adviser a fee when lower-cost share classes were available.

It was a big concession by the division not to pursue these cases, Peikin said. However, the initiative generated dozens of reports that will allow the Commission to return money to investors. The conduct involved is extraordinarily hard to detect, he noted, so the self-reporting program was a huge help to the division.

Avakian said the enforcement staff tries to be as responsive as possible, while managing the work in a way that enables the division to pivot to a new case if necessary. Peikin noted that the staff works through tips and referrals as quickly as possible. The division will not make the right call every time about whether to pursue a particular matter, he said, but it tries to get the important ones right.

Thursday, November 15, 2018

Sentences upheld in double jeopardy dispute

By R. Jason Howard, J.D.

On the heels of the Supreme Court holding in Kokesh v. SEC that disgorgement, “as it applied in SEC enforcement proceedings, operates as a penalty,” the Sixth Circuit, in a criminal sentencing appeal, held that SEC civil disgorgement is not a criminal punishment (U.S. v. Dyer, November 13, 2018, Suhrheinrich, R.).

Broad Street. For more than eight years, the defendants owned and managed Broad Street Ventures, LLC, which they used to embezzle investor funds by paying the funds out to themselves as nontaxable distributions and underreported income to evade paying taxes on it. In all, the government estimated that the amount of the loss or fraud totaled over $4.9 million.

On July 20, 2016, the SEC began a civil enforcement suit against the defendants and nine months later, in April 2017, the government filed an information charging the defendants with conspiracy to commit mail and wire fraud and tax evasion. In May 2017, the defendants pleaded guilty to the conspiracy to commit wire fraud and mail fraud, and tax evasion. As part of their plea deals, the defendants stipulated that the amount of loss caused by their conduct was greater than $3.5 million, waived any double jeopardy defenses, and agreed to pay over $538,000 in restitution to the IRS.

In May 2017, the defendants consented to entry of a final judgment in the civil case, where they agreed that the court would order disgorgement of ill-gotten gains, pre-judgment interest, and a civil penalty. In the criminal case, sentencing guidelines after all considerations left the defendants with between 46 and 71 months of imprisonment. The defendants objected to the guideline calculations, arguing that the 18-level increase of their base offense level per the guidelines, violated the Double Jeopardy Clause because the defendants were already punished by disgorgement in the civil case. The defendants also argued that the five-year statute of limitations from Kokesh prevented the court from considering conduct the occurred more than five years before the indictment.

District court holding. The district court ruled that Kokesh did not apply and that it “was allowed to consider ‘relevant conduct’ that could not be prosecuted separately because of the statute of limitations.” The court also ordered the defendants to pay restitution in the full amount of the loss, over $4.9 million.

Appeal. Despite their attempts, the Sixth Circuit explained that the holding in Kokesh was narrow and that “nothing from Kokesh serves as the ‘clearest proof’ we require to transform a civil remedy into a criminal punishment for Double Jeopardy purposes.” The court continued, stating that if anything, “Kokesh reinforces the long-held understanding that SEC disgorgement is civil in nature.”

Even if the SEC disgorgement were a criminal punishment, the Sixth Circuit explained that it would affirm the defendants’ sentences for two reasons. First, with the civil complaint alleging securities violations, the SEC had to prove that the purchase or sale of a security was involved and in the criminal case, where the defendants were charged with conspiracy, the government had to prove the defendants joined in the agreement. Those elements are exclusive to the civil and criminal cases and, as such, there is no double jeopardy. Secondly, the Sixth Circuit said that “the consideration of relevant conduct resulting in an 18-level enhancement is not ‘punishment’ for Double Jeopardy purposes.”

Holding. The defendants’ other arguments met with a similar fate and the Sixth Circuit affirmed the lower court’s ruling that the SEC’s civil disgorgement is not a criminal punishment and affirmed the defendants’ sentences.

The case is No. 17-6174.