Friday, June 23, 2017

IAC mulls capital formation, decline in number of IPOs

By Amy Leisinger, J.D.

The SEC’s Investor Advisory Committee heard from panelists on current trends surrounding capital formation and smaller companies as well as the recent decrease in the total number of initial public offerings. Costs play a role in deciding whether to go public, the panelists noted, but the changing landscape may likely be attributable to the broader availability of options for private offerings. Regulations should incentivize companies to make the right decisions in light of their particularized circumstances, they noted.

Jeffrey Solomon, President of Cowen Inc. and CEO of Cowen and Company, noted that the cost of operating small funds is quite large in proportion to potential growth and that, ultimately, investors are disadvantaged by cost constraints. Moreover, he explained, the myriad costs inherent in being public play a role in deciding on a corporate approach, and the answer may be to relax requirements in order to incentivize small funds. The decline in small cap IPOs is the result of many factors, he said, including brokerage firms’ migration to asset allocation from individual stock recommendations. In addition, Solomon noted the rise in the number of passive investment vehicles that do not participate in capital formation and potential returns on small IPOs not significant enough to encourage large investors to allocate resources away from secondary market. Regulators and industry participant should continue to consider means by which to make the market structure more conducive for small caps, and this may include extending the Tick Size Pilot Program, he stated.

Duke Law School Associate Professor Elisabeth de Fontenay agreed that the cost of regulation story remains the dominant narrative, particularly in light of JOBS Act and related regulatory changes designed to ease the burdens involved in raising capital as a private company. Public companies used to see a benefit to substantial disclosure burdens—the right to publicly raise capital—but now, much more capital is going into private companies, she noted. Moreover, de Fontenay continued, private companies are likely directly benefitting from the disclosures set forth by public companies. To increase IPOs and exchange listings, the SEC may need to re-regulate private offerings or level the playing field to ease the burdens of public-company status, she opined.

Andreesen Horowitz Managing Partner Scott Kupor noted that IPOs are currently going at a much higher value than in the past and suggested that “it just does not pay” to be a small cap company. The key is bringing back support for the small cap market and conducting a comprehensive review of the costs and tradeoffs involved in going public, he said. While the SEC focuses on its mission to facilitate capital formation and ensure investor protection, the agency cannot forget the maintenance of fair and efficient markets. The integrity of the markets is crucial for the protection of investors, and regulators must look at pricing in the market, disclosure obligations, and growth opportunities and limitations when considering regulation of public companies. This may require efforts to shift the perception of the value of going public and taking steps to regulate in a way that encourages and rewards doing the right thing, Kupor concluded.

Thursday, June 22, 2017

Staff grants relief to permit interim sub-advisory agreement to continue without shareholder approval

By Jacquelyn Lumb

The Division of Investment Management advised that it would not recommend enforcement action against NWQ Investment Management Company, LLC if it continued to serve as an investment adviser to certain series of two Nuveen Investment Trusts under written sub-advisory agreements that were not approved by a majority of the outstanding voting securities of each series. Nuveen explained that despite its best efforts, it was unable to reach a quorum required for its shareholders to vote on a reorganization and new sub-advisory agreements. The no-action relief would enable NWQ to continue to serve as investment sub-adviser for a limited period of time.

Reorganization leads to new sub-advisory agreements. Nuveen Tradewinds Value Opportunities Fund and Nuveen Tradewinds Global All-Cap Funds are series of the trusts for which Nuveen Fund Advisors serves as investment adviser and Tradewinds Global Investors, LLC served as sub-adviser. In May 2016, Nuveen decided to wind up operations at Tradewinds after significant asset outflows followed when its president and chief investment officer left. As part of the transition plan, the board of trustees approved the termination of the funds’ sub-advisory agreement with Tradewinds and appointed NWQ as the sub-adviser under an interim agreement that was scheduled to expire on December 29, 2016.

At the May meeting, the board decided that a reorganization was in the best interest of the funds. Each fund sought shareholder approval for the reorganization and for new sub-advisory agreements in a joint proxy statement/prospectus dated September 23, 2016. As of November 8, 2016, an overwhelming majority of the votes received were cast in favor of the proposals. However, Nuveen Fund Advisors concluded that there was a high probability that neither fund would receive the number of votes necessary to reach a quorum by the sub-advisory agreement’s expiration date.

Lack of quorum to approve agreements. Nuveen explained that the factors that contributed to its inability to reach a quorum included the level of redemptions since the record date for the shareholder meeting, a higher than usual percentage of each funds’ shares represented by objecting beneficial owners, and shareholder bases that were more dispersed than was typical.

Nuveen sought relief to permit NWQ to continue to serve as the investment sub-adviser after the interim period permitted by Investment Company Act Rule 15a-4, not to exceed the earlier of the consummation of the reorganization, shareholder approval of the new sub-agreement, or 60 days after the expiration date. Absent an extension, Nuveen said it may have to liquidate the funds.

Conditions to relief. As a condition to the requested relief, the funds and Nuveen Fund Advisors agreed that, during the additional period, they would continue their proxy solicitation efforts in an attempt to reach a quorum. Nuveen Fund Advisors agreed to waive the portion of each fund’s advisory fee in an amount equal to the amount of the sub-advisory fee that would be payable by Nuveen Fund Advisors to NWQ under the original terms of the interim sub-advisory agreement. Other than the changes contemplated by the no-action relief, the terms and conditions of the interim sub-advisory agreement would remain the same.

At a shareholder meeting held on December 29, one of the funds achieved a quorum and shareholders approved the new sub-advisory agreement. At a shareholder meeting on January 26, 2017, the other fund achieved a quorum and shareholders approved the new sub-advisory agreement.

Wednesday, June 21, 2017

CFTC Inspector General says not enough cost-benefit analysis on uncleared swaps margin rule

By Lene Powell, J.D.

The CFTC Inspector General (OIG) concluded that the CFTC did not analyze possible costs and benefits in enough detail in considering a 2015 rule establishing margin requirements for uncleared swaps. Among other deficiencies, OIG found that the CFTC did not sufficiently address the possibility that the rule might undermine risk-hedging by market participants or exacerbate systemic risk in times of market stress. OIG recommended that the CFTC take specific steps in considering costs and benefits of proposed rules, improve its data infrastructure, and encourage long-term academic research to increase understanding of CFTC-regulated markets.

Swap margin rule. The Dodd-Frank Act bifurcated the U.S. swaps market into cleared and uncleared swaps transactions. Among other provisions, Dodd-Frank added Section 4s to the Commodity Exchange Act, requiring the CFTC to establish margin requirements for uncleared swaps. In December 2015, the CFTC finalized a rule requiring covered swaps entities (swap dealers and major swap participants for which there is no prudential regulator) to post and collect initial and variation margin for uncleared swaps.

Cost-benefit analysis. Under Section 15(a) of the Commodity Exchange Act, the CFTC must evaluate costs and benefits of a proposed action in light of specified factors including the protection of market participants and the public. The CFTC has written guidance interpreting the cost-benefit requirement.

OIG found that the CFTC’s published consideration of the uncleared swaps margin rule failed to provide sufficient economic analysis. The discussion did not effectively explain the nature of the market failure addressed by the rule, other than by referring to the financial crisis and the undefined catch-all term “systemic risk.” Discussion of costs was mostly restricted to immediate practical concerns like the cost of funding margin collateral. Unintended consequences were mentioned cursorily, if at all. OIG said that staff working on the rule were hampered by significant data limitations and a lack of institutional commitment to the identification and quantification of costs and benefits.

OIG recommended that the CFTC analyze costs and benefits more systematically: establish a baseline, specify the market failure, and consider whether the failure stemmed from existing regulation. The analysis should apply assumptions symmetrically and consistently, quantify likely effects and possible unintended consequences, and state expectations regarding the response of market participants to the rule. All rules should be subjected to periodic retrospective analysis to gauge effects.

OIG also recommended that the CFTC focus on improving its entire data infrastructure. In addition, the CFTC should invest more in economic knowledge, shifting its personnel investment toward more economists and analysts in the business divisions, and establish the Office of the Chief Economist (OCE) as a source and repository of juried economic research fostering greater understanding of CFTC-regulated markets.

Management comments. CFTC Management believed that the margin rule demonstrated that the Commission is committed to engaging in a thorough consideration of the rule’s costs, benefits, and economic outcomes. Management observed that OIG had found that the Commission had discussed most of the nine economic areas identified as relevant, and that the Commission was hamstrung in part due to poor-quality, error-ridden data from regulated entities in the swaps markets. Management agreed that a strong data infrastructure will improve data quality for cost-benefit discussions, and said the CFTC has worked with market participants to improve data quality.

Regarding legal considerations, management noted that OIG’s suggestion that the Commission consider the costs and benefits of actions commanded by Congress is not a legal requirement under controlling case law, including the D.C. Circuit. Further, although the Commission agrees as a policy matter with the importance of quantitative analysis, this is not always possible and is not a direct requirement under the Commodity Exchange Act, as the D.C. Circuit has held.

Tuesday, June 20, 2017

SEC agrees $45M Tilton disgorgement now untimely in light of recent Supreme Court ruling

By Joanne Cursinella, J.D.

The SEC’s Division of Enforcement no longer seeks disgorgement of approximately $45 million in “ill-gotten gains” from the respondents in their administrative proceeding, In the Matter of Lynn Tilton, et al., because of the Supreme Court’s recent holding in Kokesh v. SEC that disgorgement constitutes a penalty subject to a five-year limitations period.

The Commission originally charged Tilton and her firm in 2015 with defrauding her collateralized loan obligation investors. In connection with this proceeding, among other things, the Commission sought a disgorgement of $45,447,417. On June 5, 2017, however, the U.S. Supreme Court, in a unanimous decision, held that disgorgement is a penalty subject to a five-year limitations period.

The Division acknowledged that the alleged misconduct charged in Commission’s administrative proceeding took place more than five years before the proceeding was commenced. So, it has withdrawn its disgorgement request in this matter. In its June 9 letter, however, the Division also noted that the U.S. Supreme Court has not addressed the question of whether courts are empowered to order disgorgement in SEC enforcement cases and that Kokesh did not address the Eighth Amendment's Excessive Fines Clause.

Monday, June 19, 2017

NASAA report scrutinizes senior practices and procedures

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

NASAA has released a report surveying the senior­-related practices and procedures of more than 60 U.S. broker­dealers. The study examines supervisory procedures, training, the reporting and resolution of senior issues, and the use of trusted contact forms. NASAA released the report in recognition of World Elder Abuse Awareness Day on June 15.

“Being face-to-­face with clients puts financial services professionals on the frontlines when it comes to stopping suspected cases of senior financial fraud and exploitation,” said NASAA President Mike Rothman in a news release. “As the U.S. population ages, the financial industry can help detect and report financial crime and abuse of the elderly and other vulnerable adults.”

The Investment Products & Services Project Group of NASAA’s Broker-Dealer Section conducted the study, which selected the participating broker-dealers at random but tended to focus on larger firms. The Project Group found that 54 percent of the broker-dealers surveyed lacked a formal policy defining senior customers, and only 30 percent of the firms had created senior-specific policies and procedures. Ninety percent of the firms had at least some type of internal process for addressing senior issues, however, and approximately 95 percent of the broker-dealers provided some type of training on senior issues.

Senior-specific procedures. The report found that the quality and source of senior-specific procedures varied greatly among the broker-dealers. Some firms provided written supervisory procedures that addressed senior issues in great detail, while others only briefly mentioned an issue or procedure as a guideline in the firm’s training materials or an internal memorandum.

With respect to respect to escalation policies, firms typically required that representatives be sensitive to the possibility of diminished capacity or financial exploitation and that concerns be raised to a supervisory principal or other designated person or team. According to firm procedures, suspected abuse issues were escalated within the firm and reported to appropriate state agencies while the firm took appropriate action to restrict account activity or comply with court orders. Some firms provided lists of red flags and other considerations in determining whether escalation is necessary or provided resources regarding any state requirements for escalation.

Takeaways. The report concludes that state securities regulators should continue to encourage firms to adopt policies and procedures and develop internal teams or departments dedicated to issues regarding seniors and vulnerable adults. Specifically, NASAA recommends that firms consider improving their policies and procedures in several areas, including:
  • establishing clear definitions of “seniors” and “vulnerable adults”;
  • implementing heightened suitability review for seniors triggered by certain “red flags,” such as high risk products or account concentrations;
  • using a trusted contact form and other resources to assist senior investors;
  • establishing proper escalation protocols; and 
  • addressing how and when to report matters to authorities and when to delay account disbursements as a result of escalated concerns. 

Friday, June 16, 2017

EC proposes pan-European approach to supervision of central counterparties

By John Filar Atwood

The European Commission (EC) has proposed changes to the European Market Infrastructure Regulation (EMIR) that will provide for more robust supervision of central counterparties (CCPs). The reforms introduce a more pan-European approach to the supervision of EU CCPs to ensure further supervisory convergence and to ensure closer cooperation between supervisory authorities and central banks responsible for EU currencies.

For CCPs established in the EU, national authorities will exercise supervision in agreement with the European Securities and Markets Authority (ESMA). The proposal calls for ESMA to establish a new CCP Executive Session within ESMA that will be responsible for ensuring a more consistent supervision of EU CCPs, as well more robust supervision of CCPs in non-EU countries or third countries.

The existing colleges of national supervisors established under EMIR for each EU CCP will continue to act as bodies fostering cooperation and making joint decisions. The head of the new CCP Executive Session will chair the existing EMIR colleges in order to ensure consistency between the work of the Executive Session and that of the colleges.

Third country CCPs. The EC said in a news release that the proposals will enhance the recognition and supervision of third country CCPs to better address the potential risks to the EU’s financial stability. The reforms introduce a two-tier system for third-country CCPs under which non-systemically important CCPs will continue to operate under the existing EMIR equivalence framework.

Systemically important CCPs. Systemically important CCPs will be subject to stricter requirements. These requirements include compliance with the necessary prudential requirements for EU CCPs while taking into account third-country rules and confirmation from the relevant EU central banks that the CCP complies with any additional requirements set by those central banks. The additional requirements could include the availability or type of collateral held in a CCP, segregation requirements, and liquidity arrangements. A CCP also must agree to provide ESMA with all relevant information and to enable on-site inspections, as well as the necessary safeguards confirming that such arrangements are valid in the third country.

Depending on the significance of the third-country CCP’s activities for the EU and member states’ financial stability, the EC noted that a limited number of CCPs may be of such systemic importance that the requirements are deemed insufficient to mitigate the potential risks. In those cases, the EC, upon request by ESMA and in agreement with the relevant central bank, can decide that a CCP will only be able to provide services in the EU if it establishes itself in the EU.

The EC drafted the proposed reforms based on feedback from an extensive assessment of EMIR and two public consultations. The EC took into account input received on its communication responding to challenges for critical financial market infrastructures and to its staff working document on equivalence.

Rationale for reforms. Based on the feedback, the EC determined that amendments to the supervisory arrangements for EU and third-country CCPs under EMIR were needed for two reasons. First, while supervisory colleges enable information sharing among different supervisors, under current supervisory arrangements for EU CCPs the main decisions are ultimately made by the national authorities in the member states where the CCP is established. The EC believes this arrangement is no longer adequate given the volume of cross-border activity by CCPs and the potential risks for the EU financial system as a whole. In addition, the EC determined that the important role of central banks needs to be better reflected in the decision-making process.

The second reason relates to the fact that a significant amount of financial instruments denominated in the currencies of member states are cleared by recognized CCPs in non-EU countries as a result of the equivalence regime under EMIR. CCPs from those countries are allowed to operate in the EU following a thorough appraisal of third country’s rules by the EC and of the CCP by ESMA.

However, EMIR’s current rules on equivalence and recognition have demonstrated certain shortcomings with respect to ongoing supervision in third countries, which means that EU authorities may not become aware of new or growing risks to the EU financial system. In addition, the EC determined that the actions of a third-country CCP can have an impact on the financial stability of the EU and its member states and therefore raise significant concerns for EU central banks.

Impact of Brexit. The EC also noted that with the departure of the U.K. from the EU, CCP-related risks will be particularly exacerbated, as a substantial volume of derivatives transactions denominated in Euro or other EU member states currencies are currently cleared via CCPs located in the U.K.

Thursday, June 15, 2017

Emerging regtech issues explored at FIA gathering in Chicago

By Brad Rosen, J.D.

An all-star panel of regulatory professionals convened in downtown Chicago to consider the burgeoning field of regulation and technology at a meeting of the FIA Market Technology Division. The program, titled The Current State of RegTech, featured a cross-section of leaders from various ends of the industry, including representatives from trading companies, clearing firms, exchanges, and vendor/solution providers.

Matthew Scharpf, vice president of Eurex Americas, opened the presentation by comparing the state of the futures and derivatives industry to the city of Chicago in the aftermath of its great fire in 1871. He observed that tragedy, when combined with creativity, can clear the path for great opportunity. In the case of the futures industry, the tragedy was the financial meltdown of 2008, which in turn led to the Dodd-Frank market reforms and a rising tide of regulation. The intervening years have also seen the emergence of new and disruptive technologies. These two forces have combined to form the discipline of "regtech." The stated goal of regtech is to utilize technology to help businesses comply with regulations both efficiently and inexpensively.

Regtech is an act in progress, and Sharpf turned to his fellow panelists for their insights regarding its current applications and limitations, as well as its future possibilities. Matt Lisle, a director and chief compliance officer with ABN AMRO Clearing Chicago, shared his real world perspective that over the past 30 years the industry has gone from analog to digital. However, that has not been a panacea. Lisle observed, “most in the industry have the challenge of multiple systems, no standard solutions, and are barraged by constant updates.” “Technology doesn’t always work as intended, and unintended errors can lead to big fines,” he added.

On a more positive note, Lisle sees technology as playing an important role promoting culture of compliance that focuses on behavior. He sees increased technological innovation as reengineering the workplace of the future.

Kurt Windeler, a senior director of market regulation with the Intercontinental Exchange (ICE), is deeply involved with the exchange’s regulatory function—as a cop on the beat. He sees technological innovation as playing a key role in assuring market integrity. Windeler also sees using technological tools to identify risks that impact market integrity as a core challenge. In his view, market integrity extends to various activities such as clearing, trading, interaction among market participants, and marketing

Windeler also observed that there are many issues surrounding data quality and validity. “ICE integrates multiple data sources and is increasingly becoming a data company in its own right,” he observed.

Big data and how best to use it will remain a major challenge for the industry, Corbin Kidd, a chief technology officer for DV Trading, a Chicago based proprietary trading firm noted. “We are drowning in data, what we are looking for is wisdom,” he said.

Brian Clark, the chief executive officer with Ascent Technologies, a solution provider, sees the challenge of adapting to and keeping up with the pace of change as well as the breadth and depth of information available, as just a couple of the things that are keeping folks up at night. Clark noted that the Dodd-Frank reforms resulted in over 1300 new compliance obligations across regulators. Clark and Ascent have taken the approach of providing intelligence as a service. Clark sees computers as serving as management’s right hand and will be able to address many routine problems. However, people will still have to deal with the toughest problems.

James Austin, the chief executive officer with Vertix Analytics, another service provider, shared his view that the CFTC is highly suspicious of automatic and algorithmic trading. From an enforcement perspective Vertex sees technological tools as being the extension of those persons involved in a particular activity. Austin notes that the Commission itself as trying to accelerate its embrace of technology but faces many obstacles including not receiving the funds to pursue these ends.

Most members of the panel were also skeptical of Lab CFTC, the recently announced technology initiative. Many thought it was a good idea but did not think much will come of it. Additionally, panel members noted that it appears that the Commission’s recent request for a $31.5 million budget increase for FY 2018 will likely be rejected. The lion’s share of that increase was to be devoted to technology-related initiatives according to Acting Chairman J. Christopher Giancarlo. Most of the panel thought the government’s lack of support in this regard was unfortunate and failed to recognize the importance of technological innovation in the world of regulation.

Wednesday, June 14, 2017

Treasury reports to president on financial ‘core principles’

By Mark S. Nelson, J.D.

Treasury Secretary Steven Mnuchin published the report on financial regulation core principles that had been requested in an executive order issued by President Trump. Much of report deals with banking issues, but several items broadly apply to swaps and derivatives regulations, the rulemaking process at independent financial agencies, and the Volcker rule. Some of the recommendations in the report have been captured in various bills in Congress, although the report, at times, suggests a few more nuanced approaches than law makers have so far advocated.

Reaction by Democratic lawmakers has been swift. House Financial Services Committee Ranking Member Maxine Waters (D-Cal) linked the Treasury report and the Financial CHOICE Act of 2017. "In many areas, this plan is as brazen and openly regressive as the Wrong Choice Act. It too would destroy the Consumer Bureau, and roll back critical rules in place to ensure the stability of our financial system," Waters said in a statement. Senator Elizabeth Warren (D-Mass) said Democrats would not give into the “Trump-Mnuchin financial deregulation plan.”

Meanwhile, Senate Banking Committee Ranking Member Sherrod Brown offered to work with Republicans on more focused legislation that would not upset the balance achieved in the Dodd-Frank Act. “Too many hardworking Americans still haven’t fully recovered from the financial crisis, and Washington should be focused on protecting them by holding Wall Street accountable, not doing its bidding,” Brown said in a statement. Brown also chided Treasury for allegedly consulting with far more industry groups than consumer groups in preparing the report.

Kenneth Bentsen, Jr., president and CEO of the Securities Industry and Financial Markets Association observed that “[] redundant and conflicting rules, or measures that unnecessarily outweigh stability over investment can result in inefficient regulation and stifle our growth potential.” According to Bentsen, financial confidence is grounded in “[c]lear market rules and prudent capital standards.” Bentsen “commended” Treasury for the completeness of its review.

Tuesday, June 13, 2017

Bricker identifies areas in need of additional accounting research

By John Filar Atwood

Noting that academic research can have a direct impact on the Commission’s policy decisions, SEC Chief Accountant Wes Bricker identified a number of areas that could benefit from further work by accounting researchers. At a recent accounting and public policy conference, he suggested the role of non-authoritative guidance in shaping financial reporting and the new expected credit loss standards issued by the FASB and IASB as possible topics for academic research.

In a keynote address, Bricker said that research on the impact of accounting standard setting often focuses on the accounting standard, which is a vital piece of financial reporting. However, the role of non-authoritative guidance from the staff of standard setters, accounting firms, and industry groups has not received much attention in academic literature.

Expected credit loss model. He also indicated that the recently issued expected credit loss standards issued by the FASB and the IASB offer opportunities for academic research. The FASB’s current expected credit loss model requires that the full amount of expected credit losses be recorded for all financial assets measured at amortized cost, he noted. In contrast, the IASB’s approach in IFRS 9 requires that an allowance for credit losses equal to the 12-month expected credit losses be recognized, until there is a significant increase in credit risk when lifetime expected credit losses are recognized.

Registrants are currently developing implementation plans and accounting policies for application of the expected credit loss standards, according to Bricker. He believes that research on the anticipated effect of the expected credit loss approach compared to today’s incurred loss model under various scenarios could be helpful. As an example, he suggested studies that compare the simulated performance of these models based on historical data with varying assumptions.

International standards. Bricker also advised that there are opportunities for research on the application of international accounting standards. He said that possible areas for further research include monitoring financial reports issued from jurisdictions that have not endorsed IFRS as issued by the IASB, or have done so in only a partial manner. Research in this area would contribute to an understanding of the similarities and differences in financial reporting attributes and outcomes, in Bricker’s view.

Research is also needed in the area of governance and controls, he said, including on the means of promoting appropriate ethics, tone and values within a company, oversight of performance management and accountability, and communicating information among the board, management, and internal auditors and external auditors. Studies on controls to manage risk and increase the likelihood that objectives and goals will be achieved also would be useful, he added.

Internal controls. Bricker believes there is value in furthering the existing research on the role of internal control over financial reporting (ICFR) in reducing the risk of material misstatements in financial statements. This may require moving beyond traditional database-driven research towards hand-collected data and perhaps even field studies, he noted.

Bricker encouraged researchers to advance the understanding of the role of audit committees in fostering effective ICFR, and the factors that strengthen or weaken audit committees’ effectiveness. Another area where academic research might be of interest is the characteristics and skills of audit committee members that contribute to their effective oversight of financial reporting, he said.

In Bricker’s opinion, research is needed in the area of advancing an understanding of the flow and uses of financial reporting information given the continuing changes from technology and capacity for data analytics. Studies could cover the disparate interests and financial reporting information needs of both professional and individual investors, he noted, or could examine the nature of information sources, decision styles, and implications for the accounting, audit and disclosure within the financial reporting process.

Delivery innovations. Examining the nature of delivery innovations in financial reporting, such as the role of analysts and data aggregators in the dissemination of structured and non-structured data in the capital markets, also would be helpful to the Commission staff, Bricker said. Research could examine the role of other parties in conforming the form, format, prominence, and distribution of financial statement data to investors and analysts.

Finally, Bricker mentioned the reporting of information other than in the financial statements, such as non-GAAP measures and non-financial metrics, as an area that could benefit from academic research. He noted that the staff monitors compliance in this area to foster disclosure practices consistent with Commission rules, but said that research could deepen the staff’s understanding of the determinants and consequences of both non-GAAP measures and non-financial metrics.

Monday, June 12, 2017

SEC declines to issue interpretation regarding swap instrument that is being litigated

By Jacquelyn Lumb

The SEC has issued a public statement to explain why it has declined a request to issue an interpretive position on whether a particular agreement, contract, or transaction is a swap, security-based swap, or mixed swap. The statement is in response to a letter from counsel for Breakaway Courier Corporation which asked for a joint interpretation from the SEC and the CFTC pursuant to Exchange Act Rule 3a68-2 relating to a contract labeled as a reinsurance participation agreement (RPA) (Release No. 34-80870, June 7, 2017). Breakaway previously executed RPAs with Applied Underwriters Captive Risk Assurance Company, one of which had a stated effective date of July 1, 2009, and the other July 1, 2012.

Rule 3a68-2. Rule 3a68-2 was jointly adopted by the SEC and the CFTC under the Dodd-Frank Act and establishes a process for parties to request a joint interpretation with respect to whether a particular agreement, contract, or transaction is a swap, security-based swap, or a mixed swap. The rule outlines the information that must be included in a request and the process for withdrawing a request. It also includes requirements for the manner and timing in which the agencies must act after receiving a submission under the rule if they decide to issue an interpretation. If the agencies choose not to issue a joint interpretation within the designated time period, both most publicly provide their reasons.

Litigated matter. The SEC said it was declining to issue a joint interpretation in connection with Breakaway’s request because of its understanding that the status of the RPAs is subject to ongoing litigation and the request may have a bearing on that litigation. In the SEC’s view, Rule 3a68-2 is not an appropriate vehicle for litigants to obtain the views of the SEC in connection with issues that are part of ongoing litigation. The SEC has consulted with the CFTC on the request and understands that the CFTC will issue a separate statement on the matter.

According to a footnote in the SEC’s statement, the SEC and the CFTC noted in their release adopting Rule 3a68-2 in 2012 that it is essential that the characterization of an instrument be established prior to any party engaging in the transactions so that the appropriate regulatory schemes apply.

The SEC asked that future requests under Rule 3a68-2 be provided to the Office of the Secretary with copies to the Divisions of Trading and Markets and Corporation Finance to ensure that they are routed expeditiously.

Friday, June 09, 2017

CFTC Acting Chairman Giancarlo looks to score an additional $31.5 million for 2018 budget

By Brad Rosen, J.D.

Acting Chairman J. Christopher Giancarlo made a cogent and compelling case in support of a $281.5 million budget request and 739 full-time equivalents (FTE) for the CFTC’s fiscal year 2018 operations in testimony before the House Appropriations Subcommittee on Agriculture, Rural Development and Related Agencies. This request, which was submitted in late May, was in contrast to the White House’s proposed FY 2018 budget which sought to keep spending at the FY 2017 level of $250 million and 703 FTE. Commissioner Sharon Bowen also supported the budget request but had reservations. Not surprisingly, Giancarlo received pushback from some of the subcommittee’s Republican members at the hearing.

Along with his prepared remarks, Giancarlo responded to his congressional questioners by demonstrating expertise, and a deep understanding of the complex issues at hand. In responding to a query from ranking member Rep. Sanford Bishop (D-Ga), the acting chairman clearly articulated that the request for $31.5 million in additional funding was not a formulaic or arbitrary number but rather the result of a thorough and informed assessment of what the CFTC requires to execute its mission. In particular, Giancarlo identified three areas where the additional resources would be the directed that included: (1) ramping up the Office of the Chief Economist; (2) growing the Commission’s examination capabilities in connection with the burgeoning swap markets arena; and (3) implementing Fin Tech initiatives.

In response to a question from Rep. Steven Palazzo (R-Miss) about allocating resources towards technology versus personnel, Giancarlo paraphrased hockey legend Wayne Gretzky, indicating that “the CFTC needs to skate to where the puck is going, not to where it is.” He added, “For too long the outlook at the Commission has been backward looking. Now it needs to forward looking,” and pointed to issues like high frequency trading, algorithmic trading, blockchain technology, and cybersecurity, all matters he noted were not even considered or addressed in the Dodd-Frank market reforms.

Attracting world class economists. In responding to Rep. Mark Pocan’s (D-Wis) questions about employee relations and attracting and retaining top personnel, Giancarlo stated that “the Office of the Chief Economist is severely under-resourced, and additional funding would enable the Commission to attract world class econometric thinkers.” “We are competing with Silicon Valley, and regulating a highly sophisticated and complex multi-trillion dollar market. We need very talented personnel,” he added.

Growing the Commission’s examination capabilities. The Commission is also requesting additional resources that would strengthen the Commission's examinations capability and enable it to keep pace with the explosive growth in the number and value of swaps cleared by designated clearing organizations (DCOs), pursuant to global regulatory reform implementation. Giancarlo indicated that there are currently 16 DCOs registered with the Commission, and that the notional value of the swap markets is estimated to be as high as $600 trillion. As the size and scope of DCOs has increased, so too has the complexity of the counterparty risk management oversight programs and liquidity risk management procedures of the DCOs under CFTC regulation here and abroad.

Fin Tech initiatives and keeping pace with advancing technology. “We must avoid being an analogue regulator, in a digital industry,” Giancarlo told the subcommittee. He pointed to a number of rapidly development innovations that present regulatory challenges including: (1) “big data” capabilities that enable sophisticated data analysis and interpretation; (2) artificial intelligence guiding highly dynamic trade execution; (3) “smart” contracts that value themselves and calculate payments in real-time; (4) behavioral biometrics that can detect and combat online fraud,; and (5) distributed ledger technology (more commonly known as blockchain), that may challenge the foundations to today’s financial market infrastructure.

Pushback. Subcommittee Vice Chairman David Valadao (R-Cal) expressed deep concerns whether any increase in funding would boost funding for Fin Tech initiatives rather than going to pay for increased salaries for Commission staff, who he claimed are able to bring a labor actions due to “loopholes” in labor law applicable to federal employment. He further contended that any increase in funding will simply encourage the status quo. Other Republican committee members expressed concerns with various aspects of the CFTC’s regulatory framework as a reason to avoid boosting the agency’s funding level.

Rep. Kevin Yoder (R-Kan) expressed concerns with applicable supplemental leverage ratio requirements which adversely impact farmers, ranchers, and small market participants. Similarly, Chairman Robert Aderholt took issue with proposals to lower threshold amounts in connection with the swap dealer de minimis rules.

Giancarlo was sympathetic to these concerns and underscored his commitment to take a fresh look at all of the Commission’s regulations to assure that they are sensible and being applied sensibly, and repeated a familiar sentiment of his: “The U.S. derivatives markets should be neither the most regulated nor the least regulated of the world—but the best regulated.” Whether the acting chairman will receive the additional funding to assist in scoring this goal remains to be seen. He may be on thin ice.

Thursday, June 08, 2017

SEC will take extra time to mull Chicago Stock Exchange merger with Chinese entity

By Jacquelyn Lumb

The SEC has extended the period for its decision on whether to approve or disapprove a proposed rule change relating to a transaction between the Chicago Stock Exchange and North American Casin Holdings, Inc. The proposed sale of the exchange to a group of investors led by the Chinese firm Chongqing Casin Enterprise Group raised concerns by five members of Congress who urged the SEC to consider rejecting the transaction based on national security concerns, but at a minimum, to extend the comment period given the gravity of their concerns. The SEC has now extended the period for making its determination from June 10 to August 9, 2017 (Release No. 34-80864).

Extension of original comment period. The SEC initially sought comment on the proposed rule change, which had been submitted on December 2, 2016 with the comment period closing 21 days after publication in the Federal Register (Release No. 34-79494). The SEC received five comment letters, including the one from the congressmen. On January 12, 2017, the SEC instituted proceedings to determine whether to approve or disapprove the proposal, which provided 180 additional days for its decision and during which time 21 more comment letters were received. The SEC has now found it appropriate to designate a longer period within which to issue its order so that it can consider the additional comments and the exchange’s response to the comments.

Commenters’ views. The president and CEO of the Chicago Stock Exchange accused some of commenters of distorting the facts and said the transaction would benefit the national market system by allowing it to compete with other markets. He added that the transaction has been reviewed by the Committee on Foreign Investment in the U.S. (CFIUS), which found no unresolved national security concerns.

The CEO of North American Casin also rebutted some of the commenters’ views about the consortium of investors that own the company. All of the members of the consortium are reputable business people, he wrote, and their identities have been fully disclosed to the SEC and CFIUS. He said that as a result of the transaction, Chinese companies listed on the Chicago Stock Exchange will be encouraged to further expand their investments in the U.S. by establishing U.S. subsidiaries, opening factories, and hiring local employees.

The American Chamber of Commerce in South China wrote that the transaction would make the exchange an important bridge between capital markets in the U.S. and China. However, The Public Interest Review characterized North American Casin as an "empty shell that orchestrated a scheme in a dark closet." Public Interest said the comment letter by North America Casin’s purported CEO raised more concerns than it provided given that it was printed on a blank sheet of paper with a generated letterhead, had no phone numbers or email addresses, and no physical address. Public Interest outlined a number of unanswered questions and concluded that the proposed transaction was not proper for the U.S. capital markets.

Wednesday, June 07, 2017

FIA warns European Commission not to require euro-denominated derivatives to be cleared in E.U.

By Lene Powell, J.D.

In a letter to the Vice President of the European Commission, the derivatives association FIA strongly cautioned against possible Commission plans to require relocation of euro-denominated derivatives clearing to the E.U., saying this would reduce liquidity and increase systemic risk. Such a move could also increase costs for derivatives end-users, nearly doubling margin requirements from $83 billion USD to $160 billion USD, said FIA.

Brexit and forced relocation. In a Communication on May 4, 2017, the Commission said it will present legislative proposals in June relating to the safety and soundness of central counterparties (CCPs or clearing firms). The Commission is considering strengthening supervisory functions and the responsibilities of the central bank of issue at European level. The Commission noted that after the anticipated withdrawal of the United Kingdom from the E.U., a substantial volume of transactions denominated in euro and other Member State currencies would no longer be cleared in the E.U., so would no longer be subject to EMIR and E.U. supervisory architecture.

The Commission said that where CCPs play a key systemic role for E.U. financial markets and directly affect the responsibilities of E.U. and Member State institutions and authorities, specific arrangements based on objective criteria will be necessary to ensure that CCPs are subject to safeguards under the E.U. legal framework. Safeguards would include, where necessary, enhanced supervision at E.U. level and/or location requirements.

In FIA’s letter to Vice-President Valdis Dombrovskis, FIA President and CEO Walt Lukken said the association has “grave concerns” that the forced relocation of clearing of euro-denominated derivatives to the E.U. would fragment markets, raise costs for end users, and weaken the stability of the financial system.

Market fragmentation, higher costs. According to FIA, forced relocation may fragment markets, creating two distinct pools of trading liquidity. Currently, 75 percent of the LCH SwapClear Euro-denominated interest rate swaps do not have E.U. counterparties. Forced relocation might create an offshore pool for the majority of euro-denominated swaps that are traded by foreign institutions, and a much smaller and less liquid onshore pool for swaps traded by E.U. institutions.

Market fragmentation would “most certainly” increase costs for end users, said FIA. Risk offsets will be lost and end users will have to post more margin to accommodate this heightened risk. A report by Clarus Financial Technology estimates that margin requirements would rise by as much as $77 billion USD, nearly doubling the amount of required margin to $160 billion USD.

FIA said that E.U. end users would also face higher execution costs due to lower volumes and fewer participants in the marketplace. In addition, clearing firms could pass on increased costs due to increased capital requirements resulting from bifurcation of the clearing pool.

More systemic risk. Market fragmentation could make it harder for CCPs to port or auction positions of a defaulting clearing member, making it more difficult to recover from a systemic crisis. A location policy could make it too expensive for some clearing firms to set up separate clearing services for onshore and offshore clients, and firms may decide against providing clearing for E.U. clients. This could exacerbate the trend of a decline in the number of clearing firms, further concentrating risk in fewer clearing firms and raising concerns about the market’s ability to absorb clients of a defaulting clearing member.

According to FIA, forced relocation would be the most disruptive and expensive approach, yet would not improve oversight. The association observed that other reserve currencies do not currently have a location policy. About 90 percent of the U.S. dollar-denominated interest rate swap market is cleared outside the U.S., and Canada and Australia at one time considered imposing location requirements for derivatives denominated in their currency, but both ultimately rejected the idea. For the euro to maintain its status as one of the world’s great reserve currencies, it should be traded freely and openly, and policymakers should proceed with caution in imposing any restrictions, FIA said.

Recognition and enhanced supervision. FIA favors the Commission’s suggestion of recognition and enhanced supervision, and believes the E.U. system of equivalence of third-country CCPs currently provides the necessary tools for ongoing information gathering, inspections and oversight. FIA pointed out that equivalence determinations under EMIR are comprehensive and require cooperation agreements between ESMA and the relevant competent authorities of the third-country.

But if the Commission finds it necessary to increase oversight of third-country CCPs, FIA urged that any increase in powers should be carefully calibrated. Other jurisdictions have used both recognition and direct supervision in their oversight of third-country exchanges and CCPs. The association pointed to the U.S. CFTC’s tailored approach, which provides for exemptions in certain cases, including for certain third-country CCPs that clear only the proprietary positions of U.S. institutions.

In conclusion, FIA believes that forced relocation would be unnecessary and detrimental to the economic interests of the E.U., and that supervision can be enhanced to meet the needs of the E.U. supervisors.

Tuesday, June 06, 2017

MetLife contractor’s pricing concerns didn’t amount to protected reporting

By Anne Sherry, J.D.

A terminated MetLife contractor who raised concerns about the pricing of insurance policies failed to plead a whistleblower retaliation claim under Sarbanes-Oxley. The Second Circuit agreed with the district court that the plaintiff failed to demonstrate an objectively reasonable belief that the alleged pricing irregularities constituted a violation enumerated in the statute (Kantin v. Metropolitan Life Insurance Company, June 1, 2017, per curiam).

As set out in the Southern District of New York’s opinion, the plaintiff was a longtime MetLife employee who retired and then signed back on as a contractor. He was concerned about the pricing associated with a new MetLife joint life insurance offering, known as GSUL. MetLife priced each couple’s GSUL policy based on the combination of their genders, ages, and health classifications. Each possible combination of these factors, or “cell,” was priced according to actuarial formulas that combined the life expectancies of both spouses.

The plaintiff raised concerns internally about whether MetLife would lose money if the cells were improperly priced, but it was not until his deposition taken for his whistleblower case that he first stated he believed it would have been illegal for him to sell a particular policy. Prior to his termination, he also raised concerns about a certain commission payment and a conversation with an individual; he did not believe either situation to involve illegal activity.

Granting summary judgment for MetLife, the district court held that the plaintiff could not, as a matter of law, establish the first element of a SOX whistleblower claim: that he engaged in protected activity. To be protected, an employee’s activity must relate to an enumerated violation, and his belief that his employer’s conduct was unlawful must be objectively and subjectively reasonable. The plaintiff made only one allegation relating to activity that he considered unlawful: an insurance policy that he did not allege was even sold. Even if the pricing concerns were more than speculation, they did not amount to fraud.

The appeals court also held that the plaintiff failed to make a case under SOX. The alleged commission payment and pricing irregularities simply did not sound in fraud and were wholly unrelated to any of the violations enumerated in the statute. The plaintiff admitted that he himself did not believe the commission payment or most of the pricing irregularities to be illegal. Like the district court, the appeals court reasoned that in the absence of evidence that an allegedly unlawful insurance policy was sold or intended to be sold to a customer, the mere existence of such a product could not reasonably be believed to constitute a fraud.

The case is No. 16-1091-cv.

Monday, June 05, 2017

SEC chairman calls for updated assessment of the fiduciary rule

By Jacquelyn Lumb

SEC Chairman Jay Clayton has called for an updated assessment of the current regulatory framework governing investment advisers and broker-dealers to aid in the Commission’s consideration of potential regulatory action. The Department of Labor’s fiduciary rule takes effect this week. DOL plans to issue a request for information with respect to various aspects of the rule and Secretary Alexander Acosta has called for a constructive dialogue with the SEC about the standards of conduct applicable to investment advisers and broker-dealers when they provide investment advice to retail investors. Clayton said he welcomes that invitation since the rule could significantly impact retail investors and entities regulated by the SEC.

When areas are overseen by more than one regulator, Clayton said that clarity, consistency, and coordination are key elements for effective oversight and regulation. He mentioned the reviews of investment adviser and broker-dealer regulations that have been conducted over the years, including the RAND study in 2006, a Dodd-Frank Act staff study in 2010-2011, and the SEC’s request for data and other information in 2013. These efforts reflect the complexity of the matter and the rapidly changing markets, he noted, including the evolving manner in which investment advice is delivered.

Range of options. The SEC has received recommendations on a wide range of potential actions, Clayton added, including maintaining the current regulatory structure, requiring enhanced disclosure to address investor confusion, developing a best interests standard of conduct for broker-dealers, and adopting a single standard to harmonize the regulations for investment advisers and broker-dealers when they provide advice to retail investors.

Since the SEC last solicited information from the public, Clayton said the marketplace has seen significant developments including financial innovations, changes to investment adviser and broker-dealer business models, and regulatory developments, including the issuance of DOL’s fiduciary rule. These developments call for an updated assessment, in his view.

Solicitation of comments. The SEC has set up a web form and an email box so that members of the public can submit comments on potential future actions. Clayton provided a series of questions that the public may wish to address, including whether investor confusion has been addressed with respect to the type of profession or firm that is providing investment advice, and the standards of conduct that apply to them. If the confusion remains, he asked what steps the SEC can take to mitigate it.

Conflicts of interest. The SEC is also seeking comments on whether potential conflicts of interest have been addressed, or whether retail investors are being harmed by conflicts through systematically lower net returns or greater risks in their portfolios compared to other investors in different relationships.

Technology. Advances in technology may transform the way in which retail investors receive advice, such as the use of robo-advisers and fintech. The SEC is asking for input on how retail investors perceive the duties that apply when investment advice is provided in new ways or by new market entrants and whether the SEC should address a lack of information in these areas.

The SEC is also seeking information with respect to any trends toward a fee-based advisory model for retail investors and whether any observed trends are driven by demand, fee-based income streams, regulations, or other factors.

Different standards. Clayton noted that efforts to comply with DOL’s fiduciary rule are already underway and asked for information about its implementation. Once the rule takes effect, there will be different standards of conduct for accounts subject to the DOL’s rules and those that are not. The SEC is requesting information about the costs and benefits of complying with multiple standards.

If new requirements are adopted, the SEC is asking for views on whether private remedies should be available for violations and the venues in which such claims should be brought. Another line of inquiry is how U.S. regulations compare to approaches in other jurisdictions and whether those approaches should be considered.

Friday, June 02, 2017

No Corwin cleanse for structurally-coercive Charter shareholder vote

By Mark S. Nelson, J.D.

A shareholder suit alleging defects in Charter Communications, Inc.’s attempt to acquire two companies was not a candidate for applying Delaware’s Corwin’s cleansing theory because of the structurally-coercive nature of the shareholder vote. But the director defendants’ bid to dismiss the case will have to await further action because the vice chancellor found the briefing in the case deficient regarding the next set of issues the court must address, including whether the shareholders’ claims are direct or derivative (Sciabacucchi v. Liberty Broadband Corporation, May 31, 2017, Glasscock, S.).

Deal structure. Liberty Broadband Corporation was a major shareholder of Charter Communications, Inc., which sought to acquire another company in the communications industry to match rival Comcast’s bid to acquire Time Warner Cable (TWC). As a result, Charter sought to acquire Bright House Networks, LLC and agreed to help facilitate the Comcast-TWC deal by swapping subscribers. But this arrangement, which was contingent on a successful Comcast-TWC deal, fell through when the Comcast-TWC deal failed.

Charter’s ensuing second round of deal making focused on acquiring Bright House and merging with TWC. Charter’s board ultimately approved both deals: first, the four Liberty Broadband designees on Charter’s board approved and departed the room; then, the remaining Charter directors approved both deals. In preparation for the Charter shareholder vote, Charter filed a proxy with the SEC in which the company said a vote to approve the deals would require the approval of a majority of Charter’s unaffiliated common shares.

But the TWC and Bright House deals were also conditioned on approval of several other items: a share issuance (it was supposed to help finance the Bright House and TWC deals) and a voting proxy agreement. The TWC merger garnered 90 percent approval (Bright House is not a party to the case). Eighty-six percent of shareholders approved the related share issuance, stock consideration, and voting proxy agreement after some shares were excluded from the tally. Liberty Broad Band ended up with about the same voting power it had before the transactions.

Shareholder vote structurally-coercive. The court quickly rejected shareholders’ argument that Liberty Broad Band controlled Charter. And the court noted that shareholders did receive value from the Bright House and TWC deals. But the court also emphasized that Charter’s shareholders were required to approve "extraneous" items, including the share issuance to a major Charter shareholder as well as the voting proxy agreement. As a result, the court questioned whether a scenario in which shareholders get a net benefit could legitimately be cleansed under Corwin.

Under the Delaware Supreme Court’s Corwin opinion, authored by Chief Justice Strine, the business judgment rule applies to a transaction that was approved by a fully informed, uncoerced vote of a majority of disinterested shareholders. Such a vote is said to cleanse the approval of any breaches of duty.

Vice Chancellor Glasscock explained Corwin: "The rationale behind Corwin is hardly new; it amounts to a judicial recognition that the agency problems inherent in transactions made by directors involving the property of the stockholders are obviated by a vote of those stockholders in favor of the transaction, so that the will of the owners effectively supersedes that of the agents. In other words, there is little utility in a judicial examination of fiduciary actions ratified by stockholders."

With respect to this case, the vice chancellor reasoned that "extraneous" factors played a critical role in the shareholder vote. For the vice chancellor, the agency problem that would be cleansed in a typical application of Corwin instead persists under the "unique circumstances" posed by the Charter shareholder vote. The vice chancellor further explained:
"Coercion" is a loaded term, but a vote so structured by the Defendants, to accept one (allegedly self-interested) transaction so as not to lose the benefit of another independent transaction, cannot to my mind be considered uncoerced. Put another way, a vote so structured does not eliminate the agency problem by substituting the will of the stockholder/owners for that of the directors, because the directors have structured the vote in such a way that the vote must be in consideration of factors extraneous to the matter voted on. The stockholders did not decide, necessarily, that the Liberty Share Issuances and the Voting Proxy Agreement were "in their best interest," they only decided that the Acquisitions and the Issuances and Voting Proxy Agreement were, on net, beneficial.
The vice chancellor said applying Corwin here could fail to achieve equity by legitimizing a "white-wash." According to the court, Corwin should not apply in cases where directors seek to shirk accountability by conditioning deals on shareholder approval of "self-dealing riders," even absent a controller. Moreover, the court noted that Chancellor Bouchard has previously warned against Corwin being used to broadly free corporate fiduciaries of their responsibilities. Whether the Charter shareholders pleadings stated a claim will have to await further briefing.

The case is No. 11418-VCG.

Thursday, June 01, 2017

Congressman urges enhancements to SEC’s board diversity rule

By Amy Leisinger, J.D.

House Financial Services Committee Senior Member Gregory Meeks (D-NY) has sent a letter to SEC Chairman Jay Clayton urging continuation of efforts to improve corporate board diversity disclosures. Signed by 29 House Democrats, including 15 other FSC members, the letter notes that the Commission’s 2009 board diversity rule has "proved inadequate" by failing to define "diversity" clearly and by allowing companies excessive discretion on what information to report.

"The SEC’s corporate board diversity rule is broken. Although many companies have complied with the spirit of the law, many other companies fall short of providing valuable information to investors regarding their boards’ racial, ethnic, and gender composition," Rep. Meeks said.

Stakeholder comments. The corporate board diversity rule requires public companies to disclose the extent to which they consider diversity when nominating and selecting board directors, but the lack of specificity in its text has led to vague disclosures of minimal use to stakeholders, the letter notes. Investors have called for improvement, submitting a rulemaking petition expressing concerns and recommending that the SEC require companies to share the gender, race, and ethnicity of board members. In addition, former SEC officials have recognized the need for change. Past Commissioner Luis Aguilar noted that some companies have done the bare minimum by providing only abstract information regarding diversity efforts, and former SEC Chair Mary Jo White directed the agency’s staff to review the rule and consider potential enhancements prior to her resignation.

Business leaders have also acknowledged the benefits (and minimal burdens) associated with more comprehensive diversity disclosures, according to the letter. Specifically, the SEC’s Advisory Committee on Small and Emerging Companies recommended that the SEC require specific disclosures about the self-identified race, gender, and ethnicity of their board members and nominees, the letter explains.

From an industry standpoint, Christopher A. Pickett, leader of the Securities & Financial Services industry group and chief diversity officer at law firm Greensfelder, Hemker & Gale, P.C., notes: "The securities industry is moving in the right direction after recently struggling with how it can diversify its workforce, but progress has been slow and we haven’t seen nearly the volume of diversity initiatives as in many other industries."

Formal rulemaking recommended. The letter notes that Chairman Clayton has demonstrated a willingness to work with fellow commissioners, staff, and committee members to monitor issues with diversity disclosures but urged him to go beyond compliance monitoring and propose a new corporate board diversity rule for public comment.

"It’s time to put words into action and I hope that the new Chair initiates that process through formal rulemaking," Rep. Meeks concluded.

Wednesday, May 31, 2017

PetSmart appraises at merger price

By Anne Sherry, J.D.

PetSmart shareholders who opposed the 2015 going-private merger lost their fight for a 55-percent bump in consideration. Appraising the company at the $83-per-share deal price, the Delaware Court of Chancery observed that accepting the petitioners’ $129-per-share valuation “would be tantamount to declaring that a massive market failure occurred here that caused PetSmart to leave nearly $4.5 billion on the table.” Although the gap between the two valuations could suggest that neither accurately pegged the company’s value, the “robust” sale process and lack of compelling contrary evidence led the court to defer to the deal price (In re Appraisal of PetSmart, Inc., May 26, 2017, Slights, J.).

Towards the end of 2014, the PetSmart board unanimously voted to approve and recommend a merger with BC Partners. The $83 bid was $1.50 higher than the next highest bid and significantly higher than analysts’ price targets. No topping bids emerged, and shareholders—which had been provided with management projections but “cautioned not to place undue reliance” on them—voted overwhelmingly to approve the deal. The merger closed in March.

The appraisal petitioners claimed that a discounted cash flow analysis rooted in management’s projections was a better indicator of the company’s fair value than the deal price. Both the petitioners and PetSmart offered two experts, one to address the reliability of the management projections and the other to address fair value at the time of the merger. Petitioners’ retail expert maintained that PetSmart hit a “speed bump” just before the sales process began, from which it would have rebounded. Their other expert relied on the projections in all respects for his discounted cash flow analysis, recognizing that if the court found those projections are not reliable, it should not rely on his DCF valuation. PetSmart’s own expert opined that the management projections were too aggressive and optimistic and could not be relied upon.

The court framed the dispute in terms of three questions: first, was the transactional process leading to the merger fair, well-functioning, and free of structural impediments to achieving fair value? Second, are the requisite foundations for the performance of a DCF analysis reliable enough to produce a trustworthy indicator of fair value? Finally, is there an evidentiary basis in the record for the court to determine fair value by constructing its own valuation structure outside of the two proffered methodologies?

Sale process. While not perfect, the sale process “came close enough to perfection to produce a reliable indicator of PetSmart’s fair value,” the court wrote in examining the first question. The board retained Morgan Stanley and then JPMorgan, created an ad hoc committee of experienced independent directors, was willing to walk away if it did not get a satisfactory price, and was prepared to take on a proxy fight if the company’s more active stockholders were unhappy with the board’s decision. The board announced to the world that it was open to a merger, and it did not rush the sale.

The petitioners pointed to several factors that they said rendered the deal price an unreliable measure of fair value, but the court rejected these arguments. First, the record was devoid of evidence that a seized credit market actually affected the amount any bidder was willing to offer. Second, although it was true that only financial sponsors submitted bids, private equity bidders did not know that they were only competing with each other. Third, there was no credible support for the notion that the board was forced to sell after the emergence of an activist shareholder. Fourth, the petitioners’ argument that the board was ill-informed was based primarily on a witness’s difficulty remembering certain details at trial. Fifth, any conflicts were minor and were fully disclosed. Finally, the argument that the merger price was stale by the time of closing was speculative at best.

DCF analysis. The court could not end its inquiry upon determining that the merger price was a reliable indicator of fair value; Delaware’s appraisal statute required it to consider “all relevant factors.” The court also had to examine the reliability of the other valuations of PetSmart in the trial record, namely, the discounted cash flow analysis. Ultimately, the court determined that the management projections undergirding the petitioners’ DCF analysis were “saddled with … telltale indicators of unreliability.”

Specifically, PetSmart management did not have a history of creating long-term projections; even management’s short term projections frequently missed the mark; the projections were not created in the ordinary course of business but rather for use in the auction process; and management engaged in the process of creating all of the auction-related projections in the midst of intense pressure from the Board to be aggressive, with the expectation that the projections would be discounted by potential bidders.

Because the projections were not reliable statements of PetSmart’s expected cash flows, any DCF analysis that relied upon them would produce meaningless results, the court wrote. And there was no basis in the record to make further adjustments to the projections or alter the inputs used by the experts to arrive at a more reliable DCF analysis.

The case is No. 10782-VCS.

Tuesday, May 30, 2017

Advisory group discusses enforcement efforts, reporting and quality control findings

By Amy Leisinger, J.D.

PCAOB Enforcement and Investigations Director Claudius Modesti opened the second day of the Standing Advisory Group’s meeting with a discussion of the Board’s enforcement efforts and issues that should remain at the forefront of auditors’ minds while moving through the audit process. With record disciplinary proceedings, he said, the goal must be to maintain credible deterrence of auditor misconduct.

Enforcement. In reviewing recent PCAOB enforcement and litigation matters, particularly with the late 2016 actions against Deloitte Brazil and Deloitte Mexico, Modesti stressed the increased need for a focus on cross border concerns and the roles of affiliates. Deloitte Brazil was ordered to pay an $8 million civil penalty, the largest ever imposed by the PCAOB, to settle charges that it issued materially false audit reports and attempted to conceal violations by altering documents and providing false testimony. Deloitte Mexico agreed to pay a $750,000 penalty for failing to effectively implement quality control measures to ensure proper retention of audit documentation. Like these matters, the director noted, most actions citing failure to cooperate involved improper alteration of work papers, and the staff issued an audit practice alert to address the issue. Ultimately, Modesti said, we want firms to spot and remediate issues themselves, without waiting for Board intervention. This may require a shift in conversation from “tone at the top” to “tone in the middle” to allow for broad contribution to the overall health of firms, he said.

In 2017, Modesti stated, PCAOB enforcement and investigations will focus on four specific issues: (1) investigations involving a lack of professional skepticism; (2) audit matters relating to the independence and integrity of audits; (3) matters eroding integrity of the Board’s regulatory oversight processes; and (4) investigations focusing on risks associated with cross border audits. In working towards the PCAOB’s goals, the staff will continue to coordinate with SEC enforcement, the Department of Justice, and FINRA, as well as legal and regulatory counterparts around the world, he concluded.

Economic analysis. Office of Economic and Risk Analysis Acting Director Patricia Ledesma and Senior Advisor Michael Gurbutt noted the ERA’s focus on econometric research in connection with standard-setting projects. The bulk of the ERA’s work involves preparing economic analyses to inform standard-setting and rulemaking activities, they explained. However, the use of economic and statistical techniques and research to enhance effectiveness of the PCAOB’s oversight programs and investor protections remains at the forefront as well, they explained.

Former Center for Economic Analysis Senior Fellow Preeti Choudhary of the University of Arizona shared her research on the possibility of preventing material errors by identifying and improving internal controls. She found that material weaknesses infrequently precede material errors, and, as such, internal controls of audits appear to be working. In addition, Choudhary found that lower level controls also did not seem to predict restatements. There may be more career implications for reporting material weaknesses than significant deficiencies, she said, but deficiencies do not seem to lead to weaknesses. The root of problems seems to be difficulty in testing identified controls or even identifying the proper control to test in the first place, she stated.

Former fellow Daniel Aobdia also discussed the effect of audit firms’ quality control measures on overall audit quality, efficiency, and pricing. He found that quality control deficiencies are negatively associated with audit quality, but asked the question of whether all aspects of quality control systems matter or tone at top and selected methodologies are more important. Further, Aobdia explained, partner incentives are different than firm incentives, and it may be improper to generalize findings from an individual-engagement inspection to a firm as a whole. The existence of a benefit to remediation of issues identified by PCAOB and the potential modernization of quality control standards should be considered, he concluded.

Friday, May 26, 2017

Acting SG urges justices to hear SLUSA case, provide uniformity

By Mark S. Nelson, J.D.

The Acting U.S. Solicitor General has asked the Supreme Court to take a case raising the question of whether a state court may hear a case that is a covered class action but raises only claims brought under the Securities Act. The justices invited the government to present its views on the Securities Litigation Uniform Standards Act of 1998, which sought to clarify jurisdictional issues left open following enactment of the Private Securities Litigation Reform Act of 1995. According to the government, a decision by the justices could bring uniformity to a muddled aspect of securities litigation (Cyan, Inc. v. Beaver County Employees Retirement Fund, May 23, 2017).

What does “except” mean? The underlying case involved a law suit filed in state court over disclosures made in registration statements and prospectuses and involved only claims under the Securities Act without any state law claims. The defendant below (petitioner in the Supreme Court), Cyan, Inc., lost its bid for judgment on the pleadings in the California Superior Court based on that court’s reading of a California appellate court opinion that previously held that concurrent jurisdiction in cases like this one still exists post-SLUSA. The California Court of Appeal denied Cyan’s petition for writ of mandate, and the state’s supreme court denied Cyan’s petition for review.

Securities Act Sections 16 and 22 work in tandem, albeit in a complex manner, to close a post-PSLRA loophole that many feared could lead to abusive litigation, although the specific question presented in Cyan’s petition to the Supreme Court remains unsettled:
Whether state courts lack subject matter jurisdiction over "covered class actions" . . . that allege only claims under the Securities Act of 1933.
The government characterized Cyan’s argument as going too far by asserting that Section 22’s “except” clause refers to Section 16’s definition of “covered class action.” Likewise, the government found fault in the respondent’s explanation, which was lacking in detail, but nevertheless offered an interpretation that would impose a bar only on state-law actions.

According to the government, the respondent’s view is better because Cyan’s view is out of synch with the words Congress used in the law. The government suggested that Congress may have drafted the “except” clause to deal with hybrid class actions or to ensure that general jurisdictional provisions in the Securities Act could not be used to undermine SLUSA.

Obstacles to cert grant? Despite the government’s urging the court to take the case, there may be formidable hurdles to a certiorari grant. The government, for example, relies heavily on Supreme Court Rule 10(c), which explains that the court may grant certiorari when a state or federal court decides an important federal law question that the justices ought to resolve but, for a multitude of reasons, have not done so.

The government concedes there is no split of authority among federal appeals courts (although one case is pending in the Ninth Circuit), nor is there a split among the states’ highest courts. But the government does note a split among federal district courts, especially between district courts in New York and California.

But there also is “some uncertainty” about whether the California court in Cyan’s case disposed of the company’s petition on federal or on adequate and independent state grounds. Still, the government emphasized that the practical realities of SLUSA litigation reduce the chances that lower courts will produce reviewable decisions and Cyan’s case offers the justices an opportunity to clarify Securities Act jurisdiction.

The case is No. 15-1439.