Friday, October 19, 2018

CorpFin issues new cross-border exemption C&DIs

By Amy Leisinger, J.D.

The Division of Corporation Finance has issued 27 new Compliance and Disclosure Interpretations related to the cross-border exemptions. The C&DIs replace prior Telephone Interpretations and reflect some substantive and technical changes to previous positions while also providing new guidance related to, among other things, tender offers, shareownership status and calculations, subject class determination, filing and dissemination of offering materials, and withdrawal rights.

Existing interpretations. In the cross-border C&DIs, the staff reiterates its positions that Securities Act Rules 801 and 802 are not available when there are no U.S. security holders of the issuer or the offer is not extended to U.S. security holders and that excluding U.S. security holders from an offer at a time when U.S. ownership exceeds 10 percent and then later extending the offer to U.S. security holders when ownership falls would raise concerns if circumstances indicate that the bidder excluded U.S. holders with the intent of migrating securities to a foreign jurisdiction to achieve a registration exemption.

In addition, the staff notes that securities held by the acquiror are excluded from the U.S. ownership calculation for purposes of determining a cross-border exemption and that the initial calculation of U.S. ownership is sufficient to determine eligibility for an exemption in a subsequent step of the transaction if the subsequent step is disclosed and consummated within a reasonable time after the first step. If an offeror is unable to calculate the U.S. ownership, the offeror may file a registration statement to avoid a violation and later withdraw the registration statement and rely on an exemption upon a determination that U.S. ownership is no more than 10 percent, the staff explains.

The staff also reiterates its positions that a bidder commencing a foreign tender offer for the securities of a foreign private issuer that later chooses to extend the offer to the U.S. must allow the offer to remain open at least as long as the minimum period required in the jurisdiction governing the foreign offer and that an offeror disseminating and advertisement in a home jurisdiction can satisfy the requirement to inform U.S. holders of the offer by providing a less detailed summary advertisement in a national publication that specifies how U.S. holders can get a complete copy of the offering materials in English.

The staff also states that, in order to terminate withdrawal rights, all conditions must be satisfied or waived and that the bidder must declare the offer wholly unconditional.

New interpretations. Among other things, the C&DIs also provide the following guidance: 
  • A foreign private issuer seeking to do a “warrant flush” may rely on the Tier I exemption in Exchange Act Rule 13e-4(h)(8) where the transaction is not subject to tender offer regulation in another jurisdiction.
  • The term “successor registrant” does not mean that the acquiror must be an Exchange Act reporting company following a business combination.
  • When a bidder is aware that a U.S. parent company holds authority over shares, the shareholder should be deemed a U.S. holder.
  • The “look through” analysis to determine U.S. ownership may not be eliminated even when responses are not likely to be forthcoming or may be incomplete.
  • Where the parties do not know the exchange ratio in an amalgamation at the time of announcement and cannot determine the “pro forma” U.S. ownership for the new holding company within prescribed timeframes, the staff will not object if they use the comparative market capitalizations of the parties instead.
  • The fact that holders of ordinary shares and preference shares have the same voting rights for the transaction is not dispositive as to whether securities are a single class for purposes of calculating U.S. ownership, and other factors such as different pricing should be considered.
  • A foreign private issuer that meets the conditions of Rule 801 except that its U.S. holders hold equity securities through Global Depositary Receipts rather than ADRs may extend a rights offering to its U.S. holders without registering the offering.
  • To conduct a dual offer in reliance on Rule 14d-1(d)(2)(ii), the U.S. offer must be made on terms at least as favorable as the terms offered to all other holders of the subject securities.
  • In a cross-border tender offer not subject to Regulation 14D, where U.S. ownership in the subject company is above 10 percent, a bidder may offer cash to U.S. holders of the subject company and shares to other holders.
  • A bidder can rely on Rule 14d-1(c)(2)(iii) to offer cash to U.S. holders while offering a choice between cash and stock consideration to non-U.S. holders, but the “substantially equivalent” requirement would not be satisfied if the cash consideration is less than the value of the stock consideration.
  • A foreign private issuer planning to conduct a rights offering without Securities Act registration that must file a registration statement in its home jurisdiction incorporating by reference certain documents must translate the documents into English and furnish them to the Commission under cover of Form CB.

Thursday, October 18, 2018

Commission says NYSE and Nasdaq flunked burden of proof on non-core data fees, sharpens focus on access to market data

By Mark S. Nelson, J.D.

The Commission unanimously decided to set aside certain data fees charged by NYSE Arca, Inc. and Nasdaq Stock Market LLC to market participants because the exchanges failed to demonstrate that the fees were fair, reasonable, and not unreasonably discriminatory, as required by the Exchange Act. The Commission also remanded 400 pending fee challenges to various exchanges but without setting aside those fees or otherwise opining on their propriety. The Securities Industry and Financial Markets Association (SIFMA) had challenged the propriety of NYSE Arca’s and Nasdaq’s depth-of-book access fees. The Commission’s opinion puts a spotlight on the specific fees charged by NYSE Arca and Nasdaq while also highlighting larger issues about unequal access to critical market data (In the Matter of the Application of Securities Industry and Financial Markets Association For Review of Action taken by NYSE Arca, Inc., and Nasdaq Stock Market LLC, Release No. 34-84432, October 16, 2018).

The market shifts: decimalization and high-speed feeds. The decade-long combination of litigation and administrative proceedings over NYSE Arca and Nasdaq’s depth-of-book access fees has its roots in the 1975 legislative mandate that the Commission create a national market system. During the intervening years, securities markets evolved dramatically and the more recent combination of decimalization and high-speed data access has facilitated the development of a lucrative business for market information. A further complication, however, arises from the existence of a two-speed market data system—a much slower core data set distributed via securities information processors (fees set based at least partly on cost), and faster, non-core feeds (which, among other things, include data on limit orders) that are sold directly by exchanges to market participants.

A 2008 Commission order emphasized the need for there to be significant competitive market forces regarding depth-of-book fees. In that order, the Commission found such market forces would prevent NYSE Arca from charging outsized data access fees. An appeal by SIFMA to the D.C. Circuit Court resulted in the NetCoalition I decision that upheld the Commission’s market-based approach (as opposed to a cost-based approach) for non-core data fees as permissible under Chevron deference while also finding the Commission did not vary from prior SEC practice. But the court found the administrative record did not support the Commission’s finding that NYSE Arca was subject to competitive forces that would curb its pricing power. A subsequent change in the law brought about by the Dodd-Frank Act permitted exchanges to file automatically effective rule changes regarding certain data access fees. As a result, NYSE Arca promulgated the same fee rule in 2010 and an appeal by SIFMA once again to the D.C. Circuit resulted in the NetCoalition II decision in which the court held that the Dodd-Frank Act deprived it of jurisdiction over the appeal. SIFMA then renewed its administrative challenges to both the NYSE Arca and Nasdaq fees and the matters were consolidated and assigned to an administrative law judge (ALJ) who, having previously found SIFMA had associational standing, ultimately decided in favor of the exchanges on the propriety of their data fees. The Commission explained that the assignment to an ALJ was discretionary and had been done for the purpose of expanding the record beyond that developed before the exchange but did not otherwise presage a change in how the Commission expects exchanges to handle similar proceedings.

Wednesday, October 17, 2018

Coders should be accountable for illegal smart contracts, says CFTC’s Quintenz

By Anne Sherry, J.D.

CFTC Commissioner Brian Quintenz said at the GITEX Technology Week Conference in Dubai that it would be reasonable to hold the developers of smart contract code accountable for unlawful activity, such as the unauthorized offering of event contracts. He allowed, however, that enforcement would be difficult, and posited that developers could engage with CFTC staff to determine ways to comply with CFTC regulations.

Quintenz posed a hypothetical scenario in which smart contracts are transacted on the blockchain—specifically, binary options that qualify as event contracts. The CFTC only allows off-exchange trading of event contracts in limited circumstances. This scenario, where event contracts are being executed for profit between retail customers, raises multiple CFTC concerns, not least of which is who should be held accountable for the regulatory violations.

The commissioner said that it would not be reasonable to look to the developers of the underlying blockchain, who invented a code upon which individual applications can run. Similarly, miners and general users of the blockchain cannot know and asses the legality of each particular application. It is reasonable, though, to hold the coders of the smart contracts themselves responsible. If you loan your car to someone because they want to rob a bank, it is reasonable for the government to prosecute you for the robbery, but it would be unreasonable to go after the car manufacturer, Quintenz said.

Quintenz conceded that it would be difficult to stop this activity entirely. On an anonymized, global blockchain, determined users will find a way to gain access and execute their own event contracts. Regulations also vary by jurisdiction; event contracts are permitted as a form of wagering in the U.K., for example, and certain binary options allowed in the U.S. are banned in the E.U.

Instead of enforcement, the commissioner continued, developers could engage with the CFTC to be sure their products comply with regulations. He assured the audience that Commission staff is open to engaging with innovators. Chairman Giancarlo created LabCFTC at the agency with a goal of working with innovators to deepen the agency’s understanding of technological innovations and provide guidance about how regulations may affect new developments.

Finally, Quintenz said that he disagrees with the adage that the code is law, meaning that anything permitted by software is fair game. Case law, statutes, and regulations apply to the code just as they apply to other activities, he said. Although users of the blockchain may be aware of the risks of an exploit, such as a 51-percent attack or bug in the code, it does not necessarily follow that they have submitted to those risks. Instead, the law may find the existence of an implicit agreement among participants not to undermine the blockchain’s operability or integrity. Furthermore, the contracts themselves are subject to regulations. If market integrity is clearly threatened through widely adopted contract loopholes such as a manufactured default or 51-percent attack, the CFTC should consider investigating the conduct for fraud or manipulation, Quintenz concluded.

Tuesday, October 16, 2018

SEC official urges municipal securities market participants to improve clarity of disclosure

By John Filar Atwood

In her first published address since taking over as the SEC’s Director of the Office of Municipal Securities, Rebecca Olsen urged municipal securities market participants to refine disclosure best practices and explore new areas for guidance. She noted that offering and other disclosure documents often use complex language, and she asked the industry to simplify its disclosure given the high level of retail investor participation in the municipal securities market.

In remarks at the municipal finance leadership conference, Olsen noted that municipal securities are exempt from federal securities registration and reporting requirements that apply to other publicly offered securities. As a result, market participants historically have worked together to develop voluntary disclosure guidelines and best practices.

Existing guidelines and best practices relate to the content and timing of financial statements and financial information, disclosure of pension liabilities, industry and financing specific guidelines, disclosure controls and procedures of a municipal issuer, and methods of providing disclosure, she said. Olsen applauded the willingness of industry groups to voluntarily discuss and generate ways of measuring successful disclosure, but suggested that they continue to strive for high-quality disclosure practices through development and enhancement of best practices guidelines.

In particular, she recommended that voluntary industry initiatives focus on the accessibility and understandability of information. The diversity and complexity of the municipal securities market appear to provide challenges for investors, she said, and they may have trouble understanding lengthy disclosure documents or the terms of complex municipal securities. She reiterated the SEC’s commitment to having companies communicate with investors in clear, easily understandable language.

Retail investors. She underscored the importance of clear disclosure by pointing out the high concentration of municipal securities in the hands of retail investors. The municipal securities market has over $3.853 trillion in principal outstanding, she noted, and at the end of the second quarter of 2018, individuals held, either directly or indirectly through mutual or other funds, over 66 percent of the total market.

Olsen said that in the absence of a statutory scheme for municipal securities registration and reporting, the SEC’s investor protection efforts have been accomplished primarily through regulation of broker-dealers and municipal securities dealers, including through Exchange Act Rule 15c2-12, Commission interpretations, enforcement of the antifraud provisions of the federal securities laws, and Commission oversight of the MSRB.

Commission’s efforts. Although the agency’s authority with respect to the municipal securities market is more limited than that in other markets, Olsen said that the Office of Municipal Securities recognizes that investors in municipal securities are entitled to the same transparency that investors in other markets are afforded. As a result, the Commission’s rules are designed to enhance transparency in the municipal securities market and to protect municipal securities investors. She noted that the SEC recently approved amendments to Rule 15c2-12 that are designed facilitate timely access to important information regarding material financial obligations whose terms could impact an issuer’s liquidity and overall creditworthiness.

The Commission also demonstrates its commitment to protecting municipal securities investors through the efforts of the Public Finance Abuse Unit (PFAU), she said. The PFAU is a specialized enforcement unit that is dedicated to pursuing investigations related to possible misconduct in the municipal securities market and in connection with public pension funds, including investigations relating to potential offering and disclosure fraud.

Monday, October 15, 2018

SEC unveils plan to focus on investors, innovation, and performance

By Amy Leisinger, J.D.

The SEC has announced a new strategic plan to guide its efforts through 2022. The agency intends to focus on investors and develop a better understanding of how they participate in the capital markets while modernizing disclosure and expanding investor choice. The SEC will also strive to embrace innovation and re-evaluate existing rules and procedures while elevating its own performance by enhancing technical capabilities and human capital development.

“The Plan provides a forward-looking framework for making the SEC even more effective, focusing on the most important goals and initiatives that will best position the SEC to fulfill our mission,” said SEC Chairman Jay Clayton.

In its strategic plan, the Commission notes that it will focus on the long-term interests of investors by enhancing its understanding of how retail and institutional investors access capital markets in order to more effectively tailor its policy initiatives and address emerging risks. The SEC also plans to increase its outreach, education, and consultation efforts to gather perspectives from all industry participants in order to ensure provision of timely and relevant guidance. The Commission will also focus on enforcement and examination initiatives to identify and address misconduct specifically affecting retail investors, as well as modernizing the content and delivery of disclosures to ensure clear and useful information for investors. According to the plan, the agency will also work on identifying means by which to increase the range of investment options available to retail investors.

The SEC also plans to focus on recognizing developments and trends in the capital markets to ensure effective allocation of Commission resources. Increased use of technology has introduced risks, the Commission notes, and additional efforts must be made to expand oversight capabilities to identify, evaluate, and respond effectively to these issues and examine strategies to address cyber and other system risks. As part of these enhancements, the SEC plans to consider whether existing rules and approaches are outdated or are failing to function as intended and to enhance its preparedness and ability to respond to market emergencies.

As to its own performance, the SEC will focus increasing staff capabilities and expanding the use of risk and data analytics to inform agency priorities and focus staff resources, as well as to prevent and detect misconduct. The Commission also plans to enhance its ability to respond to threats to the security of agency systems and sensitive information. According to the strategic plan, the SEC also plans to increase its efforts to promote collaboration throughout the agency to promote effective communication and maximize the efficient use of Commission resources.

Friday, October 12, 2018

Chairman, Behnam talk interest rate benchmarks at Bipartisan Policy Center

By Anne Sherry, J.D.

With LIBOR’s end date in sight, panelists gathered at the Bipartisan Policy Center to discuss topics relating to a transition to the alternative benchmark rate SOFR. SEC Chairman Jay Clayton answered questions from CNBC’s John Harwood about the benchmark and other market regulation topics, but declined to comment on the Commission’s recent tangle with Elon Musk. Following a panel focused on the transition to SOFR, CFTC Commissioner Rostin Behnam offered his take on the reference rate measures in prepared remarks.

With LIBOR being phased out by the end of 2021, the Alternative Reference Rate Committee (ARRC) established the Secured Overnight Financing Rate (SOFR) as a new benchmark rate for U.S.-dollar-based transactions. Fannie Mae, which was represented at the discussion by Wells Engledow, in July issued the first floating-rate note indexed to SOFR, and CME recently cleared the first over-the-counter SOFR interest-rate swaps.

What keeps Clayton up at night. Harwood began his Q&A by asking Clayton about life at the Shortseller Enrichment Commission, an allusion to a tweet by Elon Musk in the wake of the SEC’s enforcement action against him. Clayton laughed but shook off the remark, calling it “an old joke.” When Harwood returned to the topic towards the end of the conversation, Clayton again declined to comment on the matter or its settlement, which many perceived as generous to Musk. Clayton would only say that because there was a lot of interest from Main Street investors, he took that opportunity to put out a statement to give those investors more insight into the SEC’s stance on enforcement.

The chairman did share some of the issues that he ponders at night, noting, “I’m never content; I get paid to worry.” He said that the transition from LIBOR, as well as Brexit, are concerns. The committee did well to choose a new benchmark rate that is tied to overnight treasuries, Clayton said, but implementation will be a big job. However, he was not particularly troubled by the recent sell-off in the stock market because the SEC is not tasked with conducting monetary or fiscal policy. His concern is whether the market is functioning as it should, and his assessment is that the market did function well the day before, digesting new information and new ideas.

Harwood asked about the concentration of equity securities in the hands of a fraction of the U.S. population, observing that there are twice as many private companies as public. Clayton agreed that the spectrum of investments available to retail investors is smaller as companies are waiting longer to go public. Although he does not have a specific proposal, one of the things on his mind is how to give retail investors access to private equity or venture capital without easing investor protections. This would not necessarily involve lowering the standards for accredited investors.

Finally, both Harwood and an audience member asked Clayton about crypto-related issues. The technology has promise, he responded, but he is wary of markets that appear to be well-regulated and well-understood but do not actually function that way. Investors should be cautious that a price quote doesn’t carry the same confidence and scrutiny as a quote on NYSE or Nasdaq. Clayton asserted that the capital markets system is built around clearly defined responsibilities. In a decentralized world, he asked rhetorically, who is responsible when something goes wrong?

Behnam’s work on benchmark reform. Behnam, whose term as CFTC commissioner also ends in 2021, said that the panel discussion highlighted the importance of reference rates to the global economic system. The CFTC has been involved in the global effort against fraud and manipulation within the rate-setting process, with a total of $3.3 billion in LIBOR-related sanctions since 2012. The commissioner himself sponsors the Market Risk Advisory Committee, which met in July to focus on benchmark reform in the context of the derivatives market. The Interest Rate Benchmark Reform Subcommittee recently approved by the CFTC will provide reports and recommendations to the MRAC regarding the transition to SOFR and its impact on the derivatives markets.

Specifically, the subcommittee may consider the treatment under Dodd-Frank of existing derivatives contracts that are amended to include new fallback provisions or otherwise reference alternative benchmark rates. It may also consider the impact of the transition on liquidity in derivatives and related markets. Behnam wants to use the subcommittee to complement the AARC’s work by shedding more light on challenges ahead, identifying risks for the markets and consumers, and providing solutions within the derivatives space.

Thursday, October 11, 2018

ICOs, senior fraud drive increase in state actions against unregistered persons

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

Reversing a two-year trend, state securities regulators have reported that more enforcement actions were taken in 2017 against unregistered persons than registered members of the securities industry. In its annual enforcement report, NASAA attributes the rise to an increased focus on fraudulent initial coin offerings (ICOs) and cryptocurrencies and the growing adoption of state provisions based on NASAA’s Model Act to Protect Vulnerable Adults from Financial Exploitation.

“The results from this year’s enforcement survey demonstrate that state securities regulators continue to play a critical role in protecting investors and holding securities law violators responsible for the damage that they cause to individual investors specifically and to the integrity of our capital markets in general,” said NASAA President Michael S. Pieciak in a news release.

The report, which was based on responses from 51 U.S. jurisdictions, notes that state regulators received 7,988 complaints and initiated 4,790 investigations in 2017. The states pursued 2,105 enforcement actions last year, of which 1,682 were administrative in nature, 255 were criminal, and 116 were civil. These efforts led to more than $486 million in restitution, fines of $79 million, and criminal relief of 1,985 years, including incarceration and probation.

Crypto-assets. The report notes that enforcement personnel began to increasingly focus their efforts on cryptocurrencies as the price of Bitcoin increased to nearly $20,000 in December 2017 and the market capitalization of all cryptocurrencies reached more than $500 billion. Texas conducted the first state enforcement action against a promoter of cryptocurrency investments when it secured an emergency action, on December 20, 2017, against Dubai-based USI-Tech Limited. Another promoter, BitConnect, claimed a market capitalization of more than $2.5 billion before Texas and North Carolina regulators entered emergency orders to stop BitConnect's cryptocurrency lending program. BitConnect’s market capitalization subsequently plummeted, falling more than 98.5 percent before its cryptocurrencies were delisted from public exchanges.

Senior fraud. The report also states that seniors remain a primary target of fraudsters, with NASAA's U.S. member jurisdictions bringing formal enforcement actions involving more than 1,100 senior victims in 2017. NASAA members identified the offer and sale of unregistered securities as the scheme used most often to victimize seniors and other vulnerable adults.

According to the report, 18 states have now passed a version of the NASAA Model Act to Protect Vulnerable Adults from Financial Exploitation, which mandates reporting to a state securities regulator and state adult protective services agency when an agent reasonably believes that financial exploitation of an eligible adult has been attempted or has occurred. States that have adopted the NASAA Model Act or similar statutes have thus far received more than 500 reports of potential senior financial abuse.

Wednesday, October 10, 2018

High Court declines to address bar on private aiding-and-abetting claims

By Rodney F. Tonkovic, J.D.

The Supreme Court has denied certiorari for a petition asking it to rule on a circuit split over the assertion by private plaintiffs of aiding and abetting claims under Exchange Act Section 10(b). The petition asserted that the Second Circuit created a "co-participant" theory of liability that is at odds with the Court's bright-line prohibition against private aiding and abetting claims.

The petitioners in Bats Global Markets, Inc. v. City of Providence (18-210) were a group of national securities exchanges alleged by the respondents to have sold products and services to high frequency trading firms in a way that advantaged them over other, ordinary traders. The district court dismissed the suit, concluding that exchanges were absolutely immune from suit for much of the conduct at issue. Even if the exchanges were not absolutely immune, the plaintiffs failed to state a fraud claim under the Exchange Act based on a manipulative scheme. At best, the court said, the exchanges merely enabled the HFT firms to execute the transactions that harmed the plaintiffs. Since aiding and abetting claims are prohibited, the court dismissed the complaint.

Manipulation. The Second Circuit vacated and remanded the district court's judgment, finding (as the SEC argued in an amicus brief) that the exchanges were not entitled to absolute immunity because they were not acting as regulators in providing the challenged products and services. The panel went on to find that the exchanges mislead investors by artificially affecting market activity. And, the exchanges went beyond simply giving the HFT firms the means to commit market manipulation, and were co-participants in the manipulative scheme.

Aiding and abetting bar. At issue, the petition argued, was the long-standing bar on private securities fraud plaintiffs asserting aiding-and-abetting claims. Since Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. (1994), at least four circuits (the Third, Fifth, Seventh, and Eleventh) have applied the prohibition to hold that liability may not be imposed on a defendant where a third party had independent, ultimate authority to commit the act that harmed the plaintiff. The Second Circuit, the petition argued, created a theory of "co-participant" liability that permits private securities fraud claims in direct conflict with these rulings and that is at odds with the general rule that even substantial participation in a fraud is insufficient where the primary violator made the independent choice to commit fraud..

Manipulation. The petition also asked whether a plaintiff states a claim for market manipulation where it is undisputed that the defendant did not engage in any trading activity. Here, the petitioners note that the Third Circuit defines manipulation as injecting inaccurate information into the market, while the D.C. Circuit requires only manipulative intent combined with legitimate trading activity. The Second Circuit, the petition said, deepened this split by taking a third path and finding manipulation where non-trading conduct did not inject any price information into the market.

The response to the petition for a writ of certiorari was due on September 17, 2018. The respondents, however, filed a waiver of their right to respond on September 6. Justice Breyer took no part in the consideration or decision of this petition.

First Solar. The Court also invited the Solicitor General to file a brief in First Solar, Inc. v. Mineworkers' Pension Scheme, (18-164). At issue in this case is what the petitioner describes as a three-way split in how the appellate courts require a plaintiff to show the market's reaction to information revealing the fraudulent nature of the defendant's conduct. The petition argues that the Ninth Circuit has adopted a "dramatically less demanding" proximate cause standard for proving loss causation that is inconsistent with the Court's precedent.

Read the docket. This case, and others pending before the Court, can be referenced in the latest version of the Supreme Court Docket, a regular feature of Securities Regulation Daily. Cases are listed separately, along with a brief summary of the questions raised and the status of the appeal

The petition is No. 18-210.

Tuesday, October 09, 2018

Securities Regulation Daily’s top 10 developments for September 2018

By Lene Powell, J.D.

In a major caution for companies to take a close look at their social media policies, the SEC decisively reined in Elon Musk, the famously glib chief of Tesla, Inc., in the wake of his August tweet that he had secured a deal to take Tesla private. In late September, the SEC charged Musk with securities fraud and Tesla with having inadequate disclosure controls. When the dust settled two days later, Musk and Tesla each agreed to pay a $20 million penalty, and Musk agreed to be removed as Tesla chairman. The settlements are subject to court approval.

The SEC also swung the hammer at three former officers of the now-defunct law firm Dewey & LeBoeuf for their involvement in falsifying the firm’s financial results. The Southern District of New York ordered Steven H. Davis to pay a $130,000 civil penalty and imposed an officer and director bar, as well as smaller disgorgement orders against the firm’s finance director and controller.

In another big enforcement development, the SEC paid out the second largest whistleblower award in its history, awarding $39 million to one whistleblower and $15 million to another. Notably, the second claimant received the award even though the SEC determined that the information was not given “voluntarily,” in that he or she submitted the tip after appearing before another regulatory agency for an investigative interview. Due to a variety of factors, the SEC granted a waiver on this point.

September was a blockbuster month for virtual currency developments. The District of Massachusetts ruled that a virtual currency called “My Big Coin” was a commodity for purposes of a CFTC enforcement action under the Commodity Exchange Act, and the Southern District of New York decided that cryptocurrency tokens in two initial coin offerings (ICOs) were securities under the Securities Act and Exchange Act, at least at the motion to dismiss stage.

Further, FINRA staked its claim in the space with its first cryptocurrency enforcement action, and the SEC settled its first enforcement actions against an unregistered digital asset fund manager and unregistered broker-dealers selling digital tokens. SEC Enforcement Co-Director Stephanie Avakian also signaled that the Division of Enforcement will likely soon begin recommending substantial penalties against ICO issuers that fail to comply with securities registration requirements.

Somewhat softening this broadside, Commissioner Hester Peirce urged “humility” in the SEC’s response to cryptocurrencies and cautioned against regulatory overprotectiveness. In a speech that earned her the nickname “CryptoMom” in the Twittersphere, she warned that stifling innovation in the regulated markets would cause investors to seek out new products in less-regulated markets.

Read more below for more detail, and keep up with the WK Securities team on Twitter by following @WK_Securities and on LinkedIn at


Musk will step aside as Tesla chairman as part of settlement with SEC

Elon Musk quickly settled the SEC’s fraud charges by agreeing to several actions, including stepping down as chairman of Tesla. He also agreed to appoint two independent directors to the company’s board, and he and Tesla will pay $40 million in penalties. Musk will be replaced by an independent chairman, but is eligible to be reelected as chairman after three years. See our full coverage.


Former Dewey & LeBoeuf execs fined $181K for cooking the books

The SEC settled charges against three former executives of the now-defunct Dewey & LeBoeuf law firm for their involvement in a fraudulent bond offering that relied on materially misstated financial results. The Southern District of New York imposed a $130,000 civil penalty and officer and director bar against former chairman Steven H. Davis, as well as disgorgement orders against the firm’s former finance director and controller. See our full coverage.


Whistleblower awarded second largest award in SEC history

After giving the SEC critical information and continued assistance in bringing an important enforcement action, the SEC has determined to award $39 million to one whistleblower and $15 million to another. See our full coverage.


Virtual currency is a ‘commodity’ for purposes of CFTC fraud claims

The Massachusetts district court has declined to dismiss a complaint alleging a fraudulent "virtual currency scheme" in violation of the Commodity Exchange Act and CFTC regulations. According to the court, the virtual currency at issue is a "commodity" within the meaning of the Act, and the antifraud provisions of CEA Section 6(c)(1) and Regulation 180.1 are not restricted only to cases involving market manipulation. See our full coverage.


Crypto assets in alleged ICO fraud passed the Howey test; indictment stands

In an indictment for criminal securities fraud involving two initial coin offerings (ICOs), the U.S. successfully argued at the motion to dismiss stage that the investments in the allegedly fraudulent offerings were investment contracts and thus securities under the Securities Act and Exchange Act. The Southern District of New York also found that the Exchange Act and SEC Rule 10b-5 were not unconstitutionally vague as applied in this case. See our full coverage.


FINRA smokes out HempCoin fraud in first crypto enforcement action

In the SRO’s first enforcement action involving virtual currencies, FINRA has charged a former Massachusetts broker with fraudulently selling an unregistered cryptocurrency security called HempCoin. FINRA alleges that Timothy Tilton Ayre attempted to attract investments into the worthless public company he controlled by offering interests in what he touted as the "the first minable coin backed by marketable securities." According to FINRA, however, Ayre misrepresented his company’s business and financial status in OTC Pink Market filings while failing to register the HempCoin interests with the SEC. See our full coverage.


First enforcement action against unregistered digital asset hedge fund manager settles

A hedge fund manager falsely calling itself the first regulated crypto asset fund has been sanctioned for operating as an unregistered investment company. The Commission found that the California-based company and its sole principal conducted an unregistered, non-exempt public offering and then invested over 40 percent of the fund's assets in digital asset securities. The firm and principal agreed to pay a $200,000 penalty and consented to a cease and desist order and censure. See our full coverage.

8. ICOs

Unregistered broker-dealers settle SEC’s first digital token case

Michigan unregistered broker-dealers selling digital tokens settled with the SEC in the Commission’s first case charging unregistered broker-dealers with selling digital tokens after the 2017-released Digital Asset (DAO) Report. The broker-dealers agreed to pay $471,000 in disgorgement, $7,929 in interest and $45,000 in penalties, along with consenting to industry and penny stock bars and an investment company prohibition with the right to reapply after three years. See our full coverage.

9. ICOs

Avakian highlights enforcement efforts involving ICOs, share class disclosures

As she approaches the end of her first full fiscal year as Co-Director of the SEC’s Enforcement Division, Stephanie Avakian highlighted what she regards as some of the Division’s greatest success stories during her tenure. In particular, she focused on the Division’s approach to dealing with initial coin offerings (ICOs) and mutual fund share class disclosures. Avakian's remarks came before the University of Texas School of Law’s 5th Annual Government Enforcement Institute in Dallas, Texas. See our full coverage.


Commissioner Peirce urges ‘humility’ in regulatory response to cryptocurrency

Seeming to embrace the new moniker of "CryptoMom," SEC Commissioner Hester Peirce told attendees of the Cato Institute’s FinTech Unbound Conference that she would likely be a "free-range" mother that would encourage a child to learn and explore with limited supervision. This approach requires acceptance of a certain level of risk, she acknowledged, but achievements are often only possible with a certain level of risk-taking. Citing her recent dissents from decisions to block exchange-traded products designed to give investors access to bitcoin, Peirce noted that the capital markets are all about risks and suggested that the SEC "helicopters in with good intentions, but often without sufficient concern for the way its blades roil the markets, frustrate innovation, and potentially expose investors to greater risks." Investors should have access to a wide variety of investment options and be able to evaluate risks for themselves, the commissioner opined. See our full coverage.

Monday, October 08, 2018

CFTC’s inaugural FinTech Forward Conference explores rapid technological advancements and regulatory challenges

By Brad Rosen, J.D.

Technology innovators, market participants, thought-leaders from industry and academia, as well as representatives from various regulatory agencies convened in Washington, D.C., at the first-ever CFTC FinTech Forward Conference 2018. Over two days, attendees examined a wide range of fintech developments impacting markets, including crypto assets, machine learning, cloud technologies, regtech and other emerging financial technologies. The conference was organized by the CFTC’s LabCFTC unit in conjunction with the agency’s Office of Customer Education and Outreach.

In prepared remarks, CFTC Chairman J. Christopher Giancarlo stated, “Emerging financial technologies are taking us into a new chapter of economic history. They impact trading, markets, and the entire financial landscape with far ranging implications for capital formation and risk transfer,” he continued, “By bringing together the best minds from industry and many of the agencies that regulate financial markets, products, and technologies, we also hope to facilitate a number of introductions and ongoing dialogs.”

The content-rich conference featured numerous panel discussions, keynote speeches, and a fireside chat. A summary of a few resulting insights and observations follow:

Tokenization: Exploring “the Other Side of the Coin.” Aaron Wright, Associate Clinical Professor of Law at Cardozo Law School expressed optimism regarding continued growth in the tokenization of assets at the conference’s second panel. He noted this trend will likely include native digital assets like Bitcoin, but will also extend to intellectual property rights, interests in real property, as well as the digitization of securities.

Wright noted tokenization will lead to more liquidity, greater ease in transferring assets on a global basis, and a flowering of business opportunities and emerging activities. However, Wright recognized that in a digital world an asset which is properly described as a commodity might also appear to be security. He cautioned, “This creates a landmine from an entrepreneur’s perspective. Lawyer’s cannot even provide opinions.” He noted this makes for a very difficult regulatory environment in which to conduct business.

Scams, fraud, and education in a technology-driven world. Joe Rotunda, director of Texas State Securities Board’s Enforcement Division, noted that state securities administrators have been floored by what they are seeing in the cryptocurrency space during the conference’s third panel. Rotunda indicated that 40 jurisdictions were involved in the latest North American Securities Administrators Association (NASAA) cryptocurrency sweep. That initiative resulted in 200 investigations and 45 enforcement actions.

Rotunda noted that fraudulent businesses are going to great lengths to look like established and legitimate enterprises. They are using slick video, stock photos, fake testimonials and other high-end tools to perpetuate their scams according to Rotunda. He also indicated these fraudsters are expert at using high pressure sales tactics associated with the boiler rooms of penny stock promoters. He added their victims come from every demographic—from young people in their twenties just starting out, to retirees and the elderly living on fixed incomes.

21st century regulatory approaches and frameworks. Valerie Szczepanik, Senior Advisor for Digital Assets and Innovation at the SEC, observed that regulators need to be increasingly proactive, not just reactive during the conference’s fifth panel. She also remarked that the younger generation is very comfortable regarding technology which explains, in part, its ready acceptance of peer to peer financing, robo-advising, and crowdfunding.

Szczepanik also noted that her move from the SEC’s division of enforcement to its corporate finance section reflects the agency’s interest in engaging with industry with respect to technological innovation. She sees the SEC as often playing a lifeguard role. We’ll let market participants know when they are heading to danger. Szczepanik also suggested that the agency will be providing innovators with further guidance in form of interpretive and no-action relief in the near future with regard to crypto-assets.

A fireside chat. Commissioner Rostin Behnam explored the bigger meaning of blockchain and virtual assets in a fireside chat with Kabir Kumar, Director of Policy and Ecosystem Building at Omidyar. The two discussed the larger benefits society might reap from digital ledger technologies. Behnam, echoing some of his comments made at the United Nations in June, pointed to specific blockchain use cases which promote food purity and the sourcing and tracking of various agricultural commodities. Behnam also pointed to the positive contributions blockchain technology could make with regard to improving health care, as well as financial inclusion in development countries.

Behnam also pointed noted that the involvement and interest of large companies like IBM in blockchain technology, and the importance of institutional involvement in this burgeoning space. Behnam concluded by articulating a common theme expressed by many of the regulators at the conference—“Policymakers must assure that things happening within bounds, but at the same time, we must give innovators room to experiment.”

Friday, October 05, 2018

Thumb on scale caused Whole Foods price drop, not accounting issues

By Rodney F. Tonkovic, J.D.

A Fifth Circuit panel has weighed claims arising out of alleged overcharging by Whole Foods and found that they did not add up to fraud. Regulatory actions had revealed that Whole Foods had overcharged customers by including the weight of packaging in the price of some products. As a result, the complaint alleged, the company had fraudulently counted the overcharged money as revenue. The court ultimately concluded that the disappointing sales numbers and resulting stock price drop were more plausibly related to customer reaction to the company's public relations issues than its accounting practices (Employees' Retirement System of the State of Hawaii v. Whole Foods Market, Incorporated, October 3, 2018, King, C.).

Weights and measures. In the summer of 2015, the public learned that a sting operation in New York caught Whole Foods including the weight of packaging in the weight of many of its prepackaged products. According to the complaint, Whole Foods knew about these weights and measures issues since early 2013, when California authorities began looking into the issue. This investigation culminated in a lawsuit, and the company settled in June 2014, agreeing to implement procedures to ensure pricing accuracy and to pay $800,000.

In August 2014, and again in early 2015, regulators in New York fined the company for weights and measures violations. A June 2015 press release by the New York City Department of Consumer Affairs reported that 89 percent of the products it tested were mislabeled, causing customers to be overcharged from $0.80 to nearly $15. The inspectors said it was "the worst case of mislabeling they [had] seen in their careers." Whole Foods subsequently apologized and promised to implement policy changes. On July 29, 2015, Whole Foods hosted an earnings call during which the individual defendants attributed the lower-than-expected third-quarter results to the news that the company had overcharged its customers.

Weighty matters. The plaintiffs alleged that between July 31, 2013 and July 29, 2015, Whole Foods made three general categories of fraudulent statements that artificially inflated the price of its stock. First, the company asserted that it provided competitive pricing. Whole Foods also proclaimed that it held itself to high standards for transparency, quality, and corporate responsibility. Finally, the company's statements on its financial numbers were misleadingly inflated by the inclusion of revenues from fraudulently-labeled products.

Doesn't measure up. The district court dismissed the plaintiffs' fraud claims because it determined they failed to properly allege a material misrepresentation, scienter, or loss causation. The panel affirmed the district court's judgment.

The panel first found that Whole Foods' statements regarding the competitiveness of its prices were not rendered false by the weights and measures issues. The panel explained that it did not necessarily follow that the prices were not competitive even with the weight of the packaging added in, and the plaintiffs provided no way to compare. As a result, the complaint failed to plead with the required particularity that these statements were misleading. The panel also agreed with the district court that the generalized statements about Whole Foods' transparency, quality, and responsibility were the sort of self-serving puffery that a reasonable investor would not rely on.

Finally, the plaintiffs argued that Whole Foods overstated its revenues by $127.7 million during the time at issue. Specifically, the company violated GAAP by counting as revenue money that it was not entitled to—what the company fraudulently collected through overcharging customers. The panel noted that the plaintiffs did not plead with particularity how much of its revenue Whole Foods overstated in each statement that was alleged to have been misleading. Even if the falsity was alleged with particularity, however, the complaint failed to allege that the inflated revenues caused the plaintiffs' loss.

The plaintiffs alleged that their loss occurred when Whole Foods' stock price dropped by about 10 percent on the day after it released its third-quarter numbers. While the market had been aware for weeks that Whole Foods had been overcharging, the plaintiffs contended that the disappointing results revealed on July 29, 2015 was a partial disclosure that showed the financial impact of a previously-revealed fraud. The problem for the plaintiffs, the panel said, was that their claims were not based on misrepresentations to Whole Foods' customers (i.e., the weights and measures fraud) but were instead based on alleged misrepresentations to shareholders through its accounting errors. The public relations problems arguably led to slowed sales, but the alleged accounting issues did not cause the public relations problems, and the complaint did not allege that the accounting problems caused a separate loss in stock price.

The case is No. 17-50840.

Thursday, October 04, 2018

Enforcement Co-Director Peikin notes importance of both equitable and monetary sanctions

By Amy Leisinger, J.D.

In remarks before Practising Law Institute’s white-collar crime conference, SEC Enforcement Co-Director Steven Peikin discussed the need for more than quantitative metrics when considering the effectiveness of the agency’s enforcement activities and for a careful balance of monetary and non-monetary sanctions to achieve the SEC goals. Statistics do not provide a full picture of the quality of enforcement efforts, he noted, and the Division strives to stay focused on whether investors are protected and individuals are held accountable for misconduct while keeping pace with technological changes and effectively allocating resources.

Non-monetary sanctions. According to Peikin, while the Enforcement Division does seek some form of monetary relief in most of its actions, non-monetary relief is also important to achieving the Commission’s goals. The focus must be on punishing bad actors, restoring money to investors, achieving deterrence, and putting protections in place going forward, he explained. The most effective forms of equitable relief are undertakings requiring a defendant or respondent to take affirmative steps to come into compliance and injunctions and bars prohibiting an individual from engaging in future conduct, the co-director stated.

Undertakings make it possible to push change in a company’s processes that will serve the investors’ interests, Peikin opined. For example, he cited the recent action against Elon Musk in which Musk and Tesla agreed to a comprehensive set of undertakings, including, among other things, Musk’s resignation, the addition of two independent directors to Tesla’s board, and the adoption mandatory controls and procedures to oversee Musk’s public communications about the company. Undertakings are designed to target and address specific risks, Peikin explained.

Monetary sanctions. According to Peikin, monetary penalties are one of the primary ways that the Enforcement Division can incentivize regulated entities to remain in compliance with the SEC’s rules. However, he noted, the assessment of penalties requires careful balancing of many factors including the circumstances and nature of the misconduct. Enforcement staff also considers remedial steps taken by and self-reporting efforts of defendants and respondents, as well as the extent of cooperation with the Commission. Penalties serve a strong deterrent purpose, he said, but not every case warrants a penalty, particularly when there have been proactive remediation and/or cooperative efforts.

“What we do not do is assess large penalties simply for the sake of counting them up at the end of the year,” Peikin stressed.

While imposition of civil monetary penalties requires a balancing of factors, disgorgement is handled differently, the co-director explained. Even if cooperative and engaged in remedial efforts, a defendant or respondent should not be allowed to retain ill-gotten gains. Disgorgement is often the surest way to restore investors’ losses, Peikin explained, but the Supreme Court ruling in Kokesh v. SEC that the proceeds of misconduct obtained outside the statute of limitations are not subject to disgorgement has changed the game. Kokesh prevented the Commission from seeking approximately $800 million in potential disgorgement, he noted.

Wednesday, October 03, 2018

Chairman Giancarlo aims to get global swaps regulation ‘right’ with issuance of comprehensive white paper

By Brad Rosen, J.D.

Citing the risks of fragmenting global swaps markets and their increasing lack of resilience in the event of market shocks, CFTC Chairman J. Christopher Giancarlo released his long awaited white paper titled Cross-Border Swaps Regulation Version 2.0: A Risk-Based Approach with Deference to Comparable Non-U.S. Regulation. The Chairman asserted that given the global nature of the swaps market, where cross-border transactions are the norm rather than the exception, “it is imperative that the CFTC gets the cross-border application of its swap rules right.”

According to the agency’s release accompanying the white paper, Chairman Giancarlo intends to direct the CFTC staff to put forth new rule proposals based on the principles set forth in this white paper, to address a range of cross-border issues in swaps reform.

Adverse consequences flowing from the CFTC’s current approach. In the white paper, the chairman identifies a number of adverse consequences resulting from the CFTC’s current cross-border approach. According to Giancarlo, the current approach is flawed based upon some of the following reasons:
  • It is over-expansive, unduly complex, and operationally impractical, increasing transaction costs and reducing economic growth and opportunity.
  • It relies on a substituted compliance regime that encourages a somewhat arbitrary, rule-by-rule comparison of CFTC and non-U.S. rules under which a transaction or entity may be subject to a patchwork of CFTC and non-U.S. regulations.
  • It shows insufficient deference to non-U.S. regulators that have adopted comparable G20 swaps reforms and is inconsistent with the CFTC’s longstanding approach of showing comity to competent non-U.S. regulators in the regulation of futures.
  • It is expressed in “guidance” rather than formal regulation subject to the Administrative Procedure Act.
Recommendations for improvement. Giancarlo put forth several recommendations in the white paper calculated to improve the Commission’s cross-border approach, which he notes are supportive of the G20 swaps reforms, aligned with Congressional intent, and better balance systemic risk mitigation with healthy swaps market activity in support of broad-based economic growth. Among other things, the chairman recommended the following changes to the CFTC’s present cross-border approach:
  • Non-U.S. CCPs—Expand the use of the CFTC’s exemptive authority for non-U.S. Central Clearing Parties (CCPs) that are subject to comparable regulation in their home countries and do not pose substantial risk to the U.S. financial system, permitting them to provide clearing services to U.S. customers indirectly through non-U.S. clearing members that are not registered with the CFTC.
  • Non-U.S. Trading Venues—End the current bifurcation of the global swaps markets into separate U.S. person and non-U.S. person marketplaces by exempting non-U.S. trading venues in regulatory jurisdictions that have adopted comparable G20 swaps reforms from having to register with the CFTC as swap execution facilities.
  • Non-U.S. Swap Dealers—Require registration of non-U.S. swap dealers whose swap dealing activity poses a “direct and significant” risk to the U.S. financial system; take into account situations where the risk to the U.S. financial system is otherwise addressed, such as swap transactions with registered swap dealers that are conducted outside the United States. Moreover, show appropriate deference to non-U.S. regulatory regimes that have comparable requirements for entities engaged in swap dealing activity.
  • Clearing and Trade Execution Requirements—Adopt an approach that permits non-U.S. persons to rely on substituted compliance with respect to the swap clearing and trade execution requirements in comparable jurisdictions, and that applies those requirements in non-comparable jurisdictions if they have a “direct and significant” effect on the United States. 
The chairman reaffirms his support for the Dodd-Frank market reforms. Like he has done many times in the past, Chairman Giancarlo again affirmed his support for the post-financial crisis Dodd-Frank reforms, stating, “I have been a constant supporter of the swaps market reforms passed by the U.S. Congress in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the commitments made by the G20 leaders in Pittsburgh in 2009.” He continued, “Those are clearing standardized swaps through central counterparties, reporting swaps to trade repositories, and trading standardized swaps on regulated trading platforms. However, I have long said that I hold reservations about the CFTC’s current approach to applying its swaps rules to cross-border activities.”

Next steps. The CFTC’s release indicated that the proposals contained in the white paper will be presented to the full CFTC for its input, bipartisan consideration, and adoption. Any subsequent rulemakings would replace the cross-border guidance issued by the CFTC in 2013 and the cross-border rules proposed by the CFTC in 2016, and would address certain positions taken in CFTC staff advisories and no-action letters as well.

Tuesday, October 02, 2018

In new term, High Court drops petition on corrective disclosures, will hear Janus question

By Rodney F. Tonkovic, J.D.

The Supreme Court started its October 2018 term with a denial of certiorari for a case asking whether the filing of civil complaint can be a corrective disclosure. During this term the Court, currently with eight members, will also hear a petition from a case involving scheme liability in which the nominee for the vacancy, Judge Brett Kavanaugh, wrote a dissenting opinion. Finally, pending petitions ask the Court to consider aiding and abetting liability and loss causation.

Corrective disclosures. The Court denied certiorari in Community Health Systems, Inc. v. New York City Employees' Retirement System (17-1453). The petition asked whether the filing of a complaint in a different suit may constitute a corrective disclosure. In this case, the Sixth Circuit flatly rejected a categorical rule, adopted by many district courts, that the filing of a civil complaint is not a corrective disclosure. The petition argued that the Sixth Circuit's case-by-case approach is deeply flawed and ignores the fact that allegations are nothing more than untested claims. The petition also asked the court to address the relation back of otherwise time-barred claims asserted in an amended complaint by new plaintiffs.

In this case, the complaint pegged loss causation on a stock price drop after the filing of a lawsuit. The petition first argued that the lower courts are divided over the legal sufficiency of mere allegations of fraud. Here, the Sixth Circuit found that it was plausible that the allegations from the other suit constituted corrective disclosures. According to the petitioners, the Sixth Circuit's holding suggests that every putative disclosure of new information, from any source, must be evaluated to see if the market could perceive it to be true. The Sixth Circuit's case-by-case approach, the petition asserted, conflicts with decisions by the Ninth and Eleventh Circuits holding categorically that the filing of a civil suit does not establish liability and thus cannot constitute a corrective disclosure.

The Sixth Circuit also held that new claims in an amendment to the complaint upon which this case was based related back to the original. The court admitted that the amended complaint expanded the class definition, but this was permissible because it "conformed" the class membership to the scope of the fraud as originally alleged. The petition said that there is a circuit split with at least three different approaches over the proper test for determining relation back under FRCP Rule 15(c). Most circuits would agree that the Sixth Circuit's more lenient approach is incorrect, the petition contended.

Looking ahead. This term, the Court has agreed to hear Lorenzo v. SEC (17-1077), which asks whether a misstatement claim that does not meet the elements set forth in Janus can be repackaged and pursued as a fraudulent scheme claim. This petition was brought by a broker who was found to have defrauded two clients even though, he argues, he did not "make" false statements and sent the emails at issue on the orders of his supervisor. In a 2-1 decision, the D.C. Circuit overturned the SEC's finding that Lorenzo violated Rule 10b-5(b), but upheld the remainder of the violations, noting that Rules 10b-5(a) and (c) and Securities Act Section 17(a)(1) do not speak in terms of an individual's "making" a false statement, which was the critical language construed in Janus. While not a "maker," Lorenzo played an active role in producing and sending the emails, which constituted employing a deceptive "device," "act," or "artifice to defraud" for purposes of liability under those provisions.

The dissenting judge took the majority to task for finding that Lorenzo acted with scienter and for creating a circuit split by holding that mere misstatements may constitute the basis for scheme liability. Running with this argument, the petition maintains that the D.C. Circuit's decision allows plaintiffs to sidestep Janus by repackaging a fraudulent statement claim as a fraudulent scheme claim. Only the D.C. Circuit and the Eleventh Circuit have held that a misstatement standing alone can be the basis of a fraudulent scheme claim, the petition says, while the Second, Eighth, and Ninth Circuits have held that scheme liability requires something more than just deceptive statements.

Supreme Court nominee Judge Brett Kavanaugh was the dissenting judge on the D.C. Circuit panel that heard Lorenzo. If confirmed to the Supreme Court, Judge Kavanaugh likely would have to grapple with recusing himself because of his participation in deciding the case below.

Pending. The Court will also consider the following securities-related petitions:
  • Bats Global Markets, Inc. v. City of Providence (18-210): Whether a private plaintiff states a valid securities-fraud claim by pleading that the defendant enabled a third party to commit the acts that caused the allegedly fraudulent harm, where the primary violator undisputedly exercised an independent choice to commit those acts. 
  • First Solar, Inc. v. Mineworkers' Pension Scheme (18-164): Whether a private securities-fraud plaintiff may establish the critical element of loss causation based on a decline in the market price of a security where the event or disclosure that triggered the decline did not reveal the fraud on which the plaintiff’s claim is based.
  • Quality Systems, Inc. v. City of Miami Fire Fighters' and Police Officers' Retirement Trust (17-1056): 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. Due to settlement proceedings in the district court, the parties have requested that the Court defer action on this petition until the December 7, 2018 conference.
  • Petroleo Brasileiro S.A. - Petrobras v. Universities Superannuation Scheme Limited (17-664): This petition concerns the level of proof needed to invoke the Basic presumption of reliance. Post-settlement, the parties have indicated that they will move to dismiss the petition for certiorari. 
Read the docket. This case, and others pending before the Court, can be referenced in the latest version of the Supreme Court Docket, a regular feature of Securities Regulation Daily. Cases are listed separately, along with a brief summary of the questions raised and the status of the appeal.

Monday, October 01, 2018

Misleading financial forecast costs Walgreens $34.5M

By Matthew Garza, J.D.

The SEC settled charges against Walgreens Boots Alliance and two former officers for misleading investors about the company’s progress on hitting a key financial goal announced after a 2012 merger. Walgreens’ two-step merger with European company Alliance Boots was projected to generate between $9 and $9.5 billion in combined adjusted operating income in 2016, but the company’s CEO and CFO failed to disclose that internal projections showed increased risk in hitting that number over multiple reporting periods. By the time the second step of the merger took place in 2014, the projection was down to $7.2 billion, causing a 14.3 percent stock drop the day it was announced (In the Matter of Walgreens Boots Alliance, September 28, 2018).

Increasing risk. The CEO and CFO knew the financial target was a challenge from the beginning, said to the SEC, and from 2013 forward Walgreens’ internal forecasts showed significant and increasing risks to hitting the target. Poor sales and an industry-wide increase in the price of generic drugs placed pressure on the goal, but the company reaffirmed the target on two earnings calls in 2013 without disclosing that the company was seeing a growing risk in hitting it.

The original October 2012 financial targets were referred to internally as “challenging, stretch goals,” and the company’s Financial Planning and Analysis group regularly tracked progress and compared it to the 2012 glide path. By the spring of 2013, the group was seeing lagging performance and began to project significant shortfalls in the glide path targets for 2014-2016. The CEO and CFO were sent an email in May 2013 describing the risks, according to the complaint, and internal forecasts continued to drop through August 2014, when the company shocked investors with the lowered target.

Misleading statements. The risks identified by Walgreens internally were not adequately stated in quarterly disclosures in 2013 and 2014, the SEC charged. In earnings calls in June and October of 2013 the original forecast was reaffirmed without any warning of the risks identified internally. In a December 2013 the company disclosed that it was “tracking a bit below” the necessary pace, but they still thought it attainable. This inadequate disclosure, according to the complaint, was repeated in March 2014.

Sanctions. Without admitting or denying the findings, the company was fined $34.5 million and the CEO and CFO were penalized $160,000 each. The company was granted a waiver from the safe harbor disqualification provisions of Securities Act Section 27A(b) and Exchange Act Section 21E(b), which exclude reliance on the safe harbors for forward-looking statements if the issuer has been subject to a cease and desist order within the past three years.

“As this case shows, we are committed to holding corporate executives accountable when they are in the best position to ensure that disclosures are accurate and not misleading,” said Melissa Hodgman, associate Director of the SEC’s Enforcement Division.

Friday, September 28, 2018

First SEC enforcement charging violations of the Identity Theft Red Flags Rule

By R. Jason Howard, J.D.

The SEC has accepted an offer of settlement from Iowa-based, dually registered broker-dealer and investment adviser, Voya Financial Advisors, Inc. (VFA), for failures in its cybersecurity policies and procedures involving a breach that compromised the information of thousands of its customers (In the Matter of Voya Financial Advisors, Inc., Release No. 34-84288, September 26, 2018).

Cybersecurity intrusion. The SEC’s order stemmed from a cyber intrusion that occurred over a six-day period in 2016 where VFA contractors were impersonated and convinced VFA’s support line to change passwords which allowed them to access the personal information of 5,600 VFA customers. The order also found that weakness in VFA’s cybersecurity policies and procedures led to VFA’s failure to terminate the intrusion in a timely fashion.

Charges. VFA was charged with “violating the Safeguards Rule and the Identity Theft Red Flags Rule, which are designed to protect confidential customer information and protect customers from the risk of identity theft.”

“Customers entrust both their money and their personal information to their brokers and investment advisers,” said Stephanie Avakian, Co-Director of the SEC Enforcement Division. “VFA failed in its obligations when its deficiencies made it vulnerable to cyber intruders accessing the confidential information of thousands of its customers.”

“This case is a reminder to brokers and investment advisers that cybersecurity procedures must be reasonably designed to fit their specific business models,” said Robert A. Cohen, Chief of the SEC Enforcement Division’s Cyber Unit. “They also must review and update the procedures regularly to respond to changes in the risks they face.”

Penalties. Without admitting or denying the SEC’s findings, VFA has agreed to a censure and a $1 million penalty. It will also retain an independent consultant to evaluate its policies and procedures for compliance with the Safeguards Rule and Identity Theft Red Flags Rule and related regulations.

The release is No. 34-84288.

Thursday, September 27, 2018

More companies disclose climate change risks, but leave out financial impact, FSB task force finds

By John Filar Atwood

In a survey of 1,700 companies around the world, the Financial Stability Board’s task force on climate-related financial disclosures found that the majority of companies provide some recommended disclosure on climate change, but very few report the financial impact of climate change on the company. The survey also found that only a minority of the surveyed companies disclose forward-looking climate targets, or the resilience of their strategies under climate-related frameworks such as the 2 degree Celsius or lower scenario, which is a key area of focus for the task force.

In 2017 the task force issued recommendations that provided a framework for companies to develop more effective climate-related financial disclosures. The task force emphasized the importance of transparency in pricing risk, including risk related to climate change, to support informed capital-allocation decisions. It acknowledged the challenges associated with measuring and disclosing information on climate change-related risks, but expressed its view that moving climate-related issues into annual financial filings would allow practices to evolve more rapidly.

The newly issued status report measures companies’ progress on the 2017 recommendations. The task force found that a majority of companies surveyed provided disclosures that aligned with one or more of its recommendations. The task force believes that the results demonstrate that it is both possible and practicable for companies to disclose certain baseline climate-related information.

Findings. The task force found that while many companies describe climate-related risks and opportunities, few disclose the financial impact of climate change on the company. In addition, the survey indicated that climate change disclosures vary across industries and regions.

A higher percentage of non-financial companies reported information on their climate-related metrics and targets compared to financial companies. However, financial companies were more likely to disclose how they had embedded climate risk into overall risk management. Geographically, more companies in Europe disclosed information aligned with the recommendations than companies in other regions.

The survey results also indicate that climate-related financial disclosures are still in the early stages. The task force noted that implementation of its recommendations is an ongoing process, and that companies are in different places in terms of their exposure to climate-related risks and opportunities and their reporting capabilities.

The task force hopes that more companies will use its recommendations as a framework for reporting on climate-related risks during the next reporting cycle. It suggested that companies in the early stages of evaluating the impact of climate change on their businesses and strategies and those that have determined climate-related issues are not material should disclose information on their governance and risk management practices.

Better disclosure needed. The task force said that it was encouraged by some of the results of its disclosure review, but believes that companies need to provide more decision-useful climate-related information. In its view, improved practices and techniques would further improve the quality of climate-related financial disclosures and support more appropriate pricing of risks and allocation of capital in the global economy.

The task force intends to publish another status report in June 2019, which will allow for analysis of disclosures made in companies’ 2018 financial reports.

Wednesday, September 26, 2018

State administrators float draft cyber rules update ahead of annual meeting

By Mark S. Nelson, J.D.

The North American Securities Administrators Association issued a proposed model rule update dealing with cybersecurity for investment advisers. The draft documents began circulating as NASAA was set to kick off its annual meeting this week in Anchorage, Alaska, which also coincides with the installation of NASAA’s 101st president, Michael Pieciak of Vermont, who has announced plans to emphasize cybersecurity and related financial technology issues during his tenure. Public comments on the cybersecurity proposal are due by November 26, 2018.

Update follows common cyber approach. The model rule update would clarify that investment advisers must maintain written physical security and cybersecurity policies and procedures that are reasonably designed to ensure the confidentiality, integrity, and availability of physical and electronic records and information. The CIA approach (confidentiality, integrity, and availability) is one of two foundational methods NASAA’s proposal will employ, the other being the Department of Commerce's National Institute of Standards and Technology (NIST) Framework.

According to the proposal, investment advisers could tailor the policies and procedures to their size, services offered, and number of locations. They also should focus on reasonably anticipated threats, the safeguarding of confidential records and information, and protecting against the release of records that could harm or cause inconvenience to clients. The proposed rule also would emphasize the five functional areas identified in the NIST Framework: identification, protection, detection, response, and recovery. An appendix to the proposal contains a cybersecurity checklist prepared with the NIST Framework in mind. The proposal further would require an investment adviser to review its cybersecurity policies and procedures annually and to make updates as needed.

The proposal also addresses interactions between an investment adviser and clients. Specifically, an investment adviser must provide its privacy policy to a client upon engagement and then on an annual basis following engagement. A supplemental explanation of the model rule proposal observed that the Federal Trade Commission already requires state-registered investment advisers to deliver a privacy policy to clients and that the NASAA proposal would clarify that annual delivery is required, even though the FTC currently does not explicitly mandate annual delivery. By contrast, the NASAA proposal does not similarly mandate delivery to clients of an investment adviser’s physical security and cybersecurity policies and procedures.

Moreover, the proposal would make conforming amendments to other NASAA model rules. For example, model rules on recordkeeping and ethics would be updated to clarify that it is an unethical or fraudulent act to fail “to establish, maintain, and enforce a required policy or procedure.”

Multiyear project. NASAA has been developing what became the proposed model rule on investment adviser cybersecurity for at least four years through a combination of examinations and education outreach efforts. A consistent theme throughout these efforts was the need for additional information and tools for investment advisers to more effectively counter potential cyber threats by emphasizing the importance of cybersecurity, establishing a basic structure for designing cybersecurity policies and procedures, and to provide increased uniformity for state regulators and investment advisers. In particular, NASAA seeks to overcome the reluctance by some investment advisers who worry that they lack sufficient tools, guidance, and a directive to take action on cybersecurity concerns.

Tuesday, September 25, 2018

Panelists mull HFT, market resiliency in SEC-NYU dialogue

By Amy Leisinger, J.D.

Industry participants and academics discussed the “need for speed” among traders and the evolution of market making at the SEC-NYU Dialogue on Securities Market Regulation. Several panelists noted that the high-frequency trading (HFT) race and continued efforts to increase automation can lead to decreased focus on the actual work involved in the trading process and, as a result, a less-than-optimal outcome for investors. Further, panelists suggested that market makers aim to provide liquidity throughout the trading process but that shocks to the market can limit the risks they are willing to take. In a discussion of resiliency in markets where HFT firms are most likely to have an influence, panelists considered how uncertainty and fragmented markets affect liquidity provision and ultimate recovery from demand shocks.

SRO practices and automation. Considering whether regulations and SRO practices have incentivized the “HFT arms race,” Terrence Hendershott of UC Berkeley said that firms have always been trying to get information between markets as fast as possible and that, ultimately, HFTs profit from speed. The impact of HFT is not necessarily the same across all investors, he noted, and firms should pay particular attention to weighing the direct and indirect costs and benefits of developing increased trading speeds and focus on developing an optimal market design.

Adam Nunes of Hudson River Trading opined that the question of whether a process should be automated should depend on whether it lends itself to automation, because some processes do not. However, he explained, it would be surprising to the industry and investors if a firm was not working on further automation and increasing speed. Hendershott agreed, noting that “investors like speed,” and, in many ways, speed is important to integrating markets, especially as markets fragment.

Liquidity. In reviewing the evolving state of market making automation, profits, and obligations, Mao Ye of the University of Illinois at Urbana-Champaign noted that HFTs can provide liquidity in times of extreme price movements but often withdraw liquidity when it is most needed. On occasion, this can lead to a trading halt and time to allow trading interests to re-accumulate, he said. Before imposing any new requirements, the SEC needs to evaluate whether existing regulations are actually achieving their intended purposes, according to Ye, as these rules were designed with regard to human behavior.

Market making and automation. John DiBacco of Virtu posited that market makers basically serve as a risk transfer agent, but Jose Marques of Inferent Capital noted that no market maker will stand in front of a freight train and try to stop it, choosing instead to deal with the fallout from failing to step in. The panelists concurred that the industry needs to consider how many resources should be dedicated to market making and automation to improve market resiliency and keep a focus on both retail investors and institutional investors representing their interests.

Maintaining market resiliency. Kumar Venkataraman of Southern Methodist University discussed resiliency in terms of the speed with which liquidity rebuilds after demand shocks, noting that fragmented markets are more sensitive to stress and that periodic call auctions help with uncertainty. If trading is paused, he explained, it needs to be done in a coordinated manner; this has improved since the flash crash, Venkataraman noted.

Andrew Upward of Jane Street opined that the markets have overall become more resilient since that flash crash, partially in response to regulation but more so as a result of market reaction to the event. Echoing this sentiment, Steve Crutchfield of Chicago Trading Company urged regulators to be cautious in developing new regulations; it is important to make sure any changes actually help stakeholders, he concluded.

Monday, September 24, 2018

SEC proposes to clarify reporting exemption for single-issuer broker-dealers

By Lene Powell, J.D.

The SEC proposed to amend a reporting rule to clarify an exemption for broker-dealers who act for a single issuer. Under the proposed amendment to Rule 17a-5(e), a broker-dealer would not be required to engage an independent public accountant to certify the broker-dealer’s annual reports if, among other things, the securities business of the broker-dealer has been limited to acting as broker (agent) for a single issuer in soliciting subscriptions for securities of that issuer (Amendment to Single Issuer Exemption for Broker-Dealers, Release No. 34-84225).

Single issuer exemption. Under the broker dealer reporting rule 17a-5, broker-dealers’ annual reports generally must include reports prepared by an independent public accountant covering the financial report and, as applicable, the compliance or exemption report. However, there is an exemption for broker-dealers whose securities business is limited to acting as a broker for “the issuer” and several other conditions are met.

In context, it is clear that “the issuer” means “a single issuer,” and the SEC clarified this after the rule was adopted. But in a 2013 drafting error, the original ambiguous language was reinstated. To clarify the exemption, the proposal would amend Rule 17a-5(e) to provide that a broker or dealer would not be required to engage an independent public accountant to certify the broker’s annual reports if:
  • the securities business of the broker or dealer has been limited to acting as broker for a single issuer in soliciting subscriptions for securities of that issuer; 
  • the broker has promptly transmitted to the issuer all funds and promptly delivered to the subscriber all securities received in connection with the transaction, and
  • the broker has not otherwise held funds or securities for or owed money or securities to customers. 
The comment period will be open for 30 days following publication in the Federal Register.