Wednesday, April 24, 2019

CII offers support for PCAOB’s auditing estimate and specialist use proposals

By Amy Leisinger, J.D.

The Council of Institutional Investors has submitted comments to the SEC in support of the Public Company Accounting Oversight Board’s proposed rules on auditing accounting estimates and amendments to auditing standards for auditor’s use of the work of specialists. CII noted that auditors and other financial “gatekeepers” play a vital role in ensuring the integrity and stability of the markets and investor well-being and that the quality and reliability of information provided by audited financial statements depends directly on the quality of the standards used by auditors to ensure proper disclosures.

Proposals. In December 2018, the PCAOB unanimously approved standards on auditing accounting estimates and the auditor’s use of the work of specialists. The new standard on the auditing of accounting estimates, including fair value measurements, emphasizes the need to apply professional skepticism when auditing accounting estimates. The new standard and related amendments include an appendix that provides specific direction to address auditing the fair value of instruments, particularly when the information is provided from third parties such as pricing services and brokers and dealers.

The new standard on the auditor’s use of the work of specialists strengthens and clarifies requirements in two areas: (1) the use of the work of a company’s specialists; and (2) the use of the work of an auditor’s specialist. Regarding company specialists, the new standard is aligned with the new accounting estimates standard by incorporating risk assessment. It also sets forth factors for determining the necessary evidence to support the auditor’s conclusion regarding an assertion when using the work of the company’s specialist. The standard also adds requirements that the specialist be informed of the work to be performed and amends requirements for assessing the knowledge, skill, and ability of the auditor’s specialist.

Estimates. In support of the estimates proposal, CII explained that fair value accounting with robust disclosures provides investors with more useful information than what would be reported under amortized cost or other alternative accounting approaches. Investors value the auditor’s evaluation of estimates, and the proposal would increase auditor responsibility for auditing accounting estimates and fair value measurements and provide uniform, consistent requirements to increase the quality of information provided in financial statements, according to CII. The estimates standard “will strengthen auditor responsibilities, improve audit quality, and further investor protection,” CII opined.

In addition, CII noted, the new requirements “can reduce the non-diversifiable risk to investors and generally should result in investment decisions by investors that more accurately reflect the financial position and operating results of each company.”

Specialists. According to CII, the specialist proposal would effectively address the more frequent use of specialists seen in connection with increased investor demand for fair value accounting. Increased amounts of work completed by specialists may lead to additional risk that auditors may fail to detect potential material misstatements, CII explained, and the proposal will increase auditors’ attention to the work of a company’s specialists, thereby enhancing investor protection. The application of the proposed requirements should result in consistently rigorous practices among auditors when using the work of and supervising specialists, the organization stated. The standard’s requirements also should result in auditors developing a better understanding of respective accounting estimates in significant financial statement accounts and disclosures, CII concluded.

Tuesday, April 23, 2019

Cybersecurity Docket panel features discussion on how to deal with cyber breaches

By Amanda Maine, J.D.

Cybersecurity Docket recently hosted a panel of experts who discussed how companies and firms should deal with cybersecurity breaches and when and how to disclose these incidents at its 2019 Incident Response Forum. The panel, which included several former government officials and an assistant director from the SEC’s Division of Enforcement, outlined several factors to consider when determining when to disclose cyberattacks and how to approach regulators and enforcement officials in the event of data breaches.

When to disclose. John Reed Stark of John Reed Stark Consulting served for 11 years as the chief of the SEC ‘s Office of Internet Enforcement and moderated the discussion. He asked the panel when a public company must disclose that it has suffered a data breach. Elizabeth P. Gray of Willkie Farr, who spent 12 years at the SEC including serving as an assistant director of Enforcement and as counsel to SEC Chairman Arthur Levitt, said whether to disclose a cyber breach comes down to materiality. The information would be material if it would matter to a reasonable investor, she explained. She also emphasized the importance of the process in determining whether it is material, including consulting with the finance department, the legal department, the executives, and possibly the board of directors.

SEC Assistant Enforcement Director Deborah Tarasevich said that the Commission’s 2018 guidance on cybersecurity disclosures lists several risk factors that companies should consider when evaluating whether to disclose a cybersecurity incident. She stressed that it is a fact-specific inquiry, but some factors to examine include the nature, extent, and magnitude of the incident; the importance of the information on the company’s operations; and the potential harm to the company, which might be harm to the company’s reputation, to its financial performance, to customer and vendor relationships, and the possibility of future litigation or regulatory action.

Tarasevich also cautioned that the existence of an ongoing internal or external investigation does not mean that the cyber breach does not have to be disclosed. In addition, she warned against making disclosures about cyber breaches so boilerplate that they would not be helpful to an investor. However, she advised that when it comes to enforcement actions, the SEC will not second-guess good faith, reasonable decisions about disclosure. That said, there will be circumstances where disclosure is so lacking that the Division will bring enforcement actions, Tarasevich explained.

Serrin A. Turner of Latham & Watkins, who served as the lead cybercrimes prosecutor in the Southern District of New York, addressed the SEC’s comment letter process on companies’ financial disclosures. If SEC staff members see stories about a data breach in the press but do not see it in the company’s official disclosures, they will ask why the breach was not disclosed. One approach is to disclose the incident in an SEC filing without saying it was actually material, Turner suggested, noting that the SEC said it is helpful if companies, when describing risks, discuss incidents that have happened in the past.

Stark inquired about the SEC’s October 2018 Section 21(a) report, which detailed “business email compromises” (BECs) of nine issuers that were victims of schemes involving spoofed or compromised electronic communications from persons claiming to be executives of the companies or their vendors. The report found that the BECs resulted from insufficient internal controls. The companies were not named in the report, nor were they charged. According to Prudential Financial’s Andrew S. Pak, former senior counsel in the Department of Justice’s Computer Crimes and Intellectual Property Section, the main takeaway from the 21(a) report is not to think of documents that have the word “cyber” in them; it is necessary to think about controls that are just “human controls” that wouldn’t necessarily be linked up to a cyber program. Separating cyber policy from the specialized cyber documents is an important lesson from the Commission’s 21(a) report, Pak said.

Regulated entities. The panelists also discussed the issue of disclosing a cyber breach by regulated entities such as broker-dealers, investment advisers, and national securities exchanges. Gray said it is important that regulated entities have a system in place to address these incidents because it will make the response and the decision on materiality clearer. Regulated entities will have different assessments from public companies as to when they should go to their regulator (such as FINRA or state regulators) to disclose a breach.

Tarasevich advised that there are three main rules related to regulated entities and cyber incidents: (1) Regulation S-P, which requires investment advisers and broker-dealers to have policies and procedures in place reasonably designed to protect customer information; (2) Regulation S-ID, which protects against identity theft and applies to investment advisers, broker-dealers, and investment companies; and (3) Regulation SCI, which only applies to approximately 45 entities such as stock exchanges, clearing firms, and other entities that are critical to the functioning of the market system.

Regulation SCI requires that the subject entities have policies and procedures in place with regard to their systems, as well as requiring the entities to report to the SEC if they have any systems issues, including cyber-related issues, Tarasevich said.

Stark asked how regulated entities can avoid drawing the attention of the SEC when it comes to dealing with cyber breaches. Gray advised that it is important to have a cybersecurity system in place such as a breach response program that requires reporting up if a problem is detected. She also recommended working with counsel on the firm’s cyber system before an OCIE exam because OCIE examiners can and will refer matters to the Enforcement Division.

Stark asked about the SEC’s 2016 enforcement action against Morgan Stanley, where the firm agreed to pay a $1 million penalty due to its failure to protect customer information which was downloaded to an employee’s personal server and then hacked by a third party. Turner noted that Morgan Stanley is a sophisticated company with sophisticated controls that were supposed to make sure certain data was only available to employees with certain privileges. However, there was a glitch in the controls that was able to be exploited, he said. Turner observed that the SEC came down hard on Morgan Stanley, and they might not have been as harsh on a smaller firm.

Tarasevich added that Morgan Stanley’s control system at issue had not been audited in its 10-year existence. If you have policies and procedures in place to catch this misconduct, regularly review them and update them to make sure they are responsive to current risks, she advised.

Monday, April 22, 2019

ISS Analytics releases report on 2019 U.S. executive compensation trends

By Joanne Cursinella, J.D.

ISS Analytics has presented its review of executive compensation trends so far this year in a report released on April 12, 2019. The key findings suggest continued increases in CEO pay across all market segments and most industries; that the proportion of stock-based compensation as a percentage of total pay continues to increase; that performance-based equity compensation also continues to increase; and that CEO pay ratios remain relatively unchanged on aggregate.

CEO pay growth. According to the report, CEO pay has increased “at a relatively fast pace” with the median pay for S&P 500 CEOs at $ 12.2 million, an increase of 50 percent since 2009, and the figure almost doubling for S&P 600 CEOs, with an increase of 95 percent since pay fiscal year 2009.

ISS Analytics says that the compensation increases are the result of greater portions of pay being paid in stock. The report notes that in fiscal year 2018, the average stock grant to S&P 500 CEOs is $7.2 million, compared to $3 million in pay for fiscal year 2009, and that stock-based compensation continues to increase, while the aggregate of all other components of pay remains relatively unchanged.

Say on Pay. The increased interest of shareholders on executive compensation brought a focus on performance-based compensation, the report notes. As a percentage of total equity compensation, performance-based equity almost doubled between 2009 and 2018, the report says. And the increase in performance-based pay has continued, according to the report, despite any concern about a reversal since the removal of tax deductions on performance-based pay previously allowed under provisions of Internal Revenue Code Section 162(m).

Pay ratios. The Dodd-Frank Act requires disclosures of CEO compensation relative to the pay of the median employee, and this requirement was first implemented in last year’s proxy disclosure filings, the report notes. So far, the report says, on aggregate, the data indicates no changes in CEO pay ratios compared to last year, and median employee compensation levels also remain comparable to last year.

ISS Analytics says it plans to continue to monitor and report on executive compensation trends.

Friday, April 19, 2019

CFTC’s EEMAC focuses on major developments in shale oil and liquid natural gas markets

By Brad Rosen, J.D.

The first Energy and Environmental Markets Advisory Committee (EEMAC) meeting under the sponsorship of Commissioner Dan Berkovitz featured insightful and spirit discussions across a content filled agenda. Some of the topics of exploration included dramatic recent developments in the physical energy markets and derivative market responses, the changing face exchange-traded energy derivatives markets, as well as mounting concerns around margin and capital requirements and their potentially adverse consequences.

The U.S. has seen significant advances in energy supplies and technologies, particularly with respect to oil, natural gas, and renewable and clean energy sources noted Commissioner Berkovitz in his opening remarks. In providing larger context for the day’s meeting, Berkovitz observed, “The vitality and growth of our domestic energy industry and the improvements in the regulation of our energy derivative markets over the past decade demonstrate that we can have both strong financial market regulation and a strong energy sector. He added, “both are essential for a robust energy sector and a resilient market-based economy.”

Some initial thoughts on tight rock formations and American exceptionalism. In his opening statement, Chairman Giancarlo noted the shale revolution as “one of the greatest economic success stories the world has ever seen.” The chairman has also spoken previously about his forays into West Texas, and what he refers to as the epicenter of American exceptionalism. This is one of the greatest economic success stories the world has ever seen. Shale oil is also sometimes referred to as tight oil, as it is often contained in tight sandstone or shale rock formations.

Panel 1—The U.S. emerges as a leading energy producer on world stage: shale oil and liquid national gas come into their own. Chris Goodenow from the Commission’s Market Intelligence Branch (MIB) provided the committee with a data rich summary on some remarkable developments in physical energy markets, particularly with to crude oil and natural gas, as well as related derivative markets. Goodenow provided some of the current thinking around two reports issued by MIB last year, one of those titled Impact of U.S. Tight Oil On NYMEX WTI Futures. That report analyzed the effect of the growth of tight oil on the WTI and Brent crude oil futures contracts. Some of its findings included:
  • volume and open interest in the contract remain robust;
  • open interest in futures contracts five or more years out has declined; and
  • reduced interest in longer-dated contracts may be due to increased production in U.S. shale oil, price levels, and regulatory impacts. 
MIB’s other report titled Liquefied Natural Gas—Developments and Market Impacts assessed the recent extraordinary growth of U.S. liquefied natural gas (LNG) exports and the potential impacts of this evolution on CFTC-regulated markets. Some of the findings in that report included:
  • Global LNG trade growth is expected to continue with U.S. LNG exports having the most rapid growth rate and a competitive price advantage;
  • U.S. exports capacity expected to double in 2019;
  • U.S. LNG export growth may put upward pressure on U.S. natural gas prices and expose a relatively isolated North American market to global market dynamics; and
  • burgeoning U.S. LNG exports are affecting global LNG market dynamics, including contracting and risk management practices in CFTC regulated markets.
Panel 2—Exchange-traded energy derivatives markets continual adapt and respond to changing markets. The day’s second panel featured presentations from representatives of the exchanges with leading energy derivative products including Bryan Durkin of CME (NYMEX), Ben Jackson of ICE, and Demetri Karousos of Nodal Exchange. A significant portion their discussions focused around about how the changes in the physical energy markets are generating an appetite for new risk management tools, as well as the products the exchanges are creating to satisfy that demand.

The CME’s Bryan Durkin stated that the evolving U.S crude oil environment has generated a global appetite for new risk managements instruments, and that the CME continues to roll out new risk management tools and seeks to build liquidity in existing markets to serve the ever-changing market. Durkin pointed to the exchanges recently launched NYMEX WTI Houston Crude Oil Futures contract (HCL) which provides market participants access to the robust Houston crude infrastructure system.

Panel 3—The availability of clearing services is being undermined by inappropriate capital rules. The day’s third panel featured discussion the availability of clearing and other services in the energy derivatives markets. Notably, there was near unanimity among presenters, EEMAC members, and the commissioners themselves that that the Supplemental Leverage Ratio (SLR) imposed by the prudential regulators may be compromising the provision of clearing services for energy derivatives transactions.

The SLR is a global capital requirement for banks. It is size-based rather than risk-based and is designed to restrain bank balance sheet activity—namely lending. It requires large U.S. banks to set aside roughly five percent of assets for loss absorption. As Chairman Giancarlo noted, “The current implementation of the SLR is biased against derivatives. It does not take into account the fact that outstanding derivative contracts in a portfolio can offset each other and thus reduce the potential risk exposure.” He added, “it incorrectly treats the notional size of a derivative contract as representative of the total potential risk of that contract. It ignores the exposure-reducing effect of margin for clearing firms.”

Rob Creamer, speaking on behalf of the FIA Principal’s Trader Group, asserted that applying the SLR methodology has the potential to “catastrophically destabilize the markets” and posited that it will actually increase risk levels to rather than lead to decreases.

Creamer’s disdain for the SLR is matched by that of Commissioner Quintenz, who described imposition of the SLR to derivative transactions as “gold plating” and caustically, but insightfully, observed, “Gold plating a bad idea does not magically transform it into a good idea.” He added, “By way of analogy, if you build a ship out of gold, it looks great in dry dock. But when you put that ship in the water, it becomes the world’s most expensive scuba diving attraction.”

Previously, a number of commissioners submitted a comment letter to prudential regulators highlighting common concerns regarding the SLR. Moreover, in Chairman Giancarlo’s view, the Commission “continues to speak in a bipartisan voice regarding the SLR.”

Thursday, April 18, 2019

Cornerstone finds uptick in “core” accounting case filings, settlements

By Anne Sherry, J.D.

A report from Cornerstone Research finds that the number of securities case settlements involving accounting-related claims declined in 2018, but the total settlement value increased enormously, driven by five “mega settlements” of over $100 million each. Although the number of case filings dropped overall, the number of “core” accounting case filings increased for the first time since 2014. Last year saw a total of 143 new accounting cases, 79 of which were M&A-related and 64 of which were core cases.

Definitions. Cornerstone considers cases to be accounting cases if they allege violations of GAAP or other reporting standards, auditing violations, or weaknesses in internal controls over financial reporting. M&A filings have Section 14 claims but no Rule 10b-5, Section 11, or Section 12(2) claims. “Core” filings exclude M&A filings.

Mega cases. All five 2018 “mega settlements” involved alleged weaknesses in internal controls, four of them involved allegations of GAAP violations, and three involved restatements. Cases involving restatements made up one-fifth of the total number of core filings. Cornerstone calculates a “Disclosure Dollar Loss Index” that measures the DDL (dollar value change in the defendant’s market cap from the start of the class period to the end) over a period of time. There were three accounting cases with a DDL of at least $5 billion in 2018, but Cornerstone observes that the 2018 DDL represents an increase over the average even excluding these “mega DDL cases.”

Frank Mascari, principal at Cornerstone, said that the market capitalization losses correspond with the trend of cases being filed against large issuers. Indeed, the median market capitalization of issuers defending accounting cases filed in 2018 was $1.5 billion, more than double the average from 2009 through 2017 and the second largest in the last 10 years. Larger defendants are generally associated with higher settlements as well, the report notes, but the 2018 numbers buck trends in two respects: the larger issuers did not correlate to institutional lead plaintiffs or longer periods from filing to settlement.

Accounting settlements compared to other cases. Overall, settlements of accounting cases made up 88 percent of the total value of securities settlements—$4.48 billion of $5.1 billion total. Laura Simmons, a senior advisor at Cornerstone, called 2018 a milestone year in that the total value of post-PSLRA settlements exceeded $100 billion. Accounting cases have made up $86 billion of that total. Cornerstone Vice President Elaine Harwood also noted that these trends “indicate that accounting allegations continue to be an important part of both securities class action filings and settlements.”

Industry breakdown. Although the industrial sector saw a large increase in DDL, the number of cases in this sector dropped below its historical average and decreased by 46 percent from 2017. There were more cases in the consumer non-cyclical sector (biotech, healthcare, and pharma) than any other sector, and these cases’ DDL was over 20 percent greater than the sector’s historical average. Accounting cases in the financial sector increased by 83 percent, while cases in the energy sector decreased to their lowest level since 2009.

Energy sector settlements, although representing only 10 percent of the number of accounting settlements, made up nearly 70 percent of the total dollar value for all accounting settlements. Cornerstone notes a sharp contrast with non-accounting cases: there were no non-accounting settlements in the energy sector in 2018.

Wednesday, April 17, 2019

New Jersey is second state to propose uniform fiduciary standard

By Jay Fishman, J.D.

New Jersey is the second state after Nevada to propose a uniform fiduciary standard for broker-dealers and investment advisers. Although pre-proposal commenters advised the New Jersey Securities Bureau to wait on the rulemaking until the SEC adopts its Regulation Best Interest (RBI), the Bureau has decided to go ahead with the proposal because RBI’s proposed standard, while higher than the current broker-dealer suitability standard, is not as high as a fiduciary standard for protecting investors. Moreover, said the Bureau, RBI’s mandating broker-dealers to disclose in writing the conflicts of interests from recommending investments to their customers that might benefit the broker-dealers over the customers will not necessarily prevent the customers from incorrectly investing in the broker-dealer-benefitting recommendations.

But the Bureau has promulgated the proposal in response to advice from a Dodd-Frank Act Section 913 study recommending the SEC to create a uniform fiduciary duty standard for investment advisers and broker-dealers—when they provide advice to retail customers—that is consistent with the standard currently applied to investment advisers. But one of the primary reasons for the Bureau’s moving ahead with the proposal is because the Section 913 study revealed that investors are confused about the different roles their broker-dealers and investment advisers play as financial professionals, to the point of mistakenly believing that broker-dealers currently have a fiduciary duty to protect their customers’ investment interests.

Rulemaking highlights. As the states have historically been considered the “local cops on the beat” by virtue of being in the best position to protect their respective resident investors, New Jersey (after Nevada) has proposed a new rule, as well as amendments to an existing rule, to eradicate the investors’ confusion over the differing roles, by creating a uniform fiduciary standard for both broker-dealers and investment advisers that will take effect 90 days from the effect date of the new rule. Highlights of the proposed rulemaking include the following:
  • Making it a dishonest, unethical business practice for broker-dealers or their agents to fail to act as a fiduciary with a duty owed to the customer when providing a customer with investment advice or a recommended investment strategy, opening of, or transfer of assets to, any type of account, or a security purchase, sale, or exchange. The fiduciary standard does not apply to a “customer” that is a bank, savings and loan association, insurance or registered investment company, a broker-dealer registered with a state securities commission (or agency or office performing like functions), an Advisers Act-registered investment adviser or investment adviser registered with a state securities commission (or agency or office performing like functions), or any person (whether a natural person, corporation, partnership or trust) having at least $50 million total assets;
  • Mandating broker-dealers, agents, investment advisers and investment adviser representatives to satisfy both a duty of care and a duty of loyalty to meet the fiduciary duty requirement; the duty of loyalty requires making recommendations or providing investment advice to a customer that is free of a broker-dealer’s, agent’s, investment adviser’s, investment adviser representative’s, affiliated or related party’s, employee’s or contractor’s financial or other interests;
  • Presuming a breach of the duty of loyalty when direct or indirect compensation is offered or received to or from a broker-dealer, the broker-dealer’s agents, an investment adviser or the investment adviser’s representatives, for recommending the opening of, or asset transfer to a specific account type, or for purchasing, selling or exchanging specific securities that are not the best of reasonably available options;
  • Requiring broker-dealers, agents, investment advisers and investment adviser representatives to reasonably inquire about the risks, costs and conflict of interests pertaining to a recommendation or piece of investment advice;
  • Disclosing a conflict of interest does not, by itself, presume that the duty of loyalty is met;
  • Breaching the fiduciary duty owed to a customer does not occur when the customer’s broker-dealer or agent receives a transaction-based fee, if the fee is reasonable and is the best of the reasonably available fee options;
  • Nothing in the new fiduciary duty rule applies to a person who acts as a fiduciary to an employee benefit plan, its participants or beneficiaries (because those terms are defined in the Employee Retirement Income Security Act (ERISA)); and
  • Nothing in the new fiduciary duty rule creates a broker-dealer capital, custody, margin, financial responsibility, financial reporting, recordkeeping, or bonding requirement that differs from, or is in addition to, SEC requirements; 
Public comments. Interested persons can submit written comments about the proposed rulemaking, by June 14, 2019, to Christopher W. Gerold, Bureau Chief, Bureau of Securities, 153 Halsey Street, 6th Floor, P.O. Box 47029, Newark, New Jersey 07101. Alternatively, comments may be sent electronically to

The reference number for the proposal is PRN 2019-044.

Tuesday, April 16, 2019

Supreme Court hears arguments on private right of action for negligence

By R. Jason Howard, J.D.

The Supreme Court heard oral argument on a writ of certiorari involving a Ninth Circuit holding that Exchange Act Section 14(e) supports an inferred private right of action based on a negligent misstatement or omission made in connection with a tender offer. The petition stresses that the Second, Third, Fifth, Sixth, and Eleventh Circuits all require proof of scienter (Emulex Corp. v. Varjabedian, April 8, 2019).

Oral argument. At oral argument on April 15, 2019, petitioners argued independent reasons for asking the Court to reverse the Ninth Circuit’s decision. The petitioners’ attorney said, “as the government itself recognizes, this Court's precedents compel the conclusion that Section 14(e) does not confer any implied private right at all.”

Several Justices jumped on this argument, questioning the timing of the issue and asking whether the Court was rewarding the petitioners for not raising the issue adequately below, and in quoting counsel’s argument in the lower court where he said that his clients did not dispute that Section 14(e) provides for a private right of action.

In concluding, the petitioners’ attorney stated that “when it comes into policies of negligence versus scienter, there should be a real concern on the part of this Court that interpreting Section 14(e) to go all the way to negligence, which would be unprecedented in the 50-year history here, would result in the dumping of information, would be—ultimately be counterproductive.”

Representing the U.S. government as amicus curiae in support of neither party, Morgan L. Ratner opened his argument by saying that “Section 14(e) does cover negligent misrepresentations, but it does not authorize private enforcement.” Justice Sotomayor then asked that since “14(e) borrows the language of 10-5, and we have all along interpreted 10b-5 to require scienter, why shouldn't we require the same standard here?”

Justice Alito then reverted back to the initial question, asking the government attorney to explain why he thinks it’s appropriate for the Court to reach the question whether there’s a private right of action in light of the concern as to whether the claim was properly before the Court. In response, he explained that it is proper to consider based on “three circumstances.”

The first, he argued, was that the issue had now been “fully briefed and aired.” The second was that the issue “really is an antecedent question to the scope of Section 14(e).” Finally, he argued that the third and most dispositive reason was that the Court found, in a prior case under identical circumstances, that it was appropriate to consider this question.

The respondents’ counsel then addressed the Court, arguing that the entire dispute could be resolved by “looking to this Court's usual tools of statutory construction and the text, context, purpose, and history of Section 14(e).” As to the issue of the private right of action, the respondents argued that the case presented “the exceptionally rare situation where Congress unmistakably intended this very statute to be privately enforceable, despite not including an express private remedy.” The ultimate question is “what did Congress intend when they used the specific language in 14(e)?” Continuing, he explained that it was the respondents’ contention that “Congress in 1968 expected 14(e) and understood that it would be privately enforceable.”

After having reserved rebuttal time, the petitioners’ attorney explained that “fundamentally, the threshold question in the case is about the role of federal courts when it comes to creating implied private rights,” arguing that he had heard no answer from the respondents “as to how Section 14(e) actually satisfies the test for creating implied private rights.”

The case is No. 18-459.

Monday, April 15, 2019

New York regulator shuts down Bittrex’s bid for a BitLicense

By Brad Rosen, J.D.

The New York State Department of Financial Services (DFS) has denied the applications of Bittrex, Inc., to engage in a virtual currency business and money transmission activities in the state of New York due to its failure to meet DFS licensing requirements. Moreover, the letter dated April 10, 2019, from Daniel Sangeap, DFS Deputy Superintendent and Deputy Counsel, to Bittrex CEO Bill Shihara ordered the company to immediately cease and desist its operations in the state.

Bittrex’s customer base includes approximately 35,000 New York consumers and approximately 1.67 million users spread across numerous countries and 40 states, according to a DFS release.

Background and basis for license denial. The DFS deficiency letter noted that Bittrex has been engaged in virtual currency business activity in the state under the terms of a "safe harbor" while its license application was pending. That letter also stated DFS had worked steadily with Bittrex to address continued deficiencies and to assist Bittrex in developing appropriate controls and compliance programs. Since Bittrex’s application was pending, DFS had issued several deficiency letters.

As the basis for issuing its denial, DFS cited the following serious deficiencies on Bittrex’s part:
  • deficiencies in Bittrex’s Bank Secrecy Act/anti-money laundering/Office of Foreign Assets Control (BSA/AML/OFAC) compliance program;
  • deficient due diligence and control over Bittrex’s token and product launches; and
  • deficiency in meeting the DFS capital requirement.
AML-related compliance program was inadequate. The DFS letter stated that Bittrex's BSA/AML/OFAC compliance program failed to meet the following requirements:
  • inadequate or nonexistent internal policies, procedures and controls;
  • lack of qualification or effectiveness of the compliance officer;
  • lack of adequate training of employees;
  • inadequate auditing and independent testing of the program; and
  • inadequate customer due diligence, including a seriously flawed know-your-customer program.
Lack of adequate due diligence in launching tokens or products. While Bittrex had written policies for the review and launch of tokens and products on its exchange, during a DFS examination, the company was unable to demonstrate compliance with this policy. This was in part because partial files were provided to the examiners and actual compliance for certain files could not be established. In some cases, token applicants had refused to complete their applications. Nonetheless, the tokens were accepted for trading and allowed to trade.

Inadequate capital. The DFS letter stated, succinctly, that Bittrex has not indicated its agreement to comply with the Department’s capital requirement.

Order to cease all business operations. The DFS letter stated that effective April 11, 2019, Bittrex must cease operating in New York State and, within 60 days, wind down its business in New York, including transferring positions and transactions, and provide for the safe custody of assets involving New York residents, as appropriate.

The letter also requested that within 14 days, Bittrex provide the DFS with written confirmation that the company had ceased operations in New York State and had ceased doing business with New York State residents. Additionally, the letter asks that company provide a plan for how Bittrex plans to wind down its business with existing New York customers, as appropriate, within 60 days.

Historically, the state of New York has taken an aggressive regulatory stance to assure integrity of the virtual markets and to protect its residents. In September 2018, the New York Attorney General issued a highly critical report finding vulnerabilities across the largest virtual currency exchanges.

Friday, April 12, 2019

Garrett Institute disclosure panel reviews SEC diversity C&DIs and related state law developments

By Mark S. Nelson, J.D.

The public company disclosure panel at the 39th Annual Ray Garrett Jr. Corporate & Securities Law Institute held at Northwestern University's Pritzker School of Law discussed the SEC’s recently issued Compliance and Disclosure Interpretations on board diversity and the key differences between proposed federal board diversity legislation and the approach taken by California. The panel discussion is summarized below and then followed by a sampling of state and federal legislation plus additional information about the SEC’s updated C&DIs on board diversity disclosures.

Privacy interests. Panelist Patrick Daugherty of Foley & Lardner, LLP cited data indicating that most S&P 500 companies have at least one female director (many of these companies have two female directors). But he also noted that other data from a PwC survey found disagreement between men and women about whether political correctness underlies board room diversity efforts: overall, 52 percent said yes, but men (58 percent) were more likely than women (26 percent) to answer yes. He further noted that demands from both institutional investors and proxy advisers can influence board diversity.

Daugherty then summarized the several components of the SEC’s new C&DIs updating board diversity disclosures under Regulation S-K Rules 401 and 407. Before a disclosure could be made under the C&DIs, the board nominee or board member must first self-identify as having a diversity characteristic, that person must then consent to disclosure, the board’s nominating committee must then consider the disclosure, and finally, disclosure can be made.

Daugherty asked Michele Anderson, Associate Director for Disclosure Operations within the SEC’s Corporation Finance Division, why the agency did not go further with its C&DI update. Anderson offered two reasons: (1) C&DIs are merely guidance; and (2) the updated C&DIs reflect companies’ concerns about the privacy interests of their board members.

With respect to legislation, Daugherty noted the varied approaches under proposed federal legislation and California’s law. A bill introduced in Congress would focus on disclosure by companies of the extent to which their officers and directors self-identify as having a diversity characteristic. By contrast, California’s approach is less about disclosure and more about enforcement for a company’s failure to meet statutory diversity requirements. Daugherty observed that California’s law, if challenged, could rise or fall on Equal Protection grounds.

California’s law. In 2018, California enacted a law (SB 826) that requires a public company with its principal executive offices located in California (as determined by the company’s Form 10-K) to have at least one female director on its board of directors by the close of 2019. A company can increase the size of its board in order to comply. A further requirement states that, by the close of 2021, such companies must have a minimum number of female directors based on the size of the company’s board:
  • Six or more directors: at least three female directors.
  • Five or more directors: at least two female directors.
  • Four or fewer directors: at least one female director.
The California law also authorizes the Secretary of State to implement it via regulations and to impose penalties for violations. For example, the penalty for the failure to file required information with the Secretary of State would be $100,000. Moreover, the penalty for a first violation also would be $100,000, while a second or subsequent violation would be $300,000. However, no violation would occur if a female director held a board seat for at least part of the year.

“Female” is defined to be inclusive and would appear to include to transgender persons. Thus, “female” means “an individual who self-identifies her gender as a woman, without regard to the individual’s designated sex at birth.” The law also defines “publicly held corporation” as a company whose shares are listed on a major U.S. stock exchange.

California’s board diversity law has generated much interest and concern regarding how companies will comply with it and whether it can withstand potential legal challenges. California’s Secretary of State is due to publish its first report on the number of companies located in California with at least one female director in July 2019. At least one proxy advisory firm, ISS, has predicted that the law will result in a significant increase in women directors at California-based companies.

Illinois bill. Illinois lawmakers are likewise considering a bill to address concerns about diversity on public company boards. However, unlike California’s law, the Illinois bill (HB 3394), which passed the House 61-27, would require public companies located in Illinois to have on their board of directors at least one female director and one African American director by the close of 2020. The Illinois bill makes no provision for the size of a company’s board as does California’s law.

The definition of “female” would track the California law. The bill would define “African American” to mean “a citizen with at least partial Sub-Saharan African ancestry and who self-identifies as being African American.”

Penalties under the Illinois bill would be identical in amount to those imposed under the California law. For purposes of determining the principal executive office, reference would be made to a company’s Form 10-K. A public company would be a company whose shares are listed on a major U.S. stock exchange. During consideration of the bill in the Illinois House, lawmakers made one amendment (HB 3394 as introduced) to eliminate the penalty for the Illinois Secretary of State’s failure to publish a required report.

New Jersey. Lawmakers in New Jersey in 2018 introduced a bill (A 4726) on gender diversity on corporate boards. The bill would require a public company with its principal executive office in New Jersey (as determined by reference to its Form 10-K) to have at least one female director. Unlike Illinois, but like California, such companies must further comply with a board size provision:
  • Six or more directors: at least three female directors.
  • Five or more directors: at least two female directors.
  • Four or fewer directors: at least one female director.
The penalty amounts for violations would track both California’s law and Illinois’s proposed legislation. Both New Jersey and California provide that if a female director holds a board seat for part of the year, that would not be violation (Illinois’s bill appears to have no equivalent provision).

The New Jersey definition of “female” would be identical to definitions in California’s law and Illinois’s proposed legislation. Likewise, New Jersey’s definition of a “publicly held” company is a company with shares listed on a major U.S. stock exchange. Moreover, it would not be a violation if a female director held a board seat for part of a year and a company could increase its board size to comply with the proposed law.

Pennsylvania resolution. Members of Pennsylvania’s House introduced a resolution (House Resolution No. 114) encouraging publicly held companies in the state to have a minimum number of female directors on their boards of directors. The resolution notes California’s leadership on the issue of board diversity while also citing research by Credit Suisse Research showing that companies with women holding at least 15 percent of senior manager jobs are 50 percent more profitable than companies with fewer than 10 percent women among their senior managers.

As a result, the Pennsylvania resolution urges that by 2021 public companies in the state add female directors based on board size:
  • Nine or more directors: at least three female directors.
  • Five to eight directors: at least two female directors.
  • Fewer than five directors: at least one female director.
A 2017 Colorado resolution cited similar research and encouraged Colorado public companies to add female directors on the same terms as the more recent Pennsylvania resolution.

CorpFin issues diversity C&DI update. Companies may need to do more to meet their disclosure obligations regarding the self-identified diversity characteristics of director nominees who have agreed that the company can disclose these characteristics about them, according to a pair of new C&DIs issued by the SEC’s Division of Corporation Finance. The C&DIs note that self-described diversity characteristics can include "race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background." CorpFin’s new mirror image C&DIs (Questions 116.11 and 133.13) were its first issued since the federal government reopened and provide guidance to companies regarding how to apply Items 401 and 407 of Regulation S-K.

Under Item 401 of Regulation S-K, a company must provide a description of director nominees’ backgrounds. The C&DIs explain that this description should cover a variety of items, including "specific experience, qualifications, attributes, or skills." Under the new C&DIs, the Item 401 disclosure should, at minimum, identify self-identified diversity characteristics and state how they were considered by the nominating committee or by the board.

Item 407(c)(2)(vi) of Regulation S-K requires a description of a company’s process for nominating and evaluating director candidates. As part of that disclosure, a company must explain whether and how it considers diversity in identifying directors. A company must further describe how its diversity policy is implemented and how it judges the policy’s effectiveness.

The new C&DIs state that, for purposes of Item 407(c)(2)(vi) of Regulation S-K, a company should explain how it considered self-identified diversity characteristics under its diversity policy. That discussion also should note how the company considered other factors within the scope of its diversity policy, including "diverse work experiences, military service, or socio-economic or demographic characteristics."

Federal legislation. Senator Robert Menendez (D-NJ) and Rep. Gregory Meeks (D-NY) have introduced mirror image bills that would require public companies to disclosure data on diversity. The bills are predicated, in part, on a 2017 survey Sen. Menendez conducted in which 61 of the Fortune 100 companies participated and which, in the senator’s view, showed a need for greater diversity among corporate leadership teams. The bills also come at a time when the need to address diversity issues has become more imminent, for example, under California’s board diversity law. The SEC’s updated C&DIs also provide further reason for companies to consider self-identified diversity characteristics.

According to Sen. Menendez, the Improving Corporate Governance Through Diversity Act of 2019 (S. 360) and its House counterpart (H.R. 1018) would address the results of the senator’s 2017 Corporate Diversity Survey. That survey, the senator said, indicated a need for greater "representational diversity." This need is underscored by two trends Sen. Menendez said he sees going forward: (1) an increasingly diverse America; and (2) lagging minority representation in fields likely to see the most growth in the coming years, such as technology and professional fields.

The legislation has early backing from several major business groups. The U.S. Chamber of Commerce said the legislation would "organically" increase board diversity without reliance on quotas while also promoting transparency and creating a private sector advisory group. The Council of Institutional Investors said in a letter that the proxy disclosures required by the legislation would align with the CII’s own policies on board diversity, which look to a number of factors, including "background, experience, age, race, gender, ethnicity, and culture."

Thursday, April 11, 2019

SEC enforcement officials give tips on cooperation, Wells process at SEC Speaks

By Amanda Maine, J.D.

SEC Enforcement Co-Directors Stephanie Avakian and Steve Peikin led a panel discussion with Division officials at this year’s PLI SEC Speaks conference in Washington, D.C. The officials gave advice on how to communicate with the Division staff on ways to increase cooperation credit and how to engage in constructive communication with enforcement staff leading up to enforcement actions.

Cooperation. According to Avakian, high quality cooperation can advance the staff’s investigations in a meaningful way by reducing resources expended and returning money to harmed investors more quickly. What the Commission focuses on in determining cooperation credit falls into four broad categories: self-policing, cooperation, remediation, and self-reporting, Avakian explained.

Marc Berger, regional director of the SEC’s New York Regional Office, said that the Commission is trying to send a clear message about cooperation in its orders. For example, in February the Commission announced settled charges against Gladius Network LLC, which had not registered its 2017 initial coin offering (ICO). Gladius later self-reported its violations to the SEC and agreed to register the tokens and return any investor money upon request. Due to the company’s substantial cooperation with the SEC, it escaped having to pay a penalty, Berger explained, directing listeners to look at the language in the SEC’s order of settlement relating to remedial steps taken by the Gladius and its extensive cooperation with the staff.

Former Commissioner Daniel Gallagher, appearing on the panel as a commentator, inquired about the lack of uniformity in the Commission’s cooperation policy and whether it might adopt something more formal. Peikin noted that the Department of Justice has a much more prescriptive policy that provides more clarity about what defendants will get if they self-report. Peiken said that the SEC enforcement staff likes having flexibility, although he acknowledged that it is an imperfect science.

Avakian noted that some SEC orders, including Gladius, credit respondents’ affirmative assistance with staff in an investigation. Expanding on affirmative assistance, Berger said it can take the form of factual presentations by the respondent’s counsel that can help narrow issues. With respect to the staff’s document requests, Berger advised that they can sometimes have unintended consequences, and it is helpful if counsel can help eliminate some of the “noise” resulting from a document request that includes documents that are not useful to the investigation. The staff is trying to streamline investigations, and it will be noticed if a respondent is proactive and forthright and establishes a good relationship with the enforcement staff.

When asked if a privilege waiver is necessary to receive cooperation credit, Associate Director Anita Bandy said the short answer is no, and the staff generally avoids asking for a privilege waiver. The Division tries to work with counsel in coming up with a plan that balances privilege with cooperating, she said. Companies that want to cooperate will find a way to strike this balance, she added. For example, if a company declines to tell the staff what a witness said during its own internal investigation, causing the staff to “redo” the investigation of the witness, the company should not expect the same cooperation credit as a company that did communicate what the witness said, she explained.

Some of SEC orders of settlement involve the respondent agreeing to engage an independent compliance consultant (ICC). Bandy said the Division looks at a variety of factors in determining on whether to recommend an ICC, including the nature of the conduct, how widespread the conduct was, and how far up the conduct extended. The Division will also examine what kind of remediation has taken place, how long remedial measures have been in place, and whether they have been effective. We don’t take a cookie-cutter approach to ICCs, she added, noting that the terms of an ICC have become more variable, both in length and in scope. Being mindful of scope-creep, the staff wants to make sure that any independent compliance consultancy be tailored to the conduct at issue, Bandy said.

Multi-jurisdictional investigations. Berger also addressed how the Division approaches multi-jurisdictional investigations. If the SEC is involved at the outset, there should be both investigation and resolution coordination, he said. The staff is always assessing whether it is in the SEC’s best interest to pursue these cases given its limited resources but assured that once the SEC becomes part of the investigation, it is it the Commission’s interest to see it through.

He also advised that the SEC wants a global resolution to investigations and that it is not helpful when parties try to split regulators off and try to negotiate separately. Moving toward a global resolution will result in offsets, such as criminal restitution offsetting civil disgorgement, he said, pointing specifically to the parallel actions brought against Lumber Liquidators last month. Lumber Liquidators agreed to pay $6 million in disgorgement, which was offset from the DOJ’s action in which the company agreed to pay $33 million in criminal fines and forfeiture. Internationally, he gave the example of the litigation against Petrobras, which was subject to offsets involving non-U.S. enforcement actions.

Wells submissions. The staff gave some pointers on how to respond to a Wells notice and how not to respond. Chief Counsel Joe Brenner advised counsel to prioritize and focus on what really in dispute. A Wells notice will typically identify every statute and rule that the staff thinks was violated; however, it is not necessary to address each and every one in a Wells submission, Brenner explained. He advised counsel to be realistic on goals for the Wells submission, observing that if every single thing is challenged, the submission risks losing credibility.

Peikin, who has spoken publicly about the Wells process, asked whether counsel should include in its Wells submission what commissioners have said about Wells submissions in their public remarks. Brenner noted that the staff interacts with the commissioners on a daily and weekly basis and quoting what a commissioner has said publicly is generally not effective.

Regarding expert reports in a Wells submission, Brenner said that they can be effective if they are able to be admitted in court. However, he added that some seem designed just to inform the Division if the case ends up in litigation, the defendant’s counsel will be presenting an expert. Peikin also noted that some submissions try to get around page limits by using small fonts and very small margins, which he cautioned against because that just results in losing the attention of the staff.

Meeting with Division staff. Avakian asked what can be effective when counsel presents its views to Division staff in a meeting. Bridget Fitzpatrick, chief litigation counsel, first advised that it is not effective if counsel describe how experienced they are, how smart they are, and how the staff should be intimidated. She quipped that the SEC has gone up against some of the best trial lawyers in the country and will not be intimidated by such talk.

Instead of general proclamations about counsel’s litigation prowess, it would be more effective to provide specifics, such as explaining how testimony regarding specific document introduced at trial with a key witness would frustrate the Division’s attorneys during cross examination, Fitzpatrick explained. Peiken agreed, adding that it is effective if counsel can describe how they will beat the SEC at trial, and not just that they will beat the SEC at trial.

Wednesday, April 10, 2019

Commissioner Peirce fears that overuse of staff guidance creates “secret law”

By Lene Powell, J.D.

SEC staff guidance performs a “critical function” by helping market participants navigate the complexity of the federal securities laws, said Commissioner Hester Peirce in remarks at the PLI “SEC Speaks” conference in Washington, D.C. But the current proliferation of no-action relief and other staff guidance is dangerous because it creates a body of “secret law” beyond judicial or even Commission review.

Likening staff guidance to the hidden, walled garden in the children’s book “The Secret Garden,” Peirce said that highly intricate securities laws create fascinating puzzles for legal practitioners, but a “compliance minefield” for those with “real skin in the game.” Staff no-action letters can help make the minefield passable by allowing for flexibility in areas where the SEC’s rules are newly developing or clunky, and can also provide for a quicker response than the Commission can offer. Yet staff guidance can also perpetuate the problem of complexity by adding to a sprawling, inconsistent patchwork.

Peirce noted that staff no-action letters were not always public. In the 1960s, before staff guidance was routinely made public, a law professor named Kenneth Davis characterized the body of staff no-action letters as “law.” Then-SEC Chairman Manuel Cohen retorted that staff letters might be lore, but they were not law. However, the point was taken, and the SEC subsequently decided to make staff guidance public.

Peirce said she does not want to make the no-action process overly burdensome. But when she hears that staff will not accept questions on whole categories of issues, or practitioners half-jokingly say that the patchwork of public and private rulemaking is so vast that half of it could be tossed out without any effect, she is “concerned that a line has been crossed.” As a practical matter, said Peirce, staff guidance does bind market participants, yet it is often impossible to tell if it applies to all similarly situated registrants equally.

Peirce closed by suggesting that unless there is some confidentiality requirement, “all of our regulatory gardens should be subject to public review.”

“Let’s work together to take down the walls,” said Peirce. “Or at least make a doorway.”

Tuesday, April 09, 2019

‘Substantive economic dealings’ in advance of procedural protections necessitates further review

By Amy Leisinger, J.D.

The Delaware Supreme Court has affirmed in part and reversed in part the Chancery Court’s dismissal of a complaint alleging that certain oil and gas companies and their executives caused stockholders to approve an unfair transaction based on a misleading proxy statement. According to the court, the Court of Chancery correctly held that the complaint failed to state a disclosure claim, but the complaint should not have been dismissed in its entirety, as intervening case law has provided that dismissal is not warranted if a complaint has pleaded facts supporting a reasonable inference that companies engaged in substantive economic negotiations before required procedural protections have been put in place. The court remanded the matter to the Chancery Court for further consideration (Olenik v. Lodzinski, April 5, 2019, Seitz, C.).

Dismissal, intervening law. According to the Chancery Court, the business judgment rule applied to the transaction to combine Bold Energy with Earthstone Energy because it was structured to comply with the conditions set forth in Kahn v. M&F Worldwide Corp. (MFW). The proxy statement informed the stockholders of all material facts about the transaction, and, although, the parties worked on the transaction for months before Earthstone’s special committee extended an offer with the MFW conditions, those interactions “never rose to the level of bargaining,” the court stated. EnCap Investments (formerly the controller of Earthstone through Oak Valley Resources) and Earthstone preconditioned the deal on MFW’s requirements in an August 19, 2016, letter, the special committee was well functioning, and the stockholder vote was informed and not coercive, according to the court. As such, the court found, the MFW protections applied, and the transaction was subject to business judgment deference, which, in turn led in dismissal.

However, while the matter was on appeal, the Delaware Supreme Court decided Flood v. Synutra International, Inc. under which the court held that, to invoke the MFW protections in a controller-led transaction, the controller must “self-disable” using the MFW conditions prior to the start of “substantive economic negotiations.” The court noted that MFW protections will not result in dismissal in connection with the business judgment rule when a complaint has adequately pleaded facts supporting a reasonable inference that the procedural protections were not put in place early and before the commencement of substantive economic negotiations.

Substantive economic negotiations existed. The court noted that, in mid-2015, EnCap began looking for ways to sell Bold and retained an investment banker to determine whether there was a market for sale. Earthstone was pursuing a number of acquisitions, which led to its interest in a transaction. Discussions went on for several months and a substantial amount of information was exchanged, the court stated. Earthstone management met with multiple investment banks, and the Earthstone board met several times to discuss the potential transaction. “While some of the early interactions could qualify as preliminary discussions,” the court explained, “the complaint support[s] a pleading stage inference that the preliminary discussions transitioned to substantive economic negotiations when the parties engaged in a joint exercise to value Earthstone and Bold.” The MFW procedural protections and the involvement of the special committee were not put in place until after almost eight months of substantive economic dealings and negotiations concerning of the financial play between the among the parties, the court found.

“MFW protections must be established ‘up front’ if they are to serve as a ‘potent tool to extract good value for the minority,’” the court stated, and Synutra clarified that MFW is not satisfied if a controller has not accepted that a transaction will not move forward without special committee and disinterested stockholder approval “early in the process and before there has been any economic horse trading.”

Further rejecting the defendants’ argument that EnCap was no longer a controller by the time of the transaction, the court reversed the Chancery Court’s dismissal of the claims for breach of fiduciary duties and remanded for consideration of the application of Synutra. The court did, however, affirm dismissal of the complaint’s disclosure claim, noting that the proxy disclosed financials showing that Bold was “distressed and needed to sell.”

The case is No. 392, 2018.

Monday, April 08, 2019

Amazon must allow proposals on facial recognition technology and hate speech

By Mark S. Nelson, J.D.

The staff of the SEC’s Division of corporation finance stated that, Inc., may not exclude a pair of shareholder proposals on facial recognition technology from its proxy materials. The proponents had raised concerns about the potential for misuse of facial recognition technology and the impact such misuse may have on civil and human rights. SEC staff later declined to reconsider its conclusion that the proposals may not be excluded; Amazon had argued, in part, that facial recognition policy should be left to Congress. In March, a bipartisan group of senators proposed legislation that would address privacy worries surrounding facial recognition technology. As for other recent Amazon shareholder proposals, CorpFin staff said the company may not omit from its proxy materials a proposal on hate speech and offensive products, but it may omit proposals on general social issues.

Amazon’s Rekognition service. According to a letter from Amazon’s counsel, Gibson Dunn, Amazon’s Amazon Web Services (AWS) includes a machine learning unit that created Amazon Rekognition to perform a variety of services for customers who pay for access to the cloud-based service. The company’s letter explained that Rekognition exists “to help identify objects, people, text, scenes, and activities, as well as to detect inappropriate content” (footnote omitted). Amazon said Rekognition launched in 2016 and has been used for numerous law enforcement and commercial purposes, including the identification of “public figures who are speaking at large events or live on-air” and to combat human trafficking and child exploitation. Other uses cited by Amazon include creating childrens’ educational apps and allowing users to search for their celebrity look-alikes.

As the proponent’s analysis observed, the ACLU claimed to have discovered flaws in Rekognition, which the ACLU said misidentified 28 members of Congress. For its part, Amazon has defended its technology. For example, Dr. Matt Wood, general manager of artificial intelligence at AWS, blogged last year that Rekognition is just one of several facial recognition services available from different providers and he asserted that no reports exist that Rekognition had been misused by law enforcement. He also suggested that technology invariably brings risks and that responsible use is the key. “But we believe it is the wrong approach to impose a ban on promising new technologies because they might be used by bad actors for nefarious purposes in the future. The world would be a very different place if we had restricted people from buying computers because it was possible to use that computer to do harm,” said Wood.

The facial recognition proposals. Amazon received two proposals on its facial recognition technology. One proposal submitted by the Tri-State Coalition for Responsible Investment asks Amazon’s board to ban the sale of such technology to governments unless the board conducts an investigation and concludes that independent evidence shows the technology does not aid civil and human rights violation. Another proposal submitted by John C. Harrington asks Amazon’s board to commission an independent study of Amazon’s Rekognition technology and to issue a report addressing three items: (1) the danger of the technology to privacy and civil rights; (2) the extent to which the technology is marketed or sold to foreign governments; and (3) the financial and operational risks inherent in the technology.

CorpFin staff concluded that Amazon could not exclude the twin proposals on the basis of the economic relevance exception, the ordinary business exception, or because of duplication of proposals:
  • Economic relevance exception—The economic relevance exception contained in Exchange Act Rule 14a-8-(i)(5) allows for exclusion if the proposal is not significantly related to the company’s business (i.e., less than 5 percent of total assets, net earnings, and gross sales, respectively). The proponent asserted that Amazon’s facial recognition component of Amazon Web Services could reach $23 billion; the proponent also cited concerns the company could experience a “spillover effect” to Alexa and other products if consumers come to distrust the company. Amazon, by contrast, sought exclusion because Rekognition was just one of 165 AWS services, Rekognition’s financials fall below the numerical thresholds of the economic relevance exception, and the proponent had couched its claims about misuse of the technology as merely “potential” issues. SEC staff rejected this basis for exclusion.
  • Ordinary business exception—Under the ordinary business exception in Exchange Act Rule 14a-8-(i)(7), exclusion is permitted if the proposal deals with a matter relating to the company's ordinary business operations. CorpFin staff said Amazon could not invoke this basis for exclusion. The proponent argued that, although Amazon was not obligated to issue an opinion on the matter, the company’s argument for exclusion sidestepped Staff Legal Bulletin 14I’s opportunity to provide such response. The proponent also decried Amazon’s “break-then-fix” business model and noted the high public visibility of concerns about facial recognition technology, including an Amazon spokesperson’s call for regulations, all of which suggest the proposal transcends Amazon’s ordinary business. Amazon claimed there was an insufficient nexus between the policy issue and the company’s business to invoke the significant policy exception under Rule 14a-8-(i)(7) because the proposals address only potential misuse by Amazon customers, something that would violate Amazon’s user agreements on acceptable use, so the proposals would not transcend the company’s ordinary business.
  • Duplication—Exchange Act Rule 14a-8-(i)(11) permits exclusion of a shareholder proposal if the proposal would be duplicative of a previously submitted proposal that will be included in the company’s proxy materials. According to CorpFin staff, Amazon may not exclude the Harrington proposal on this basis. The proponent argued that, although multiple proposals exist, they actually are distinct rather than duplicative because one focuses on stopping sales to governments (prohibition) while the other focuses on social issues regarding facial recognition technology (disclosure). Amazon had argued that the TriSate proposal arrived first, so the Harrington proposal was duplicative; the company also had stated that it planned to include the TriState proposal if the staff disagreed with its other bases for excluding it. 
Congressional action on facial recognition. The Commercial Facial Recognition Privacy Act of 2019 (S. 847), introduced in March 2019 and co-sponsored by Sen. Brian Schatz (D-Hawaii) and Sen. Roy Blunt (R-Mo), would limit the use of facial recognition technology by making it unlawful for a “controller” to knowingly use the technology to collect facial recognition data without first obtaining an end user’s “affirmative consent” and, to the extent possible, providing notice that the technology is present along with documentation stating the capabilities and limits of the technology. A controller also would be prohibited from using the technology to discriminate in violation of federal and state law, using the technology for any purpose not disclosed to end users, and sharing facial recognition data without affirmative consent that is separate from the end user’s initial consent.

The Federal Trade Commission would be the primary regulator enforcing the proposed Act. However, state attorneys general and certain other state officials could bring civil suits on behalf of state residents, although the FTC could intervene in these suits.

“Our faces are our identities. They’re personal. So the responsibility is on companies to ask people for their permission before they track and analyze their faces,” said Sen. Schatz, ranking member of the Senate’s Subcommittee on Communications, Technology, Innovation, and the Internet. Committee member Blunt noted that the bill would give consumers choices. “That’s why we need guardrails to ensure that, as this technology continues to develop, it is implemented responsibly. This bill increases transparency and consumer choice by requiring individuals to give informed consent before commercial entities can collect and share data gathered through FR,” said Sen. Blunt in a separate press release.

In February 2019, before the Commercial Facial Recognition Privacy Act was introduced, an Amazon blog post by Michael Punke, vice president of global public policy at AWS, said the company welcomed a “national legislative framework” that would protect civil rights and ensure government transparency, while suggesting that “outside groups” that obtained false results from Rekognition may have used the service incorrectly. Punke also suggested five criteria for using facial recognition technology: (1) follow the law; (2) law enforcement should employ human review of images and not allow for an “automated, final decision;” (3) law enforcement should use the 99 percent confidence threshold and use facial recognition as only one factor in investigations; (4) law enforcement should ensure transparency in its use of facial recognition technology; and (5) notice should be given when video surveillance and facial recognition are used together in public or commercial spaces.

Hate speech and offensive products. CorpFin staff also recently issued responses to Amazon requests to exclude additional shareholder proposals. In one matter, the proponent asked Amazon to report on how it handles hate speech and the sale of offensive products. Amazon had argued that the proponent failed to meet the eligibility requirements (continuous ownership of shares) and that the proposal was nevertheless excludable under the ordinary business exception (deals with product selection). Amazon also said: “Under the processes outlined above, the Company has removed hundreds of thousands of product listings from its stores during the past 12 months, including products that promote, incite, or glorify hatred, violence, racial, sexual, or religious intolerance or promote organizations with such views.” CorpFin staff, however, said the proponent appeared to have met the eligibility requirements of Exchange Act Rules 14a-8(b) and 14a-8(f), while also noting that the proposal focused on an issue that is significant to Amazon for purposes of the ordinary business exception.

Excludable Amazon shareholder proposals. Moreover, the CorpFin staff concluded in two other instances that Amazon could exclude shareholder proposals under the ordinary business exception. One of these proposals called for the company’s board to annually report to shareholders on Amazon’s community impact. The proponent argued that the proposal dealt with the significant social policy of inequality, while Amazon countered that the proposal focused on the location of the company’s facilities, which Amazon said is part of its ordinary business. The SEC staff observed that the proposal was very general in nature and did not focus on an issue that transcended ordinary business. A second proposal also could be excluded under the ordinary business exception because it too was too general in nature. The proponent had called for Amazon’s board to create a committee on “societal risk oversight.”

Friday, April 05, 2019

Chairman Giancarlo advances his vision for global derivatives regulation in his final European tour as CFTC leader

By Brad Rosen, J.D.

In one of his final speeches to European counterparts at the Eurofi Financial Forum, CFTC Chairman J. Christopher Giancarlo articulated a framework for global financial regulators in a speech titled A New Vision For EU-US Regulatory and Supervisory Cooperation for Derivatives Markets.

The chairman’s remarks centered around his core assertion that regulatory cooperation between European and U.S. policymakers is a priority that ensures financial markets continuing to support the growth of mature market economies and increased prosperity for its citizens. Failing to cooperate, Giancarlo observed, “will stunt the efficiency of our markets, producing fragmentation and denying our firms, businesses and farms the necessary capital and risk hedging tools needed to increase productivity . . ."

In somewhat of a departure from the Trump Administration’s hostility and reservations regarding international commitments and cooperative undertakings, the chairman expressed his unbridled optimism that the U.S. and Europe, by working together “can show the rest of the world the benefits of free and open markets underpinned by sound regulation and strong enforcement.”

Addressing historical difficulties. Chairman Giancarlo also recognized Europe and the U.S. have not always found it easy to cooperate on matters of financial regulation, and conceded that some fault may rest with the CFTC. Specifically, the chairman admitted that the CFTC could have been seen to have started the current rift in cross-Atlantic swaps cooperation with its 2013 cross-border guidance which imposed CFTC transaction rules on swaps traded by U.S. persons even in jurisdictions committed to implementing G-20 swaps reforms.

Giancarlo acknowledged that this approach alienated many overseas regulatory counterparts and squandered important American leadership and influence in global reform efforts. The chairman identified the steps he has taken as chairman to address the CFTC’s expansive approach to applying its swaps rules to cross-border activities, and the detailed program he has laid out to remedy the errors of past policies.

The time has come to rebuild trust. The chairman also shed light on some measures taken and efforts towards increasing transparency and rebuilding trust among regulators in the U.S., Europe and Asia. These include:
  • issuing detailed white papers laying U.S. leadership’s views on the regulation of swaps execution facilities, the effectiveness of the CFTC’s implementation of the Dodd-Frank Act, and cross-border policies. One purpose of these white papers is to inform global regulatory counterparts of the direction of U.S. policies and the principles upon which that direction is set; and
  • the CFTC becoming an increasingly active, engaged and positive participant in international standards setting activities. Today, the CFTC participates in more international work streams than ever in its history. The agency is an active contributor to the International Organization of Securities Commissions (IOSCO), Financial Stability Board (FSB), and IOSCO’s joint work with the Committee on Payments and Market Infrastructures and Basel Committee on Banking Supervision. 
A commitment to shared principles. Chairman Giancarlo also pointed to a number of shared principles which serve as a key ingredient to successful regulatory and supervisory cooperation. These include:
  • a commitment to market-based solutions. When facing common regulatory challenges, the U.S. and Europe should see how its rules and policies can help make the markets work better and more efficiently;
  • a commitment to open markets and competition. Both European and U.S. policymakers have a common interest to make its respective markets the most effective places to trade and to do business; and
  • a commitment to outcomes-based deference. That can be through equivalence and recognition decisions or through substituted compliance orders and exemptions. In the chairman’s view, this is the only rational way to ensure that jurisdictional rules can work constructively to provide sound regulation for cross-border trade, investment and risk mitigation. 
Difficult challenges remain. While expressing a generally optimistic outlook for the future relations among financial regulators, Giancarlo was also mindful of considerable obstacles and challenges confronting regulators in the global arena. Some of the chairman’s concerns include:
  • The European position with respect to EMIR 2.2, and the longtime unwillingness by the European Commission to acknowledge any commitment to the 2016 agreement between the CFTC and EC on CCPs;
  • Insulating market regulation from politics. Market regulation must focus on investor protection, the safety and soundness of market utilities, and the efficiency of trading markets. When, instead, domestic politics determines regulatory priorities, and interferes with the operation of the market—then cross border regulatory and supervisory cooperation is challenged. According to Giancarlo, regulatory cooperation works best when it is conducted free of political considerations;
  • The need for honest and frequent communication among regulators. The chairman noted that much depends on the day-to-day relationship of the people who serve the different authorities, and the need to be honest brokers and truthful interlocutors. In his view, when these elements are not present, cooperation has little chance. 
In closing, Chairman Giancarlo summarized that he looks toward to a future where Europe and the U.S. grow markets that support prosperity and encourage innovation, and which include the shared principles of market-based solutions, healthy competition and regulatory deference.

Thursday, April 04, 2019

SEC staff advises on ‘investment contract’ analysis for digital assets, grants relief to company selling tokens for services

By Amy Leisinger, J.D.

The SEC's Strategic Hub for Innovation and Financial Technology (FinHub) and Division of Corporation Finance have issued a framework for market participants to consider in assessing whether a digital asset is offered or sold as an investment contract and, thus, is a security. The framework is not intended to provide an exhaustive overview, but rather, an analytical tool to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a digital asset. Separately, CorpFin issued a response to a no-action request, indicating that it would not recommend enforcement action to the Commission if a charter flight company uses a blockchain and creates digital assets to facilitate payment for air travel without registration.

“As financial technologies, methods of capital formation, and market structures continue to evolve, market participants should be aware that they may be conducting activities that fall within our jurisdiction,” said CorpFin Director Bill Hinman and FinHub Senior Advisor Valerie Szczepanik.

“Investment contract” considerations. The framework advises those considering engaging in the offer, sale, or distribution of a digital asset to consider whether the digital asset is a “security” under the federal securities laws. The Supreme Court’s decision in SEC v. W.J. Howey Co. found that an “investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. The “investment of money” prong of the test is usually satisfied in an offer and sale of a digital asset because it is typically acquired in exchange for value, and a common enterprise also normally exists given the group of participants involved, according to the framework.

Where the main issue arises in a Howey analysis of digital assets is whether a purchaser has a reasonable expectation of profits derived from the efforts of others, the framework explains. A purchaser may expect to realize a return through participating in distributions or realizing appreciation on the asset, and when a promoter or sponsor provides essential managerial efforts that affect the success of the enterprise and lead to an expectation of returns, this prong of the Howey test is met. However, the focus should be on the manner in which the digital asset is offered and sold and on the transaction as a whole, according to the framework.

When considering whether there is reliance on the efforts of others, a participant should evaluate whether required efforts are significant as opposed to more ministerial and whether it is responsible for the development, improvement, or operation of the network or the digital asset. Other relevant considerations include whether the participant supports the market or price for the digital asset and whether investors would reasonably expect it to undertake efforts to promote its own interests and enhance the value of the network or digital asset. These issues may need to be reevaluated in later offers or sales, the framework notes.

In analyzing whether a reasonable expectation of profits exists, a participant also should consider whether the digital asset gives a holder the right to share in the enterprise’s profits or to realize gain from capital appreciation and whether it is offered broadly to potential purchasers compared to being targeted to expected users of the goods or services, according to the framework. Among other things, a participant also should evaluate whether there is a correlation between the purchase price of the digital asset and the market price of the particular goods or services that can be acquired with it, the framework explains.

When assessing whether there is a reasonable expectation of profit derived from the efforts of others, the framework notes that courts look to the economic reality of the transaction, including whether the digital asset is offered and sold for use or consumption by purchasers. It is less likely that the Howey test is met when holders are immediately able to use the digital asset for its intended purpose on the network or the digital asset is designed to meet the needs of a user, rather than to feed speculation as to its value, according to the framework. However, even in cases where a digital asset can be used to purchase goods or services on a network, there may be a securities transaction if, among other things, the digital asset is offered or sold at a discount to the value of the goods or services or in quantities that exceed reasonable use.

The framework notes that it is not a rule, regulation, or statement of the Commission and does not modify or replace any existing applicable laws or regulations.

No-action relief. Separately, the Division of Corporation Finance concluded that it would not object if TurnKey Jet, a provider of air-charter services, develops a token platform to facilitate token sales for air-charter services via a private blockchain network without registration. Under the program, consumers would redeem purchased tokens for air-charter services from TurnKey or other brokers on the system. The tokens would be smart contracts between TurnKey and consumers with terms that obligate TurnKey to release token escrow funds to a broker or carrier to pay for services to token holders redeeming the tokens at their equivalent value for those services. “In short, the Tokens, Platform and Network will simply be an air charter services payment debit/credit system for large financial transactions,” according to TurnKey.

TurnKey acknowledged that because the purchase of tokens will require the payments of funds and because it will run the platform for managing the tokens and allowing transfer and redemption for services, an “investment of money” and a “common enterprise” may exist under the Howey test. However, TurnKey contends, the interest represented by a token will be a consumptive right to redeem the escrowed funds to pay for air-charter services, and there is no reasonable expectation of any profit on the part of any member, as consumers will have no right to a share of any income generated or to dividends, rewards, or other distributions. Consumers also will have no reasonable expectation of profit based on capital appreciation, TurnKey explains.

According to TurnKey, all marketing materials will say clearly state that the tokens should be purchased solely for the purpose of obtaining prepaid air-charter services and not for investment purposes or with an expectation of profits. Further, consumers will be required to acknowledge that the tokens are not being acquired as an investment, that they will have no equity interest in TurnKey, and that if tokens are transferred between them, they will not represent that the tokens involve an investment opportunity.

Based on TurnKey’s representations, the staff granted the requested relief.

Wednesday, April 03, 2019

ATB Coin is a ‘security’ under Howey test

By Amy Leisinger, J.D.

The Southern District of New York declined to dismiss a complaint against a technology start-up that offered digital assets through an unregistered initial coin offering. According to the court, the complaint established that the virtual currency at issue was an “investment contract” under the test set forth in SEC v. W.J. Howey Co. and, thus, a security under the federal securities laws because of “the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” The court also rejected the defendants’ contention that it lacked personal jurisdiction over them and appointed a lead plaintiff to represent the class (Balestra v. ATBCOIN LLC, March 31, 2019, Broderick, V.).

ICO. From June 2017 through September 2017, ATBCOIN conducted an ICO through which it offered digital ATB Coin to the general public in exchange for other digital assets. The primary purpose of the ICO was to raise capital to enable ATBCOIN and its co-founders to launch a new blockchain on which the ATB Coin would operate. In promotional materials, ATBCOIN and its co-founders stated that the ATB Blockchain would be “the fastest blockchain-based cryptographic network in the Milky Way galaxy,” and the value of the ATB Coins was expected to increase as more users adopted the ATB Blockchain. The ICO raised over $20 million from thousands of investors, and the blockchain was launched in September 2017. However, the ATB Blockchain was much less capable than advertised and failed to deliver many of the promised features. As a result of the poor performance, the value of ATB Coins has continuously decreased.

An ATB Coin holder filed a complaint alleging that ATBCOIN and its co-founders violated Securities Act Section 12(a) by offering and selling unregistered securities and that the co-founders are also liable for ATBCOIN’s violation as control persons. The defendants moved to dismiss, arguing that ATB Coin is not a security and that the court lacked personal jurisdiction.

ATB Coin is a security. Under the Howey test, the determination of whether a particular offering involves an investment contract (and, thus, a security) turns on whether there is an investment of money in a common enterprise with an expectation of profits to be derived from the efforts of others. The court noted that a plaintiff may demonstrate a “common enterprise” by pleading the existence of “horizontal commonality,” meaning that “‘the fortunes of each investor in a pool of investors’ are tied to one another and to the ‘success of the overall venture.’” The funds raised through the ICO were pooled to facilitate the launch of the ATB Blockchain, which, if successful, would increase the value of ATB Coin, the court stated.

In addition, according to the court, the complaint sufficiently pleaded that the value of ATB Coin was entirely dependent on the defendants’ success in launching the ATB Blockchain. Although ATB Coin purchasers had control over their coins, the court explained, they had no control over the development of the ATB Blockchain and relied on ATBCOIN and its co-founders to successfully launch it and thereby increase the value of ATB Coin. As such, the court found, the complaint plausibly alleged facts demonstrating that the ATB Coin qualifies as an “investment contract” under the Howey test.

The court also found that the complaint adequately alleged that the co-founders can be held both primarily liable and liable as control persons for ATBCOIN’s unregistered ICO. The individual defendants were personally involved in publicizing the ICO and engaged in specific efforts to pitch ATB Coin to potential investors. Further, the court stated, as the sole members and officers of ATBCOIN, they stood to directly benefit from sales of ATB Coin. The individual defendants’ leading roles in promoting ATBCOIN’s lone product are sufficient at the dismissal stage to establish their status as control persons under the Securities Act, the court concluded.

Other issues. The court also declined to dismiss the complaint on the ground that it lacked personal jurisdiction over the defendants. The claims arise under the Securities Act, which authorizes nationwide service of process, the court stated. Moreover, according to the court, the complaint provided “ample evidence” that the individual defendants targeted the U.S. market in promoting the sale of ATB Coin, including a press release stating that they had attended a conference in New York regarding the launch of ATB Coin. “Given their substantial suit-related conduct in the United States,” the court found, exercising jurisdiction over the individual defendants would not offend due process.

Finding that the complainant established his large financial interest in the litigation and otherwise meets applicable Rule requirements and that and no party has rebutted his claim to be the most adequate plaintiff, the court appointed him as lead plaintiff and approved his selection of Levi & Korsinsky, LLP as lead counsel.

The case is No. 17-CV-10001 (VSB).