Tuesday, August 19, 2014

House Panel Approves Bi-Partisan Legislation Mandating Cost-Benefit Analysis of Volcker Rule Updates

The House Financial Services Committee has approved and reported out to the House floor bi-partisan legislation, H.R. 3913, that would require the five federal financial regulators that adopted the Volcker Rule, SEC, CFTC. Fed, FDIC and OCC, to conduct a cost-benefit analysis of any modifications of the Volcker Rule or any future rulemaking undertaken pursuant to the Dodd-Frank Act Volcker Rule provisions. The sponsor of the legislation, Rep. Sean Duffy (R-WI), noted that a cost-benefit analysis of the Volcker Rule was never conducted. However, he continued, the legislation is not retroactive. Thus, H.R. 3913 mandates a cost benefit analysis when the Volcker Rule is updated. It mandates a prospective cost-benefit analysis when the Volcker Rule is modified.

The Chair of the Committee, Rep. Jeb Hensarling (R-TX) supported the bill, noting that, as a general principle, the benefits of a regulation must be weighed against the cost and the Volcker Rule should be no exception. It is a modest and narrowly tailored piece of legislation, added the Chair. However, the Committee’s Ranking Member, Rep. Maxine Waters (D-CA), noted that the bill will discourage any necessary modifications of the Volcker Rule.

After initially being approved by a voice vote, a later and requested recorded vote on H.R. 3913 revealed some bi-partisan support for the legislation.

Sen. Casey Asks Treasury What Non-Legislative Measures Could Stop Corporate Inversions

Senator Robert Casey (D-PA) asked Treasury what actions short of legislation could be taken to stop corporate inversions. In a letter to Treasury Secretary Jacob Lew, he asked how existing regulations and tax laws could be improved in order to better target inversion transactions motivated primarily by tax considerations, rather than inversions motivated solely by business considerations. Specifically, the Senator wants to know what Treasury and the Internal Revenue Service can do right now within existing authorities to more effectively enforce existing anti-inversion penalties. He also asks what additional resources, if any, would be required to support more effective enforcement of current regulations.

Many proposals to address the inversion trend, including a proposal in the Administration’s Fiscal Year 2015 Budget proposals, would enact or amend tax domicile rules based on whether a company’s management and control is based in the United States, or the company maintains significant business activities in the United States. Senator Casey wants to know how easily enforceable these proposals would be, and what additional resources, if any, would be needed to ensure fair, transparent and effective enforcement.

While an anti-inversion provision has been part of the Internal Revenue Code since 2004, experience has shown that this provision insufficiently deters inversion given the large tax rate and other tax disparities between the United States and the countries to which formerly U.S.-based multinationals have relocated.

Under current law, U.S. companies can invert and avoid paying U.S. income taxes if a merger transfers just 20 percent of its stock to shareholders of an offshore company. One legislative vehicle is available for Congress right now. It is the Stop Corporate Inversions Act, S. 2360, introduced by Senator Carl Levin (D-Mich.). The measure would raise the 20 percent threshold to 50 percent so that if the majority of a company’s stock remains in the hands of the U.S. company’s shareholders, it is treated as a U.S. company for tax purposes. The bill would also bar companies from shifting their tax residence offshore if their management and control and significant business operations remain in the U.S. There is a companion bill in the House, H.R. 4679, introduced by Rep. Sandy Levin (D-MI).

IM Staff Reports on Use of Form PF Data

[This story previously appeared in Securities Regulation Daily.]

By Amy Leisinger, J.D.

The staff of the SEC’s Division of Investment Management has issued its second annual report relating to the use of data collected from private fund advisers on Form PF. Under the Dodd-Frank Act, the Commission must report annually to Congress on how it has used the data regarding the operations and strategies of private funds to protect investors and the integrity of the markets. According to the report, during the past year, the SEC staff has used Form PF data to assist in examinations and investigations of private fund advisers, to enhance the Commission’s risk-monitoring activities, to provide guidance to filers, and to work with other regulators concerned with the activities of private fund advisers.

Background. Under the Dodd-Frank Act, the Commission must direct investment advisers to report information regarding the hedge funds and private funds they advise in order to provide a source of data for the Financial Stability Oversight Council (FSOC) to use in monitoring systemic risk. This information must include total assets under management (AUM), use of leverage, counterparty credit risk exposure, and trading practices. The Dodd-Frank Act also provides specific confidentiality protections for proprietary information collected.

In 2011, in consultation with FSOC members, the Commission adopted Form PF and Investment Advisers Act Rule 204(b)-1 to establish filing requirements for private fund advisers. Reporting content and frequency varies based on the amount of the adviser’s AUM and the types of private funds it manages. Most advisers are required to file Form PF once a year and report only basic information regarding the private funds they advise, such as the types of private funds advised and each fund’s size, leverage, liquidity, and performance. Hedge fund advisers also must report information about fund strategy, counterparty credit risk, and trading and clearing activities. Large private fund advisers must report more frequently and provide more detailed information, including data on exposures, geographical concentration, turnover by asset class, and use of leverage, among other things. The Commission has controls and systems in place for the proper handling of confidential Form PF data.

Commission uses of Form PF data. In its report, the staff notes that, in addition to providing Form PF data to FSOC for use in its systemic-risk-monitoring obligations, the Commission itself uses Form PF information in its regulatory programs and investor-protection efforts. Specifically, the report states, Form PF data is used in the SEC examinations and enforcement investigations of investment advisers that manage private funds. The staff will review an adviser’s Form PF filing as a part of a preliminary evaluation and will use the data to track inconsistencies and discrepancies with other documentation, especially those items provided to investors, according to the report.

In addition, the staff observes, the Commission has increased the use of Form PF data in its ongoing risk monitoring and rulemaking activities, particularly in the form of reports generated by the Division of Economic and Risk Analysis (DERA). Examiners use the DERA database to identify advisers engaging in particular activities and to identify red flags, and the Division of Investment Management uses Form PF information to inform policy and rulemaking initiatives with regard to private funds. The staff continues to provide guidance to Form PF filers regarding a variety of filing issues, the report states.

Finally, the report explains, the Commission staff uses Form PF data in conjunction with other agencies and groups during collaborative efforts regarding private funds and advisers. Not only is the data used in connection with FSOC’s systemic risk efforts, the staff adds, but it is also included and addressed in discussions with other federal regulators. The staff has also provided aggregated, non-proprietary Form PF data to the International Organization of Securities Commissions (IOSCO) to provide the organization with a more comprehensive view of the global hedge fund market, according to the report.

Monday, August 18, 2014

Senate and House Companion Bills Would Provide Tax Credit for Angel Investors

Senator Chris Murphy (D-CT) introduced legislation that would provide incentives to angel investors to invest significant capital in startups. The Angel Tax Credit Act, S. 2497, would allow them to claim a tax credit equal to 25 percent of their aggregate qualifying equity investments of $25,000 or more to U.S.-based high-tech startups. Establishing this incentive, said Senator Murphy, would help create a funding pipeline to grow startups and target job growth in the science, technology, and engineering fields so the United States can continue its leadership in these fields. A companion bill, H.R. 4931, has been introduced in the House by Rep. Steve Chabot (R-OH).

Timing of Announcement of Ford Payments Did Not Show Fraud

[This story previously appeared in Securities Regulation Daily.]

By Matthew Garza, J.D.

A Ford investor was unable to convince a Third Circuit panel that the auto maker or an investment trust it created violated Exchange Act Rule 10b-17 through the timing of its announcement of payments to the trust (Gold v. Ford, August 15, 2014, Roth, J.).

Background. The plaintiff held over 21,000 of Ford trust preferred securities that were issued by the auto maker through a Delaware trust in 2002. The trust invested in Ford debt and received quarterly interest payments from Ford in return, which was then distributed to holders of the trust preferred securities. Ford could also suspend quarterly interest for a maximum of 20 quarters under the contract, which it did in April 2009.

Announcement of resumption of the payments took place on June 30, 2010. The plaintiff sold his shares on that day, after Ford’s distribution announcement, but before the New York Stock Exchange set the “ex-distribution date.” That date was set at July 1, meaning the plaintiff was not entitled to a cash distribution made by Ford on July 15, 2010.

Court’s determination. The court said that to show a violation of the Rule 10b-17, which requires issuers to give FINRA a 10-day advance notice of a cash distribution, a plaintiff must plead the 10(b) elements: (1) a material misrepresentation or omission, (2) scienter, (3) a connection with the purchase or sale of a security, (4) reliance, (5) economic loss, and (6) loss causation.

The court found that the plaintiff did not sufficiently plead scienter under the heightened PSLRA standard. The investor argued that Ford’s history of complying strictly with the 10b-17 notice requirement showed the company knew 10b-17 was a “bright line” rule, so deliberately disregarding it was a demonstration of scienter. The court said the assertion speaks too broadly about Rule 10b-17 and would mean that every violation of the notice requirement would establish scienter. “Simply put, missing a deadline is not scienter,” said the court.

The case is No. 13-2328.

Sunday, August 17, 2014

Hopes Fading for Dodd-Frank Act Corrections Bill in 113th Congress

It is becoming increasingly apparent that a Dodd-Frank corrections bill is not going to be enacted by the 113th Congress, even though the House has passed a number of Dodd-Frank stand-alone corrections pieces of legislation by overwhelmingly bi-partisan majorities. For example, the House passed the Swap Data Repository and Clearinghouse Indemnification Correction Act, H.R. 742, by a vote of 420 to 2, which would remove an indemnification requirement imposed on foreign regulators as a condition of obtaining access to data repositories. Also, the House passed the Business Risk Mitigation and Price Stabilization Act. H.R. 634, to exempt non-financial derivatives end users from the margin requirements of Dodd-Frank by a vote of 411 to 12. But the Senate has not taken up these bills.

What began with such hope with Senate Banking Committee member Mark Warner (D-VA) telling the Bipartisan Policy Center that the 113th Congress should consider major Dodd-Frank Act corrections legislation, seems to be heading for a dismal end. While Dodd-Frank broadly got things directionally right, said Senator Warner, historically, with any major piece of federal legislation, Congress never gets it entirely right the first time.

There are not many legislative days left in the 113th Congress to get this done. When Congress returns in September, there is likely to be a session of only about three weeks before a break for the elections. Even if there is a lame duck session after the elections, enactment of a Dodd-Frank corrections bill during it are unlikely.


Friday, August 15, 2014

Court Trims Proposed "Draconian" Permanent Penny Stock Bar

[This story previously appeared in Securities Regulation Daily.]

By Rodney F. Tonkovic, J.D.

A district court declined to order a penny stock bar against a lawyer who took part in an international boiler room scheme. Phillip Powers acted as an escrow agent without registering as a broker-dealer. The Commission sought to permanently bar Powers from participating in penny stock offerings, but the court concluded that an injunction against such participation that was already in place was sufficient (SEC v. Benger, August 13, 2014, Cole, J.).

Background. The SEC brought this action against the participants in boiler room scheme that took in approximately $44 million from penny stock sales to foreign investors. The defendants, Illinois citizens acting as distribution or escrow agents (Powers, in this case), skimmed about 60 percent of the proceeds as commissions for themselves and the foreign boiler room operators. The stock purchase agreements seen by the investors represented that there were no commissions and that there was only a nominal transaction fee.

In February 2014, Powers, without admitting or denying the allegations, agreed to the entry of a final judgment against him for having violated the Exchange Act's broker-dealer registration requirements. The court noted that the Commission filed four versions of its complaint, all of which ultimately failed (see, for example, our coverage on March 29, 2013 and March 22, 2013). Powers, an attorney, conceded that he failed to register as a broker-dealer and was subject to an injunction prohibiting him from participating in penny stock offerings while allowing him to give his clients advice about penny stocks. In this case, the Commission sought a broader, permanent bar from participating in penny stock offerings, including advising Powers' clients about penny stocks. This would, the court observed, impact Power's ability to practice law, and Powers objected to the bar as "too draconian."

Penny stock bar. The court noted that a lifetime bar is an extraordinary remedy, usually reserved for defendant who intentionally violated the securities laws and who were likely to do so in the future. In seeking a permanent bar, the Commission relied on cases that involved violations beyond merely failing to register as a broker-dealer. Powers' gains from his efforts amounted to $77,560, which, the court remarked, while not a pittance, was "hardly an economic stake at all," and his conduct was not so egregious as to warrant a life-time bar with no allowance for him to practice law in a limited area.

In fact, the court continued, Powers' emails suggested that he had some awareness and concern about possible improprieties. He was likely not the "self-focused, smirking cheat" preying on the infirm and elderly, as suggested by the Commission, the court said. Powers ultimately stuck with the venture, however, but he was a "small cog" in a scheme the Commission claimed reaped tens of millions in ill-gotten proceeds.

Most importantly, the court said, Powers had no prior violations of the securities or any other laws. His record as a lawyer was "unblemished," and the court concluded that this episode was an isolated occurrence in Powers' career. There was no indication, the court said, that Powers would repeat this kind of behavior.

The court accordingly denied the Commission's motion for a permanent penny stock bar. Finding, however, that some bar was appropriate, the court modified the injunction against Powers to prohibit him from participating in penny stock offerings for five years, while allowing him to advise his clients about securities law compliance involving penny stocks.

The case is No. 09 C 676.

Thursday, August 14, 2014

Fed Official Calls for Comprehensive Review of Broker-Dealer Regulations

[This story previously appeared in Securities Regulation Daily.]

By Jacquelyn Lumb

The president and CEO of the Federal Reserve Bank of Boston has called for a comprehensive reevaluation of broker-dealer regulations. Eric S. Rosengren, in a keynote address at a conference on the risks of wholesale funding sponsored by the Federal Reserve Banks of Boston and New York, noted that broker-dealers played a dramatic role in the 2008 financial crisis yet the SEC’s capital and liquidity requirements have not materially changed. Broker-dealers that are not part of bank holding companies remain under a similar regulatory environment as before the crisis, according to Rosengren, and he called for an increase in the capital required for any holding company with significant broker-dealer operations.

Financial crisis. Many of the most significant runs that occurred during the financial crisis involved financial institutions other than banks. Rosengren mentioned money market mutual funds in particular. The SEC adopted new liquidity requirements, but Rosengren said he would have preferred even more protections against runs on money market mutual funds. He said he is on record as questioning whether the withdrawal restrictions and fees the SEC adopted will help stabilize these funds in a crisis situation.

The most dramatic runs during the crisis affected security brokers and dealers. Rosengren noted that these broker-dealers fund their holdings in uninsured short-term credit markets, which makes them more susceptible to runs than financial institutions that finance their holdings through longer-term or insured borrowing. He said there have been significant reductions in some broker-dealers’ holdings of highly risky assets and some improvements in capital and liquidity positions, but their reliance on a wholesale funding models remains surprisingly unchanged.

Possible solutions. The potential funding problems have not been fully addressed since the crisis, and Rosengren discussed a number of possible responses. The most direct approach would be to require financial organizations that are dependent on unstable funding to hold significantly more capital, he advised. A larger share of long-term subordinated debt could be used to finance securities positions, he suggested.

Another option is to limit the amount of maturity transformation that can be done with repurchase agreements, which would require a limit on the extent to which short-term repurchase agreements could be used to finance long-term assets or high credit risk assets. Another option is to prohibit money market mutual funds from holding repurchase agreements secured by collateral that, by rule, they cannot purchase.

Rosengren suggested that additional remedies be explored, including a regulation that specifies the eligible collateral for a repurchase agreement and mandates a haircut, or a change in accounting treatment so that repurchase agreements with less liquid collateral could not be counted as cash and cash equivalent to the investor. His most controversial possibility was to open the Federal Reserve’s discount window to provide a liquidity facility for broker-dealers, based on the rationale that market-making is as important to the economy as lending.

Rosengren acknowledged that the discount window option was not likely, but said a significant reevaluation of the broker-dealer regulatory requirements is needed and that much higher solvency standards would reduce the risk of runs. Given the broad support provided to broker-dealers and the difficulties they experienced during the crisis, Rosengren said a comprehensive reevaluation of their regulation is long overdue.

Wednesday, August 13, 2014

Senate Leaders Urge Executive Action to End Corporate Inversion Mergers

Three leading Senators urged executive action to end corporate inversions motivated by tax considerations. In a letter to President Obama, Senate Assistant Majority Leader Dick Durban (D-IL), and Senators Jack Reed (D-RI) and Elizabeth Warren (D-MA), key members of the Banking Committee, urged him to use executive authority to reduce or eliminate tax breaks for companies that shift their headquarters overseas to avoid paying U.S. taxes. As Congress considers legislative solutions to the problem, the lawmakers emphasized the need for immediate action, considering the growing trend in corporate tax avoidance. While there is legislation pending in the House and Senate, noted the Senators, the coming flood of corporate inversions justifies immediate executive action.

Senator Coburn Report Says New Market Tax Credit Wrongly Benefits Large Financial Firms and Hedge Funds

A report by Senator Tom Coburn (R-OK) revealed that global financial firms and hedge funds have taken advantage of a tax credit designed to spur new or increased investments into operating businesses and real estate projects located in low-income communities. The New Markets Tax Credit (NMTC) created by the Community Renewal Tax Relief Act of 2000 has become an opaque, poorly-designed, duplicative federal program that on one level has worked as a ``goodie bag’’ for large financial institutions at taxpayer expense. Senator Coburn’s report recommends that the New Market Tax Credit be repealed or reformed.  

The New Market Tax Credit program allows banks and other financial entities to claim a tax credit for investing in businesses in low-income areas. The Coburn report revealed that over the last decade, a niche group of investors, such as financial institutions and hedge funds, have worked with Community Development Entities and projects to maximize their return while maximizing the cost to taxpayers as well. As of 2007, nearly 40 percent of all NMTC claimants were banks or other regulated financial institutions. The New Market Tax Credit program has not only aided large financial firms, but the increasing complexity of NMTC investments benefits lawyers and accountants involved in the transactions.

The Senator’s prime recommendation is that Congress let the New Markets Tax Credit expire and focus its efforts on creating a fair and equitable tax code that will generate economic growth and opportunity for every American, not just the well connected. However, if Congress choosers to extend the tax credit, a number of reforms should be considered, including increased data collection and transparency requirements. He noted that a recent GAO report reveals that there is insufficient data collection by the Treasury Department, which administers the program, which means that taxpayers, lawmakers, and even program beneficiaries do not have access to important details about the program's effectiveness, including how much fees, transaction costs, and interest rates reduce the amount of the investment made into low-income communities.

The New Markets Tax Credit is not a permanent provision of the tax code, observed the report, yet Congress routinely reauthorizes the program. Congress should no longer provide these tax credits to some of the country’s biggest financial firms and corporations, but should allow the tax credit to expire.

Tuesday, August 12, 2014

Kansas Failed to Disclose Significant Underfunding of Pension System While Conducting Bond Offerings

[This story previously appeared in Securities Regulation Daily.]

By Jacquelyn Lumb

The State of Kansas has consented to an SEC cease-and-desist order in connection with its failure to disclose, in the offering documents for a series of bond offerings, that its pension system was significantly underfunded. The failure to disclose the underfunding, by some estimates the second-most underfunded statewide public pension system in the nation, made the official statements materially misleading, according to the order. The SEC accepted the state’s offer of settlement after taking into account the remedial actions that were promptly undertaken.

Years of underfunding. The SEC said the Kansas Public Employees Retirement System (KPERS) experienced financial difficulties as a result of years of insufficient contribution rates to cover normal costs and unfunded actuarial accrued liability. The need for increased funding was both reasonably predictable and within the control of the state, according to the SEC. At the end of the 2008 calendar year, KPERS had a total retirement system unfunded actuarial accrued liability of $8.3 billion and a 59 percent funded ratio. The SEC noted that the liability was substantial since, by comparison, the state’s tax-supported debt was $3.1 billion in 2008.

Heightened risk. The SEC also noted that the Kansas legislature must annually appropriate money to pay the principal and interest on the debt issued by the Kansas Development Finance Authority (KDFA) on its behalf. The major credit rating agencies routinely reduce the rating assigned to bonds by one level where there is a risk, as here, of non-appropriation.

Lack of communication. The SEC found that the KDFA believed that the Kansas Department of Administration (KDA) was responsible for providing the information and disclosures in the official statements relating to financial issues that affect the state, while the KDA though the reverse. The lack of clear communications and the absence of effective written policies and procedures at either organization resulted in neither one identifying the absence of the KPERS unfunded liability or the need to add the disclosure to the official statements.

Remedial actions. Soon after the SEC began its nationwide review of municipal bond disclosures and began questioning the disclosures related to the Kansas bond offerings, Kansas began to adopt new policies and procedures to improve its disclosure about its pension liabilities. The SEC reported that Kansas has now fully implemented those remedial actions.

Monday, August 11, 2014

46 Senators Urge Retention of Cash Basis Accounting in New Tax Code

46 U.S. Senators want to keep the traditional cash basis accounting method for businesses in any overhaul of the federal tax code. In a bi-partisan letter to Finance Committee Chair Ron Wyden (D-OR), the Senators said that the cash method is currently available to C corporations with no more than $5 million in average annual gross receipts, and also for individuals, partnerships, S corporations, and professional services corporations. The letter was prompted by concerns that a draft discussion on tax reform legislation issued by former Finance Committee Chair Max Baucus (D-MT) would require many businesses to change to the accrual method of accounting. Indeed, the draft would require all businesses and individuals that exceed $10 million in annual gross receipts to use the accrual method of accounting.

In the view of the Senators, this change has not been fully vetted and would create unnecessary complexity in the tax code and substantially increase the cost of compliance. It would also create long-term financial hardships, not just a one-time cost. In addition to the substantial cost of changing accounting systems, these businesses would also have to pay tax on income before it is actually being received. The basic tenet of taxation is the ability to pay, noted the Senators, and forcing businesses to recognize income before they receive payment violates this basic tenet. Thus, they strongly encouraged the Finance Committee to maintain the current ability of pass-through entities, and personal service corporations to use the cash basis of accounting for tax purposes irrespective of annual gross receipts.

Friday, August 08, 2014

SIFMA Offers Cybersecurity Guidance to Increasingly Targeted Small Financial Firms

[This story previously appeared in Securities Regulation Daily.]

By John Filar Atwood

Cyber criminals are increasingly targeting smaller companies, according to data compiled by security firm Symantec, and the Securities Industry and Financial Markets Association (SIFMA) is taking steps to help small financial firms ensure that they adequately protected. SIFMA released guidance with eight action items for small companies that will improve their defenses against network intrusions.

Cyber attack statistics. Cyber attacks against companies with fewer than 250 employees accounted for 31 percent of all cyber attacks in 2012, according to Symantec, up from 18 percent the year before. In addition, research from Ponemon Institute indicates that small companies incur a higher cost per capita than larger organizations—$1,564 to $371, respectively—due to cyber attacks.

As a result of this data, SIFMA has prepared cybersecurity guidance based on a framework developed by the National Institute of Standards and Tech­nology’s (NIST). That framework is built around the five principles of identify, protect, detect, respond and recover, and SIFMA has tailored it to fit small financial firms.

In a press release, SIFMA advised firms to apply the best practices in the guidance in a risk-based, threat-informed approach based on the resources available and in support of the firm’s overall business model. SIFMA said that its goal is not compliance to a standard, but to increase firms’ cybersecurity and ensure the protection of their customers.

Action steps. Verizon’s 2013 data breach investigations report indicates that 76 percent of network intrusions and the top five methods of hacking both used weak or stolen credentials. Consequently, SIFMA drafted its guidance to help firms try to combat these intrusions. It acknowledged that the action steps will not protect against all types of attacks, but will defend against the most common ones.

SIFMA recommends that firms strictly enforce robust password security in accordance with NIST standards, and allow only trusted software to execute on operating systems through the use of application whitelists. Firms also should restrict administrative and privileged access to systems and data through preventative and detective controls to prevent unauthorized access or alteration of systems and/or data.

Another recommended action step is updating anti-virus software, in addition to web security software, to reduce the risk of unintentional and intentional computer infection. SIFMA’s guidance also suggests that firms use trusted, up to date operating systems that meet common criteria. Using unsupported or outdated operating systems, such as Windows XP, presents risks to the network and critical data, SIFMA said.

Smaller firms should use automatic software updates and check that the updates are applied frequently to ensure software currency, and should invest in and use cloud or physical external hard-drive backup systems. Finally, SIFMA recommends that companies ensure that mobile devices are secure with passwords and the data is encrypted in the event of loss.

Thursday, August 07, 2014

Commissioner Gallagher Dissents to Retroactive Application of New Dodd-Frank Industry Bars

[This story previously appeared in Securities Regulation Daily.]

By Matthew Garza, J.D.

Commissioner Daniel Gallagher laid out his argument against the retroactive application of collateral bars from association with municipal securities advisors and Nationally Recognized Statistical Ratings Organizations (NRSROs) in a dissenting opinion in the SEC’s case against John Lawton, an investment adviser subjected to a full collateral bar in a December 13, 2012 Commission opinion.

Gallagher noted that collateral bars were freely imposed by the SEC before 1999, when the D.C. Circuit put in place a high bar for their application in Teicher v. SEC. The SEC then refrained from imposing collateral bars until Dodd-Frank Act Sec. 925 gave it express authority to do so in 2010. Dodd-Frank allowed the SEC to impose bars from association with municipal securities advisors, which were created by the Dodd-Frank Act, and NRSROs, which had been placed under the SEC’s authority in 2006 by the Credit Rating Agency Reform Act.

The central question of the Lawton case, as framed by Commissioner Gallagher, was: even if the Commission does have the authority to impose certain bars collaterally and retrospectively, would the retrospective imposition of the two new Dodd-Frank bars -- based entirely on pre-Dodd-Frank conduct -- give impermissible retroactive effect to Sec. 925 of the Dodd-Frank Act? Gallagher concluded that it would and dissented from the imposition of the bars against Lawton.

Supreme Court precedent. Citing to the 1994 Supreme Court case Landgraf v. USI Film Products, which reasoned that it was an “elementary consideration of fairness” that people be given notice of the law before being expected to conform their conduct to it, Gallagher pointed out that Dodd-Frank Sec. 925 itself is silent on the issue of its retroactive application and did not become effective until July 22, 2010. The conduct that gave rise to the SEC’s full collateral bar took place in 2008 and 2009. Absent “an express command” from Congress, Landgraf requires the SEC to determine if the new provision attaches new legal consequences to events completed before enactment of Dodd-Frank, Gallagher said.

Lawton was on notice that the SEC could impose collateral broker, dealer, municipal securities dealer, and transfer agent bars for pre-Dodd-Frank conduct and those bars were proper, but prior to Dodd-Frank the SEC had no power to impose NRSRO or municipal advisor bars and, thus, Lawton could not have been on notice that his conduct could lead to a bar from those industries, Gallagher said.

In Landgraf, the Supreme Court set out an exception to the presumption against retroactivity for measures that constitute “prospective relief,” such as statues that affect, in future, injunctive relief. Although the majority of the SEC relied heavily on that exception, Gallagher said, he believes this argument is a red herring.

Failure to supervise case. The majority places undue emphasis on what he described as a “tangential discussion” and “an exchange of dicta between competing opinions” in Landgraf, which does not answer the questions in the Lawton case, according to the commissioner. Gallagher instead cited to what he believes is a more applicable case, the D.C. Circuit’s opinion in Johnson v. SEC, which addressed a six-month supervisory bar for failure to supervise a broker who misappropriated customer funds. This case, which he says was given “short shrift” by the majority, largely answers the questions at hand.

Using the reasoning of the D.C. Circuit in Johnson, the municipal advisor and NRSRO bars: (1) inflict collateral consequences beyond merely remedying the harm; (2) punish Lawton by restricting his occupational freedom; and (3) are punitive in effect, even if the purpose is remedial. If the six-month bar was considered a penalty in Johnson, Gallagher argued, two permanent industry bars must be considered penalties, and the Johnson opinion should have been given more weight by the majority.

The refusal of the SEC to apply retroactivity to the whistleblower provisions in the Dodd-Frank act are further support for his position, according to Gallagher. The same analysis used by the Commission in its Order Denying Whistleblower Award Claim in Release No. 34-70772 should apply to the Lawton matter, he asserted. “Both logic and the interpretive canon of expressio unius est exclusio alterius compel the conclusion that Congress did not intend for Sec. 925 of the Dodd-Frank Act to apply retroactively,” concluded the Commissioner.

Wednesday, August 06, 2014

NASAA Concerned Over Privacy Bills Requiring Warrants for Email Searches

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

NASAA has expressed concern that two bills in Congress concerning email privacy could severely hamper the ability of state regulators to prevent securities fraud. In separate letters to leaders of the House and Senate Judiciary Committees, NASAA wrote that provisions of the Email Privacy Act (H.R. 1852) and the Electronic Communications Privacy Act Amendments Act of 2013 (S. 607) could significantly limit the effectiveness of state civil and administrative investigations if state securities regulators are required to obtain search warrants in order to gain access to email communications stored by an Internet service provider (ISP).

Search warrant requirement. NASAA observed that federal law currently authorizes a governmental entity to use an administrative subpoena to obtain the contents of an electronic communication from an ISP, once notice has been provided to the customer. The proposed legislation, however, aims to amend 18 U.S.C. § 2703(b) by prohibiting ISPs from providing a governmental entity with the contents of any communication that is in electronic storage or maintained by the provider without a search warrant.

No independent authority. In NASAA’s view, the bills would effectively foreclose securities regulators from obtaining email or other electronic communications from an ISP in civil or administrative investigations. NASAA observed that state securities regulators typically rely on subpoenas, not warrants, to obtain critical investigative information. Many state regulators do not have independent authority to obtain a search warrant from a court, thus leaving the agencies that lack independent criminal authority with no practical way to obtain the warrants that the bills would require.

SEC concerns. NASAA noted that SEC Chair Mary Jo White has also expressed concerns about the “significant negative impact” that S. 607 would have on the SEC’s enforcement efforts. In a letter last year to the Senate Judiciary Committee, Chair White suggested that Congress might strike a better balance between privacy interests and investor protection by amending the bill to establish a mechanism enabling a federal civil agency to obtain electronic communications from an ISP for use in a civil enforcement investigation upon satisfying a “judicial standard comparable to the one that governs receipt of a criminal warrant.” NASAA wrote that state regulators would also support such an approach, provided that the mechanism is fully accessible to both state and federal civil agencies.

Tuesday, August 05, 2014

Lawson Opinion Explained, but Lack of Protected Activity Sinks Whistleblower Claim

[This story previously appeared in Securities Regulation Daily.]

By Mark S. Nelson, J.D.

A worker who alleged misappropriation of intellectual property and other claims against his former employer that later became a subsidiary of a public company may have had some timely Sarbanes-Oxley Act (SOX) whistleblower claims, but even these claims failed because the worker did not sufficiently allege a protected activity. The case arose from Kurt Fuqua’s being fired by SVOX AG (SVOX) for not signing an intellectual property agreement as a condition of at-will employment.

The decision may be remembered more for what it had to say about the Supreme Court’s Lawson opinion and SOX jurisdictional and timing issues than for its result: dismissal (without prejudice) of SOX whistleblower claims and its refusal to stay a related arbitration (Fuqua v. SVOX AG, August 1, 2014, Tharp, Jr., J.).

Lawson, logic and covered persons. A key question for the court was whether Fuqua was a “covered person” under SOX. Fuqua said he was as defined by the relevant SOX regulations and under the Supreme Court’s Lawson opinion, decided just months ago. SVOX said Fuqua could not be a covered person because SVOX was not a public company at the time Fuqua worked there.

In Lawson, the Supreme Court held that the employees of private contractors and subcontractors who do work for public companies can assert SOX whistleblower protections. But the court here said Lawson was inapt because the mutual fund employers there fell within the scope of SOX while the plaintiffs in that case worked for contractors advising the funds. The court said Fuqua’s argument would stretch Lawson too far.

Still, a bit of logic may bring Fuqua within SOX’s reach. The key fact was SVOX’s later acquisition by a public company, Nuance, after Fuqua left SVOX. Fuqua said at least some of SVOX’s allegedly retaliatory acts happened after the acquisition.

SVOX cited the Fourth Circuit’s 2007 Depaoli opinion as a reason not to find Fuqua is a covered person under SOX. In that case, the appellate court said a small company that later becomes a big one cannot be held liable under Title VII for acts taken during its slimmer, formative years.

The issue here, noted the court, may be one of first impression. The court said Fuqua filed a state suit and a second OSHA complaint after SVOX became a covered Nuance subsidiary; the DOL’s administrative law judge also found SOX could apply to retaliation Fuqua said occurred after Nuance acquired SVOX.

Said the court: “The ‘formerly worked for’ definition of ‘employee’ is susceptible to the reading that an individual who formerly worked for an entity that is now public (whether he did so before or after the company became public) and who engages in protected activity under Sarbanes-Oxley after the company goes public may sue for retaliation that occurs in response to that protected activity.”

No jurisdictional reset. Prior to deciding the extent to which Fuqua was a “covered person,” the court took on the issue of its own jurisdiction to hear Fuqua’s case. Much of the discussion focused on the highly circuitous route Fuqua’s claims against SVOX took through the Department of Labor (DOL) and the Illinois and federal courts.

Fuqua argued that more than 180 days had elapsed since he filed his first OSHA complaint, so the court could hear his case. SVOX countered that Fuqua reset the 180-day clock each time he amended his complaint. According to the court, SVOX’s theory that Fuqua’s actions bar federal court jurisdiction now is not backed by legal authority.

But the key question, said the court, is whether Fuqua engaged in bad faith. While the court noted that Fuqua’s repeated amendments of his OSHA complaint might qualify, they had little impact on the ability of authorities to process his complaint. Even assuming the clock reset upon Fuqua’s last amendment, the DOL’s ruling in Fuqua’s case was late by one day. Because the many amendments did not reset the SOX jurisdictional clock, the district court could hear Fuqua’s case.

SOX limitations period. Actions Fuqua said SVOX took against him in retaliation for blowing the whistle (e.g., withheld wages) when he still worked at SVOX in 2009 and 2010 were tardy, said the court. Likewise, two SVOX legal filings within the applicable limitations period also could not be retaliatory because they merely replied to legal actions started by Fuqua. But the SOX limitation period did not bar Fuqua’s claim that SVOX is still allegedly retaliating by continuing to misappropriate his intellectual property.

No protected activity. In the end, Fuqua’s timely misappropriation claim failed because he did not engage in a protected SOX activity. SOX requires an employee to hold an objectively and subjectively reasonable belief that the conduct he blew the whistle on fell within one of the specified types of activity.

According to the court, despite Fuqua’s poorly crafted (subjective) references to mail and wire fraud, these allegations fail because Fuqua did not make objectively reasonable allegations of a scheme to defraud and he failed to overcome the heightened pleading requirements of FRCP 9(b). Similarly, Fuqua’s Economic Espionage Act allegations fail because this law is not one specified by SOX’s whistleblower provision.

Moreover, Fuqua’s securities fraud allegations failed to show the outlines of a securities fraud case. SVOX also had no shareholders during the time period covered in Fuqua’s complaint.

The case is No. 14 C 216.

Monday, August 04, 2014

House Bill Would Open Up FSOC Designation of Non-Bank SIFIs

A bi-partisan House bill would make more transparent the designation of asset managers, hedge funds and other non-bank actors as systemically important financial institutions (SIFIs) by the Financial Stability Oversight Council (FSOC). Introduced by Rep. Dennis Ross (R-FL), the FSOC Improvement Act, H.R. 5180, would require the Council to involve the firm or fund’s primary regulatory prominently in the SIFI designation process. The Council would have to determine that the firm’s primary regulator has not taken proposed or adopted regulations or taken other regulatory action that would mitigate or prevent the identified risk. In addition, FSOC would have to provide the non-bank financial company with written notice of a proposed determination, including an explanation of the basis of the proposed determination of the Council that the firm is a systemically important financial institution and a detailed explanation of why other regulatory action by the company's primary financial regulator agency, if any, is insufficient to mitigate or prevent such risk.

NASAA Proposes Model Rule on IA Business Continuity

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

NASAA has requested public comments on a proposed model rule concerning business continuity and succession planning for investment advisers. The proposal seeks to ensure that smaller advisers fulfill their responsibilities under state securities laws to maintain business continuity, protect clients from interruptions in an investment adviser’s business, and mitigate client harm in the event of a significant business interruption.

Background. The proposal notes that state securities regulators regularly witness the importance of proper business continuity and succession planning in their communities. While business interruptions may result from natural disasters such as Hurricane Sandy that affect a large geographic region, business interruptions to an advisory practice may also result from more localized events, such as fire or localized flooding, or from the death, disability or other unavailability of key personnel. Issues concerning succession planning are particularly important for advisers functioning as sole proprietorships or single-member LLCs because the death or disability of a sole investment adviser representative can lead to an immediate cessation of activity with no notification or guidance to the firm’s former clients, who may heavily depend upon the adviser for financial services.

Proposed Model Rule. The proposal includes general rules under both the Uniform Securities Act of 1956 and the Uniform Securities Act of 2002 with respect to business continuity and succession planning. Given the wide range of business models operating in different jurisdictions, NASAA believes that a very specific, prescriptive rules-based approach may not apply equally to each state-registered investment adviser. For example, procedures may differ dramatically depending upon the size and number of locations from which the investment adviser operates. Despite the differences in operations, however, NASAA believes that a broad rule is necessary to require some sort of business continuity and succession plan, and that every plan should include certain general elements.

Proposed Model Guidance. The proposal also includes Model Guidance which is intended to be considered in conjunction with the proposed model rule. The guidance covers a variety of issues that should be considered by investment advisers in developing their own business continuity and succession plan, focusing on the issues unique to smaller businesses and the risks associated therewith. The Model Guidance is broad and is designed to allow investment advisers to tailor their business continuity and succession plans in a manner cost-effective to their business models.

The Model Guidance discusses issues relating to recordkeeping and disaster recovery issues, but also focuses on issues most common to small advisers such the loss of key personnel. The guidance does not prefer any one method of dealing with these potential issues, but raises specific issues based on state securities regulators’ collective experience so that advisers can consider those possibilities in developing their own plan.

Request for comments. The public comment period will remain open from August 1, 2014, until October 1, 2014. NASAA has requested that comments be sent to Patricia Struck, Chair of NASAA’s Investment Adviser Section, and A. Valerie Mirko of the NASAA Legal Department at the addresses specified in the proposal.

Sunday, August 03, 2014

Senate Panel Hears Testimony on Revising SEC Regulation NMS

A hearing before the Senate Banking Committee on the SEC’s regulation of the equity markets revealed a growing consensus that Regulation NMS, while it has served nobly over the past years, is in need of comprehensive reform to reflect dynamically changing markets. The testimony demonstrated that many of the concerns raised by market participants and investors are the outgrowth of SEC Regulation NMS, noted the Committee’s Ranking Member Mike Crapo (R-ID), and the overall patchwork approach to market trading infrastructure and stability taken by the SEC in the past. Senator Crapo sounded a word of caution as the SEC engages in a comprehensive review of market regulation. While it is important and prudent for regulators to periodically review existing regulations to ensure that they are still appropriate in today’s automated world, said the Ranking Member, any such holistic review of regulation should be based on empirical analysis, data-driven, and incorporate the input of market participants, industry and the investors who make the investments. In other words, Senator Crapo believes that everyone should have a seat at the table in this important discussion and everyone must be willing to roll up their sleeves to find the right solutions.

While much has been made recently of the potential dangers of automated trading, noted Senator Crapo, what is often forgotten is that technology and innovation have benefitted investors by leading to tighter spreads, lower costs and more efficient markets. Today, he noted, an individual retail investor has an easier time participating in the equity markets than at any time in the history of those markets. With fees under $10 a trade, the spreads between bid and ask prices for most stocks are as narrow as they have ever been, and with trading being done in a matter of sub-seconds rather than minutes, retail investors have been able to enjoy greater involvement in, and access to, the markets. To continue this level of investor participation, he emphasized that Congress and the SEC must ensure that the markets have the resiliency and capabilities to handle the evolving speed and complexity of today’s trading world.

Senator Richard Shelby (R-AL), a former Chair of the Banking Committee, expressed concern about investor confidence in the equity markets, particularly with retail investors. This is an overall concern of Senator Shelby as high frequency trading and dark pools become more pervasive in the equity markets. The very term ``dark pool’’ can impact investor confidence in the markets, again, particularly with retail investors.

Jeffrey Sprecher , ICE CEO, ( and in November of last year, ICE completed its acquisition of NYSE Euronext), testified that, while Regulation NMS sought to increase competition among markets and consequently increased fragmentation, the costs associated with maintaining access to each venue, retaining technologists and regulatory staff, and developing increasingly sophisticated risk controls are passed on to investors and result in unnecessary systemic risk. The fragmentation also decreases competition among orders, he noted. Orders routed to and executed in dark trading centers do not interact or compete with other orders, which detracts from the price discovery function that participants in lit markets provide. The lack of order competition in a fragmented market negatively impacts markets in the form of less liquidity, information leakage and wider spreads

While Regulation NMS achieved its goal of increasing competition among markets, said the ICE CEO, the pendulum has swung too far at the cost of less competition among orders. Action must be taken to correct these trends and rebalance the trade-offs of yesterday, and consequently build the confidence of individual investors and companies seeking to access the public markets and to bring back the balance set out in the Securities Exchange Act of 1934.


The ICE CEO detailed a number of measures that should be taken. For example, he said that order competition should be enhanced by giving deference to regulated, transparent trading centers where orders compete and contribute to public price discovery information. Limited exceptions could apply for those with unique circumstances. He also called for a ban on maker-taker pricing schemes at trading venues. Rebates that were used to encourage participants to quote on regulated, transparent markets add to complexity and the appearance of conflicts of interest.

Mr. Sprecher urged a lowering of the statutory maximum cap on exchange fees. Regulation NMS set a cap of what regulated transparent markets can charge to access a quote. In combination with giving deference to regulated, transparent markets and eliminating maker-taker rebates, the SEC should require lowered exchange access fees.

He also called for a revamp of the current market data delivery system. ICE supports the SEC taking a closer look at the current Securities Information Processors and proprietary data feeds to adopt policies that promote fairness. More broadly, in order to increase transparency in the way that markets operate, the SEC should demand that all trading centers report trade executions in real time, and all routing practices should be disclosed by those trading centers and brokers who touch customer orders.

Kenneth Griffin, CEO of Citadel, a global asset management firm, testified that as the SEC considers various reform ideas and assertions about problems with the current equity market structure, the Commission needs a rich set of data to analyze methodically, which will ensure that the SEC has the best information available when making these critical decisions.

He said that Regulation NMS and the foundational regulations that preceded it, along with technological advances, have helped unleash an enormous degree of competition among market centers. But in recent years, the costs that each new market center imposes on the market in terms of additional complexity and operational risk have started to outweigh the marginal benefits of a new competing market center.

Mr. Griffin said that specific regulatory action is needed to restrike this balance by requiring that market centers have sufficient resources and make sufficient investments in operational excellence. Over time this will reduce fragmentation by eliminating marginal market centers that rely on the low cost of market entry and operation.

More granularly, the Citadel CEO called for a reduction in access fees to reflect declining transaction costs and the broadening of caps on access fees. Under Regulation NMS, he explained, the charge to liquidity takers in today’s maker-taker system is called an access fee. The current NMS maximum access fee of 30 cents per 100 shares is now significantly greater than the cost of providing matching services by the exchanges, he noted, and should be reduced to reflect the current competitive reality. Exchanges are permitted to share the access fees they charge with liquidity providers in the form of exchange rebates. A meaningful reduction in the maximum access fee would materially reduce such rebates.

In general, exchange rebates encourage exchanges and liquidity providers to be more competitive. Exchange rebates also reward and encourage displayed liquidity, which greatly benefits the price discovery process. Banning exchange rebates would dampen competition between exchanges and would result in less posted liquidity and could result in wider quoted spreads. Mr. Griffin noted that the SEC has wisely focused on disclosure and other mechanisms to manage any potential conflicts of interest that may arise as a result of these fee structures.

Citadel believes that a reduction in the minimum tick size for the most liquid low priced securities combined with a reduction in the maximum permitted access fee would serve the best interests of all market participants. More importantly, he urged the SEC to close gaps by adopting an access fee cap in important segments of the market that have no access fee cap. Specifically, he asked the SEC to expand the access fee cap to include quotes that are not protected by Regulation NMS. He also urged the Commission to implement a parallel and proportionate access fee cap for sub-dollar stocks. The SEC should also move forward with its proposed rulemaking to cap access fees in the options markets.

BATS Global Markets CEO Joe Ratterman applauded the SEC’s plan for a continuous and comprehensive review of the state of the national market structure under Banking Committee oversight. Such a review is timely, he testified, because changes after the implementation of Regulation NMS reflect a relatively recent and dramatic evolution in the manner in which securities trade.

Specifically, Mr. Ratterman supports the review of current SEC rules designed to provide transparency into execution quality and broker order routing practices. In particular, Rules 605 and 606 of Regulation NMS require execution venues to periodically publish certain aggregate data about execution quality and require brokers to publish periodic reports of the top ten trading venues to which customer orders were routed for execution over the period, including a discussion of any material relationships the broker has with each venue. In his vierw, the publication of this data has helped better inform investors about how their orders are handled.

Nonetheless, he continued, these rules were adopted nearly 15 years ago and the market has evolved significantly enough to warrant re-examining whether additional transparency could be provided that would benefit investors. For example, advances in technology now permit significant market events to occur in millisecond time frames, and audit trails are granular enough to capture that activity.

However, the current requirements of Rule 605 effectively allow a trading venue to measure the quality of a particular execution by reference to any national best bid or offer in effect within the one-second period that such order was executed. Given the frequency of quote updates in actively traded securities within any single second, compliance with this requirement may not in all cases provide adequate transparency into a particular venue’s true execution quality. In addition, the scope of Rule 605 could be extended to cover broker-dealers, and not just market centers. Transparency could further be improved by amending Rule 606 to require disclosure about the routing of institutional orders, as well as a separate disclosure regarding the routing of marketable and non-marketable orders.

The BATS CEO also noted that all exchanges are given a significant competitive advantage regardless of their size by virtue of the order protection rule under Regulation NMS. While this was necessary in an era where legacy exchanges routinely ignored their competitors, he noted, current practices have reduced the need for regulatory protections of smaller venues. Recent events provide evidence that market forces ultimately can correct for venues that add only marginal value. The existing concentration of exchanges among scale providers means that in some cases the marginal operating cost for a new exchange is near zero.

The cost and complexity of connectivity to a small venue for market participants, however, can be substantial. Thus, he urged the SEC to revise Regulation NMS so that, until an exchange achieves greater than a de minimis level of market share, perhaps 1 percent, in any rolling three-month period, they should no longer be protected under the order protection rule; and they should not share in any NMS plan market data revenue.

House Oversight Chair Takes Treasury Secretary to Task over Volcker Rule’s Adverse Impact on Bond Market

Noting the Volcker Rule’s adverse impact on the corporate bond market, House Financial Services Committee Chair Jeb Hensarling (R-TX) suggested that Treasury Secretary Jacob Lew is not doing his duty to ensure that the Volcker Rule does not imperil or disrupt the capital markets. In a letter to Secretary Lew, Chairman Hensarling said that the Secretary’s recent testimony before the Committee denying the Volcker Rule’s ill effects on liquidity in the corporate bond market in the face of overwhelming evidence to the contrary puts into stark relief that the duty to monitor the Volcker Rule for ill effects on the financial markets is not being fulfilled. While Chairman Hensarling requested quarterly reports on corporate bond market liquidity from thel five regulators charged by the Dodd-Frank Act with implementation of the Volcker Rule, the SEC, FDIC, CFTC, Fed and the OCC. The oversight Chair believes that it is incumbent on the Treasury Secretary as Chair of the Financial Stability Oversight Council to ensure that the Volcker Rule does not adversely impact the capital markets.

In the letter, Chairman Hensarling noted that, beyond compliance, the restrictions on proprietary trading in the Volcker Rule, with limited exemptions, will likely have a chilling effect on fixed-income markets, including the corporate bond market. Yet, said the Chair, in recent testimony before the Committee, the Secretary downplayed these concerns, stating that it was premature to evaluate the effect of the Volcker Rule on the corporate bond market because the regulatory implementation process is in its early stages and the Volcker Rule has not taken effect in the marketplace. Contrary to that testimony, asserted the oversight Chair, the Volcker Rule’s adverse impact on the corporate bond market has been apparent since at least 2012 and liquidity in that market has only worsened in the intervening two years.

The Chair cited a June 2012 Financial Times article reporting that large investment and asset management firms were finding it harder to purchase or sell bonds from dealer banks because the banks were reducing their own holdings of corporate bonds partly because of new regulations, one of which was identified as the Volcker Rule. He also pointed to September 2012 remarks by SEC Commissioner Daniel Gallagher echoing these concerns. Moving up to January of 2014, the Chair noted SEC staff guidance entitled ``Risk Management in Changing Fixed Income Market Conditions’’ in which the staff observed that primary dealer inventories of corporate bonds appear to be at an all time low. The staff noted that this reduction in market making capacity may be a persistent change to the extent it results from broader structural changes such as fewer proprietary trading desks at broker-dealers and increased regulatory capital requirements at the holding company level. The guidance posited that a significant reduction in dealer market-making capacity has the potential to decrease liquidity in the fixed income markets.