Friday, February 23, 2018

SEC extends compliance date for open-end fund liquidity classification

By Anne Sherry, J.D.

The SEC added six months to the deadline by which open-end funds must comply with classification-related elements of the liquidity risk management program rule. The new compliance dates are June 1, 2019, for larger fund groups, and December 1, 2019, for smaller fund groups. The other requirements of the liquidity rule will hew to the original schedule of December 1, 2018, and June 1, 2019, for larger and smaller groups, respectively. Staff in the Division of Investment Management also issued an additional set of FAQs to address questions that have arisen with respect to liquidity classification (Release No. IC-33010, February 22, 2018).

Liquidity risk management. In October 2016, the Commission approved Rule 22e-4 to require open-end management investment companies to adopt LRM programs that include classifications of the liquidity of portfolio assets and to conduct periodic evaluations of liquidity risk. The final rule provides four liquidity time-frame categories and requires reporting of the percentage of each classification on a quarterly basis. The changes require enhanced disclosure regarding fund liquidity and redemption practices, and funds must periodically review whether assets have become illiquid over time. The rule excludes money market funds from all requirements and ETFs that qualify as "in-kind ETFs" from certain requirements.

FAQs. Investment Management’s work on the FAQs adds 19 questions to the 15 that were issued last month. The new guidance addresses asset class liquidity classification; reasonably anticipated trading size; price impact standard; classifying investments in pooled investment vehicles; professional investment classification and compliance monitoring; timing and frequency of classification; pre-trade activity and the 15 percent illiquid investment limit; related reporting requirements; and ETF investment classification.

For example, the staff recognized that highly sensitive exception methodologies for funds using an asset class method of investment classification may result in too many false positives, undermining the balance the Commission sought in permitting class-based classification. Funds should include in their policies and procedures a reasonable framework for identifying exceptions, which may rely on automated processes. The fund need not justify every classification on a CUSIP-by-CUSIP basis, and potential exceptions are not necessarily required to be reclassified.

In determining reasonably anticipated trading sizes for portfolio investments and asset classes, a fund need not predict which specific portfolio positions it will sell or consider actual trades executed for reasons other than meeting redemptions, nor does it need to predict its future portfolio management decisions relating to meeting redemptions. As to the price impact standard, funds retain the flexibility to establish the meaning of what constitutes a “significant change in market value” in their policies and procedures. This includes the flexibility to use a fixed number or use different standards for different investments or asset classes.

The rule does not specify when a fund must make the initial classification of a newly acquired investment, but requires at least monthly reviews of classification status. Investment Management staff would not object if a fund waits until its next regularly scheduled monthly classification to classify a newly acquired investment or consider an investment for reclassification. Moreover, funds are required under the rule to conduct intra-month reviews of an investment’s liquidity classification when a fund becomes aware of changes in relevant market, trading and investment-specific considerations that are reasonably expected to materially affect an existing classification of that particular investment. The staff does not see this as a de facto ongoing review requirement and would not object if a fund complied by identifying in its policies and procedures events that it reasonably expects would materially affect an investment’s classification.

A fund is not required to classify an investment or conduct related compliance monitoring before acquiring that investment. For purposes of the 15 percent illiquid investment limit, a reasonable method of compliance with respect to acquisitions would be to preliminarily identify asset classes or investments the fund reasonably believes are likely to be illiquid. The staff believes funds could automate such a preliminary evaluation of asset classes or investments, and they could base that evaluation on the general characteristics of the investments the fund purchases. While it would not be reasonable to assume a fund is only selling a single trading lot, the fund could use any reasonable method to evaluate the market depth of the asset classes or investments it preliminarily identifies as likely being illiquid.

This is Release No. IC-33010.

Thursday, February 22, 2018

Updated cybersecurity guidance addresses policies and procedures, insider trading

By Jacquelyn Lumb

The SEC has issued new interpretive guidance relating to registrants’ cybersecurity disclosure obligations under the federal securities laws. The guidance updates the interpretive release issued in 2011, elevates it from the staff to the Commission level, and includes two new topics about the importance of cybersecurity policies and procedures and the application of insider trading prohibitions in the cybersecurity context. Chairman Jay Clayton issued a statement in which he urged public companies to examine their controls and procedures, not only with their securities law requirements in mind, but also the reputational considerations around the sales of securities by executives. The guidance is effective upon publication in the Federal Register (Release No. 33-10459, February 21, 2018).

Given the frequency, magnitude, and cost of cybersecurity incidents, the guidance notes that it is critical that public companies take all required actions to inform investors about material cybersecurity risks in a timely fashion. In order to make the required disclosure, the guidance advises that disclosure controls and procedures should provide a method for determining the impact on a company’s business, financial condition, and results of operations.

Risk of insider trading. The guidance also warns that officers, directors, and other corporate insiders must not trade a public company’s securities while in possession of material nonpublic information, which may include knowledge about a significant cybersecurity incident. Public companies should have policies and procedures to guard against insiders taking advantage of the time between the discovery of a cybersecurity incident and the public disclosure of the incident.

Selective disclosure. The guidance also reminds companies to refrain from making selective disclosure of material nonpublic information about cybersecurity risks or incidents. The Commission considers omitted information material if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision or if the disclosure of the omitted information would have been viewed by the reasonable investor to have significantly altered the total mix of information that was available.

Delays in disclosure. A company is not expected to make detailed disclosures that could compromise its cybersecurity efforts, but it must disclose risks and incidents that are material to investors, including the potential financial, legal, or reputational consequences. The SEC recognizes that it may take some time to determine the full implications of an incident and it may be necessary to cooperate with law enforcement, which could affect the scope of the disclosure. The guidance added, however, that an ongoing internal or external investigation would not on its own provide a basis for avoiding the disclosure of a material cybersecurity incident.

Duty to correct. Companies also have an obligation to correct any disclosures that subsequently are determined to be untrue at the time they were made, so they should consider revisiting previous disclosure while investigating a cyber incident.

Unanimous approval, with reservations. The SEC had originally scheduled an open meeting for February 21, 2018 at which the cybersecurity guidance was to be considered. However, the commissioners unanimously approved its adoption seriatim on February 20. Commissioner Robert Jackson issued a statement that his support was given reluctantly. Jackson said he hoped the guidance was just the first step in countering those who use technology to threaten our economy. He noted that the effectiveness of the 2011 staff guidance has frequently been questioned, and that many have raised concerns about under-reporting due to differing interpretations of materiality.

Commissioner Kara Stein also released a statement in which she noted that during a roundtable discussion on cybersecurity issues, a number of participants criticized cybersecurity disclosure because it was mostly boilerplate language that did not provide meaningful information to investors. She expressed disappointment in the Commission’s limited action in issuing the guidance.

While the updated guidance may provide valuable reminders since the 2011 guidance and raises it to the Commission level, she questioned whether it would actually help companies provide investors with “comprehensive, particularized, and meaningful disclosure about cybersecurity risks and incidents,” and concluded that it likely would not. She said there is so much more the Commission could have done, including engaging in rulemaking rather than mere guidance.

Wednesday, February 21, 2018

Federated urges elimination of bucketing reqs in liquidity risk management rule

By Amy Leisinger, J.D.

In comments on the SEC’s new liquidity risk management rule, Federated Investors, Inc. urged the Commission to re-propose Rule 22e-4 to eliminate the bucketing framework and related portfolio-level liquidity disclosures. Instead, Federated recommended adoption of a more principles-based regime to enable advisers to provide liquidity risks estimates in connection with both normal and stressed market conditions based on more practical liquidity assessments.

Liquidity risk management. In October 2016, the Commission approved Rule 22e-4 to require open-end management investment companies to adopt liquidity risk management programs that include classifications of the liquidity of portfolio assets and to conduct periodic evaluations of liquidity risk. The final rule provides four liquidity time-frame categories and requires reporting of the percentage of each classification on a quarterly basis. The changes require enhanced disclosure regarding fund liquidity and redemption practices, and funds must periodically review whether assets have become illiquid over time. The rule excludes money market funds from all requirements and ETFs that qualify as “in-kind ETFs” from certain requirements.

The Commission delayed implementation of the reporting obligations under the rule late last year to further review potential issues with the reporting process.

Further review, new requirements. In a rulemaking petition, Federated opines that, as it completes its review, the Commission also should consider new evidence that the disclosure requirements of Rule 22e-4 may have unanticipated consequences. The public disclosure mandate is designed to alert investors to potential liquidity risks in stressed market conditions, but the current bucketing requirements under the rule could inadvertently lead to dissemination of false or misleading information and cause investors to underestimate true liquidity risk.

The current process requires an adviser to consider reasonably foreseeable stressed market conditions and related redemptions, determine how a portfolio holding would be sold to meet redemptions without significantly harming remaining shareholders and assign each holding to one of the four liquidity buckets, and disclose the results to the Commission and shareholders. In making the assessments, SEC guidance directs an adviser to use current market conditions for the expected transaction costs, not transaction costs that reasonably could be expected to prevail during periods of market stress. This difference could result in an understatement of liquidity risks in disclosures, according to the petition.

As such, Federated recommends re-proposal of Rule 22e-4 to eliminate the “onerous and defective” bucketing regime in favor of simpler, more reliable liquidity metrics governed by a principles-based framework. Proposed methods should enable advisers to provide realistic liquidity risk estimates with regard to both normal and stressed conditions, the firm concludes.

Tuesday, February 20, 2018

SEC’s Jackson questions rationale for dual-class ‘forever shares’

By Mark S. Nelson, J.D.

New SEC Commissioner Robert Jackson hit the ground running in his first substantive speech as a commissioner by taking on the topic of the proliferation of companies that have adopted dual-class share structures. Jackson’s speech in San Francisco at a Silicon Valley event on M&A, antitrust, and governance issues comes at a time when initial public offerings (IPOs) have become scarcer and an abundance of private capital allows growing start-ups to remain private longer, thus giving the founders of some companies that do go public the leverage to demand share structures that may protect their jobs. For Jackson, though, the question is one of how long a company should retain a dual-class structure post-IPO rather than a debate about the merits and demerits of such structures. He said the outcome of the debate over dual-class structures may have long term implications for Main Street investors.

Control vs. accountability. Jackson observed that dual-class structures can benefit newly public companies by giving their founders the freedom to shape a growing business without immediate external demands for outsized results. But he suggested that that the benefits of dual-class structures diminish over time and may conflict with American notions of fairness in both politics and business.

Jackson likened dual-class structures to the aristocratic traditions eschewed by America’s founders. The perpetual or “forever” variant of the dual-class structure, he noted, could result in a company’s founders’ offspring controlling a company for generations regardless of their business acumen and without an effective mode to hold them accountable for company performance.

According to Jackson, the trend toward adoption of dual-class share structures has increased among public companies since 2005 (one percent) and 2015 (14 percent). Still, Jackson said the larger question is whether a public company with a dual-class structure should retain that structure forever. He noted that half of all public companies adopting dual-class structures during the last 15 years were on the forever track.

Jackson also said some stock indexes have already sought to limit the inclusion of companies with dual-class share structures. He urged exchanges to likewise mull proposals to deal with dual-class share structures. Jackson suggested the impact of dual-class structures on Main Street investors, absent some limits, could be significant over time because of the market share held by dual-class companies. In an appendix to his speech, Jackson cited data compiled by Capital IQ showing that, as of just over a week ago, there were 852 publicly-traded, U.S.-incorporated companies with dual-class structures representing $5.1 trillion in market capitalization (See appendix, n. 3; more on Jackson’s appendix below).

A tale of two valuation trends. Unlike many SEC commissioners, who might cite outside studies or the work done by the SEC’s Division of Economic and Risk Analysis, Jackson and his staff “ran the numbers” and obtained “preliminary” data on the impact of dual-class share structures on public company valuations over time. Jackson said the results suggested that while dual-class structures can help a newly public company, the benefits often decrease and the company’s valuation begins to lag versus its peers without dual-class structures or that have given them up.

For his study, Jackson examined 157 IPOs during the last 15 years. Of these companies, 71 had sunset provisions that would eventually end their dual-class share structures. However, a majority of the companies (86) did not provide for the sunset of their dual-class structures. According to Jackson, both groups of companies had comparable, predicted valuations for up to two years post-IPO. But by year seven post-IPO, these companies’ predicted valuations began to drift apart with companies that sunset their dual-class share structures outperforming companies that did not.

For those who wish to dig deeper into Jackson’s data, he offers an appendix on the methodology he employed and a spreadsheet containing the data he analyzed. In the methodology appendix, one table stands out beyond the other charts showing a divergence in predicted valuations between companies with perpetual and non-perpetual dual-class structures. Table A.1 shows dual-class IPOs from 2001 to 2016 and indicates whether the dual-class structure was perpetual or subject to a sunset. In 12 of the 16 years depicted, 50 percent or more of dual-class IPOs were of the perpetual variety; overall, 55 percent of the 157 dual-class IPOs reviewed involved perpetual structures.

Two footnotes to Jackson’s speech (Nos. 22 and 23) also suggest some caveats. For one, he appeared to counter the possible objection that he compared only variants of dual-class share structures (perpetual versus sunset) rather than comparing perpetual dual-class structures to single-class structures; Jackson explained that the latter comparison could overlook key, uncontrollable differences. Moreover, in the context of companies enjoying better valuations after they abandoned dual-class structures, Jackson cautioned that the results of his analysis did not necessarily mean that there is a causal relationship between lower valuations and dual-class share structures. Still, Jackson said his review of IPOs suggests an association between perpetual dual-class structures and lower valuations.

Monday, February 19, 2018

Iowa proposes BD merger exemption, IA business succession rule

By Jay Fishman, J.D.

The Iowa Insurance Division has proposed the following amendments and additions to its securities rules:
  • Adds a merger acquisition exemption from licensing for qualified broker-dealers; Iowa adopts the NASAA model rule’s merger acquisition broker exemption; 
  • Changes its business continuity and succession plan rule for investment advisers from a licensing to an examination requirement; 
  • Mandates the use of NASAA’s Electronic Filing Depository (EFD) for unit investment trust notice filings under federal Securities Act Section 18(b)(2), starting January 1, 2019; 
  • Amends its intrastate crowdfunding exemption to bring it up-to-date with more current state requirements; 
  • Adds FINRA’s Securities Industry Essential Exams to the written examination requirement for investment adviser representatives; and 
  • Updates federal Advisers Act references in its private fund adviser exemption. 
Public comments and hearing. Interested persons may mail written comments about the rule proposals to Craig Goettsch at the Insurance Division, Two Ruan Center, 601 Locust, Fourth Floor, Des Moines, Iowa 50309. Comments may alternatively be emailed to or faxed to (515) 281-3059. Comments must be received by 4:30 p.m. on March 6, 2018, the date of the public hearing on the proposals at 10:30 a.m.

The anticipated effective date of the proposals is May 16, 2018.

Friday, February 16, 2018

Rescheduled TAC meeting worth waiting for

By Brad Rosen, J.D.

Commissioner Brian Quintenz led off the first meeting of the CFTC’s Technology Advisory Committee (TAC) in 22 months, noting the rapid evolution of technological developments in the derivative markets even since the committee’s last gathering in 2016. The TAC meeting, which was rescheduled due to the brief government shutdown in January, consisted of comprehensive and engaging discussions exploring five key areas impacting the global markets including digital ledger technology, virtual currencies, artificial intelligence, automatic trading, and cybersecurity.

Chief Innovation Officer Daniel Gorfine, who serves as TAC’s designated federal officer, oversaw the day’s proceedings which included presentations from some of the leading figures in derivatives and technology space. Commissioner Quintenz, the TAC sponsor, was also joined by his fellow commissioners, Chairman J. Christopher Giancarlo and Rostin Behnam. Some of the highlights and insightful observations that came out of the meeting follow.

2018 is the year digital ledger technology is about to get real. Charley Cooper, a managing director with R3, a company that leads a consortium of more than 70 of the world's largest financial institutions in the development of distributed ledger technology, sees commercial deployments of distributed ledger solutions taking hold in 2018. Cooper also implored U.S. regulators and governments to be intimately involved with regulated financial institutions as these markets and technologies continue to evolve.

The view from a regulator. CFTC Division of Market Oversight (DMO) Dan Busca responded favorably to Cooper’s call. He noted that providing the CFTC with a seat at the table will afford the agency the opportunity to provide input and minimize the burden of regulatory requirements. Specifically, Busca noted, “The evolution of DLT could allow regulators to access data automatically and seamlessly every time a trade is posted on a particular blockchain without the need for human intervention or intermediaries.” He added, "It could increase the speed and improve the reliability of data. Commission access could be incorporated into distributed ledgers of reporting parties.”

State regulation of the cryptocurrency ecosystem is inefficient and burdensome. Jerry Brito, a prominent voice in the crypto-regulation space and the executive director of Coin Center, noted the primary role of the states in regulating spot cryptocurrency markets, though their money licensing requirements, and the problems resulting from approach. He observed that firms must seek a license in every state in which they do business in, in which they have customers, and for an internet business that means every state. Brito noted a firm is made no safer to the consumers when it passes its 50th background check than when it passed its first. Brito also noted state by state money transmission licensing has no provision for market supervision or exchanges, which is increasingly of interest to federal policymakers.

Gary DeWaal, special counsel at Katten Muchin Rosenman, amplified these views and further warned of the dangers of regulatory proliferation. He noted that New York state came up with a bit license where six firms are regulated as limited purpose trusts effectively applying the bit license rules in New York state. He also observed the state recently expanded its requirements so as to deal with additional oversight, manipulation and fraud. DeWaal cautioned, “it's not like the bit license replaced the money transmitter requirements. It's both. And it's not like anyone is talking about implementation of this new virtual currency act replacing money transmitters.”

More promising, as noted by Brito, the uniform law commission has developed a uniform virtual currency business regulation act that is now being considered by several states. He concluded, “Unfortunately a state by state reform does not scale.”

Battle lines remain drawn over Regulation AT. Commissioner Behnam stated that he was pleased that the TAC plans to resuscitate at least some of Regulation AT (Reg AT), noting that the Commission issued proposals in both 2015 and 2016 to establish pre-trade risk controls in an effort to mitigate the potential dangers of an unchecked automated trading system. Benham asserted that it is vitally important that the Commission take immediate action on Reg AT before an automated trading system that runs amok causes harm to market participants. On this point, he concluded, “the question of a market event, flash crash or otherwise, is not if, but when.”

While not specifically responding to Commissioner Behnam’s comments, Bryan Durkin, president of the CME Group, set forth a vigorous and impassioned defense of the CME’s active measures and protocols to address risk, volatility and potential disruptions. He noted, “These protocols include global credit controls, price spanning, price order quantities, messaging controls, stop logic functionality, such as circuit breakers, price protection points and kill switches.” Durkin continued, “Our credit controls, which every clearing firm utilizes, includes mechanisms such as order blocking, order cancellations, automated email notifications, and these can be set at various levels and thresholds.”

More to come. During the course of the TAC meeting, the committee members approved the creation of four subcommittees covering Blockchain developments, virtual currency regulation, automated trading technologies, and cybersecurity. Accordingly, it appears that there will be more to come from TAC under the leadership of Commissioner Quintenz and Chief Innovation Officer Gorfine.

Thursday, February 15, 2018

European risk board offers recommendations to mitigate investment fund systemic risks

By John Filar Atwood

The European Systemic Risk Board (ESRB) issued recommendations to address the systemic risks related to liquidity mismatches and the use of leverage in investment funds. The recommendations, which are addressed to the European Securities and Markets Authority (ESMA) and the European Commission, focus on five areas where the ESRB sees a need for ESMA to provide supervisory authorities with needed guidance and/or for legislative changes to be made.

In drafting the recommendations, the ESRB took into account the existing international and European efforts in this area. The ESRB said in a news release that it considered a number of risks that may stem from the increasing role played by investment funds in financial intermediation and could result in the amplification of any future financial crisis.

Fire sales. In the ESRB’s view, mismatches between the liquidity of open-ended investment funds’ assets and their redemption profiles could lead to “fire sales” to meet redemption requests in times of market stress. This could affect other market participants holding the same or correlated assets, and may amplify the impact of negative market movements.

The ESRB believes that additional liquidity management tools and supervisory requirements, along with tighter liquidity stress testing practices can address risks from liquidity mismatches. The ESRB recommended making available to fund managers liquidity management tools such as the ability to impose redemption fees and to temporarily suspend redemptions.

In order to prevent excessive liquidity mismatches at open-end alternative investment funds (AIFs) holding a large amount of less liquid assets, the ESRB suggested requiring those funds to show supervisors that they would be able to maintain their investment strategy under stressed market conditions. The ESRB also recommended that ESMA develop further guidance on how fund managers should carry out liquidity stress tests to help reduce liquidity risk and strengthen the ability of entities to manage liquidity in the best interests of investors.

Harmonized reporting. The ESRB stated that risks from leverage can be addressed by creating a harmonized reporting framework and by making better use of existing possibilities to set leverage limits. It recommended establishing a harmonized reporting framework across the EU for undertakings for collective investment in transferable securities.

The ESRB also suggested that ESMA should develop guidance to help supervisory authorities assess leverage risks in the AIF sector, and design and implement macroprudential leverage limits. In the ESRB’s opinion, the guidance would facilitate the implementation of Article 25 of the EU Alternative Investment Fund Managers Directive, which provides a macroprudential tool to limit leverage in AIFs.

Wednesday, February 14, 2018

Payton, Durant insider trading verdict upheld

By Mark S. Nelson, J.D.

The Second Circuit issued a summary order upholding a district court jury verdict holding Daryl Payton and Benjamin Durant liable for insider trading. The court rejected claims by Payton and Durant that the SEC failed to prove the breach of a duty of confidentiality and rebuffed arguments that they deserved a new trial because of other trial irregularities (SEC v. Payton, per curiam, February 13, 2018).

The case arose when an associate at a large law firm handling IBM’s acquisition of SPSS, Inc. told a friend about the pending deal; that friend then told a broker who in turn told Payton of the deal. Durant also learned of the IBM-SPSS deal. According to the summary order, Payton admitted at trial that he and Durant bought short-term options in SPSS. Both Payton and Durant profited handsomely from the trades: Payton received nearly $244,000 and Durant received more than $606,000.

Verdict stands. Payton and Durant argued that they were entitled to judgment as a matter of law because a reasonable juror could not find for the SEC. Specifically, Payton and Durant cited a text message from the law firm associate’s friend for the proposition that that friend owed no duty of confidentiality to the law firm associate. The law firm associate’s friend and the broker also testified that benefits received by the associate’s friend from the broker had nothing to do with the SPSS tip. Moreover, Payton testified that deal rumors are common and that the broker was inexperienced such that Payton and the other defendants did not consciously avoid discovering the source of the SPSS tip.

But the court, applying a de novo standard of appellate review, said the jury could have inferred that the law firm associate never intended for his friend to trade on or share confidential information, that the friend had a duty to the associate, that the broker’s email attempt to help the associate’s friend with to deal with an arrest for destruction of property could serve as a quid pro quo, and that the jury could infer Payton’s and the other defendants’ conscious avoidance based on their clandestine meeting at a hotel the day the IBM-SPSS deal was announced for the purpose of hiding their trades.

Other alleged trial irregularities. The Second Circuit also quickly dispatched Payton’s and Durant’s arguments for a new trial based on their complaints about the jury instructions. The defendants had argued that the instruction told jurors they could find the law firm associate’s friend owed the associate a duty of confidentiality even if the associate intended for the friend to trade on the information. Instead, the court said the jury instruction was agnostic in that regard and simply, accurately stated the elements of the SEC’s claim.

As for the challenged evidentiary rulings, the court found no support for Payton’s and Durant’s arguments. In one instance, the court found that the defendants failed to lay the foundation for a possible hearsay exception for a declarant's then-existing state of mind. In another instance, the court concluded that the challenged evidence was either admissible as a statement against interest or that the evidence was not prejudicial.

The case is No. 17-290-cv.

Tuesday, February 13, 2018

Court denies settlement that secured ‘utterly useless’ disclosures

By Anne Sherry, J.D.

In a sometimes scathing opinion that could serve as a primer for the policy reasons against disclosure-only settlements in the M&A context, a New York state court rejected such a settlement. The court admonished plaintiffs’ counsel for conflating cases involving management projections (material) with those involving, as in the instant case, analyst projections (immaterial). “This case is not a close call,” the court wrote. “All of the supplemental disclosures are utterly useless to the shareholders” (City Trading Fund v. Nye, February 8, 2018, Kornreich, S.).

Disclosure settlement. In early 2015, the court denied preliminary approval of the settlement, calling it “disturbing” and highlighting “the modus operandi” of the plaintiffs and their counsel, the Brualdi Law Firm, of purchasing nominal amounts of shares in public companies and then suing when one of the companies announces a merger. City Trading Fund was an E*Trade brokerage account that owned 10 shares of Martin Marietta Materials, Inc., prior to the company’s merger with Texas Industries, Inc. To settle the disclosure lawsuit, MMM made some additional disclosures and agreed to pay Brualdi a $500,000 fee. As the 2018 decision explains, many shareholders vociferously opposed the settlement.

Delaware and New York authority. In the intervening three years following the 2015 decision, the Delaware Court of Chancery cracked down on disclosure-only settlements in Trulia and other decisions, while the Appellate Division of the New York Supreme Court adopted a more lenient settlement approval standard in Gordon v. Verizon Communications, Inc. Unlike Trulia, Gordon does not require the plaintiff to rule out all doubts as to the materiality of the new disclosures. Instead, in factoring in the best interests of the class, Gordon requires that the supplemental disclosures provide “some benefit” to shareholders. Whether or not Gordon was intending to mirror the Delaware standard for mootness fees, the only reasonable interpretation of “some benefit” is that the disclosures would aid a shareholder’s voting decision.

“Utterly useless” disclosures. In the end, however, the court’s task was made easier by the fact that it was not a close case; all of the supplemental disclosures were “utterly useless to the shareholders.” The new information comprised terse “tell me more” disclosures, third-party projections, disclosures of positions in Texas Industries held by large-bank shareholders, and a disclosure that MMM’s president and CEO could see a bump in compensation after the merger.

Notably, in this case, a supplemental disclosure was of analyst projections, unlike the management projections that the Delaware chancery court has held to be material. The court admonished plaintiffs’ counsel for “a deceptive portrayal of the law” by simply referring to the importance of “financial projections” when discussing the authority. “While counsel is not wrong to assume that Delaware courts know more about these issues than this court, … it is deceptive to leverage that perceived ignorance by not accurately portraying the law,” the court wrote. “Such conduct is particularly egregious in a situation where, as here and at the appellate level, there is no adversarial briefing.”

With regard to the banks’ holdings, the court noted that most large banks prior to the Volcker Rule had proprietary trading desks that had positions in virtually every public company, and this practice continues today. Given the walls between research and trading divisions at large banks, there is no reason to believe that the incentives of bankers who had influence in the merger were affected by their colleagues on the trading desk. And if the banks had net long positions in Texas Industries, it would make even less sense to believe they would recommend an unwise merger, because the market would react and the stock price would fall.

The court also observed that it was rational for the company to settle the disclosure lawsuit. However, it emphasized that this question should not be conflated with the question of whether the settlement was in the best interest of the company and its shareholders.

The case is No. 651668/2014.

Monday, February 12, 2018

Appeals court says CLO managers are not ‘securitizers’ under Dodd-Frank

By R. Jason Howard, J.D.

The D.C. Circuit Court has reversed the district court’s ruling that collateralized loan obligations (CLOs) are "securitizers" under SEC credit risk retention rules (The Loan Syndications and Trading Association v. SEC, February 9, 2018, Williams, S.).

Retention rules. Congress, pursuant to Section 941 of the Dodd-Frank Act, directed the defendant agencies and two other banking agencies to “prescribe regulations to require ‘any securitizer’ of an asset-backed security to retain a portion of the credit risk for any asset that the securitizer ‘transfers, sells, or conveys’ to a third party, specifically ‘not less than 5 percent of the credit risk for any asset,’” reasoning that “when securitizers retain a material amount of risk, they have ‘skin in the game,’” which aligns their interests with investors in asset-backed securities.

The SEC, along five other federal banking agencies, however, adopted final credit risk retention rules that did not exempt open market CLOs. Those CLOs securitize assets bought on the secondary market (as compared to balance sheet CLOs, which securitize assets held by one institution).

The Loan Syndications and Trading Association (LSTA) claimed the “final rules stretched the definition of ‘securitizer,’ inaptly used fair value in calculating risk retention, and failed to provide exemptive relief.”

District court. The district court held that the SEC’s and federal banking agencies’ implementation of final joint credit risk retention rules met the requirements of the Administrative Procedure Act and were entitled to Chevron deference.

Appeal. On appeal, the LSTA’s primary contention was that, “given the nature of the transactions performed by CLO managers, the language of the statute invoked by the agencies did not encompass their activities.”

The appeals court agreed with LSTA that CLO managers are not “securitizers” under Section 941 and that they need not retain any credit risk. Upon reaching that determination, the appeals court did not need to address the risk calculation issue.

The lower court’s decision was reversed and the case remanded with instructions to grant summary judgment to the LSTA on whether application of the rule to CLO managers is valid under Section 941. The district court was also ordered to vacate summary judgment on the issue of how to calculate the 5 percent risk retention and to vacate the rule insofar as it applies to open-market CLO managers.

The case is No. 17-5004.

Friday, February 09, 2018

Investor concerns, compliance risks top OCIE 2018 exam priorities

By Amy Leisinger, J.D.

The SEC’s Office of Compliance Inspections and Examinations has announced its 2018 examination priorities in its continuing effort to encourage compliance, prevent fraud, and identify and monitor potential risks. This year’s priorities focus on five main areas: (1) compliance of and risks associated with service providers; (2) issues directly affecting retail investors; (3) the activities and operations of the Financial Industry Regulatory Authority and the Municipal Securities Rulemaking Board; (4) cybersecurity; and (5) anti-money laundering programs.

As markets and products and services evolve, OCIE remains committed to those aspects of the industry posing the greatest potential risks to investors and/or to market integrity, said OCIE Director Pete Driscoll.

Retail investors. For retail investors, OCIE examinations will focus on disclosures concerning the costs of investing and potential conflicts of interest, calculation of fees and expenses, and supervision of sales representatives. The staff will continue to examine investment advisers and broker-dealers that offer investment advice through automated or digital platforms or that are associated with wrap fee programs that charge investors a single, bundled fee based on percentage of assets. OCIE will also review how broker-dealers oversee interactions with senior investors and maintain internal controls designed to supervise representatives and examine mutual funds and ETFs that have experienced poor performance, are managed by less-experienced advisers, or hold securities difficult to value in times of market stress. As cryptocurrencies continue to evolve, examiners will review risk disclosures made by registrants involved in offers and sales and whether financial professionals maintain adequate safeguards to protect these assets from misappropriation. Examinations will specifically target circumstances in which retail investors may have been harmed, OCIE explains.

Compliance and risks in market infrastructure. OCIE will continue to examine the operations and compliance of entities that provide services critical to the proper market functioning, including clearing agencies, national securities exchanges, and transfer agents. The staff will annually examine clearing agencies that the Financial Stability Oversight Council has designated as systemically important, focusing on compliance with the SEC’s standards for covered clearing agencies and corrective actions taken in response to prior examinations. OCIE will also review internal audits conducted by exchanges, the payment of fees, and the operation of certain NMS plans and examinations of transfer agents will focus on transfers, recordkeeping, and the safeguarding of assets. The staff will also evaluate SCI entities to ensure that they have effectively implemented written policies and procedures and controls and assess entities’ business continuity plans and risk management activities.

Other priorities. OCIE will continue to examine the effectiveness and operations of both FINRA and the MSRB, as well as the quality of FINRA’s broker-dealer examinations. Examiners will also work with firms to identify and manage cybersecurity risks and examinations will focus on governance and risk assessment, access controls, data loss prevention, and training, among other things. The staff will also will examine whether entities are complying with applicable anti-money laundering requirements and adapting their programs to properly address risks.

OCIE notes that the published 2018 priorities are not exhaustive and that it may conduct examinations relating to risks, issues, and policy matters that arise from market developments or new information that comes from tips, complaints, and referrals.

Thursday, February 08, 2018

NASAA to FINRA: Reforms will help, but expungement remains broken

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

State securities regulators have offered qualified support for a FINRA proposal to reform the process for expunging customer dispute information from a stockbroker records in the Central Registration Depository (CRD). In a comment letter regarding FINRA Regulatory Notice 17-42, NASAA President Joseph Borg wrote that FINRA has taken a necessary first step toward short-term solutions that would improve the existing expungement process. NASAA cautioned, however, that the current process remains broken and that stop-gap fixes cannot be applied indefinitely to a “fundamentally flawed” foundation.

Unanimity. As it had in a 2015 comment letter to FINRA, NASAA reiterated its position that expungement should be an extraordinary remedy that is granted solely in limited circumstances. Accordingly, NASAA supports the proposal’s requirements that all expungement recommendations be made unanimously by a three-person arbitration panel. NASAA also supports FINRA’s corresponding proposal to eliminate the option to have a single arbitrator in a simplified arbitration proceeding make an expungement recommendation.

Expungement-only arbitration panels. NASAA also supports a requirement that expungement requests that are not decided during the underlying arbitration dispute be heard by a specialized panel of arbitrators with particular expertise and training. NASAA observed that post-settlement expungement hearings often consist of a one-sided presentation of the facts because investors and their counsel have little incentive to participate after the investor’s concerns have been resolved.

NASAA also supported the proposed qualifications for arbitrators on expungement-only panels, which require public chairpersons that have completed advanced expungement training, are licensed to practice law, and have at least five years of relevant experience. NASAA encouraged FINRA, however, to consult with state regulators when developing the new “enhanced expungement training” program.

Expungement requests. NASAA also supports provisions requiring brokers named as a party in a customer-initiated arbitration to request expungement in the course of the underlying dispute. The lack of timeliness of expungement requests is a significant concern for state regulators, NASAA wrote, given the difficulties in evaluating the merits of a request as more time passes. In the event that a firm does not request expungement on behalf of a broker who is unnamed in a customer arbitration but is the “subject of” the dispute, NASAA supports a requirement that the unnamed broker bring a request for expungement within one year after the closing of the underlying customer case.

Further reforms needed. NASAA believes, however, that wholesale reform is necessary in order to truly fix the expungement process. In NASAA’s view, a workable expungement framework would be built around the following core principles:
  • substantive standards that properly limit the scope of expungement requests; 
  • a mandatory process for expungement requests designed to close loopholes; 
  • increased regulatory participation, including allowing for a regulatory determination regarding the merits of an expungement request; 
  • earlier notices to state regulators; 
  • limitations on the ability of arbitrators to “grant” expungement requests, instead only allowing factual recommendations that are not considered awards; and 
  • preservation of the requirement that a court order the expungement of records prior to the removal of any information from the CRD.

Wednesday, February 07, 2018

SEC again extends exemptive relief for security-based swaps

By Amanda Maine, J.D.

The SEC has issued an order extending temporary relief pertaining to security-based swaps. The order grants temporary relief from compliance with the Dodd-Frank Act provision which amended the definition of “security” under the Exchange Act to encompass security-based swaps. The SEC had previously extended the original July 2011 relief in 2014 and 2017. In the order, the SEC advised that the exemptive relief is necessary to evaluate the rules pertaining to security-based swaps once they are finalized (Release No. 34-82626, February 2, 2018).

Original exemptive relief. Title VII of the Dodd-Frank Act expanded the Exchange Act definition of “security” to include security-based swaps. The Commission’s original 2011 order granted temporary exemptive relief from these provisions for security-based swap activity for any person who meets the definition of “eligible contract participant” under the Commodity Exchange Act prior to the signing of Dodd-Frank and who is a SEC-registered broker or dealer. According to the order, the SEC was seeking to maintain the status quo during Dodd-Frank’s implementation.

Relief extended in 2014 and 2017. The Commission’s 2014 order extending the expiration dates for the temporary exemptions distinguished between temporary exemptions related to pending security-based swap rulemakings (“Linked Temporary Exemptions”) and temporary exemptions that generally were not directly related to a specific security-based swap rulemaking (“Unlinked Temporary Exemptions”). The Linked Temporary Exemptions were tied to the compliance date of the specific rulemaking to which they were “linked.” The Unlinked Temporary Exemptions were set to expire in three years—February 5, 2017. The SEC explained that the Commission needed this flexibility while Dodd-Frank rulemaking was ongoing.

The Commission again extended the expiration date in 2017 to February 5, 2018. One of the comments on the 2017 extension called for permanent exemptive and other relief for security-based swap market participants.

Latest extension. The Commission’s latest order notes that, while a substantial portion of the Title VII regulatory regime for security-based swaps has been implemented, it is still in the process of finalizing its rules. To avoid potential market disruption stemming from the application of certain Exchange Act provisions and rules to security-based swap activities, the SEC stated it was in the public interest to further extend the Unlinked Temporary Exemptions for another year.

Regarding the suggestion that the Commission provide permanent relief, the SEC’s order advises that, because some rules have been proposed but not finalized, including rules relating to the capital, margin, and segregation requirements for security-based swap dealers and participants, additional time is needed to evaluate the new regulatory regime before making a determination on whether permanent relief should be provided.

The Commission is welcoming comments on whether further relief should be granted with respect to any specific Unlinked Temporary Exemptions past the new expiration date of February 5, 2019.

The release is No. 34-82626.

Tuesday, February 06, 2018

SEC okays NYSE rule change to allow companies to list without completing an IPO

By John Filar Atwood

The SEC has approved the NYSE’s proposed change to its listing rules that will allow companies that have not completed an underwritten IPO to be traded on the exchange. Listing will be at the NYSE’s discretion, and will be subject to the company providing evidence that the value of its publicly held shares is at least $250 million.

Prior to the rule change, the NYSE generally expected companies to list in connection with a firm commitment underwritten IPO, upon transfer from another market, or pursuant to a spin-off. However, the rules did acknowledge that companies that have not previously had their common shares registered under the Exchange Act, but which have sold them in a private placement, may wish to list their shares on the NYSE at the time of effectiveness of a registration statement covering a resale of the shares. Under the rule change, the NYSE will now have the discretion to list companies under these circumstances.

Valuation requirements. The NYSE requires companies that list on the exchange to have publicly-held shares valued at either $40 million or $100 million, depending on the type of listing. Companies wanting to take advantage of the new rules also will have to meet specified valuation requirements.

In the absence of any recent trading in a private placement market, the NYSE will determine that a company has met its market value of publicly-held shares requirement if the company provides a recent valuation evidencing a market value of publicly-held shares of at least $250 million. The rule change accommodates companies that are large enough to be suitable for listing on the exchange, but either do not have their securities traded on a private placement market or have a limited private placement market that does not provide a reasonable basis for reaching a valuation.

The SEC agreed with the NYSE’s conclusion that adopting a valuation requirement that is at least two-and-a-half times the existing $100 million requirement will provide a degree of comfort that the market value of the company’s shares will meet the NYSE’s standards. The SEC noted that the valuation must be provided by an entity that has significant experience in providing such valuations.

Independence of valuation agent. The rule change establishes certain criteria that precludes a valuation agent from being considered “independent.” An agent will not be deemed to be independent if: (1) at the time it provides the valuation, the valuation agent or any affiliated person beneficially owns more than 5 percent of the class of securities to be listed, including any right to receive any such securities exercisable within 60 days; (2) the valuation agent or any affiliated entity has provided any investment banking services to the listing applicant within the 12 months preceding the date of the valuation; or (3) the valuation agent or any affiliated entity has been engaged to provide investment banking services to the listing applicant in connection with the proposed listing or any related financings or other related transactions.

The rule change also addresses how a designated market maker should establish the reference price in connection with the opening on the first day of a trading of the shares of a company taking advantage of the rule change. If the shares have a sustained trading history on a private placement market, the price will be the most recent transaction in that market. If not, the designated market maker will have to consult with a financial adviser to the issuer.

Regulatory halt. Finally, the rule change permits the NYSE to declare a regulatory halt in certain securities that are the subject of an initial pricing on the exchange and have not been listed on an exchange or quoted in an over-the-counter quotation medium immediately prior thereto. The regulatory halt is for the limited purpose of precluding other markets from trading a security until the NYSE has completed the initial pricing process. The SEC believes this proposed change will facilitate the initial opening by the designated market maker of certain securities not listed in connection with an underwritten IPO, and thereby promote fair and orderly markets and the protection of investors.

Monday, February 05, 2018

Giancarlo announces new paradigm for measuring swaps

By Brad Rosen, J.D.

CFTC Chairman J. Christopher Giancarlo called for the adoption of a bold new paradigm in the way the global interest rate swaps market is considered and how its size is measured in remarks before DerivCon 2018 in New York City, New York. A year ago, the chairman called upon the agency’s Chief Economist, Dr. Bruce Tuckman, to develop a more accurate measurement of the swaps market, with a specific focus on the market’s risk transfer functions. The roll out of this new paradigm and approach has significant regulatory implications with respect capital requirements, determining the swap dealer de minimis thresholds, as well as many other issues.

Giancarlo noted in his speech that the numbers typically describing of the size of the over-the-counter derivatives markets, where the notional figures are in the hundreds of trillions of dollars, have long been without meaning and barely comprehensible for many observers. Chief Economist Tuckman has addressed this problem straight on with the recent publication of his paper Introducing ENNs: A Measure of the Size of Interest Rate Swap Markets. The paper advances a new way of looking at this notional value problem, and breaks new ground with its development of Entity-Netted Notionals (ENN) concept. Dr. Tuckman provides further explanation of his paper and ENN on Episode 29 of the CFTC Talks podcast.

Historical background and a fog of confusion. In his remarks, Chairman Giancarlo observed that after ten years have passed since the financial crisis, we remain haunted by some of the decisions that were made, sometimes frantically, in an effort to save the financial system. While the swaps markets came under the regulatory umbrella with the enactment of the Dodd-Frank reforms, monumental decisions were made based on information and data available at the time, that in retrospect, was “vague, hard to understand, even inflated, bloated, or misunderstood.” In particular, Giancarlo noted, “sometimes the data may have been wrong, or, at least, wrongly used … [t]he worry is that there was a fog or distortion or myopia or fear that mis-framed the financial picture.”

Swaps have a large number problem. Giancarlo further stated plainly that swaps have a problem of large numbers, and asserted “that sizing the global swaps markets in hundreds of trillions of dollars has done nothing to bring clarity to newspaper accounts, policy discussions in Congress, or regulatory policy setting in the decade since the financial crisis.” He pointed out that notional amounts are frequently used to describe the size and risks of the global interest rate swap (IRS) markets. For instance, a recent headline provided, “the notional value of OTC derivatives contracts outstanding was $630 trillion.” The chairman observed this amount is eight times greater than global output and 6.5 times larger than outstanding debt securities, and leads to a misleading picture of the true size of markets for swaps and derivatives

ENN analysis in a nutshell. In his paper, Dr. Tuckman explained that notional amount is not a good measure of the size of the IRS market for two basic reasons. First, most swaps involve interest instruments that are based on overnight indexes or otherwise have very short terms. Accordingly, a focus on the notional value involved exaggerates the true extent of risk present. Consequently, Tuckman’s approach deals with the term of a given swap by expressing its risk on five-year risk equivalent basis.

Additionally, interest rate swap trading conventions do not recognize that a market participant may have positions with multiple counterparties involving risk-offsetting long and short positions. Without netting out these offsetting positions, the notional amounts may dramatically overstate the actual risk transfer among various counterparties.

Accordingly, Dr. Tuckman’s analysis introduces the concept of entity-netted notionals (ENNs), which are designed to more accurately measure the actual risk transfer in swaps markets. By netting longs and shorts among counterparties, ENNs capture the market risk transfer in IRS markets much more accurately than notional amounts. Moreover, empirical evidence of ENNs shows that there is, in fact, a tremendous amount of such netting in the IRS market.

The impact of the ENN approach can be appreciated with reference to the analysis that follows.
  • For all U.S. reporting entities as of December 15, 2017, the notional amount across all currencies and across the dominant IRS products is $179 trillion;
  • Expressed in 5-year risk equivalents, that notional amount falls to $109 trillion; and, 
  • Applying the netting conventions set forth in the ENNs analysis, the figure drops to $15 trillion, or just over 8 percent of original notional amount.
“Suddenly, at $15 trillion, the IRS market is more normalized and intelligible as part of the [U.S.] economy,” the chairman observed.

Regulatory implications. The chairman noted that the first step in the CFTC’s swaps Reg Reform 2.0 initiative will be to introduce a more accurate measure of swaps market size. He also indicated that these measures historically have been used in in important regulatory calculations, like capital requirements and various other thresholds. Chairman Giancarlo concluded, “Dr. Tuckman’s analysis is a necessary perspective, achieving much-needed clarity and accuracy. It is time we all agreed to look ahead with such clarity. The alternative is to continue to live with inexactitude, misinterpretation, and inaccuracy.”

Friday, February 02, 2018

Consensus and greater clarity regarding self-certification of new futures contracts apparent at MRAC meeting

By Brad Rosen, J.D.

The first meeting of the CFTC’s Market Risk Advisory Committee (MRAC) convened under the sponsorship of Commissioner Rostin Behnam in Washington, D.C. to explore the regulatory processes and statutory framework in connection with the listing of new products through the self-certification on CFTC-regulated designated contract markets.

The MRAC meeting came in the aftermath of a contentious dispute between stakeholders in the clearing firm community and the Chicago Mercantile Exchange, Inc. (CME) and the CBOE Futures Exchange, LLC over the self-certification and listing of Bitcoin related futures products in early December, 2017. The clearing firm community contended it was not given a meaningful opportunity to provide input and comment about the new and volatile products. This displeasure was reflected in an open letter from FIA CEO Walter Lukken to CFTC Chairman Giancarlo.

Commissioner Benham, in his opening remarks at the MRAC gathering, made clear that the purpose of the meeting was not intended to question the efficacy or usefulness of self-certification itself. Rather, he noted the overarching theme of the meeting was to focus on process, though observing “we are now living in an age that is not big on process, but often prefers to emphasize ‘likes’ and tweetable sound bites.” Importantly, Benham noted that the self-certification had served market participants, the CFTC, and the general public very well over the years. He pointed out that since Congress authorized the CFTC to establish a self-certification process for the listing of new futures products in 2000, exchanges have self-certified 10,628 new products, which has provided more risk management tools for commercial end-users across many different asset classes.

Chairman Giancarlo. In his remarks, Chairman Giancarlo addressed the self-certification process straight on, noting “it is DCMs and Designated Clearing Organizations (DCOs) - and not CFTC staff - that must solicit and address stakeholder concerns in new product self-certifications. Interested parties, especially clearing members, should indeed have an opportunity to raise appropriate concerns for consideration by regulated platforms proposing virtual currency derivatives and DCOs considering clearing new virtual currency products.”

In an effort to quell some of the concerns from the clearing firm community regarding the opportunity to provide comment and input, Giancarlo indicated that he has requested CFTC staff to add an additional element to its Review and Compliance Checklist for virtual currency product self-certifications which would require DCMs and Swaps Execution Facilities (SEFs) to disclose to CFTC staff what steps they have taken in their capacity as self-regulatory organizations to gather and accommodate appropriate input from concerned parties, including trading firms and FCMs. The Chairman recently made this same point at the annual conference of the ABA Section on Derivatives and Futures Law.

Commissioner Quintenz. Commissioner Brian Quintenz was also in attendance at MRAC, sharing his views which included that, “the self-certification process ensures that the market’s introduction of new products is not delayed by regulators’ political considerations. It reflects the government providing the market with the freedom and space to innovate outside of Washington bureaucracy.” He added, “I think we all benefit from that free market approach.”

The MRAC meeting provided many of the participants an opportunity to rehash and relitigate earlier positions and arguments, although the level of acrimony seemed to have significantly dissipated compared to the final month of 2017.

FIA position. Ed Pla, the Global Co-Head of Execution and Clearing for UBS, presented at the meeting on behalf of the FIA’s FCM clearing member community, and noted that FIA strongly supports the self-certification process as enacted in the Commodity Futures Modernization Act, but observed that while Congress provided exchanges with the extraordinary power to self-certify their products, this self-policing authority comes with reciprocal responsibilities that exchanges act in the best interests of the marketplace.

Pla further noted that the FCM community believes that the launch of the exchange-traded derivatives in cryptocurrencies would have benefited from more two-way dialogue among regulators, exchanges, clearinghouses and the clearing firms who will be absorbing the risk of these instruments during a default. Nonetheless, Pla stated that FIA applauds Chairman Giancarlo’s recent announcement to improve the self-certification process by requiring exchanges to show that the industry was properly consulted before the launch of such cryptocurrency products. Still, he noted that this undertaking “must be more than a ‘check the box’ exercise and allow for a healthy and rigorous dialogue with market participants.”

A view from the exchanges. The comments of Julie Winkler, Chief Commercial Officer for the CME, were representative of other MRAC participants appearing on behalf of the exchange community. She noted that the CME was looking at the Bitcoin futures product for nearly two years before launch and was engaged in close and ongoing communications with CFTC staff throughout about the contract as well as the underlying index which serves as the reference rate for the contract. She also noted the exchange solicited input and feedback from clients and firms as that helped in creating the contract that the exchange ultimately launched.

Thursday, February 01, 2018

Rulemaking petition seeks modernization of equity market data regime

By Jacquelyn Lumb

Healthy Markets Association has petitioned the SEC to initiate rulemaking proceedings to reduce the conflicts of interest, market complexity, and costs related to the provision of equity market data. The regulatory regime that governs equity market data has not evolved to reflect significant changes in the marketplace such as the conversion of exchanges to for-profit entities, Healthy Markets explained. The non-competitive forces for market data and connectivity has resulted in significant price increases with little regulatory scrutiny. Healthy Markets asked the SEC to address conflicts of interest in the NMS plan structure; excessive costs and market participant concentration; increased market complexity and venue fragmentation; increased risk and market failures; and burdens on competition for market data provision.

Changing markets. When the NMS plan was created, the self-regulatory organizations were non-profit entities. All have since become for-profit entities while retaining their SRO status, Healthy Markets noted. The SROs are required to ensure that the public has a timely, consolidated view of market relevant information, which they do through SIP data feeds. The SIP tape revenues were intended to cover the expenses of the system, according to Healthy Markets, but now the public SIP data feeds act as competitors to the private data feeds and connectivity products sold by the exchanges.

Healthy Markets advised that the privileged regulatory status of the exchanges and their conflicted oversight of data fees and connectivity has led to skyrocketing prices for both public and private data. Market participants must have information on both feeds and faster connectivity to remain competitive and in some cases to comply with their regulatory obligations. Some have argued that these surging fees are a leading contributor to consolidation in the industry.

Eliminate SRO privileges. Healthy Markets recommends that Congress and the SEC work together to eliminate the regulatory responsibilities and privileges held by the SROs, including the elimination of NMS plans and immunity. Meanwhile, the SEC should revise its rules, guidance, and enforcement efforts to require the justification of data, connectivity, and fee changes for both public and private feeds. The staff also should review all changes for fairness, potential discriminatory impacts, and potential undue burdens on market participants.

In addition, Healthy Markets urged the SEC to clarify that rule filing requirements apply to all data derived from an exchange’s role in the national market system and marketed to anyone, and that standards for market data filings apply. The SEC should acknowledge the governmental function of the SIP data feeds and prohibit the exchanges from generating any profits from the operation and maintenance of the SIP data system, in Healthy Markets’ view.

Simplify pricing models. The coalition also urged the SEC to simplify pricing models within the SIP to eliminate the need to count end users, accounts or terminals, display versus non-display uses, and eliminate the distinction between professionals and non-professionals. The SEC should establish clear parameters for market data audits by exchanges or their representatives; increase the transparency of revenue collection and cost; and expand the SIP feed information to include the order depth of book.

Other proposed improvements. Healthy Markets also recommended that the SEC minimize the time discrepancies between private and SIP data feeds; require exchanges to provide detailed financial information about their fees, revenues, and expenses related to public and private data and connectivity; and increase transparency about enhancements to SIP resiliency.

While Healthy Markets would prefer the elimination of NMS plans, to the extent that this option is not possible, it suggested a change to NMS plan governance to include voting representation from investment advisers and broker-dealers and the elimination of one vote per exchange, to be replaced by one vote per exchange group on NMS plans. If competing SIPs are permitted, Healthy Markets said the SEC should establish means of mitigating conflicts of interest and abuses.

The regulatory framework for equity market data is outdated and must be modernized to reduce conflicts of interest, market complexity, and costs to participants, Healthy Markets concluded.

Wednesday, January 31, 2018

High Court asked to weigh in on mixed statement mix-up

By Rodney F. Tonkovic, J.D.

A petition for certiorari has been filed asking the Supreme Court to resolve a circuit split over how to interpret the PSLRA safe harbor provision for forward-looking statements. At issue is whether a defendant must admit that non-forward-looking statements made as part of "mixed statements" are false in order to have safe harbor protection for the accompanying forward-looking statements? In this case, the Ninth Circuit held that if the non-forward-looking statement is alleged to be false, the forward-looking statement is not protected by the safe harbor unless the cautionary language admits that the non-forward-looking statement is false. This requirement, the petition says, establishes "a new extreme among those circuits that have chipped away at the PSLRA’s safe harbor" (Quality Systems, Inc. v. City of Miami Fire Fighters' and Police Officers' Retirement Trust, January 26, 2018).

Dismissal and reversal. The complaint alleged that software company Quality Systems, Inc. had real-time sales information that contradicted its public statements denying any decline. The district court dismissed the case, concluding that the challenged statements were either protected forward-looking statements or, in the case of the non-forward-looking statements, non-actionable puffery. A Ninth Circuit panel disagreed, however, finding that some of the statements were "mixed" and contained non-forward-looking statements that were materially false or misleading. The decision was reversed and remanded.

According to the appellate court, some of the statements at issue were "mixed statements" that contained both forward-looking statements of projected revenue and earnings and non-forward-looking statements. This issue had not yet been addressed in the Ninth Circuit, but the panel agreed with other circuits which have concluded that non-forward-looking statements are not protected under the PSLRA safe harbor where defendants make mixed statements containing non-forward-looking statements as well as forward-looking statements. Here, many of the non-forward-looking statements were materially false and misleading, and, short of an outright admission of falsehood, any cautionary language accompanying the forward-looking part of a mixed statement was insufficient to correct these misrepresentations, the panel said.

Mixed statements. The petition asks whether or in what circumstances a defendant must admit that non-forward-looking statements are false or misleading, in order to be protected by the PSLRA safe harbor for forward-looking statements. The petition notes that most courts confine their analysis to the factors identified by the company in the actual cautionary language accompanying the forward-looking projections. Other courts look beyond the cautionary language and consider whether the company failed to mention unstated risks that it faced when the forward-looking statement was made. In this case, the petition maintains, the Ninth Circuit took the latter approach to a new extreme, holding that the PSLRA "meaningful cautionary language" requirement is not satisfied when a forward-looking statement is accompanied by an allegedly false non-forward-looking statement unless the company admits the falsity of the non-forward-looking statement. This conclusion was reached even though held that the cautionary language was meaningful and would have triggered the safe harbor, if considered without reference to the false non-forward-looking statements.

The Ninth Circuit's rule, the petition asserts, is "a stark outlier" from the tests applied by other circuits and, moreover, is simply "wrong." According to the petition, the PSLRA does not require that all important factors be identified, and it does not require that companies make an outright admission of the falsity of any non-forward-looking statements. The petition argues further that the Third, Sixth, Eighth, and Eleventh Circuits have held that courts should examine only the cautionary language accompanying the forward-looking statement. The Seventh and D.C. Circuits, on the other hand, also look at whether the cautionary language is misleading by omission. The Ninth Circuit takes the latter approach to a new extreme, the petition argues, by imposing an affirmative requirement to admit falsity.

Additionally, the Ninth Circuit's position is at odds with the text, structure, and history of the PSLRA. The petition contends that the court imposed a categorical requirement requiring cautionary statements to warn against risks associated with non-forward-looking statements that is not in the statutory text. False or misleading non-forward-looking statements are independently actionable, the petition continues, but should not be a basis for denying safe harbor protection to forward-looking statements.

If allowed to stand, the Ninth Circuit's rule will effectively nullify the PSLRA safe harbor, broaden the scope of liability in securities cases, and cause companies to stop providing meaningful forecasts and projections. For "obvious reasons," the petitioner remarks, no company will include an affirmative admission of falsity in its cautionary language. There are currently at least three different approaches to the PSLRA safe harbor, the petition says, and the Ninth Circuit's rule serves only to exacerbate the confusion and invite forum shopping.

The petition is No. 17-1056.

Tuesday, January 30, 2018

NERA reports record merger-objection class action filings, stingier settlement totals

By Amy Leisinger, J.D.

A report issued by National Economic Research Associates found that total filings of securities class actions have continued to rise with 432 class actions filed in 2017 (an 89 percent increase over the past two years), with the growth dominated by a record 197 federal merger-objection filings. According to the report, however, the value of settlements declined markedly, plunging to lows not seen since the early 2000s.

“In addition, there was a record rate of case resolution, which was driven by increases of more than 40 percent in dismissals and 30 percent in settlements,” said NERA Managing Director Dr. David Tabak.

Filings. NERA’s Recent Trends in Securities Class Action Litigation: 2017 Full-Year Review noted a “dramatic increase” in securities class action filings, reflecting growth not seen in nearly 20 years. The 432 federal securities class action suits filed in 2017 involved approximately 8.2 percent of publicly traded companies, marking an increase in the average probability of a listed firm being subject to litigation from 3.2 percent for the 2000-2002 period, according to NERA. In 2017, the number of pending cases in the federal system increased to 785, up 12 percent from 2016, the report states. The increase in filings was led by a more-than-doubling of merger-objection filings typically alleging violations of Exchange Act Section 14 and/or breaches of fiduciary duty by managers of the acquisition target, according to the report. This shift is likely the result of state court decisions restricting “disclosure-only” settlements, the most prominent of these being the Delaware Chancery Court’s Trulia decision, NERA explains.

Foreign companies continued to be disproportionately targeted in standard actions, the report states. In addition, the health care, technology, and financial services sectors have been involved in the largest number of actions, but the share of filings in these sectors fell from 63 percent in 2016 to 53 percent in 2017, NERA notes.

Settlements and fees. A total of 353 securities class actions were resolved in 2017, including a near-record 148 settled cases, the report states. Aggregate NERA-defined investor losses for filings totaled $334 billion in 2017 (50 percent more than the five-year average), mostly due to numerous large cases alleging various regulatory violations, NERA explains. However, the average settlement in 2017 fell to less than $25 million, a nearly 66 percent drop when compared to 2016, likely due to a lack of large settlements seen in previous years, according to the report. For the first time since 1998, no case settled for more than $250 million, NERA notes.

According to the report, aggregate attorney fees and expenses were $467 million—a drop to a level not seen since 2004. This shift reflects a trend toward fewer and smaller settlements, NERA explains. However, the report notes, the drop is still less than the overall 70 percent decline in aggregate settlements, likely as a result of the increase in smaller settled cases with typically higher fee payout ratios.

Monday, January 29, 2018

FIA and ISDA recommend in-depth study before expansion of ESMA’s powers

By John Filar Atwood

In a comment letter to the European Commission (EC), the Futures Industry Association. (FIA) and International Swaps and Derivatives Association. (ISDA) said that any consideration of expanding the direct supervisory powers of the European Securities Markets Authority (ESMA) should require an in-depth assessment, including a cost/benefit analysis and a consultation with concerned entities. FIA and ISDA said that the value of supervision by national authorities should be recognized, given their knowledge of local markets, best practices and national legal frameworks.

The comment letter responded to the EC’s consultation on a draft implementing regulation on the operations of the European Supervisory Authorities (ESAs) and a proposed supervisory framework. There are three ESAs—the European Banking Authority, the European Insurance and Occupational Pensions Authority, and ESMA—but the FIA and ISDA focused their suggestions on ESMA.

The FIA and ISDA support the goals of the ESA proposals, which include: (1) reinforcing coordination of supervision across the EU; (2) extending direct capital markets supervision by ESMA where appropriate; (3) increasing engagement and creating a culture of continuous dialogue with market participants; (4) improving governance and funding of the ESAs; and (5) promoting sustainable finance and fintech.

In the letter, the FIA and ISDA stated that increased supervisory convergence would help to deepen capital markets in Europe. They also believe there is an opportunity to increase the efficiency and competitiveness of Europe’s capital markets through initiatives to streamline and simplify supervisory processes and remove duplication. In their view, the proposed recalibration of supervisory structures should be considered carefully to ensure structural stability, given that relevant EU legislation is still in the process of implementation.

Executive board. The FIA and ISDA said that they welcome the introduction of an independent executive board with full-time members replacing the current management board. However, they recommend that further clarification be provided regarding the role of the full-time members of the executive board in the management of the ESAs. They agreed that the Board of Supervisors should continue to be the main decision-making body of the ESAs.

ESA funding. With respect to funding, the EC proposals state that the funding levels of the ESAs should be stable and commensurate to what is necessary to fulfill the objectives and tasks set out in their founding regulations. Currently, the ESAs’ revenues are based on contributions from national regulators (60 percent) and from the EU budget (40 percent). In addition, ESMA receives some funding from the private entities it directly supervises such as credit rating agencies and trade repositories.

The FIA and ISDA said that given the need to increase resources of the ESAs, they would accept a funding system partly funded by the industry, subject to a dedicated industry consultation and within certain parameters. They believe there is a need for fees and contributions to be commensurate as a reasonable level of fees will ensure that the provisions of financial services remains cost effective and that the competitiveness of the EU marketplace is not affected.

They recommended that fees be fairly allocated across the regulated population. It would be inappropriate to carve out specific categories of entities just because they are smaller in size than the largest financial institutions, they said. In their view, proportionality should be at the heart of the allocation.

The FIA and ISDA recommended that the EC further clarify how the proposed executive board would work with the proposed central counterparty executive session on the authorization of central counterparties. They also suggested that ESMA and national competent authorities take a differentiated approach to supervision with regards to wholesale and retail customers.

Suspension powers. The associations recommended that the ESAs be provided with powers to temporarily suspend the application of certain regulatory requirements in certain circumstances and within a reasonable time frame. The suspensions would effectively relieve firms from any enforcement action during that time period.

The FIA and ISDA also said that they support ESMA supervision for pan-European crucial IBOR benchmarks such as EURIBOR and EONIA. They believe that national competent authorities should retain the supervisory authority over benchmarks at national level and retain the ability to determine if their local benchmarks are critical.