Friday, June 15, 2018

Is it back to the drawing board for Form CRS?

By Anne Sherry, J.D.

Witnesses at the SEC Investor Advisory Committee meeting suggested that much more work needs to be done to craft a relationship summary for broker-dealer and investment adviser clients that complements Regulation Best Interest without overwhelming retail investors. The SEC is seeking comment on the Form CRS proposal, including three sample forms: one for broker-dealers, another for investment advisers, and a third for dual registrants. Even at just four pages, these forms may be too confusing, the witnesses posited, and one committee member even doubted whether it is possible to create a simple, paper document that addresses complex issues.

Testimony identifies areas for improvement. Dale Brown, President and CEO of Financial Services Institute, advocated for a two-tier disclosure system. The first tier would be a document given to investors at the point of sale and would include only the most salient information such as an explanation of the broker’s or adviser’s duty of care, the services to be provided, nature of the engagement, nature and scope of compensation, and conflicts of interest. Brown posited that there could be a safe harbor for firms that use a model form, similar to the model privacy form under Gramm-Leach-Bliley. The second tier of disclosure would include more detail and would be searchable, with a hard copy provided to investors upon request.

David Certner of AARP agreed with the idea that the information should be kept nontechnical and as short as possible. One weakness is that the current standard does not define key concepts such as a “fiduciary standard” or “best interest standard,” or the nuances between the two, he said. Retail investors already expect financial professionals to act in their best interest and are unaware that there are differing legal standards. Certner commended the SEC’s effort to restrict the use of the term “adviser,” but said that industry advertising will ultimately determine whether the spirit of this restriction is achieved. Marketing may eventually use other terms that cause the same confusion.

Susan Kleimann, the founder and President of Kleimann Communication Group, broke down for the committee how humans actually approach disclosures by skimming, asking questions, relating the information to themselves, and finding the story. The three sample disclosures are all “cursed by knowledge,” she said, meaning that the drafters assumed that the end user would share their level of knowledge. But the inclusion of a list of questions at the end of each sample form hints at a solution to the problem. Kleimann urged the committee to reimagine a disclosure organized around those questions to offer the same information in a format that readers are inclined to respond to.

Finally, Joe Carberry of Charles Schwab offered four core critiques of the proposal. First, it tries to do too much: dual registrants like Schwab would have to fit 40 items into 4 pages. Second, the form includes extraneous information that can confuse retail investors. Third, it may be duplicative by including information that the investor already has access to. Finally, it is not a layered approach, which would allow for further information based on a customer’s interests and concerns. Schwab developed a single-page prototype for consideration; Carberry suggested that such a form could stand out so starkly against other financial disclosures that customers could be more inclined to read it.

Testing a disclosure format. Committee member Jennifer Marietta-Westberg, Senior Economist at Cornerstone Research, asked the witnesses how the SEC should test disclosures for effectiveness. Kleimann said that one very effective but also very rarely conducted test is to go out in the field after the disclosure is in place and determine whether people are actually using it. Certner cautioned that warnings can have unintended consequences by indicating to people that a product has been evaluated and tested. The product must be okay because it is still on the market.

Putting disclosure in a larger context. Damon Silvers of AFL-CIO took a more holistic view of the problem. The committee and Commission cannot undertake this project without understanding the relationship between the disclosure regime and the quasi-fiduciary regime. Disclosure can inform investors about the different models for fees and what duties are required under each model, but it cannot provide most investors with sufficient information to be able to police conflicts of interest, he said. And the issues are intertwined with the distinction between a fiduciary standard and a best interest standard. Disclosure regimes in this context have always had an element of paternalism due to the imbalance of information, time, and focus between the investment manager and the client. To task the client, who specifically seeks out the professional because of that imbalance, with policing misconduct is nonsensical, he concluded.

Is a simple paper document achievable? Barbara Roper of the Investor Protection Consumer Federation of America also stressed the complexity of the issues. Roper doubted whether it was possible to develop a simple disclosure document covering complex issues. There is no sentence in the forms, she said, that an investor can be assumed to understand—not even something as fundamental as “This is a brokerage account.” When it comes to the nuances of a best interest standard compared to fiduciary standard, even people who have spent their entire careers in the industry sometimes have trouble understanding the difference. Roper believes every sentence in the disclosure needs to be layered and it is unlikely that this will work outside of an electronic context. In the retail market, however, 40 to 50 percent of investors prefer paper disclosures.

Commissioner Peirce observed the apparent preference for plain, simple disclosure, but said that one of the pushbacks when developing Form CRS was that not everything should be simplified and that there should be an effort to get investors comfortable with complex terms. Kleimann agreed that this goal is critical and said that “plain and simple” does not mean technically inaccurate. Certner added that different people want different levels of information, so the disclosure should offer a skimmable summary along with more detail, preferably on paper, for those who want to go further. Finally, Carberry said that the disclosure regime can assume intelligence on the part of investors. It is not a question of their ability, but their willingness, he said.

Thursday, June 14, 2018

Chairman Giancarlo expounds on grit and sharp moves in remarks to Women in Derivatives

By Brad Rosen, J.D.

Margaret Thatcher once observed, “If you want something said, ask a man; if you want something done, ask a woman.” So noted CFTC Chairman J. Christopher Giancarlo in his opening remarks before the Women in Derivatives Forum in Washington D.C. Giancarlo also lauded the virtues of professional networking, grit, as well as the recently created “Market Intelligence Branch” (MIB), a unit residing within the Division of Market Oversight.

Networking, grit and empowerment. In his comments, Giancarlo recognized the preeminence of professional networking in achieving success through sharing ideas and experience. He observed, “Women in Derivatives shows how this can happen in a complex, demanding, and difficult field.”

The chairman also noted the importance of “grit” as another predictor of success and pointed to the “Grit Scale” —a scale that measures passion, endurance, and perseverance. Speaking to the gathering, Giancarlo observed, “there is a lot of grit in this room: accomplishment over adversity, commitment instead of defeat, courage over concession.”

The chairman also took on the controversial issue of female economic empowerment as he summarized the central argument in The Confidence Code, a book by BBC’s Katty Kay, noting, “Women in the workplace need a “blueprint for confidence,” to get moving “in the right direction.” … [W]omen should talk more, demand to be heard, take an equal role in business meetings.” Giancarlo noted that Women in Derivatives represents these strong, powerful, informed, and persuasive voices, and serves as a model for networking and advancement.

Looking at sharp price moves. The chairman transitioned his comments to more general industry matters by noting that global derivative markets know no gender. Giancarlo turned his attention to the work done by recently created MIB that looked at large intra-day price movements in U.S. commodity futures markets, what that research calls “sharp price moves.”

Specifically, MIB staff engaged in a data-intensive research effort where 2.2 billion transactions from 2012 through 2017 were analyzed. The data included 16 different futures contracts from all four major commodity market sectors: agricultural, energy, financial, and metals products. The major findings from MIB’s research include: 
  • There is no clear indication of a wide-spread increase in the frequency or intensity of sharp price movements in recent years; 
  • Sharp price movements occur more often during periods of elevated volatility;
  • News and recurring market data releases are a factor in many contracts studied; and 
  • Some contracts see large movements in overnight trading but not a disproportionate amount when compared to volume traded during day/night. 
Significance of analysis and next steps. According to Chairman Giancarlo, MIB’s research dispels the narrative that recent changes in market structure, particularly the growing presence of principal trading firms and high frequency trading, has in some way made markets less stable. Rather, he observed short-term price swings can better be explained by longer-term, heightened market volatility and by the direct revelation of information and news events.

Giancarlo also stated, “The analysis tells us that today’s US commodity futures markets continue generally to function well, are able to digest information quickly and readily accommodate heightened volatility. In short, U.S. futures markets remain the premier price discovery mechanism for the world.”

Giancarlo concluded that MIB’s research efforts, like many such undertakings, lead to more questions. He stated further studies will be conducted, noting that important concerns remain about satisfactory liquidity conditions and adequacy of market making outside of actively traded market and asset classes.

Wednesday, June 13, 2018

SEC to publish ‘bedbug’ letters on EDGAR

By Mark S. Nelson, J.D.

Halloween came early to the SEC as the Division of Corporation Finance announced that it has decided to deal publicly with a creepy-crawly issue of sorts by posting ‘bedbug’ letters on EDGAR. Letters the SEC staff issues to companies with grossly deficient filings have come to be known as “bedbug” letters, a missive no company wants to receive. The SEC will begin publishing letters regarding companies’ seriously deficient filings on EDGAR beginning June 15, according to CorpFin’s announcement.

Transparency. CorpFin said seriously deficient filings letters would be made available on EDGAR as part of the agency’s effort to improve the transparency of its filing review process. That process includes making determinations not to review certain filings that fail to meet even minimal standards of completeness. “This will make it clear that the Division believes the filing under consideration is not minimally compliant with statutory or regulatory requirements,” said CorpFin.

At present, SEC staff comment letter dialogs with companies are released on EDGAR no earlier than 20 business days following the completion of the filing review process. By contrast, letters regarding seriously deficient filings will be available on EDGAR within 10 calendar days after they are issued to a company.

Filing review process. The SEC’s filing review process swings into action when companies file registration statements. Beginning with the Jumpstart Our Business Startups (JOBS) Act, staff reviews of registrations filed by emerging growth companies can be done on a confidential, nonpublic basis, with the company publicly filing its registration (including amendments) on EDGAR at least 15 days before conducting a road show (See, Securities Act Section 6(e)). The confidential, nonpublic review option has since been extended to other types of issuers (See, CorpFin announcement and FAQ) and is the subject of legislation that would codify the process for all issuers (See, H.R. 3903, which passed the House 419-0, the Financial CHOICE Act (H.R. 10, Section 499), which passed the House 233-186, and S. 2347).

The Sarbanes Oxley Act also brought changes to the SEC’s filing review process by directing SEC staff to regularly and systematically review the filings of issuers who report under Exchange Act Section 13(a) and who have a class of securities listed on a national securities exchange or association. Reviews mandated by SOX Section 408 must occur at least once every three years, although the SEC sometimes reviews selected companies more frequently.

In recent years, CorpFin also announced that it was discontinuing the practice of having companies state in reply to staff comments that a company understands that it is responsible for the adequacy and accuracy of its filings and will not raise staff comment letters as a defense in any legal proceeding. The prior requirement, called “Tandy” language, was an outgrowth of a comment letter dialog between the SEC and Tandy Corporation. The SEC now includes similar language in its letters to companies.

Tuesday, June 12, 2018

Insiders participating in buybacks hinder long-term growth, Commissioner Jackson says

By Amy Leisinger, J.D.

In a recent speech, SEC Commissioner Robert Jackson questioned whether executives use corporate stock buybacks as a chance to cash out the shares received as compensation in a manner that long-term growth and development. According to the commissioner, the provision of stock in executive compensation packages is designed to encourage creation of long-term, sustainable value, but this can only happen if corporate managers are required to hold the stock over the long term. Jackson urged the SEC to update its rules to limit executives’ use of buybacks to cash out and to make sure employees, investors, and communities are protected.

Jackson noted that, following passage of the Trump Administration’s tax bill, domestic companies repatriated billions of dollars of overseas money, but many organizations used the influx of cash to execute stock buybacks, as opposed to funding innovation efforts or increasing wages. Typically, when a company announces a stock buyback, it causes the company’s stock price to jump, he said, and there is evidence that many executives use buybacks as a chance to cash out shares received as executive pay, often at investor expense.

Tying executive compensation to the growth of the company only works when executives are required to hold the stock over the long term, Jackson opined. Reviewing 385 buybacks over the last fifteen months, the SEC staff found that at least one executive sold shares in the month following the announcement in half of the buybacks, and twice as many companies have insiders selling stock in the eight days after an announcement as sell on an ordinary day. While this practice is not necessarily illegal, it is troubling, as it indicates that executives tend to focus on short-term trading and financial engineering instead of long-term value creation, according to Jackson.

The Dodd-Frank Act included several provisions designed to give investors more information about executive cash outs, but the SEC has not promulgated required rules, he explained. While the Commission’s regulations provide companies with a safe harbor from fraud liability when pricing and timing of buyback-related repurchases meet certain conditions, several gaps remain, particularly with regard to limits on boards and executives using buybacks and the safe harbor as an opportunity to cash out, Jackson stated.

It is important to ensure that management has skin in the game, according to the commissioner, and the SEC’s rules should be updated to deny the safe harbor to companies that choose to allow executives to cash out during a buyback. More generally, Jackson stated that the Commission should reexamine its rules and seek comment on whether they adequately protect companies, employees, and investors, especially given the record number of recent buybacks. Compensation committees also should be required to carefully review and approve the decision that executives may use a buyback to cash out and disclose to investors why this decision is in the company’s long-term best interest.

“Investors deserve to know when corporate insiders who are claiming to be creating value with a buyback are, in fact, cashing in,” Jackson concluded.

Monday, June 11, 2018

Corp Fin director discusses cybersecurity, GDPR disclosure implications at SAG conference

By John Filar Atwood

Bill Hinman, director of the SEC’s Division of Corporation Finance, said the staff is looking closely at companies’ risk disclosure surrounding cybersecurity in this year’s filings following the update to the SEC’s cyber guidance that was issued in February. At the PCAOB’s recent Standing Advisory Group meeting, he noted that some aspects of the guidance have been controversial, so he explained some of the Commission’s thinking behind the guidance.

Hinman said that the staff wanted to focus the guidance on a few areas to which it wanted to draw more attention. The first area was internal controls and how companies were designing internal controls so that when a cyber incident occurs, there were the right procedures in place to escalate the issue.

Companies should not just have IT personnel looking at cyber risks anymore, he said. The issues now should be brought to the attention of disclosure experts at the company, as well as the general counsel. Hinman said the staff wanted to remind companies that they should have procedures in place that would cause escalation to occur, so it was added to the guidance.

Trading by insiders. One controversial aspect of the guidance has been the staff’s advice on companies’ trading policies, he said. The staff has found that companies are still trying to understand what the staff meant by this section of the guidance, he noted.

Hinman said that the staff believes that escalating a cyber issue gives a company the opportunity to think about what the implications are for its trading policy. The guidance says that as a company escalates cyber incidents through the disclosure team, it should bear in mind that the information may be material and the company will want to be issuing disclosures. He acknowledged that sometimes it hard to determine what is a material attack and what is not.

Hinman said that at some point a company might want to have a prophylactic policy that says that its officers, directors, and anyone with actual knowledge of a cyber incident is prevented from trading in the company’s shares. At a minimum, a company should counsel people about not trading while the company is sorting out whether the incident is material, he added.

There have been a number of high profile situations where Congress has gotten excited and consumers have been offended by companies’ cyber incidents, he noted, and legislation has been proposed in this area. In writing the cyber guidance, the staff thought it made sense for a company to get out ahead of the issue, and maybe avoid a bright line congressional approach, by thinking about how it wants to advise its insiders who may want to trade while the company is deciding if the information is material.

Hinman said that when a company has an incident where there is a reasonable chance that it will be material, it should consider whether it wants to block trading by insiders in the way that it might block trading at the end of a quarter. He acknowledged that it can be difficult for companies to work with this part of the guidance because so many incidents occur. The staff recognizes that it is asking a lot of the companies when it suggests that that is something to bear in mind, he said, but the staff believes it is something about which companies should be thoughtful.

In the guidance, the staff also asked for a little more disclosure on what the board’s oversight role is, according to Hinman. It reminded companies of the general requirement to disclose how the board approaches various risk management areas. If cybersecurity is an area where a company thinks it may have material risks, then it should work that into its disclosure, he said, adding that the staff is reviewing for that this year.

GDPR rules. With regard to the EU’s General Data Protection Regulation (GDPR), Hinman noted that they are designed to protect a company’s email user and not its investors. The Commission views the issue from the perspective of whether it is going to be material to investors, he said.

GDPR does have implications a lot of SEC registrants, he stated. A company has to think about how the regulation may impact its business plan, including considering possible fines for non-compliance, which may be up to two percent of annual sales.

In GDPR, there are also some very rigid rules around disclosures to individuals whose information may have been compromised, he said. He advised that even in situations where there may be small groups whose information is compromised, if a company is disclosing under the GDPR rules that it has had a breach it will have implications for how the company wants to manage its U.S. public disclosure.

Friday, June 08, 2018

PCAOB technology officer discusses cybersecurity at Standing Advisory Group meeting

By John Filar Atwood

Companies face hundreds, if not thousands of attempts to break into their systems on a daily basis, according to Bill Powers, deputy director for technology at the PCAOB. Cybersecurity is an important issue for the Board, and it is working with audit firms to keep track of what is being done to protect client and stakeholder data against cyber-attacks.

Powers said that cybersecurity became a focus for the PCAOB three years ago, Powers said. At that time, the Board began to interview engagement teams where there had been an incident to see how they handled it, and how the company was supporting their efforts, he noted.

Inspection observations. Powers offered a number of observations from the last three years of audit firm inspections. First, he noted that most companies recognize that cybersecurity is not just an IT issue anymore. It is a business issue, he said, and as a result the risks associated with it can be significantly larger than the issues associated with just IT.

He also observed that audit committees are interested in what auditors have to say about cybersecurity. In his experience, audit committees have been vocal about their expectations with respect to how auditors are handling cyber issues.

Powers noted that many companies have provided guidance to their engagement teams in the area of cybersecurity. The guidance often addresses how to go about assessing risk when starting an audit, and what to do when it is discovered that a cyber incident occurred during the course of an audit, or during the period under audit, he added.

Another observation that Powers made from recent inspections is that many companies are factoring cyber issues into their overall risk assessment. In his view, there is a real focus by companies on understanding how cyber incidents occurred, and what the impact was both from a financial reporting point of view and an internal controls over financial reporting standpoint.

Costs of cybersecurity. He has seen many companies wrestling with the costs associated with cyber incidents in recent years. Sometimes the costs are apparent and sometimes are more subtle, he noted. Companies and auditors are examining potential cyber costs as they work on the financial statements, he said.

The PCAOB is finding that engagement teams are retaining audit evidence regarding what companies have done to understand the cyber incidents, according to Powers. At this point in time, the Board has seen no material misstatements of financial statements because of a cyber incident, he said.

Going forward. Looking ahead, Powers said that the PCAOB is continuing to work with engagement teams to try to understand what they are doing in the area of cybersecurity. This year, the program is expanding to focus on what the firms are doing to protect client and stakeholder data that they retain, he said.

The staff is specifically reviewing cyber strategies, what governance policies are in place to oversee and manage the strategy, how companies identify and prioritize risks, and what kinds of controls they establish, according to Powers. Equally important, in his view, is an evaluation of how companies monitor their controls to ensure they are operating effectively.

The PCAOB is trying to understand how companies respond to cyber incidents and how they establish, maintain and conduct timely communications both internally and externally with regulators and outside organizations, he said. Also of interest to the Board is what companies have done, or will do, to develop and recover from cyber incidents to get back to normal operations, he noted. The Board will continue to monitor what other regulators are requiring of issuers and audit firms in this area, he concluded.

Thursday, June 07, 2018

Clayton, Giancarlo make case for bigger budgets

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

SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo both cited U.S. market competitiveness and cybersecurity concerns in making their case for increasing their agencies’ budgets in FY 2019. In testimony before a subcommittee of the Senate Appropriations Committee. Clayton said that the SEC’s request of $1.658 billion for operations represented a modest increase that will allow the agency to leverage technology and lift a hiring freeze that has been in place since late in FY 2016. In defending the CFTC’s request for $281.5 million, an increase of $32.5 million, Giancarlo noted that adequate funding for his agency is necessary if the U.S. derivatives markets are to continue to be the world’s best regulated.

Clayton’s testimony. In his formal testimony, Clayton stated that the daily touchstone for the SEC staff is the long-term interests of the tens of millions of Americans who are invested in the securities markets. Clayton said that the level of funding requested for FY 2019 will enable the SEC to continue its work in a number of important areas, including: leveraging technology and enhancing cybersecurity and risk management; facilitating capital formation; protecting Main Street investors; and maintaining effective market oversight by expanding the agency’s depth of expertise. In particular, Clayton said that the Commission’s cybersecurity program will remain a top priority during FY 2019. Among other actions taken in this area, Clayton has directed the SEC staff to conduct a review of the sensitive personally identifiable information gathered by the Commission to make sure it does not take in more information than is needed to carry out its mission.

Giancarlo’s testimony. For his part, Giancarlo stressed that the well-regulated U.S. derivative markets are the world’s largest and most influential. As a result, many of the world’s most important commodities are priced in U.S. dollars in the U.S. derivatives markets, providing a tremendous advantage to American producers. Giancarlo cautioned against complacency, however, noting that the Chinese government has now opened up its domestic futures markets to international participation as part of a long-term strategy to expand China’s influence over the pricing of key industrial commodities. The best response for U.S. commodity market participants, Giancarlo said, is to ensure that derivatives markets in the U.S. continue to be of the highest quality, which requires an adequately funded regulator. Even though the agency has asked for an approximately 12 percent increase, Giancarlo defended the CFTC’s budget request as being “bare-bones, no waste, fiscally conservative, and mindful of taxpayer dollars.”

Cybersecurity. Returning to the topic of cybersecurity, Sen. Chris Van Hollen (D-Md) asked Clayton to consider taking another look at the SEC’s interpretive guidance designed to assist public companies in preparing disclosures about cybersecurity risks and incidents. In particular, Van Hollen questioned whether the concept of “materiality” may be too loosely defined. In response, Clayton emphasized the importance that he attaches to this issue, referencing the SEC’s recent enforcement action against Yahoo! for failing to properly inform investors about a cybersecurity breach, which resulted in a $35 million settlement. Clayton also reiterated his belief that it's “good corporate hygiene” for companies to have controls that prevent senior executives from trading, once a determination has been made about a material event.

Swaps reform. Asked about the CFTC’s recent decision against lowering the de minimis threshold required for swap dealer registration, Giancarlo said that he believes the current $8 billon threshold is still correct. He did, however, agree with Subcommittee Chair James Lankford (R-Okla) about the benefits of reviewing the threshold on a regular cycle, perhaps every four or five years. Giancarlo also expressed his continued overall support for the swaps reforms enacted by Title VII of the Dodd-Frank Act, saying that the legislation “got it right” and that the clearing mandate has worked well. According to Giancarlo, the question now is how to oversee swaps reporting, because regulators still do not have a clear picture of the extent of counterparty credit risk.

Wednesday, June 06, 2018

CFTC Sunshine Act meeting clouded by commissioner dissent

By Brad Rosen, J.D.

The first open meeting of the CFTC under the chairmanship of J. Christopher Giancarlo, and as attended by Commissioners Brian Quintenz and Rostin Behnam, revealed fissures and discord among Commission members. While three proposed rules were approved by the Commission, Behnam, the sole Democrat on the CFTC, voted against two of the proposals.

Behnam also lodged concerns that he was essentially cut out of the loop from providing input in connection with amendments related to the Volcker Rule. He noted, “My message is we’re better than this. I came to this agency ready to roll up my sleeves and work together with the chairman and Commissioner Quintenz to make our rules better.” Benham also voted against the Commission’s proposed rule to keep the swap dealer de minimis exception threshold at $8 billion rather than reducing it to $3 billion as scheduled. He issued a statement of dissent on this score as well.

Giancarlo supports keeping the swap dealer de minimis threshold unchanged. The Commission’s action marks yet another chapter in a long drawn out history surrounding this issue. In testimony before Congress in October 2017, Chairman Giancarlo asserted more time was needed to study the rule. The threshold reduction to $3 billion had been delayed on two prior occasions. Most recently, it was set to take effect on December 31, 2019. A lower de minimis threshold would have the effect of requiring smaller, or less active, market participants to become registered as swaps dealers, as well as becoming subject to additional regulatory requirements.

Giancarlo justified keeping the de minimis threshold at $8 billion, asserting that its reduction to $3 billion would not have an appreciable impact on coverage of the marketplace, noting “[A]ny impact would be less than one percent - an amount that is truly de minimis.” On the other hand, the Chairman observed, “the drop in the threshold would pose unnecessary burdens for non-financial companies that engage in relatively small levels of swap dealing to manage business risk for themselves and their customers.” “That would likely cause non-financial companies to curtail or terminate risk-hedging activities with their customers, limiting risk-management options for end-users and ultimately consolidating marketplace risk in only a few large, Wall Street swap dealers,” he added.

Benham expresses grave concerns. Commissioner Behnam asserted that “my gravest concern is that the Commission is moving far beyond the task before it— setting the aggregate gross notional amount threshold for the de minimis exception— to redefine swap dealing activity absent meaningful collaboration with the Securities and Exchange Commission (“SEC”), as required by the Dodd-Frank Act, and to the detriment of market participants eager for regulatory certainty.”

Behnam also noted that the proposed rule purports to create Commission authority to determine the methodology to be used to calculate the notional amount and then immediately delegates that authority to the director of the Division of Swap Dealer and Intermediary Oversight (DSIO). Expressing his dismay, he noted, “I’m concerned that the Commission is proposing to both establish its authority and immediately delegate such authority without any internal discussion, without any public deliberation, and within this Proposal.” He continued, “The Commission has simply not articulated a sound rationale for moving abruptly forward on this rule proposal without fulsome consideration of its legal authority, potential risks, and possible alternatives.”

Proposed rule doesn’t go far enough for Quintenz. According to Commissioner Quintenz, the entire notion of linking swap dealer registration and oversight to an aggregate gross notional value measure is suspect at best. Rather, he believes that the criteria for determining swap dealer registration should be more closely correlated to risk. Quintenz expressed “some reservations about this proposal’s continued reliance on a one-size-fits-all notional value test for swap dealer registration.” He asserted, “If we fail to calibrate this threshold appropriately, firms at the margin will likely reduce their activity to avoid registration as opposed to serving their clients’ interests and accepting the burdens of registration.” He concluded, “A public policy choice which drives away market participants and reduces market activity is undeniably flawed.”

Volcker Rule. According to Chairman Giancarlo, “this proposed rule seeks to simplify and tailor the Volcker Rule to increase efficiency, right-size firms’ compliance obligations, and allow banking entities - especially smaller ones - to more efficiently provide services to clients.” He further notes that the rule “adopts a risk-based approach relying on a set of clearly articulated standards for both prohibited and permitted activities and investments.”

Commissioner Behnam disagrees and notes “we are missing the mark here. In fact, we are actually further complicating the Volcker rule and calling it simplification.” Behnam points to the proposed rule creating three categories of banking entities with different rules for each and concludes by asking whether we should have this complex tapestry at all.

Indemnification rule. Notably, all three commissioners voted in favor of the final rule on amendments to the swap data access provisions of Part 49 of the CFTC regulations, formerly known as the swap data repository (SDR) indemnification rule. This rule in designed to put the Commission and its foreign counterparts in a much better position to consider and evaluate data, and ultimately identify heightened market risk.

Tuesday, June 05, 2018

Shareholders of parent in reverse triangular merger lack appraisal rights

By Anne Sherry, J.D.

The Delaware Court of Chancery held that the state’s corporation law does not provide appraisal rights to shareholders of the parent of a party to a merger, as the parent is not a “constituent corporation.” Furthermore, shareholders of Dr Pepper Snapple Group, which is creating a subsidiary to merge into Keurig Green Mountain in a reverse triangular merger, are retaining their shares in connection with the transaction; the appraisal statute contemplates that the shares will be relinquished (City of North Miami Beach General Employees’ Retirement Plan v. Dr Pepper Snapple Group, Inc., June 1, 2018, Bouchard, A.).

Merger and proposals. Through the reverse triangular merger, a merger subsidiary of Dr Pepper will combine with the parent of Keurig, making Keurig an indirect wholly owned subsidiary of Dr Pepper. Dr Pepper stockholders will receive a special cash dividend of $103.75 per share and will retain their shares, which will account for 13 percent of the shares of the combined company. The indirect owners of Keurig will hold the remaining 87 percent as shares of Dr Pepper.

Dr Pepper stockholders are not being asked to approve the merger, but to approve two proposals necessary to effect the transaction. On March 8, Dr Pepper issued a preliminary proxy statement that stated that its stockholders will not have appraisal rights under Section 262 of the Delaware General Corporation Law. Two institutional stockholders filed an action asking the court to enjoin the merger until stockholders are provided their appraisal rights, or alternatively to permit class members to demand and petition for appraisal.

DGCL does not provide appraisal rights. The Chancellor held, however, that the DGCL does not provide appraisal rights to the plaintiffs for two statutory reasons. First, Dr Pepper is not a “constituent corporation” in the merger. Although the DGCL does not explicitly define the term, the provisions that use it “clearly imply that ‘constituent corporations’ are entities that actually were merged or combined in the transaction and not a parent of such entities.” The plaintiffs offered dictum from a chancery court opinion suggesting that it might be appropriate at times to disregard corporate formalities in the context of an asset sale, but that reasoning would have more significant negative repercussions in the context of the appraisal statute. “The fact that Merger Sub merely functions as an intermediary entity, solely formed to facilitate the Merger, does not confer Merger Sub’s status as a constituent corporation on its parent Dr Pepper,” the court explained.

The second statutory reason that Dr Pepper stockholders are not entitled to appraisal rights is that they are not being forced to give up their shares. The three-step process for determining entitlement to appraisal “plainly contemplates that the stockholder relinquish its shares.” The statute does not bestow appraisal rights upon a mere sale of control, but only when stockholders’ shares “are being taken from them in certain, statutorily specified types of transactions.” The court did not believe that its decision would open the door to abuse as the form of transaction has been used for nearly ten years, but even so, it is for the legislature to amend the statute if it is concerned that stockholders lack appraisal rights in such a transaction.

The case is No. 2018-0227-AGB.

Monday, June 04, 2018

Vermont permits LLCs to operate blockchain technology business

By Jay Fishman, J.D.

The Vermont General Assembly’s House and Senate passed a bill signed by Governor Phil Scott on May 30, 2018 permitting Vermont-based limited liability companies to use blockchain technology for a material part of their business operations. The law, effective July 1, 2018, allows LLCs to become blockchain-based limited liability companies (BBLLCs) by: (1) specifying in their respective articles of organization the election to be a BBLLC; and (2) meeting the requirements of the new law.

A BBLLC may be entirely or partly governed by blockchain technology by providing in its operating agreement:
  • A summary of the BBLLC’s mission and purpose; 
  • The decision whether the BBLLC’s consensus ledger or database will be fully or partially decentralized and whether the ledger or database will be fully or partially public or private, including the extent of participants’ access to information, as well as read and write permissions regarding protocols; 
  • Voting procedures; 
  • Proposals to upgrade software systems and protocols and to amend the operating agreement;
  • Protocols addressing system security breaches or other unauthorized actions affecting the blockchain technology’s integrity; and 
  • The rights and obligations of each participant group within the BBLLC. 
Lastly, a BBLLC may adopt reasonable algorithms setting forth the consensus processes for validating records, conducting operations and deciding the blockchain technology to be used. In addition, a BBLLC can modify the existing processes or substitute new ones.

Friday, June 01, 2018

Study: More hedge fund investors want responsible investment

By Amanda Maine, J.D.

A report published by the Alternative Investment Management Association (AIMA) has found that investors in hedge funds are increasingly embracing “responsible investment” strategies and that this demand has driven growth in responsible investment by hedge funds. The report, From Niche to Mainstream: Responsible Investing and Hedge Funds, which was commissioned by the AIMA and the Cayman Alternative Investment Summit, surveyed 80 asset managers with $550 billion in hedge fund assets under management (AUM).

Responsible investment. The study cites the United Nations Principles for Responsible Investment (UN PRI), which are six investment principles aimed at ensuring that asset management is socially responsible and environmentally sustainable. The UN PRI calls for signatories to incorporate environmental, social and governance (ESG) issues into their investment analysis and decision-making processes and to seek appropriate disclosure on ESG issues.

Investor demand. According to the report, investor demand for responsible investment is becoming mainstream, where in the past it had been largely limited to religious organizations and Scandinavian countries. AIMA’s study revealed that slightly over half of survey respondents had experienced an increase in interest of their firm’s responsible investment strategies, with the strongest interest coming from investors in North America and Europe. The study also found that investor interest was strongest among the largest hedge funds. The report noted that larger hedge funds do tend to have a greater variety of investors who can express interest in responsible investing. However, the report added that responsible investment is not limited to the largest hedge funds.

More and more investors are demanding that their capital be put towards responsible investing, partly due to changing risk perceptions, according to the report. Long-term risks such as environmental damage have become more of a concern to investors than in the past. There is also a generational shift occurring where millennial investors are actively thinking about ESG factors when investing, the report noted.

Hedge funds and responsible investment. The report states that 36 percent of survey respondents have either signed or plan to sign the UN PRI, with larger hedge funds of more than $1 billion in AUM to be the most likely signatories. Geographically, U.K.-based hedge fund firms are far more likely than those in North America to sign the UN PRI or to fill out the Responsible Investment Due Diligence Questionnaire (RI DDQ). The report observes that “since North American firms dominate the overall hedge fund industry assets under management, it will be interesting to see whether this gap closes in the coming years.”

While smaller hedge fund firms with less than $100 million in total firm AUM are less likely to engage in responsible investment on an absolute basis, the report found that they are far more likely to commit a significant portion of their assets to responsible investing. This suggests, according to the report, that these are specialized firms that have committed to responsible investing. In contrast, the report found that for the larger hedge fund firms, while more likely to have capital invested in responsible investment strategies, the level of commitment can vary, reflecting the challenge of integrating these strategies into an existing investment philosophy.

Approaches and challenges to responsible investment. The report notes that a relative lack of data regarding responsible investment opportunities can make it difficult to build an algorithm to evaluate responsible investment opportunities. However, the report forecasts that this will likely change in the near future, given increased computing power and the wider accessibility of data.

Two challenges go “hand-in-hand” for firms looking to incorporate responsible investment into their investment strategy: inadequate methodologies for the calculation of sustainability risks and the lack of relevant disclosures from companies. Without companies publicly disclosing ESG data performance, firms will find it difficult to evaluate the environmental and social impact of potential investments, the report advises.

The report notes, however, that there are several initiatives aimed at encouraging companies to report on issues such as carbon emissions, gender diversity, and employee compensation, including the GRI Standards, the Sustainability Accounting Standards Board, and the Carbon Disclosure Project. Even companies like ExxonMobil are facing pressure from investors to study the impact of their business on issues like climate change.

While improving measurement capabilities was cited as one of the biggest challenges to integrating responsible investing, the report notes that a third of the respondents to the survey were skeptical about such investments being able to generate double-digit returns, and a quarter said responsible investment presented a lack of attractive investment opportunities. These barriers were fairly consistent across firms of different sizes in the survey.

The report also finds that hedge fund managers are looking to expand their responsible investment expertise. Hiring responsible investment experts has increased, and several hedge funds surveyed have announced additions to their responsible investment teams. The report observes that these experts do more than just evaluate potential investment opportunities—they also talk to investors and explain how the impact of responsible investing is measured. Such expertise is likely to become even more important in the future, according to the report.

Thursday, May 31, 2018

Trade and public interest groups clash with exchanges over proposed NMS fee pilot

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

Industry trade and watchdog groups and exchanges are divided in their reactions to the SEC’s proposed pilot program to assess how exchange transaction fees and rebates affect market quality for national market system (NMS) stocks. As the comment period ended, the Investment Company Institute (ICI) urged the SEC to go forward with the proposal, writing that current exchange pricing models may create conflicts of interest for broker-dealers, decrease market transparency, and increase market complexity and fragmentation. Industry watchdog Better Markets agreed, saying that payments by the exchanges that incentivize and induce routing decisions at the expense of best execution and market quality represent an “entrenched and insidious” market practice that requires forceful intervention by the Commission. Nasdaq and Cboe Global Markets sharply disagreed, however, with Nasdaq even writing that the current proposal will likely harm investors and issuers.

Designed to facilitate an informed discussion about possible alternative approaches to prevailing fee structures, the SEC’s proposed pilot would subject exchange transaction fee pricing, including "maker-taker" fee-and-rebate pricing models, to new temporary pricing restrictions across three test groups and require exchanges to prepare and publicly post data. The pilot would last for up to two years and apply to all NMS stocks and include all equities exchanges, including "taker-maker" exchanges.

ICI. In the view of the ICI, the proposed pilot is well-designed and should provide the Commission and others with data on how changes to Rule 610(c) under Regulation NMS affect equity market quality. The ICI believes that the structure of the test groups may encourage exchanges to compete on the basis of innovation, differentiation of services, and ultimately on the value their trading model presents to investors, not on the amount of money rebated to their participants. In particular, the ICI noted the importance of Test Group 3, which prohibits the use of rebates. This test group will allow an objective assessment of the broadly-held view that rebates contribute to undesirable market behaviors, and the data gathered could suggest an appropriate direction for future SEC rulemaking to correct these behaviors, the ICI wrote.

Better Markets. The SEC should approve the pilot as quickly as possible, Better Markets wrote, stating that the Commission has heretofore lacked sufficient data to outlaw rebates and other practices such as front-running and information leakage that harm investors. As did the ICI, Better Markets noted the importance of the “no-rebate” test group, observing that the SEC’s proposal itself shows that all of the exchanges that engage in rebates have done so even when the access fee is very low. Given the history of the exchanges in subsidizing rebates, a very low access fee cap (as was proposed by the Equity Market Structure Advisory Committee) is not an effective way to simulate a “no-rebate” environment, Better Markets wrote.

Better Markets also stressed that the pilot must include all NMS stocks above $2 per share without regard to capitalization levels. In Better Markets’ view, leaving out small or mid-cap issuers will handicap efforts to settle debates regarding market liquidity issues and harm efforts at future reforms. Better Markets believes that the pilot should also prohibit issuers from exempting themselves out of the pilot, given that no issuer currently has any say over the exchanges’ decisions to set access fee or rebate levels on its stock, or over exchanges’ decisions to sell special access and premium exchange data to certain market participants.

Nasdaq. Nasdaq blasted the proposal, however, writing that the SEC’s record lacks even the most basic evidence to justify a pilot. Before the Commission can even consider studying how transaction fees impact order routing behavior, Nasdaq wrote, it must first gather and analyze existing data and improve existing transparency tools, such as enhancing the Duty of Best Execution and modifying SEC Rule 606 to enhance disclosure of order routing behavior, as recommended by the Treasury Department. Moreover, the proposal as designed will not achieve its stated goal because it excludes Alternative Trading Systems and broker-dealer matching venues that account for 39 percent of U.S. trading volume. In Nasdaq’s view, the proposal erroneously assumes a static environment, when it is changing a major variable (access fees) in one segment of the market without properly anticipating or accounting for the dynamic impact on the remaining 39 percent.

Nasdaq also regards the proposal as a “risky market experiment” with public companies and public investors. Nasdaq observed that the proposal would affect 3,000 issuers and their shareholders, with potential unintended consequences that may reverberate throughout the U.S. economy. Accordingly, the proposal cannot be considered a mere pilot, and the

SEC cannot avoid its burden of conducting accurate cost-benefit analysis by categorizing a risky experiment as a “pilot,” Nasdaq wrote. The proposal’s enormous scope will also make it intrusive and costly, imposing far greater costs through “government rate-making” than the potential benefits sought. In addition, the SEC’s failure to apprise itself of the economic consequences the proposal makes its promulgation arbitrary and capricious and not in accordance with the Exchange Act and the Administrative Procedure Act.

Cboe Global Markets. Cboe Global Markets also questioned the proposal’s logic and the SEC’s legal authority to impose federal price controls. In Cboe’s view, the Commission has proposed to perform a large-scale experiment on the deepest and most liquid equities market in the world, despite demonstrable evidence that investor execution quality is higher than ever before.

Cboe believes that the pilot will likely impact investors by disrupting the pricing structures for 3,000 equity securities, thus increasing spreads and lowering liquidity. Cboe estimates that if the pilot causes effective spreads to widen by as little as 10 percent for only the top 100 securities, the pilot would cost investors over $400,000,000 more in annual execution costs. Cboe asserted that the SEC’s price control pilot is unnecessary, that data resulting from the pilot will not yield useful information, and that potential conflicts of interest can be examined and addressed in much less intrusive ways and without subjecting the equities market and investors to potentially significant harm.

Wednesday, May 30, 2018

Alabama Securities Commission issues five cease and desist orders as part of Operation Cryptosweep crackdown

By Brad Rosen, J.D.

The Alabama Security Commission (ASC) has issued cease and desist orders in five enforcement proceedings since late April as part of an international crackdown on fraudulent initial coin offerings (ICOs) and cryptocurrency-related investment products. In a release describing the actions, ASC Director Joseph Borg, observed “The actions announced today are just the tip of the iceberg.” The sweep is being coordinated by the North American Securities Administrators Association (NASAA), of which the ASC is a member.

Cease and desist orders. Each of the enforcement actions brought by the ASC contained allegations that the respective respondent failed to register securities as required or otherwise qualify for an exemption from registration. Moreover, each matter contained allegations that the applicable respondent made materially misleading statements or omitted material facts. A summary of those matters is as follows:
  • Chain Group Escrow Service (CGES) purported to conduct business as an internet-based escrow company and located in Kirkland, Washington. In the cease and desist order, CGES claimed to pay investors 0.2 percent per day, “guaranteed,” over a 500-day period. 
  • Extrabit Ltd. (EXB) purported to conduct business as a cryptocurrency mining firm based in Los Angeles, California. According to the cease and desist order, EXB promised a 185 percent return on investment every quarter for investors who maintain a positive balance in their EXB wallet.
  • Leverage (LEV) is a technology company located in Los Angeles, California. According to the cease and desist order , LEV claimed that an investor may store the LVP coins, and any other cryptocurrencies in the "platform wallet" and earn a variable, daily interest rate (0.5 percent-2.1 percent) determined by the length of the investment period and the amount of staked capital.
  • Pooltrade represents itself as an internet-based business with located in Los Angeles, California. According to the cease and desist order, the Pooltrade website made no representations concerning the type of investment fund or interest-generating vehicle was being offered. In addition, Pooltrade omitted a material fact-that the pooled investment plans are securities and are not registered with the Commission.
  • Platinum Coin (“PLATINUM”) represents itself as an internet based business located in Miami, Florida. According to the cease and desist order, the PLATINUM white paper advertised “a "promise" to pay"... at least 320 percent per annum on the funds invested in them." The white paper also claimed that the 320 percent return was based on a "pilot model" that was derived from marketing and mathematical specialist that were hired by PLATINUM.
ASC undertakings to fight cryptocurrency fraud. “Fraudulent activity involving ICOs and cryptocurrency-related investment products is a significant threat to Main Street investors in Alabama,” noted ASC Director Joseph Borg. “Cryptocriminals need to know that the Alabama Securities Commission is committed to swiftly and effectively protecting investors from schemes and scams involving these products”, he added.

According to its release, the ASC has joined with more than 40 other state and provincial securities regulators in the United States and Canada in “Operation Cryptosweep,” resulting in nearly 70 inquiries and investigations and 35 pending or completed enforcement actions since the beginning of May. NASAA members are conducting additional investigations into potentially fraudulent conduct that may result in additional enforcement actions. These actions are in addition to more than a dozen enforcement actions previously undertaken by NASAA members regarding these types of products.

A critical component of “Operation Cryptosweep” is raising public awareness of the risks associated with ICOs and cryptocurrency-related investment products. “Not every ICO or cryptocurrency-related investment is fraudulent, but we urge investors to approach any initial coin offering or cryptocurrency-related investment product with extreme caution,” Borg said.

The cases are No. CD-2018-0003, No. CD-2018-0004, No. CD-2018-0005, No. CD-2018-0006, and No. CD-2018-0007.

Tuesday, May 29, 2018

Live Nation shareholder sues to block vote on board members due to misleading proxy statement

By Rebecca Kahn, J.D.

After the world’s largest live music producer awarded nearly $11 million in executive bonuses for exceeding 2017 targets, a shareholder sued the company and executives for including false and misleading compensation information in its 2018 proxy materials. Filed in the Eastern District of New York, the complaint seeks injunctive relief, including blocking an upcoming vote on compensation committee members, a corrected proxy statement, and the return of any wrongfully awarded cash and stock bonuses (Stein v. Live Nation Entertainment, Inc., May23, 2018).

Live Nation Entertainment, Inc. claims to be the world’s largest live entertainment company, producing live music concerts, providing an advertising network for corporate brands, as well as a ticket sale and marketing company. Live Nation reported its 2017 Adjusted Operating Income (AOI)as $625,142,000. In April, shareholders were provided with a 2018 proxy statement to solicit the irproxies for management proposals, including voting for compensation committee members, at an annual shareholders' meeting on June 6,2018.

Shareholder Shiva Stein has sued the company and executives under Exchange Act Section 14(a) and SEC rules and regulations. She seeks an injunction to prevent a vote on the company’s compensation committee because of false and misleading statements in the Compensation Discussion & Analysis (CD&A) section of the 2018 proxy statement.

Bonuses. Stein’s complaint alleged that the CD&A contains false and misleading statements concerning cash performance bonuses paid to certain executive officers and restricted stock awards that vested for the same officers. The CD&A represented that the bonuses and restricted stock awards were contingent on achieving at least 90 percent of an AOI of $700 million for the year 2017. The CD&A also falsely stated that the company achieved 104 percent of its AOI performance target, which would be $728 million.

The CD&A refers shareholders to a page in the company’s 2017 annual report for a reconciliation of AOI to operating income. However, the referenced page lists the 2017 AOI as only $625, 142,000—less than 90 percent of $700 million. Therefore, the complaint alleges, none of the name dexecutive officers should have received a cash incentive award or had their restricted stock awards vest for 2017.

The total cash bonuses awarded to the named executive officers based on the false Adjusted Net Income target was $9,600,667 plus total restricted stock awards vested to the executive officers worth $1,254,327.

Three scenarios. The complaint claims that the 2018 proxy statement was false under any of three scenarios: (1) it misreported the target of $700 million where, in fact, a lower target applied; or (2) the Form 10-K was false (and by extension the 2018 proxy statement) because it under reported the AOI of $625 million; or (3) the 2018 proxy statement was false because Live Nation did not achieve its target AOI and the named executive officers were awarded bonuses and restricted stock awards they did not deserve.

The case is No. 1:18-cv-03030.

Friday, May 25, 2018

'Gamesmanship' one reason court won’t revive interest-rate-swaps antitrust claims

By Anne Sherry, J.D.

In a multi-district litigation over antitrust violations in the market for interest-rate swaps, the Southern District of New York denied plaintiffs’ efforts to revive claims based on pre-2013 conduct. For one thing, the proposed amended complaint would not remedy the “gauntlet of deficiencies” that led to the claims’ dismissal in 2017. Independent of that futility, amendment would delay litigation and unduly prejudice the defendants given that discovery was well underway based on the 2013+ claims only. The court admonished plaintiffs’ counsel for “gamesmanship” in not disclosing their intent to seek revival of the pre-2013 claims (In re Interest Rate Swaps Antitrust Litigation, May 23, 2018, Engelmayer, P.).

The plaintiffs allege that the defendants—11 investment banks, an IRS broker, and a provider of IRS trading services—colluded to prevent the establishment of an electronic platform that would allow all-to-all, anonymous IRS trading. In 2010, the Dodd-Frank Act created a comprehensive new regulatory framework for swaps with the goal of increasing accountability and transparency, which included enabling IRS to be traded via anonymous all-to-all trading platforms. After Dodd-Frank, three companies, including plaintiffs Javelin Capital Markets and Tera Group, developed trading platforms for all-to-all anonymous trading of IRS. The plaintiffs allege that the defendants conspired to boycott these platforms and instructed their clearinghouse affiliates to refuse to clear trades executed through them, resulting in the defendants controlling 70 percent or more of the IRS market and none of the structural changes intended by Dodd-Frank having been made.

In its decision on the defendants’ motions to dismiss in 2017, the court separated the claims into pre-Dodd-Frank (2007-2012) and post-Dodd-Frank (2013-2016). During the pre-Dodd-Frank time period, the court found, the dealers took no actions to support the emergence of all-to-all exchange-based IRS trading as a matter of self-interest, but there was no inference of collusion, and the court dismissed the claims. For the post-Dodd-Frank time period, however, the motion to dismiss was denied as the plaintiffs successfully pleaded that the defendants engaged in a group boycott.

Post-dismissal discovery. Following that opinion, the parties negotiated, and the court approved, a case management plan that governed fact discovery. The plan set a deadline of May 21, 2018, for the substantial completion of document production and a deadline of December 21, 2018, for the completion of fact discovery. Counsel’s work and negotiations, along with the document production, were informed by the decision on the motions to dismiss. “The Court’s rulings as to discovery were premised on—and took as durable—the Court’s central holding that the surviving claims in the case were limited to the 2013-2016 time period.”

Motion for leave to amend pre-2013 allegations. On February 21, 2018, plaintiffs’ counsel sought leave to file a third amended complaint which would add a plaintiff to serve alongside the existing class plaintiff, amplify allegations with respect to the 2013-2016 conduct, and restore the claims as to 2008-2012 conduct. The motion, a memorandum in support, and the proposed complaint were filed on the last day for motions seeking leave to amend under the case management plan.

The court granted leave to amend the complaint to add the additional plaintiff and add allegations pertaining to 2013-2016 conduct, neither of which additions the defendants contested. However, the court denied the most consequential request, for leave to restore the 2008-2012 claims. First, amendment would be futile as the proposed amended complaint did not fix “the gauntlet of deficiencies” that led the court to dismiss the claims. The plaintiffs’ theory of injury would remain too conjectural to survive even assuming the conspiracy claim were well-pleaded, and certain allegations remained conclusory. Furthermore, the claims were time-barred, and the plaintiffs’ bid for equitable tolling due to fraudulent concealment was unpersuasive.

The court also denied leave to restore the pre-Dodd-Frank claims on the independent basis that it would substantially delay the litigation and unduly prejudice the defense. The court further held that plaintiff’s counsel’s communications with the court and defense during the discovery period “conveyed a misleading impression” that the claims were fixed at 2013-2016 when in fact counsel had been actively pursuing an amendment to restore the claims as to the preceding five years. The court wrote that it was “regrettably, constrained to find an unwelcome degree of gamesmanship meriting denial of the motion for leave to amend.”

The two amendments that the court allowed were readily accommodated within the case schedule. In contrast, allowing the pre-2013 claims would be close to “allowing a new MDL-sized lawsuit to be hitched to the existing claims.” In practice, the narrative for those claims implicates events, entities, concepts, and personnel outside the scope of the post-Dodd-Frank claims and discovery. As a result, discovery would be delayed by at least 12 months, the court estimated.

The amendment would also prejudice the defendants who, on the premise that the claims were limited to 2013-2016, expended time, money, and energy in discovery. Reviving the claims would send the parties back to the drawing board on discovery, the court reasoned, and result in wasted or duplicative fees and costs extending “well into seven figures” across the 11 defense firms.

Finally, the court discussed its gamesmanship rationale for denying leave to amend. Plaintiffs’ counsel made an affirmative decision not to disclose their intention to amend the complaint until the last moment, despite seven months of communications in which counsel “fed the false impression” that the claims were limited to the 2013-2016 range. “Audaciously,” the court added, plaintiffs’ counsel “chided the defense for filing a discovery motion that could disrupt the orderly case schedule to which plaintiffs professed to be ‘diligently’ committed.” In a footnote, the court clarified that it chose not to reach the issue of whether counsel’s conduct rose to the level of bad faith. Its discussion of gamesmanship should not be taken as reflecting such a finding, and the court, “deeply respectful of the vigor and top quality of plaintiffs’ counsel’s overall representation … is confident that this episode will prove aberrational.”

The case is No. 16-MD-2704.

Thursday, May 24, 2018

Chairman Clayton reflects on recent SEC developments at FINRA conference

By Amanda Maine, J.D.

In a “fireside chat” at FINRA’s annual conference, FINRA president and CEO Robert Cook asked SEC Chairman Jay Clayton what the biggest surprises have been almost a year into his tenure as chairman. Clayton remarked that he has been surprised by the activities in the crypto-asset space, including cryptocurrencies and ICOs. Clayton also said that the amount of retail fraud he has seen surprises him. Given the advances in technology, one would think the ability to detect fraud would increase, but he noted that with advanced technology, the ability to perpetrate fraud also increases.

Regulation BI. Cook asked Clayton about the Commission’s recent proposal for a Regulation Best Interest (Reg BI) standard and related disclosures. Clayton said that in approaching the issue, the Commission examined the relationship a client has with a broker-dealer or with an investment advisor and asked what would a reasonable investor expect of that relationship. In the cases of both broker-dealers and investment advisers, a reasonable investor should expect that an investment professional cannot put his or her interests ahead of the investor’s interests, he said.

This is true even though the relationship model will be different between the transaction-based relationship of a broker-dealer compared to a portfolio and time-based relationship of an investment adviser, Clayton explained.

Cook inquired why the proposal does not use the word “fiduciary.” Clayton replied that while both broker-dealer and investment adviser relationships involve a fiduciary principle, calling them both “fiduciary” would not make it clear that the relationship models are different. Using the same term, he explained, might lead an investor to believe that the relationship between an investor and a broker-dealer and between an investor and an investment adviser are the same.

SALI. Cook asked Clayton about one of the Commission’s latest investor protection initiatives, the SEC Action Lookup for Individuals (SALI) tool. Launched earlier this month, SALI allows investors to search whether a person trying to sell investments to them has a judgment or order against him in an SEC enforcement action. Clayton noted that a good deal of fraud perpetrated on investors is by those who are not registered investment advisers or broker-dealers, so they won’t appear on investor.gov or FINRA’s BrokerCheck search. With SALI, the Commission has provided investors with a database of individuals that did not exist before, Clayton said.

ICOs. Turning to initial coin offerings, Cook asked Clayton to highlight Commission developments with respect to ICOs. The U.S. has an incredible economy where people are able to use public offerings or private placements to raise capital while following the law, Clayton said. Regarding ICOs, people are not following the rules for either private placements or public offerings. They are able to take the most advantageous parts of a public offering, including broad dissemination and the promise of secondary trading, while providing none of the protections that would be provided even in a private placement, Clayton advised.

Cook asked Clayton how people with questions about ICOs should interact with the SEC. Clayton responded that the Division of Corporation Finance welcomes people to approach them about how they’d like to conduct their offering, whether they want to conduct a public offering, or if they need guidance on complying with private placement rules.

Retail investors and access to capital. Noting that FINRA has been taking a fresh look at its own operations and has recently issued a progress report on the changes it has made, Cook inquired about the Commission’s own outreach to industry groups and investors around the country and if there are any key takeaways from these conversations. Clayton said that a group that has a significant impact on his thinking is the Commission’s foreign regulatory colleagues. “The way our markets work is the way everybody wishes their markets work,” Clayton stated. While we have the tendency to be self-critical, and we should be, the way we do it is the envy of the world, according to Clayton.

Giving up the democratization that results from broad participation in the capital markets is something that Clayton does not want to happen. He continues to worry that retail investors will not have access to as broad a slice of the U.S. capital markets as he would like them to have. To the extent that private capital has become so robust, it has shrunk some of the opportunities for retail investors. If this trend continues, the result is a much more select group that is participating in the market, which Clayton said he finds bothersome. Part of the solution can be broadening the number of public companies as well as providing channels for retail investors to have access to the private capital markets, Clayton recommended.

Wednesday, May 23, 2018

CFTC staff advises exchanges, clearinghouses dealing in virtual currency products

By Amy Leisinger, J.D.

The CFTC staff has issued an advisory to provide guidance for registered exchanges and clearinghouses dealing in virtual currency derivative products. The advisory clarifies the staff’s expectations during review of new virtual currency derivatives for listing or clearing and highlights areas that require particular attention, including, among other things, enhanced market surveillance, large trader reporting, and risk management. According to the staff of the Division of Market Oversight and the Division of Clearing and Risk, the advisory is designed to help registrants to meet their statutory and self-regulatory obligations while facing the unique challenges associated with these emerging products.

Noting the importance of encouraging innovation and growth in virtual currency derivatives products within an appropriate oversight framework, the advisory provides guidance for registrants considering new virtual currency derivatives to be listed on a designated contract market or swap execution facility or to be cleared by a derivatives clearing organization. Because of the differences between virtual currencies and other commodities, it is difficult to provide frame of reference for the virtual currency prices quoted on the spot markets, the advisory recognizes. In addition, the advisory notes that potential risks virtual currency platforms present to CFTC-regulated markets justify close scrutiny, particularly as they lack the transparency and regulatory protections of traditional derivatives platforms.

Surveillance. In light of these concerns, the advisory provides a list of key areas that warrant particularized attention when listing a new derivatives contract based on virtual currency pursuant to self-certification or voluntary submission for Commission review. As self-regulatory organizations (SROs), DCMs and SEFs must establish and maintain effective oversight programs designed to detect and prevent manipulation and delivery and cash-settlement disruptions. However, the advisory states that, without a clear view into the spot markets underlying trading in listed virtual currency derivatives, an exchange may lack the ability to effectively identify and address risks.

As such, the advisory explains that the CFTC staff will assess an exchange’s ability to look into underlying spot markets as part of its review of the exchange’s market surveillance program. The advisory posits that a well-designed surveillance program for virtual currency derivatives includes information-sharing arrangements with the underlying markets that provide access to trade data, including prices, volumes, times, and quotes. Regular monitoring serves to identify anomalies and address problems in a timely manner, according to the advisory, and close coordination with the CFTC’s surveillance group will allow the staff to better oversee and monitor trading in newly listed contracts.

Reporting. Under the CFTC’s rules, clearing members, futures commission merchants, and foreign brokers must file daily reports with the agency showing futures and option positions of traders with large positions; however, an exchange can set the reporting level in a particular commodity at a lower level than specified by the Commission, and thereby provide additional reporting. Because it could be difficult to obtain information about trading in the virtual currency spot markets, the advisory suggests that the existing large trader reporting framework could help to identify traders engaging in manipulative activity in virtual currency markets. The staff recommends that exchanges set the reporting threshold for any virtual currency derivative contracts at five bitcoin (or equivalent) to facilitate surveillance of relevant information in the spot markets.

Outreach and risk management. In light of the concerns about price volatility and lack of transparency regarding virtual currencies underlying derivatives contracts, the advisory urges exchanges to engage with relevant stakeholders in developing contract terms and related rules.

According to the advisory, the CFTC staff expects exchanges to solicit stakeholder views prior to listing a new contract on virtual currency, including individuals and entities beyond those interested in trading the new contract. Further, the advisory explains that exchanges should consider including explanations of substantive opposing views as part of its submission to the Commission for self-certification or prior approval for listing of a virtual currency derivative contract.

To increase transparency, if the staff cannot confirm that a contract subject to self-certification complies with the Commodity Exchange Act and CFTC regulations while the exchange lists (or intends to list) the contract, the staff may inform the exchange of its concerns and publish the notification as appropriate.

In addition, once the DCO that will clear a proposed contract is identified, the CFTC staff will request information relevant to clearing and review proposed margin requirements to assess whether they match up with the risks of the contract.

In a statement, CFTC Commissioner Rostin Behnam said that the advisory represents “another step in providing the public with greater transparency into this process.” However, he noted his desire to continue to explore further options, including possible parameters for determining when self-certification may not be appropriate and when matters should be brought before the Commission.

Tuesday, May 22, 2018

Coordination, innovation key in blockchain regulation, say NASAA FinTech panelists

By Anne Sherry, J.D.

Panelists at the NASAA Fintech Forum in Washington, D.C., examined the challenges and opportunities ahead as regulators grasp with blockchain-related innovations. At a morning panel about virtual currency regulation, regulators and a defense attorney debated whether regulatory certainty is a help or hindrance in this emerging area. A more tech-focused afternoon session focused on the evolution and future of blockchain technology.

Virtual currency regulation. Representatives from the SEC, CFTC, and Conference of State Bank Supervisors, along with a Ballard Spahr partner, discussed the regulatory landscape around virtual currencies. This conversation focused around innovation, cooperation, and coordination.

Ballard Spahr partner Marjorie Peerce said that uncertainty in the landscape makes it difficult to counsel clients about the rules. There is no confusion or disagreement when it comes to fraud, but the number of different agencies—both federal and state—overseeing licensing and registration leads to confusion, especially among innovators who have never before been in the financial space. Peerce believes that the Uniform Law Commission’s Regulation of Virtual-Currency Businesses Act is a step in the right direction, but the track record for adoption of uniform laws is low.

Brian Trackman, the lead attorney for the CFTC’s LabCFTC initiative, responded that the agency needs to be careful not to stifle innovation. “There’s a loud call for certainty, but be careful what you wish for,” he countered. “We’re in a better place letting these technologies play out and taking time to educate ourselves as regulators.” Peerce clarified that while it is important to enable technology, it is the absence of consistency that is confusing. Different states have different perceptions, or even no perceptions, on these issues, and the Howey test for identifying securities is hard to analyze in these circumstances.

SEC Attorney Valerie Szczepanik said that the agency is always willing to engage with the public. The SEC encourages innovators such as Peerce’s clients to bring counsel and talk about their ideas; the agency can throw down a red flag if they see it. Trackman said that the CFTC has the same policy and has “taken meetings with the smallest of entities, including individuals literally wearing hoodies.” Internally, LabCFTC is like a think tank, but externally, it is a point of contact, he explained. John Ryan, President and CEO of the Conference of State Bank Supervisors, also offered that Pennsylvania Securities Commissioner Robin Wiessmann completed a project of compiling a single point of contact for innovation at every state.

Blockchain technology. Wiessmann moderated the next panel, which focused more heavily on technology and its impact on the securities industry. Isabell Corbett, senior counsel at R3, defined four use cases for blockchain in the industry: (1) anti-money-laundering and know-your-customer requirements; (2) repo clearing; (3) derivatives clearing; and (4) cross-border payments. Together, blockchain can save up to $80 billion across these use cases, she said.

R3’s Corda blockchain platform differs from a proof-of-work system like Bitcoin in that data is not broadcast to the entire system, but rather is provided to those who have a right to see it and a need to see it. This is borne out of the fact that R3 is a consortium of banks, who are legally barred from sharing certain data. Corda, which is open-source, also allows for regulators to pull certain data fields on transactions they have a right to see. Charles De Simone, First Vice President, SIFMA, agreed in the importance of regulators being able to pull data in a usable format, rather than the current model of industry participants pushing massive amounts data as less useful Excel files or flat files.

Fredrik Voss, Vice President of Blockchain Innovation at Nasdaq, opined that blockchain is a foundational technology. Changing the foundational components of capital markets is a long process, but he cited DTCC and central counterparty clearing as examples of how valuable it can be. The most viable commercial opportunity in the near term is on markets that are already structured on a peer-to-peer basis but are using less efficient technology, he added. FINRA’s Haime Workie agreed that improvements will be most dramatic in inefficient markets. But he emphasized that distributed ledger technology is just that, a technology or tool. Where it goes depends on what market participants desire and whether the tool exists to speak to those desires—the tools will not change the desires.

An audience member asked whether it was really improving efficiency in the capital markets to create various blockchains for different purposes and for different firms. Corbett predicted that the market will eventually converge around two to three major blockchains, with interoperability between them. Workie seemed skeptical: regulators want to see a convergence, he said, but market forces work against this in favor of discrete systems. The networking effect will determine what platforms take off. Finally, De Simone said that the core assumption among SIFMA members is that use cases should be allowed on existing regulatory platforms, with modifications to rules as needed. Furthermore, regulators’ role should be limited to activities, markets, and products—not technologies themselves. As use cases and markets evolve, there should be a way to incorporate them into a framework that is technology-agnostic.

Monday, May 21, 2018

CII again criticizes IPOs with multi-class share structures

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

The Council of Institutional Investors (CII) has again written to companies that are about to engage in initial public offerings to express concerns about their multi-class share structures. In separate but similar letters to independent directors of GreenSky, Inc. and Pluralsight, Inc., CII wrote that the dual-and tri-class voting structures employed by the two companies, respectively, would severely limit long-term accountability to public shareholders. Accordingly, CII urged the companies to reconsider using their unequal voting rights structures as public companies, or, failing that, to incorporate sunset provisions that revert to one share, one vote within seven years.

CII noted that under GreenSky's unequal voting structure, holders of Class B shares will carry super-voting rights that entitle them to ten votes per share. Under Pluralsight’s structure, the Class C shares owned by co-founder, CEO, and Chairman Aaron Skonnard will carry super-voting rights entitling him to ten votes per share. CII acknowledged that both companies appear to be employing an “Up-C” structure that confers certain tax benefits and requires the companies to issue two separate classes of common stock. In CII’s view, however, nothing about the Up-C structure requires the class of shares held by insiders to carry super-voting rights.

CII pointed out that most publicly traded companies that use the Up-C structure, including Shake Shack, Spirit Airlines, and GoDaddy, provide insiders and public investors equal voting rights by assigning one vote to both Class A and Class B shares. As a result of the super-voting rights attached to their Class B shares of GreenSky, however, insiders will control 97 percent of the voting power, leaving public shareholders with just 3 percent of the vote despite owning over 20 percent of the company. In the case of Pluralsight, CEO Skonnard will control over 54 percent of the voting power despite owning just 10 percent of the equity.

One share, one vote. CII observed that the principle of “one share, one vote” was the first policy adopted by CII when it was formed in 1985. This approach has been underlined repeatedly by market participants since that time, including recent moves by index providers to discourage unequal voting structures. CII believes that a company’s decision to go public with an unequal voting structure will undermine confidence of public shareholders in the company. And when the company encounters performance challenges, as most companies do at some point, disenfranchised public shareholders will have no ability to influence management or the board.

Although acknowledging that some technology companies have attracted capital on public markets despite having multi-class structures, CII noted that the performance record of these companies is decidedly mixed, with the evidence suggesting that unequal voting structures do not enhance company value beyond the short-term. In addition, Yelp, Fitbit, Kayak, Twilio, and Mulesoft all went public with time-based sunsets on their unequal voting structures. Accordingly, public shareholders at these companies know that they will have a say in company matters equal to their ownership interests within reasonable periods of time. To emphasize this point, CII quoted the remarks of SEC Commissioner Robert Jackson in a recent speech, “If you run a public company in America, you’re supposed to be held accountable for your work—maybe not today, maybe not tomorrow, but someday.”

Friday, May 18, 2018

CBS not entitled to halt controlling shareholder’s efforts to force Viacom merger

By Amy Leisinger, J.D.

The Delaware Court of Chancery has denied a request to temporarily restrain a controlling shareholder’s efforts to push through a merger despite opposition by the board’s special committee and efforts to issue a share dividend to dilute the controller’s voting power. According to the court, while the company and its independent directors stated a colorable claim for breach of fiduciary duty, they were unable to show that full relief would be unavailable if the injunction is denied. Further, the court stated, precedent supports a controller’s right to preemptively protect a control interest (CBS Corporation v. National Amusements, Inc., May 17, 2018, Bouchard, A.).

Corporate battle. CBS and Viacom were part of one company until they were split into the standalone entities in 2005. According to the complaint, Shari Redstone, who (with her control of National Amusements, Inc.) effectively controls nearly 80 percent of the voting power of CBS, began to pursue a merger of CBS and Viacom. By January 2018, Redstone formally approached the boards of CBS and Viacom, and the boards formed special committees to evaluate the possibility of a combination. On May 13, 2018, the CBS special committee determined that a merger is not in the best interests of its stockholders, other than NAI. The special committee found that, in response, Redstone could immediately replace directors to force through the merger and decided to recommend that the CBS board approve a stock dividend of voting shares to all holders. If approved, the dividend would dilute NAI’s, and thereby Redstone’s, voting power.

The next day, CBS and the independent directors moved for a temporary restraining order, alleging that NAI and Redstone breached their fiduciary duties as a controlling stockholder and requesting that the court temporarily enjoin the defendants from interfering with the composition of the CBS board or with the issuance of a share dividend. The defendants then executed and delivered consents to amend CBS’s bylaws to require 90-percent director approval at two separate meetings held at least 20 days apart in order to declare a dividend, which would allow NAI to block enactment of the dividend proposal.

Colorable claim. To obtain a temporary restraining order, a movant must demonstrate: (1) a colorable claim; (2) a likelihood of imminent, irreparable harm if relief is withheld; and (3) greater hardships if the relief is not granted than the defendants would suffer if restrained.

Rejecting the defendants’ contention that the plaintiffs must make a stronger showing because a TRO would effectively provide final relief by blocking action before the vote on the dividend proposal, the court found that the plaintiffs stated a colorable claim for breach of fiduciary duty by a controlling shareholder. According to the complaint, Redstone allegedly refused during negotiations to agree to typical public company governance or submit any potential transaction to a public shareholder vote and had in the past interfered with board nominations and the CBS management team. “[G]iven CBS’s proclaimed commitment to independent board governance, these allegations are sufficient to state a colorable claim for breach of fiduciary duty,” the court stated.

Irreparable harm. The plaintiffs argued that, if the court does not grant relief to prevent interference with the proposal, Redstone would be able to replace directors and “cram down a merger with Viacom.” Despite the 90-percent bylaw effort coming within hours of the hearing on the TRO, the court was not convinced that harm would be irreparable. The court has the power to provide redress if Redstone violates her fiduciary obligations and could set aside the bylaw if it is shown to be invalid or inequitable, the court stated. Further, recourse is available if it is proven that a merger is the result of a fiduciary breach, according to the court.

Balance of equities. The court noted that, in granting a TRO, it may not risk greater harm to the defendants than it seeks to prevent. Precedent recognizes a controlling shareholder’s right to preemptively address threats to its control and potential disenfranchisement, even in the form of a bylaw amendment, and no precedent has sanctioned the type of relief that the plaintiffs request in this matter, the court explained. While NAI and Redstone collectively have the right to protect their majority interest, exercise of that right can be subjected to judicial review, which could afford full relief to the plaintiffs, the court found.

Finding that equity weighed in favor of NAI and Redstone, the court denied the plaintiffs’ motion for a TRO.

The case is No. 2018-0342-AGB.