Friday, August 28, 2015

Commissioner Aguilar Calls for “Calibrated” Waiver Process

By Mark S. Nelson, J.D.

SEC Commissioner Luis A. Aguilar once again voiced his worries that the agency’s waiver process fails to capture the ambiguities that typically infuse the decision to grant or deny a person or entity accused of misconduct a waiver from certain disqualifications under the federal securities laws. This time, Aguilar said in a public statement the SEC should adopt a more “flexible” or “calibrated” mode of evaluating waiver requests.

According to Aguilar, the SEC’s existing waiver process is fraught with predictive judgments about how a person who acted badly in the past is likely to behave in the future based mostly on a pledge of better behavior. He said this is of special concern when the person or company seeking a waiver has previously asked for multiple waivers.

“In fact, my own review of many waiver applications indicates that waivers do not always fit neatly into ‘grant’ or ‘deny’ buckets, but oftentimes fall somewhere in between,” said Aguilar. “The Commission’s waiver protocol could be strengthened by adopting a more versatile approach, one that allows cases that might fall in the grey area to avoid a total prohibition by allowing the requesting party to adopt appropriate limitations designed to protect investors and the public.”

Aguilar urged the SEC to think about expanding its use of conditional waivers, like the one the Commission approved for Bank of America, N.A. last year. Aguilar also said he advocates conditional waivers because they can help to deflect criticism from legislators and others that the SEC has a light touch when it comes to disqualifications of large banks.

Moreover, Aguilar said the SEC’s internal process for tracking waivers is less transparent than it should be, especially when the agency’s staffers act under delegated authority. Aguilar said while the situation has improved under SEC Chair Mary Jo White, the Commission still needs to find a way to get a “holistic view” of waivers, and he said the Commission should think about creating a public website that shows each stage of the waiver process.

He noted that Rep. Maxine Waters (D-Cal), the ranking member of the House Financial Services Committee, wrote to White earlier this year asking the agency to improve the public transparency of its waiver process. Waters has circulated a discussion draft of a bill that seeks to clarify the SEC’s waiver requirements.

Earlier this year, Aguilar joined Commissioner Kara M. Stein in dissenting from an order granting Oppenheimer & Co., Inc. a waiver after it was fined by the SEC and became the subject of charges by the Financial Crimes Enforcement Network. Stein has voiced her objections to waivers on at least two other occasions regarding Deutsche Bank AG and for multiple waivers granted to UBS AG, Barclays Plc, Citigroup Inc., JPMorgan Chase & Co., and the Royal Bank of Scotland Group Plc.

Thursday, August 27, 2015

Puerto Rico Seeks Supreme Court Review in Bankruptcy Preemption Case

By Kevin Kulling, J.D.

The government of Puerto Rico has filed a petition for a writ of certiorari with the United States Supreme Court in an effort to overturn a federal appeals court decision holding that the bankruptcy code preempted Puerto Rico’s own statute that created a mechanism for the commonwealth’s public utilities to restructure their debt (Puerto Rico v. Franklin California Tax-Free Trust, August 21, 2015).

Meanwhile, separate bills that would revise the bankruptcy code to allow Puerto Rico to authorize its municipalities to seek bankruptcy protection and revise its debt remain pending in Congress.

Case history. Plaintiffs are investors who hold nearly $2 billion of bonds issued by one of Puerto Rico’s distressed public utilities. Under the federal bankruptcy laws, Puerto Rico is not included in the definition of a state for purposes of authorizing its municipalities, including its public utilities, to seek federal bankruptcy relief under Chapter 9 of the U.S. Bankruptcy Code. In June 2014, Puerto Rico attempted to allow its utilities to restructure their debt by enacting its own municipal bankruptcy law, the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (“Recovery Act”), which expressly provides different protections for creditors than does the federal Chapter 9.

The bond investor plaintiffs brought suit to challenge the Recovery Act’s validity and sought to enjoin its implementation. The district court ruled in their favor, finding that the Recovery Act was preempted by the federal bankruptcy law. On appeal, Puerto Rico argued that the definition of “State” in the federal bankruptcy code rendered the bankruptcy code inapplicable.

The First Circuit Court of Appeals affirmed the district court’s holding that the bankruptcy code preempted the Recovery Act.

Supreme Court appeal. In its petition seeking to have its Recovery Act declared constitutional, Puerto Rico observed that that law as it stands provides Puerto Rico with “the worst of both worlds: it is not entitled to the benefits of Chapter 9 but remains subject to the burdens of Chapter 9” by preempting Puerto Rico’s attempt to restructure its debts beyond the scope of the chapter.

In seeking Supreme Court review, Puerto Rico claims that its dire financial situation is “the most acute fiscal crisis in its history.” The petition asserts that Puerto Rico’s three major public utilities, which provide electricity, water, and roads for its citizens have a combined debt of some $20 billion, which they cannot pay. The petition further asserts that this is “one of the rare cases that calls for [the Supreme Court’s] immediate review” based partly on the fact that the “Commonwealth is in the midst of a financial meltdown that threatens the island’s future.”

Congressional relief. Congressional action to amend the bankruptcy code to provide Puerto Rico with the same relief afforded the states has been the subject of prior testimony before Congressional committees. There are bills pending in both the Senate and the House that would grant Puerto Rico relief by including it in the definition of a state covered by Chapter 9 of the bankruptcy code.

Wednesday, August 26, 2015

Laurie Bebo Must Go Through SEC Administrative Process

By Mark S. Nelson, J.D.

The Seventh Circuit upheld the dismissal of Laurie A. Bebo’s constitutional challenge to the SEC’s administrative enforcement procedures by finding that process will afford her adequate opportunity to get meaningful judicial review if the Commission issues a final adverse order. The panel said nothing in Exchange Act Section 25’s text, structure, and purpose implied that Congress wanted a person already subject to an SEC administrative proceeding to be able to ask a federal district court to shut down the proceeding on constitutional grounds (Bebo v. SEC, August 24, 2015, Hamilton, D.).

The Chicago-based panel is the first federal appeals court to rule on the jurisdictional issues that have plagued the many recent cases seeking to upend the SEC’s administrative law judge regime. Bebo could ask for panel or en banc rehearing of the decision, or she could appeal to the Supreme Court. Bebo’s administrative hearing was expected to end in June after several weeks of testimony. The latest order in the matter set a deadline of September 2 for Bebo and the SEC to work out the details for any exhibits.

Bebo’s case, like others brought against the SEC, has been stuck on the question of district court jurisdiction rather than on the plaintiffs’ merits claims about the SEC’s ALJ regime. The SEC faces at least nine cases in addition to Bebo’s, and appeals in a few of them are pending in the Second and Eleventh circuits with at least the potential to create a split of authority with the Seventh Circuit.

Dodd-Frank and home-court advantage. The SEC alleged in December 2014 that Bebo, the ex-CEO of Assisted Living Concepts, Inc., engaged in books and records violations, made false representations to auditors, and made false disclosures in SEC filings. Bebo unsuccessfully tried to get the federal district court in Milwaukee to stop the SEC’s enforcement proceeding against her.

Bebo’s complaint alleged that the SEC’s ALJ regime violated Article II of the U.S. Constitution by creating too many layers of good cause removal between the president and the ALJs. This merits claim was grounded in principles announced by the Supreme Court in its Free Enterprise opinion and the outcome in that court’s Freytag opinion, which found that special tax court judges were inferior officers. (The SEC has defended itself in Bebo’s case and others by relying on the D.C. Circuit’s Landry opinion, which held the Federal Deposit Insurance Corporation’s ALJs were employees).

Bebo also claimed that Dodd-Frank Act Section 929P amended the securities law in a way that facially infringed her Fifth Amendment rights of due process and equal protection. The 2010 financial reform law made it possible for the SEC to impose civil penalties against unregulated persons in administrative proceedings, which have fewer procedural and evidentiary safeguards than do similar proceedings in federal district courts. Previously, the SEC would have had to bring a matter like Bebo’s in federal court. The SEC’s choice of forum adds to its potential home-court advantage when it opts to bring an administrative enforcement action.

Meaningfulness omnipresent. The Seventh Circuit panel understood the Supreme Court’s seminal Free Enterprise decision to emphasize the omnipresent question of whether an agency’s administrative enforcement regime permitted a respondent to obtain meaningful judicial review. The panel said two other factors are relevant, but they are not “controlling.” Ultimately, Bebo can raise her constitutional claims about the SEC’s ALJs in the either Seventh Circuit or the D.C. Circuit, if the Commission rules against her in a final order.

In reaching this conclusion, the panel rejected Bebo’s expansive view of Free Enterprise which would have given the district court jurisdiction of her case because the outcome does not turn on the truth or falsity of the SEC’s allegations against her, and the case does not “implicate” the SEC’s expertise. The court said the Supreme Court’s teachings in its 2012 Elgin case favored a narrower reading of Free Enterprise, even if Bebo’s view “has some force.”

The Supreme Court held in Elgin that the Civil Service Reform Act of 1978’s statutory review scheme barred a district court from hearing constitutional claims raised by male U.S. treasury employees who had been fired because they failed to register for the selective service as required by the Military Selective Service Act.

The Seventh Circuit drew some lessons from Elgin: (1) the characterization of a claim as facial (as Bebo did) does not automatically get the case into a district court; (2) the jurisdictional question is not dependent on the agency’s authority to decide constitutional claims or whether such claims are beyond the agency’s expertise; (3) the looser procedural and evidentiary rules in administrative proceedings still can afford meaningful judicial review; and (4) the possibility that a respondent in an administrative matter might win and thus never get the chance to assert their constitutional claims in an Article III court does not necessarily cut against a statutory process.

As for the “wholly collateral” issue, the Seventh Circuit noted the Supreme Court’s decisions offer some basis for either of two approaches: (1) emphasize the ties between the administrative allegations and the constitutional merits claims; or (2) examine whether the constitutional claims are just a “vehicle” to shut down the agency’s administrative process.

Several district courts took the first option (based on Free Enterprise) for claims made in the related cases of Hill v. SEC (the judge in Hill recently reached the same conclusion in another case, Gray v. SEC, which the Seventh Circuit did not mention), Duka v. SEC, and Gupta v. SEC. The second option (based on Elgin) prevailed in Tilton v. SEC and in the lower court in Bebo. The SEC has appealed Hill and Gray to the Eleventh Circuit, and Lynn Tilton has appealed her case to the Second Circuit.

Still, the Seventh Circuit said the key Free Enterprise factor is whether an administrative respondent can get meaningful judicial review. According to the panel, even if it assumed Bebo’s claim is wholly collateral, that one omnipresent Free Enterprise factor still would lead the court to find that it is fairly discernable that Congress wanted matters like Bebo’s to go through the administrative enforcement regime. Bebo can still seek federal appellate review of any adverse Commission decision.

As the panel noted at the beginning of its opinion, Bebo can make use of the SEC’s statutory process. “Although Bebo’s suit can reasonably be characterized as ‘wholly collateral’ to the statute’s review provisions and outside the scope of the agency’s expertise, a finding of preclusion does not foreclose all meaningful judicial review.”

The panel later explained that Free Enterprise and another case, McNary, are exceptions: the first because no PCAOB standard was challenged and the plaintiffs there need not have violated a PCAOB rule in order to invoke federal court jurisdiction; the second because the plaintiffs did not have to surrender for deportation to get into federal court.

For good measure, the panel also rejected Bebo’s claim that she was unfairly being asked to defend herself in a costly, unconstitutional administrative proceeding. This argument is an outgrowth of her worry that, depending on how the administrative matter is resolved, she may never get a chance to dispute the validity of the SEC’s ALJ regime.

The panel noted that the Supreme Court’s Standard Oil opinion from 35 years ago counseled against giving administrative respondents easy access to federal district courts merely because the administrative process may be costly. The panel said Standard Oil’s holding “is fundamental to administrative law.”

The case is No. 15-1511.

Tuesday, August 25, 2015

Derivative Suit Over Online Gambling Investment Doesn’t Pay Off for Shareholder

By Amanda Maine, J.D.

A panel of the Eighth Circuit Court of Appeals affirmed the decision of the lower court granting summary judgment to a mutual fund that invested in an online gambling company. The panel agreed with the district court that the shareholder who brought the derivative suit failed to show that the special litigation committee that reviewed her demand on the board was not independent or did not act reasonably (Seidl v. American Century Companies, Inc., August 21, 2015, Colloton, S.).

Background. Laura Seidl is a shareholder in a mutual fund called the Ultra Fund, one of 18 funds offered by American Century Mutual Funds, Inc., which is controlled by American Century Companies, Inc., an investment management company. From July 2005 through January 2006, the Ultra Fund purchased nearly 35 million shares totaling $81 million in PartyGaming Plc, a Gibraltar company that facilitated online poker gambling. PartyGaming’s June 2005 IPO prospectus acknowledged uncertainty about the legality of online gambling and noted that investors could lose their investment if U.S. authorities took action.

In July 2006, the Ultra Fund divested itself of all its shares of PartyGaming following increased U.S. government enforcement against illegal internet gambling, resulting in a loss of $16 million. In 2008, Seidl filed suit against American Century Companies, its affiliated entities, and individual defendants asserting several state law claims, but the district court dismissed the action and ruled that her claims must be brought in a derivative action.

Rejected demand. In June 2010, Seidl sent a letter to American Century’s board of directors demanding that it pursue the claims contained in her complaint. In response, the board formed a special litigation committee. In January 2011, the committee issued an 81-page report recommending that the board not pursue Seidl’s claims, which was unanimously adopted by the board. The district court granted summary judgment in favor of American Century in July 2014, finding that the special litigation committee’s business judgment was entitled to deference under Maryland law and that it would not disturb the board’s decision to reject Seidl’s demand. Seidl appealed.

Committee’s independence and good faith. Seidl argued that the special litigation committee’s independence was impugned because its two members received compensation as members of the board of directors. However, the appellate panel pointed out that compensation itself is insufficient to demonstrate that directors are interested. It also rejected her argument that one of the committee members had a social relationship with a defendant director, noting that the record did not show that they were “intimate friends,” but were acquaintances, citing the fact that the two played golf over ten years ago and may have attended a large party hosted by the defendant director. These allegations were insufficient to raise a question of fact as to whether the committee members were incapable of making a decision with only the best interests of the company in mind.

Reasonableness of the investigation. The panel also disagreed with Seidl that American Century had not shown that the special litigation committee conducted a reasonable investigation to support its conclusions. The panel pointed out that the committee, together with independent counsel, reviewed over 4,000 documents, participated in 22 interviews, met approximately every week over the course of four months, and ultimately produced an 81-page report detailing the committee’s investigation procedures and its conclusions. Given the cost of litigation and the weakness of the claims, pursuing Seidl’s claims was not in American Century’s best interests, the committee determined, a finding that was reasonable and a permissible exercise of business judgment given the thoroughness of the investigation, the panel concluded.

In addition, the panel rejected Seidl’s argument that the committee’s investigation was improperly insulated from scrutiny, noting that the board had provided her with all the relevant documents and memoranda and that she had deposed both of the committee members. The panel also denied Seidl’s request that the court unseal part of the deposition of one of the committee members, siding with the district court’s conclusion that it was protected as attorney work product.

The panel accordingly affirmed the judgment of the district court.

The case is No. 14-2796.

Monday, August 24, 2015

California Legislature Amends Fraud Provision, Public Utility and Share/Membership Exemptions

By Jay Fishman, J. D.

The California Legislature amended one of its fraud provisions, as well as the public utility and corporation share/membership exemptions within the Corporation Securities Law of 1968. The amendments take effect January 1, 2016.

Fraud. The fraud provision, as amended by AB-1517, makes it unlawful for any person to offer or sell a security in California, or to buy or offer to buy a security in the state, by using any written or oral communication that includes an untrue statement of a material fact or an omission of a material fact to make the statement appear not misleading under the circumstances.

Eliminated from the fraud provision were the following subsections: (1) “employ a device, scheme, or artifice to defraud”; and (2) “engage in an act, practice or course of business that operates or would operate as a fraud or deceit upon another person.”

Public utility exemption. This exemption, also amended by AB 1517, is available for any security issued or guaranteed by any railroad, other common carrier, public utility, or public utility holding company: (1) that is subject to jurisdiction of the Federal Energy Regulatory Commission under the Public Utility Holding Company act of 2005 and whose rates and charges are regulated by the United States or a state; or (2) whose issuance or guarantee of a security is regulated by a governmental authority of either the United States (or any state) or Canada (or any Canadian province), and the security is registered with, or authorized for issuance by, that authority.

Share/membership exemption. This exemption, as amended by AB-816, is available for any shares or memberships issued by a corporation organized and existing under the California Consumer Cooperative Corporation Law, provided the aggregate investment of any shareholder or member does not exceed $1,000 (previously $300).

Friday, August 21, 2015

GAO Reports on Company Digs to Disclose Conflict Minerals

By Jay Fishman, J.D.

The U.S. Government Accountability Office (GAO) reported on its September 2014—August 2015 audit of companies required make disclosures about their products that are sourced from conflict minerals.

Background. The Dodd-Frank Act (Act) Section 1502 addressed these “conflict minerals” —tantalum, tin, tungsten and gold—by directing the SEC, the Department of State (State), the U.S. Agency for International Development (USAID) and the Department of Commerce (Commerce) to take actions implementing the Act’s conflict mineral provisions. Among these actions, Section 1502(b) mandated the SEC, in consultation with State, to set forth disclosure and reporting regulations for companies whose products use conflict minerals from the Democratic Republic of the Congo (DRC) and adjoining countries. The SEC’s rule, adopted in August 2012, requires companies whose products use conflict minerals to make certain inquiries potentially leading to public disclosures about their minerals supply chains on new Form SD or in a conflict minerals report.

The Act also required State, in consultation with USAID, to submit to appropriate congressional committees a conflict minerals strategy to address the connections between human rights abuses, armed groups, mining of conflict minerals, and commercial products. Lastly, the Act required the GAO to report, beginning in 2012, and annually thereafter, on the effectiveness of the SEC rule’s ability to promote peace and security in the DRC and adjoining countries, and to report annually, beginning in 2011, on the rate of sexual violence in war-torn areas of the DRC and adjoining countries.

Audit findings. The GAO reported that respecting SEC-filed company disclosures submitted for the first time in 2014, most companies were unable to determine the source of their conflict minerals. Reported characteristics of these disclosures were as follows:
  • The companies’ filing disclosures comprised one or more of the four conflict minerals (tantalum, tin, tungsten and/or gold);
  • Most of the companies (87 percent) were based in the United States;
  • Almost all of the companies (99 percent) reported performing country-of-origin inquiries for the conflict minerals used;
  • Companies the GAO spoke to cited difficulty obtaining the necessary information from suppliers because of delays and other communication challenges;
  • Most of the companies (94 percent) reported exercising due diligence on the source and chain of custody of conflict minerals used but many (67 percent) were unable to determine whether those minerals came from the DRC or adjoining countries, and none could determine whether the minerals financed or benefitted armed groups in those countries; and
  • Companies disclosing that conflict minerals used in their products came from the DRC or adjoining countries indicated that they are or will be taking action to address the risks associated with the use and source of conflict minerals in their supply chains.
Conflict minerals case. On August 18, 2015, the date this audit report was issued, a two-judge majority of a D.C. Circuit panel upheld an earlier decision finding that the SEC’s conflict minerals rule violated the First Amendment. The earlier decision found the Dodd-Frank Act provision and the SEC’s implementing rule unconstitutional to the extent they require regulated entities to report to the SEC and to state on their websites that any of their products have “not been found to be ‘DRC conflict free.’” A lengthy dissent, however, objected to the majority ruling (National Association of Manufacturers v. SEC, August 18, 2015, Randolph, A.).

Thursday, August 20, 2015

PCAOB Continues to Find Deficiencies in Audits of Broker-Dealers

By Jacquelyn Lumb

The PCAOB has issued an annual report on its interim inspection program for the audits of brokers and dealers in which it reported that unacceptably high levels of deficiencies continued to be found despite the Board’s outreach and guidance efforts. The Board said it was particularly concerned about the lack of due professional care in the conduct of some of the audits, based on the lack of attention to the SEC’s rule requirements and the lack of professional standards in planning and performing procedures on some of the engagements. The report includes the Board’s observations from 106 audits conducted by 66 firms that took place in 2014, summarizes its observations since the inception of the interim inspection program in October 2011, and includes observations from seven audits in which deficiencies were identified in a previous inspection (Release No. 2015-006, August 18, 2015).

GAAS audits. The annual report covers audits that were required to be performed under generally accepted auditing standards that were applicable before the SEC amended its rules to require audits of brokers and dealers to be performed in accordance with PCAOB standards. Last year, the Board also inspected five firms that were required to conduct audits under the PCAOB’s standards and issued a report on those audit observations on January 28, 2015. Those engagements are not included in the annual report.

Selection process. The Board selected firms for inspection based on the number of broker or dealer audits they performed, whether they also issued audit reports for issuers, which would subject them to regular PCAOB inspections, and considered other characteristics in order to review a cross-section of firms. The Board advised that its observations are not necessarily indicative of the full population of firms or audits.

Deficiencies found at all 66 firms. Twenty-seven of the firms that were inspected audited issuers as well as broker and dealers, so they were subject to regular inspections by the Board. The Board reported that it identified deficiencies at all 66 firms that were inspected and in portions of 92 of the 106 audits. In reviewing the seven firms’ audits where deficiencies had previously been identified, the staff found at least one deficiency in the same area as previously identified in each of the seven audits. The deficiencies related to revenue recognition, risks of material misstatements due to fraud, related party transactions, and the net capital rule.

Independence violations. The inspection team found that in 26 of the audits, auditors were involved in the preparation of the financial statements they audited, or the terms of the engagement included an indemnification of the auditor in the event that losses occurred, both of which are contrary to the SEC’s independence rules. The Board advised that it reports independence violations to the SEC since they may affect the broker’s or dealer’s compliance with Exchange Act Rule 17a-5. The Board said the independence violations were particularly troubling given the SEC’s long-standing rules with respect to a firm’s involvement in the preparation of financial statements.

Most frequent deficiencies. According to the annual report, the most frequent deficiencies involved revenue recognition, reliance on records and reports, fair value accounting estimates, financial statement presentation and disclosures, and the customer protection rule.

Potential disciplinary action. The Board said that many of the inspected firms need to significantly improve their audit work and reminded firms that information that is obtained during the interim inspection program may lead to an investigation or a disciplinary proceeding. For example, the Board has settled disciplinary orders against 14 audit firms for violating the independence rules as of the date of the annual report.

The Board also reports to the SEC and the designated examining authorities when it finds financial statements that are not fairly stated in conformity with GAAP or where there are possible violations by brokers or dealers of laws, rules or regulations. The SEC announced last December that it had settled actions for violations of the independence rules against eight audit firms, which were not the same firms that reached settlements with the Board.

The Board urged firms to re-examine their audit approaches, read the annual report to see whether they need to take any corrective actions, and review the staff guidance the Board issued for auditors of SEC-registered brokers and dealers.

Permanent inspection program. The staff currently plans to develop a proposal for a permanent inspection program for brokers and dealers in 2016. The proposal will address whether to exempt any category of registered public accounting firm.

Wednesday, August 19, 2015

Complaint Over Nondisclosure of Pledged Shares Falls Short

By Anne Sherry, J.D.

The PSLRA ensnared a complaint alleging that the former CEO of ZAGG, Inc.’s failure to disclose that he had pledged his shares rose to the level of fraud. The Tenth Circuit affirmed the district court’s dismissal of the suit, holding that the plaintiffs did not meet the PSLRA’s heightened pleading requirement of alleging intent to defraud with particularity (In re ZAGG, Inc. Securities Litigation, August 18, 2015, Tymkovich, T.).

Background. According to the complaint, prior to the class period, Robert Pedersen—the co-founder of the electronics accessories company, and its CEO and chairman at the time—pledged almost half of his ZAGG shares on margin as collateral. ZAGG did not disclose Pedersen's pledged shares as it was required to do under Regulation S-K. In December 2011, and twice more in August 2012, margin calls forced Pedersen to sell his shares. In late August 2012, ZAGG announced Pedersen's resignation, which was attributed to the margin calls.

The complaint, filed in the district of Utah, alleged that Pedersen and several other ZAGG officers and directors deceived the investing public and artificially inflated and maintained ZAGG's stock price, which caused the plaintiffs to purchase ZAGG stock at artificially inflated prices. Specifically, the plaintiffs alleged that the defendants failed to disclose Pedersen's pledges and that ZAGG had a secret succession plan for replacing Pedersen.

Dismissal. The district court found that the plaintiffs’ allegations established that Pedersen knew of the pledged shares but failed to give rise to an inference that he intended to deceive investors or recklessly disregarded a risk of misleading investors. Reviewing the dismissal de novo, the appeals court agreed. Contrary to the plaintiffs’ arguments, the defendants’ statements on ZAGG’s filings were not inconsistent. Furthermore, neither Pedersen’s position nor the failure to comply with a regulatory requirement was, by itself, enough to raise a strong inference of scienter, and the only particularized fact alleged in support of the claim that Pedersen understood the risk of his pledging was a statement made months after the alleged omissions occurred.

Even giving the plaintiffs the benefit of the doubt that the complaint raised some inference of scienter, it was not “at least as compelling as any opposing inference one could draw from the facts alleged.” The defendants put forward the plausible inference that Pedersen did not know of the Regulation S-K requirement and believed he appropriately disclosed the margin account following each margin call. A reasonable person would not deem the inference of scienter to be at least as strong as the nonculpable inference set forth by the defendants, the court concluded.

The case is No. 14-4026.

Tuesday, August 18, 2015

Morrison Limitations Don’t Apply to Advisers Act

By Matthew Garza, J.D.

An investment adviser that managed a Bermuda-based fund failed to convince the Sixth Circuit that the limitations on extra-territorial application of Exchange Act Section 10(b) established by Morrison v. National Australia Bank also applied to Investment Advisers Act Section 206. The Exchange Act focuses on the nature of the securities transaction, reasoned the court, while the Advisers Act focuses solely on the conduct of the adviser (Lay v. U.S., August 17, 2015, Merritt, G.).

Background. Mark D. Lay was convicted by a jury of fraud under Investment Advisers Act Section 206, as well as mail and wire fraud, based on advice he provided to the Ohio Bureau of Workers’ Compensation through his SEC-registered adviser, MDL Capital Management. MDL managed the Bureau’s investments in a U.S. fund focused on long-term Treasury bonds and also in a hedge fund it started in Bermuda. Lay leveraged the Bureau’s investments in the Bermuda fund in excess of the limitations agreed to and lost big, leaving the Bureau only $9 million out of a $225 million investment.

Lay was sentenced to 60 months in prison on the Advisers Act Section 206 count and concurrent sentences of 144 months on three wire and mail fraud charges. The Supreme Court’s decision in Morrison v. National Australia Bank limited the extra-territorial reach of Exchange Act Section 10(b), holding that because the Act is silent on the extra-territorial application of 10(b), it must presume that Congress intended to limit its application to securities transactions occurring with the U.S. The district court found that the fiduciary duty Lay owed to the Bureau was sufficient to satisfy the requirement in Morrison that the fraud was domestic.

Advisers Act. Lay argued that the Advisers Act is also silent as to its extra-territorial reach, and because the fund at issue was domiciled in Bermuda, he too should be considered outside of the reach of U.S. courts after Morrison. The Sixth Circuit disagreed. First, the Exchange Act and Advisers Act regulate different aspects of securities transactions, said the court, and second, the only aspect of the case not tied to the U.S. was the Bermuda-based fund. Lay had a “wholly domestic” relationship with the Ohio Bureau of Workers’ Compensation, said the court.

The court wrote that Advisers Act Section 206 establishes that registered investment advisers have federal fiduciary obligations of good faith, loyalty, and fair dealing to clients, whereas the Exchange Act does not set forth a standard of conduct for advisers. Lay tried to take the position that his client was the Bermuda fund and not the Ohio Bureau, but the court found that the original agreement to invest in Treasury bonds and the later in the Bermuda fund was a “single investment relationship” encompassing both the foreign and domestic funds.

Other distinctions between Morrison and Lay’s case also existed, said the court. First, this was a criminal case brought by U.S. authorities, not a private civil case. Second, unlike in Morrison, the plaintiff and defendant are both U.S. citizens. Third, the defendant managed both a domestic and U.S. fund as part of the same investment program. Fourth, the victim was an Ohio state agency holding money in trust for Ohio citizens, and fifth, the fraudulent conduct took place in the U.S.

The case is No. 13-4021.

Monday, August 17, 2015

Dissolution the Solution for Owners’ Dysfunction and Resulting 'Tantrums'

By Amy Leisinger, J.D.

The Delaware Chancery Court has granted a motion for dissolution of a highly profitable company. According to the court, the “state of management of the corporation has devolved into one of complete dysfunction” and “irretrievable deadlocks over significant matters” are threatening the business. After reviewing in detail the co-owners’ “temper tantrums” and “mutual hostaging,” the court appointed a custodian to sell the corporation. The court also dismissed one co-owner’s claims of “abdication of business judgment” and “sabotage” against the other, finding them barred by unclean hands (In re Shawe & Elting LLC, August 13, 2015, Bouchard, C.).

Background. TransPerfect Global, Inc. (TPG), one of the world’s leading providers of translation, website localization, and litigation support services, is owned and operated by Elizabeth Elting and Philip Shawe, who started the company in a college dorm room over 20 years ago. TPG has 100 shares of common stock issued and outstanding: Elting owns 50, Shawe owns 49, and Shawe’s mother owns the remaining one. Shawe has treated his mother’s share as his own property and considers himself a 50-percent owner of the company. TPG’s third director seat has remained vacant since the company organization, and Shawe and Elting never entered into any written agreements governing the operations of the company or their relationship as stockholders.

Nearly five years ago, disputes between Shawe and Elting became a regular occurrence. They argued over business and personal expenditures, hiring and firing of employees, and methods by which to cover tax liability. Elting suggested that Shawe buy her out and had a draft stockholders’ agreement prepared. However, the agreement was never signed, and the parties began to engage in “mutual hostaging,” blocking each other’s activities to garner approval of their own, and regularly undermined each other’s decisions. The tumultuous relationship continued over time, and several attempts to compromise failed. Shawe harassed employees loyal to Elting and spied on her communications with TPG employees and the counsel she retained with regard to the business issues, and Elting took steps to block execution of Shawe’s decisions. Shawe began to disparaging Elting within TPG and publicly, even filing an assault charge against her after a tense interaction, and Elting impeded the annual review of the TPG’s financials.

Elting filed a motion for dissolution of TPG and the appointment of a custodian to sell the company and to resolve the deadlocks between Shawe and Elting.

Dissolution. Under Delaware law, the court may appoint a custodian for dissolution of a solvent corporation when “the stockholders are so divided that they have failed to elect successors to directors” and the business of the corporation is suffering or is threatened with irreparable injury because the directors are so divided. The court found that Shawe and Elting are deadlocked on several matters of critical importance to TPG but noted that the issue of harm is a closer question because the company has been highly profitable. However, the court stated, the business of a profitable corporation may be suffering from an “irreparable injury” when the directors’ approaches are so diametrically opposed that they are unable to govern. Further, TPG has already suffered from dysfunction and is threatened with much more grievous harm if the issues are not addressed, according to the court. As such, the court granted Elting’s motion for dissolution but refused to impose her proposed conditions on a sale of TPG or to enter an order barring Shawe from bidding to acquire the company,

Unclean hands. The court also rejected Shawe’s claims against Etling for breach of fiduciary duty and unjust enrichment. Shawe failed to prove his allegations, the court stated, and Elting successfully raised the affirmative defenses of unclean hands and acquiescence. Both Shawe and Elting were involved in the dysfunctional management of TPG, and, as such, the claims must be dismissed, the court concluded.

The case is No. 9661-CB.

Friday, August 14, 2015

Shareholder Proposal Withdrawn After Company Agrees to Eliminate Tax Gross-Ups for Senior Executives

By Jacquelyn Lumb

The AFL-CIO Equity Index Fund withdrew its shareholder proposal after Parker-Hannifin Corporation agreed to adopt a policy that it would not make any tax gross-up payments to senior executive officers unless they were made in connection with a plan, policy, or arrangement that applies to management employees generally, such as a relocation or expatriate tax equalization policy. In its proposal, the fund explained that tax gross-ups were not consistent with compensation programs that closely tie pay to performance and use company resources efficiently. Tax gross-ups sever the pay/performance link, in the fund’s view.

Tax gross-ups. For purposes of its proposal, the fund said that a gross-up is a payment to or on behalf of the senior executive in an amount that is calculated by reference to the executive’s estimated tax liability. The fund said it was not seeking to eliminate gross-ups or similar payments that were broadly available to management employees since they were smaller and would not raise the same concerns about fairness and misplaced incentives.

The fund explained that gross-up amounts can be sizable, especially when related to excise taxes on outsized golden parachute payouts in a change of control context. The fund said these amounts strike it as unduly generous.

ISS reports. The fund noted that according to Institutional Shareholder Services, in 2014, only 33 companies in the S&P 500 continued to gross-up payments on excise taxes and did not have a policy against entering into new agreements that provided for gross-ups. The fund successfully engaged with 31 of the 33 firms, which either adopted new policies to prohibit future payments of gross-ups on excise taxes or agreed to disclose an existing policy that had not been made public. That left Parker-Hannifin as one of only two companies that had no policy to eliminate gross-ups. The remaining firm is Linear Technology Corporation, according to the fund and based on ISS research reports.

Request for reports. Parker-Hannifin initially sought to omit the proposal from its proxy materials because it said the proposal contained unsubstantiated references to non-public materials which the fund had not made available for evaluation. The company explained that it had requested the ISS research reports referred to in the proposal but the materials had not been provided.

Response to request. The fund responded to Parker-Hannifin’s letter seeking the staff’s concurrence that it could omit the proposal from the company’s proxy materials by noting that upon receiving the request for the materials, the fund immediately called the company’s representative. The fund explained that the materials were outdated since it had successfully engaged with 31 of the 33 firms referenced in the reports, but agreed to respond to the information request. Shortly after Parker-Hannifin provided an email address to which the material should be sent, it submitted its no-action letter to the SEC stating that the fund had not responded to its request for information.

Parker-Hannifin also had argued that it should not have to expend company resources to purchase and review the reports. The fund wrote that it found it curious that the company expended resources to file a no-action letter rather than wait for the fund to provide the requested information. The fund submitted the relevant information on July 15.

Since the fund withdrew its proposal, and Parker-Hannifin withdrew its no-action request, the staff said the matter was moot and it would have no further comment.

Thursday, August 13, 2015

Federal Court Halts SEC ALJ Proceeding Over Constitutional Issues

By Amanda Maine, J.D

The federal district court in Manhattan entered a preliminary injunction against the SEC, ordering the agency to halt administrative proceedings against former S&P managing director Barbara Duka. The court determined that, absent the injunction, proceedings against Duka would cause irreparable harm. The court also stated that SEC administrative law judges (ALJs) were not appropriately appointed according to the U.S. Constitution, and that Duka therefore had established a likelihood of success on the merits of her case (Duka v. SEC, August 12, 2015, Berman, R.).

ALJs and the Constitution. Duka’s case is one of several brought in federal district courts on constitutional grounds. Administrative proceedings instituted against Duka in January 2015 alleged a scheme and a fraudulent practice or course of business that led to false and misleading statements by S&P concerning its post-financial crisis methodology for rating commercial mortgage-backed securities. Duka and others subject to proceedings presided over by SEC ALJs have argued that ALJs are “inferior officers” under the Constitution. The Constitution requires that “inferior officers” be appointed by the President, the heads of departments, or courts of law. Duka and others have argued that ALJs are similar to persons deemed to be inferior officers, contending that SEC ALJs are “established by law”; that their duties, salary, and means of appointment are specified by statute; and that they carry out “important functions” such as taking testimony, conducting trials, ruling on the admissibility of evidence, and possessing the power to enforce discovery compliance.

The court stated that because the SEC ALJs involved in the administrative proceeding against Duka were not appointed by the SEC, they were not appropriately appointed, which violates the Constitution’s Appointments Clause. The court disagreed with Duka’s secondary argument that the ALJs’ two-level tenure of protection violated the Constitution’s appointment and removal powers, however.

The first argument was sufficient to support the entry of a preliminary injunction, the court concluded. Duka had sufficiently demonstrated that she would suffer irreparable harm if forced into an unconstitutional proceeding from which she would be unable to recover monetary damages, according to the court. Duka had also demonstrated a likelihood of success on the merits of her claim that the SEC had violated the Appointments Clause of the Constitution. As such, the court found that a preliminary injunction against the administrative proceeding against Duka was appropriate.

The case is No. 15-CV-00357-RMB.

Wednesday, August 12, 2015

SEC Justified in Refusal to Accept Fund’s Alternative Accounting Method

By Amy Leisinger, J.D.

A D.C. Circuit panel declined to overturn the SEC’s denial of an exemption for a mutual fund from rules governing the calculation and reporting of deferred tax liability. According to the court, the fund’s arguments questioning the SEC’s reasoning in denying the exemption failed to meet the high standard necessary to overcome deference afforded to the Commission’s decision (Copley Fund, Inc. v. SEC, August 11, 2015, Srinivasan, S.).

Background. In September 2013, Copley Fund, Inc. requested a Commission exemption from Investment Company Act Rule 22c-1 and Rule 4-01(a)(1) of Regulation S-X to permit it to alter the manner in which it accounts for tax liability. Copley proposed to account for its deferred tax liability on unrealized gains by establishing a tax reserve based on a pre-set formula designed to present a more accurate and fairer disclosure to the investing public of its invested assets and net asset value (NAV). Copley had used this method until 2007, when the SEC informed it that this method violated GAAP and that it would recommend enforcement action if Copley did not change its accounting method.

The SEC denied Copley's application for exemptive relief, noting that, if a high level of shareholder redemptions forced Copley to liquidate portfolio assets with significant unrealized gains in order to pay the redeeming shareholders, then the actual tax liability from those gains could exceed the partial deferred tax liability that Copley proposed to record. The lower recorded tax liability could yield a higher NAV per share at the time of redemptions, causing redeeming shareholders to receive more than their pro rata share of the fund’s net assets, while the higher actual tax liability could yield a lower NAV per share following the redemptions and cause non-redeeming shareholders to receive a lower price for their pro rata share. The disparity would produce an “unfair and inequitable result” among Copley’s shareholders, the SEC said, which is contrary one of the Investment Company Act's primary purposes.

Copley appealed the SEC’s decision to the D.C. Circuit, arguing that the denial of its request was arbitrary, capricious, and an abuse of discretion.

Review denied. Rejecting Copley’s argument that the SEC’s decision was “based solely” on “hypothetical speculation,” the panel agreed with the Commission’s determination that the fund cannot necessarily anticipate potential redemptions and that a high level of redemptions could result in disparate treatment of redeeming and non-redeeming shareholders. The Commission did not abuse its discretion in using an example (as opposed to hard data) to illustrate the potential problem, the panel noted. Further, according to the panel, the SEC did not err in rejecting Copley’s offer to disclose its alternative calculation methods or its additional arguments against full recognition of deferred tax liability. Noting the deference to be afforded to agency decisions, the paneled denied Copley’s petition for review of the denial of the requested SEC exemption.

The case is No. 14-1142.

Tuesday, August 11, 2015

Court Calls Foul on Attempt to Bench Receiver

By Anne Sherry, J.D.

The receiver winding down an LLC will stay in that role, but the Delaware Court of Chancery determined that his 10-percent contingency fee should be determined on a net, rather than gross, basis. Although the LLC was no longer susceptible to the self-dealing and corporate looting that precipitated the receivership, the court was not convinced that the plaintiff’s motion seeking to terminate the receivership was supported by the interests of the LLC rather than animus towards the receiver (Jagodzinski v. Silicon Valley Innovation Co., August 7, 2015, Parsons, D.).

Background. Silicon Valley Innovation Company, LLC (SVIC) was placed into receivership at the request of a unitholder, Jagodzinski, who also successfully requested the appointment of one of his employees, Portnoy, as receiver. Portnoy ceased to be employed by Jagodzinski, but carried on as receiver. The Chancery Court changed his compensation arrangement from an hourly rate to a flat monthly rate with a contingent bonus of 10 percent of all funds collected by the receivership estate going forward. (SVIC’s main assets are lawsuits against the company’s former management and advisors.) The fee was worded as a gross recovery, but Jagodzinski assumed that it would be a net fee, similar to Portnoy’s compensation structure as an employee of Jagodzinski’s investment management company. After it was revealed that one of the lawsuits could secure a $100 million recovery for the estate, Jagodzinski moved to terminate the receivership, remove Portnoy as receiver, or reduce his pay.

Factors in terminating receivership. In view of the scant case law on the circumstances in which a receivership should be terminated, the court concluded that a receivership should continue until its purpose has been fulfilled. The Chancery Court has expressed a reluctance to allow interested parties to attempt to terminate a receivership, especially where they may have ulterior motives. In this case, while it was true that SVIC is no longer being looted, there is no dispute that the company is unlikely to return to operations again, and so the task of gathering and disposing of its assets through litigation continues. Four factors led the court to conclude that the receivership should continue and that Portnoy should remain as receiver:

  • Portnoy began the investigation of SVIC, did the initial diligence, and launched the lawsuits, which will likely require his participation due to his unique knowledge of the situation;
  • Jagodzinski originally asked the court to appoint Portnoy and indicated that he favored Portnoy’s compensation arrangement;
  • Jagodzinski’s suggestions that the receivership belongs to him “are not only wrong, but also a brazen affront to the Court”; and
  • Ending the receivership would likely place SVIC at serious risk of being placed into bankruptcy.
Compensation structure. However, the court did find it appropriate to revise the contingent portion of Portnoy’s fee. Receivers are entitled only to reasonable compensation, and shifting to a net recovery while retaining the 10-percent contingency was most appropriate, in the court’s view. Accordingly, the contingent fee arrangement was modified to 10 percent of the monies collected, net of fees paid to Portnoy and any out-of-pocket expenses of administering SVIC’s estate (other than contingent attorney fees).

The case is No. 7378-VCP.

Monday, August 10, 2015

Exemption Granted to Online Offering; Substantive Pre-Existing Relationships Possible via the Web

By Joanne Cursinella, J.D.

The Division of Corporation Finance, based on representations that sales of limited liability company interests though a website would be made available only to members with whom an online venture capital firm had a “substantial relationship,” granted no-action relief for such sales without Securities Act registration. The Division concluded that the procedures described would create a “substantive, pre-existing relationship” between the capital firm and prospective investors such that the offering and sales on the firm’s website would not constitute general solicitation or general advertising within the meaning of Rule 502(c) of Regulation D.

In a new, related Compliance and Disclosure Interpretations (CDI) (Question 256.23, August 6, 2015), the Commission has stated that while the use of an unrestricted, publicly available website to offer or sell securities still constitutes a prohibited general solicitation for purposes of Rule 502. Rule 506(c), which does not rely on Rule 502, may still be available to issuers when offering or selling securities through unrestricted, publicly available websites or other forms of general solicitation.

The plan. CitizenVC, Inc. and its affiliates (CVC) proposed to offer and sell, without registration, limited liability company interests (Interests) of special purpose vehicles (SPVs) established and managed by a wholly owned subsidiary of CVC in order to aggregate investments made by members of the CVC online venture capital investment platform (the "site”).

To do this, CVC said it would not rely on the exemption from registration provided under Rule 506(c) for the SVP sales nor, it claimed, would it engage in any general solicitation or general advertising. Rather, CVC plans to establish pre-existing, substantive relationships with prospective members of the site. While the site is hosted on the Internet and so publicly accessible, the firm said it would not attempt to sell any interests to prospective investors until a relationship has been established with them.

CVC qualification policies and procedures. Potential members must be accepted for membership. This involves a process whereby CVC would initiate a "relationship establishment period" when the firm would perform various actions to connect with the prospective investor and collect information it deems sufficient to evaluate the potential investor’s sophistication, financial circumstances, and ability to understand the nature and risks related to an investment in the Interest by generally fostering interactions both online and offline.

The relationship establishment period is a process based on specific written policies and procedures created by CVC to ensure that the offering of Interests is suitable for each prospective investor. Only when CVC has taken all reasonable steps necessary to create a “substantive relationship” with the prospective investor would it admit the prospective investor as a member of the site, providing a password so that the new member can investigate online investment opportunities and the related offering materials.

Facts and circumstances determine relationship. In its response, the Division noted CVC’s representation that its policies and procedures are designed to evaluate the prospective investor's sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered. The Division agreed that there is no specific duration of time or particular short form accreditation questionnaire that can be relied upon solely to create such a relationship. Whether an issuer has sufficient information to evaluate, and does in fact evaluate, a prospective offeree's financial circumstances and sophistication will depend on the facts and circumstances.

Friday, August 07, 2015

SEC ALJ Declines to Impose Sanctions Against ex-Wells Fargo Compliance Officer

By R. Jason Howard, J.D.

SEC Administrative Law Judge, Cameron Elliot, has found that former Wells Fargo compliance officer, Judy K. Wolf (Wolf), aided and abetted and acted with scienter in causing Wells Fargo’s violations of the Exchange Act but the factors that weighed in favor of sanctions for her actions were outweighed by the public interest factors of egregiousness, degree of harm, and deterrence. Accordingly, the ALJ declined to impose any sanctions (In the Matter of Judy K. Wolf, August 5, 2015).

Background. Wolf worked in Wells Fargo’s compliance department and in September 2010, Wolf reviewed the trading of Waldyr Da Silva Prado Neto (Prado), a Wells Fargo registered representative. She then generated a document memorializing her review. Prado was later sued by the Commission for insider trading. In December 2012, Wolf altered her document to make it appear that her September 2010 review was more thorough than it actually was and the altered document was produced to Commission staff without mention of its alteration.

ALJ proceeding. The discussion in the ALJ proceeding acknowledged that Wolf acted with scienter because, based on her professional experience, she must have known that it was improper to alter compliance records. Moreover, although Wolf conceded at the hearing that the falsification of records was wrong, Wolf maintained that she was not culpable because she did not alter the documents for purposes of misleading anyone or for purposes of falsifying documentation. The ALJ continued, saying that while Wolf “sincerely regrets the consequences resulting from her alteration of the Log, and the profound effect it has had on her life, she does not recognize the wrongful nature of her misconduct.”

On the other hand, explained the ALJ, Wolf’s alteration of the log was an isolated event. She provided assurances against future violations, explaining that she had no desire to work in the securities industry again; she doubted she would even be able to because of the allegations in the proceeding and at 62 she is functionally retired. For those reasons, the ALJ said that “Wolf is not, and is unlikely to ever be, in an occupation presenting opportunities for committing securities violations.”

Conclusion. While the ALJ said he did not condone Wolf’s conduct or her deceit in attempting to cover it up, he reiterated that Wolf’s violation was not egregious and it caused no proven harm to investors or the marketplace and that while books and records violations can be egregious, no documents were destroyed and there was no evidence that Wolf’s misconduct made any material difference to the investigation of Prado.

Finally, the ALJ said that “neither the Division nor the Commission as a whole should tolerate falsified records or knowingly false testimony, and the Division was quite right to at least investigate Wolf. But now that the evidence has been fully aired, it is clear that sanctioning Wolf in any fashion would be overkill. Accordingly, no sanction will be imposed.”

The case is No. 3-16195.

Thursday, August 06, 2015

SEC Clarifies Whistleblower Reporting

By Rodney F. Tonkovic, J.D.

The SEC has issued an interpretive rule to clarify the scope of the employment retaliation protections afforded under Exchange Act Section 21F. The Commission explained that Rule 21F-2(b)(1) alone governs the procedures that an individual must follow to qualify as a whistleblower. This interpretation resolves an ambiguity arising from a requirement to report to the Commission found in Rule 21F-9(a), which, the Commission said, applies only in the context of Rule 21F's award and confidentiality provisions of Section 21F (Interpretation Of The SEC’s Whistleblower Rules Under Section 21F of the Securities Exchange Act of 1934, Release No. 34-75592, August 4, 2014).

Ambiguity. In its release, the Commission stated that when it promulgated rules implementing the whistleblower program, it recognized that Section 21F is ambiguous as to the scope of its employment retaliation protections. Courts have also struggled with this ambiguity (see e.g., Somers v. Digital Realty Trust, Inc., in which the court notes that the majority of courts considering the matter have found ambiguity in the interplay between Sections 21F(h)(1)(A)(iii) and Section 21(F)(a)(6)).

The Commission explained that Section 21F(h)(1)(A) contains a catchall provision that prohibits an employer from retaliating against a whistleblower for "making disclosures that are required or protected under" SOX, the Exchange Act, or other laws or rules "subject to the jurisdiction of the Commission." The adopting release explained that the reporting covered by this provision includes reports "to persons or governmental authorities other than the Commission." Section 21(F)(a)(6), however, defines "whistleblower" to mean someone who reports a violation "to the Commission."

To resolve this ambiguity, the Commission promulgated two definitions of "whistleblower" in Rule 21F-2. The first, found in Rule 21F-2(a), applies only to the award and confidentiality provisions of Section 21F and requires reporting in accordance with procedures set forth in Rule 21F-9(a). The second, set forth in Rule 21F-2(b)(1), relates to Rule 21F(h)(1)'s anti-retaliation protections and requires reporting as described in Section 21F(h)(1)(A). Despite this language, the Fifth Circuit in 2013 did not credit the SEC’s broader definition in Section 21F(h)(1)(A) because, the court said, the plain meaning of Exchange Act Section 21F defines "whistleblower" as a person who provides information about a possible securities violation to the SEC.

Interpretation. The Commission remarked that it appreciates the fact that Rule 21F-9(a) can be construed, if read in isolation, to require reporting to the Commission. This construction, however, is not consistent with Rule 21F-2 and would undermine the aim of the whistleblower program, the Commission said.

First, the Rule 21F-2(b)(1)'s express application to the employment retaliation context demonstrates that it should control over Rule 21F-9(a), the Commission said. Next, Rule 21F-2(a)(2) provides that the reporting procedures set forth in Rule 21F-9(a) are among the procedures that must be followed to recover an award. This contrast supports the Commission's interpretation that "the availability of employment retaliation protection is not conditioned on an individual’s adherence to the Rule 21F-9(a) procedures."

According to the Commission, its interpretation avoids a two-tiered structure and removes a disincentive to internal reporting by employees in appropriate circumstances. A contrary interpretation would undermine other incentives put in place to encourage internal reporting, such as collecting a whistleblower award, the Commission said.

The release is No. 34-75592.

Wednesday, August 05, 2015

Event Prediction Contracts Were ‘Commodity Options’ Within CFTC Jurisdiction

By Lene Powell, J.D.

Adding certainty to the status of event prediction contracts under federal commodities law, the D.C. federal district court handed the CFTC a win in its enforcement action against two Irish companies that operated an online event predictions market, ruling that the contracts offered by Intrade.com were commodity options within the CFTC’s jurisdiction and that one company had violated a 2005 CFTC administrative order prohibiting it from accepting orders from U.S. residents. The court also found the companies in civil contempt for failing to comply with a discovery order (CFTC v. Trade Exchange Network Limited, July 31, 2015, Lamberth, R.).

Event predictions market. Trade Exchange Network Limited (TEN) and Intrade the Prediction Market Limited were Irish companies based in Dublin. Between 2007 and 2014, the companies shared directors, office space, and equipment, and had a substantial overlap in shareholders. The companies operated www.intrade.com, an online platform where customers could buy and sell contracts predicting the outcome of real-world events, like sports events and changes in the price of commodities. There were two possible outcomes for each event: yes, the event would happen as described, or no, it would not happen. A customer bought shares if they believed the event would happen and sold shares if they believed it would not, and profited or not depending on the outcome.

In 2005, the CFTC entered an administrative order against TEN for violating Section 4c(b) of the Commodity Exchange Act (CEA) and Regulation 32.11 by accepting orders from U.S. residents for commodity options. TEN consented to entry of the order and agreed to refrain from violating the CEA, pay a $150,000 civil monetary penalty, and prevent U.S. customers from using the website to order contracts. Despite the agreed order, the companies accepted orders from U.S. customers between 2007 and 2012 via Intrade.com to trade various contracts including bets on future changes in the price of gold, the U.S. unemployment rate, and the price of currency pairs. In all, although 443 contracts were blocked to U.S. customers, over 2,000 contracts were not blocked.

According to notices on the Intrade.com website, Intrade ceased offering trading services to customers via the website as of March 10, 2013, and as of June 14, 2014, Intrade intended to fully liquidate all remaining customer accounts by December 31, 2014. A November 1, 2014 notice said the company was “working very hard” to resolve the CFTC case in order to resume commercial operations.

Commodity options. The court granted summary judgment on the first count of the CFTC’s complaint, that TEN and Intrade violated CEA Section 4c(b) and Regulation 32.11 regarding the offering of prohibited commodity options. The court rejected the companies’ narrow definition of the term “option,” noting that although case law was scant, the contracts met the characteristics of what are known to the trade as “binary options.” The CFTC has previously regulated binary options, and the companies did not fall into any exceptions that would allow them to lawfully offer commodity options for trading. Under Chevron and other Supreme Court precedent, deference was due to the CFTC’s construction of a statutory scheme it was entrusted to administer.

The court also declined to limit the definition of commodity options to contracts on commodities specifically enumerated by the CEA, like gold and crude oil. The “excluded commodity” category did not apply and served to demonstrate the span of the term “commodity.” Accordingly, Intrade’s contracts on climate and weather outcomes as well as U.S. economic numbers were commodity options under the CEA.

Orders from U.S. customers. The court also granted summary judgment on the CFTC’s second claim, that TEN violated CEA Section 6c by offering contracts to U.S. customers in violation of the 2005 order. Although TEN and Intrade had separate Irish corporate registration numbers, maintained separate bank accounts, and filed separate tax returns, they operated as a common enterprise because they had the same officers and directors, shared office space, and commingled funds. The companies violated the 2005 order by offering contracts to U.S. customers identical to contracts specifically prohibited by the order, and by not informing U.S. customers which contracts they were not allowed to trade. TEN was responsible for the actions of then-director and officer John Delaney, who was acting in scope of his employment and without an interest adverse to TEN.

The court did not grant summary judgment on Count III of the CFTC’s complaint, regarding violation of CEA Section 9(a)(3) concerning false statements and omissions. The court directed the parties to prepare a scheduling order regarding Count III and the appropriate amount of disgorgement and civil monetary penalties under Counts I and II.

Contempt. In a separate opinion and order, the court found the companies in contempt for failing to comply with a June 24, 2014 discovery order, which denied the companies’ motion for a protective order under the Irish Data Protection Act and directed them to produce documents and CEO Ronald Bernstein for a deposition. The companies were ordered to pay reasonable expenses incurred by the CFTC, including attorney fees, as a result of the failure to comply with the order.

The case is No. 12-1902 (RCL) [summary judgment, contempt].

Tuesday, August 04, 2015

Staff Asks GlaxoSmithKline About Move Into U.K. Patent Box

By Mark S. Nelson, J.D.

The lure of “patent box” regimes has captivated firms around the globe by enticing them with tax benefits. The SEC staff recently asked GlaxoSmithKline plc (GSK) to explain rapid changes in its overseas tax rates and intellectual property benefits as reported in its annual report on Form 20-F.

U.K. tax rates. The SEC staff directed GSK to identify which tax jurisdictions impacted its financials, and to describe how a patent box regime works. In its initial reply, GSK said its tax rates changed because it moved intellectual property from other jurisdictions into the U.K.’s patent box regime when it finished reorganizing its internal intellectual property ownership structures. GSK said its tax rates had been most impacted by the U.S., India, Japan, and France.

In reply to a follow-up comment, GSK told the SEC it would include new language in its future periodic reports to better explain how patent box regimes impact its business. The proposed language would tell GSK investors that differences in its tax situation arose from moving intellectual property out of countries with rates above the U.K. statutory rate (and a few countries below that rate). Prior unfavorable rates were partially offset by higher profits after GSK’s move into the U.K. patent box regime.

The new text also explains that patent box regimes can reduce corporate income taxes if a company has qualifying patents. In GSK’s case, benefits from the U.K. patent box accounted for much of the company’s total patent box benefits in the prior two years (75 percent in 2014), although the U.K. regime will be phased in over a number years. The SEC later said it had finished its review of GSK’s Form 20-F.

Legislative activity in U.S. Not to be outdone by the U.K. or other countries, U.S. legislators are planning to create a U.S. patent box regime. Patent box regimes are a partial response to the spate of co-called corporate inversions by which a company changes its tax domicile to take advantage of lower overseas corporate tax rates.

Last week, Rep. Charles W. Boustany, Jr. (R-La) and Richard E. Neal (D-Mass) said they plan to publish a discussion draft of their proposal to update U.S. tax laws to include a patent box, or as they call it, an innovation box. A company’s “qualified intellectual property” would be entered into a formula that results in an “innovation box profit” to be taxed at 10 percent instead of at the 35 percent general corporate rate.

The legislation also would make repatriation of overseas intellectual property to the U.S. a non-taxable event. The legislators noted that seven European countries besides the U.K., plus China, already have patent box regimes with tax rates of 5 to 14 percent.

Senators Charles E. Schumer (D-NY) and Rob Portman (R-Ohio) both expressed willingness to pursue patent box legislation following Rep. Boustany’s announcement. The senators recently submitted a report by the International Tax Bipartisan Tax Working Group to the Senate Finance Committee in which they recommend creating a U.S. patent box regime.

Monday, August 03, 2015

GAO Report Finds Rating-Analyst Organization Viewed as Premature

By Amy Leisinger, J.D.

The U.S. Government Accountability Office (GAO) has issued a report on a Dodd-Frank-mandated study of the merits and feasibility of creating a professional organization responsible for establishing standards for, and overseeing compliance of, rating analysts employed by nationally recognized statistical rating organizations (NRSROs). According to a statement by the GAO, industry views varied on the propriety of this course of action and the attendant challenges, and some commenters suggested it may be premature to make a decision, particularly in light of the SEC’s new mandate that NRSROs establish standards for their credit rating analysts.

Findings. For the study, the GAO interviewed industry participants, experts, and stakeholders to gather information from all aspects of the market. Noting that independent professional organizations are generally established to help protect the integrity of a specific profession and provide safeguards for stakeholders, the report found many organizational participants believe that a group for NRSRO analysts would improve the industry's reputation, enhance the quality of work provided, and provide supplementary oversight to address issues in the industry.

However, some analyst and NRSRO representatives expressed concern that creating an organization could result in duplicative and even contradictory standards. In addition, they explained, obtaining funding through membership fees may present challenges, given the overall small population of analysts, and providing equitable representation for all members may be difficult, given the fact that the vast majority of analysts work for only three of the 10 total NRSROs. The differences in NRSRO operations and methodologies and analyst specialization may also make it difficult for an organization to develop uniform professional standards, education requirements, and training approaches and to create structures to oversee compliance, several commenters opined. According to the report, several study participants stated that it is unclear whether a professional organization truly could address the complicated, widely reported problems that have harmed the reputation of NRSROs. Some suggested that expanded SEC oversight or the use an existing organization may be more appropriate to govern analysts, the report states.

Further, some commenters explained, it may be too early to determine whether a professional organization would add value; the effectiveness of SEC's new rules requiring each NRSRO to establish training, experience, and competence standards for analysts should be evaluated first, they noted. According to these contributors, defining the purposes of an organization would be arduous without knowing how the impact the new rules will have on the industry. Commenters suggested that “it would be difficult at this time to effectively identify potential gaps in the training, credentialing, or oversight of credit rating analysts that a new organization would be designed to address,” the report notes.

The report was provided to the SEC for review and comment, as well as to appropriate congressional committees and other interested parties for their consideration.