Thursday, August 25, 2016

Commodities 'spoofing statute' survives constitutional challenge

By Anne Sherry, J.D.

Defendants accused by the CFTC of spoofing activity in futures contracts lost a challenge to the constitutionality of the Commodity Exchange Act and a CFTC regulation. 3Red Trading, LLC, and its principal allegedly engaged in a four-year manipulative scheme by manually placing large orders on one side of the market, then canceling prior to execution. The Northern District of Illinois held that the CEA's spoofing provision, which refers to the activity by that name and then offers a parenthetical explanation, put the defendants on notice as to the conduct it prohibited (CFTC v. Oystacher, August 23, 2016, St. Eve, A.).

Statute not void for vagueness. CEA Section 4c(a)(5)(C) prohibits trading that " is of the character of, or is commonly known to the trade as, 'spoofing' (bidding or offering with the intent to cancel the bid or offer before the execution)." Moving for a judgment on the pleadings in the CFTC enforcement action, the defendants argued that the statute was unconstitutionally vague because it failed to give notice of the conduct it prohibited.

But the court observed that economic regulations are subject to a less stringent void-for-vagueness inquiry, which depends on the context of the specific case at hand and not a hypothetical trader. The CFTC explicitly alleged that the 3Red trader placed both bids and offers with the intent to cancel before execution, and illustrated the unlawful intent by detailing the manipulative trading patterns. Considering these allegations as true, the trading behavior fell within the spoofing statute's parenthetical definition of spoofing. The statute's scienter requirement also mitigated vagueness concerns by narrowing the scope of prohibited behavior and limiting prosecutorial discretion.

Reg. also withstands challenge. The defendants also lost their constitutional challenge to CFTC Regulation 180.1, which prohibits the use of "any manipulative device, scheme, or artifice to defraud." Given the scienter requirement, clear prohibition of manipulative schemes, and relation to the SEC's Rule 10b-5, this rule is not unconstitutionally vague.

Congress properly delegated authority. Finally, the spoofing statute did not represent an unconstitutional delegation of power to the CFTC and federal courts. Congress cannot delegate its legislative power to another branch of government, but the nondelegation doctrine does not prevent Congress from obtaining their assistance. A delegation is constitutionally sufficient if Congress clearly delineates the general policy, the agency that is to apply it, and the boundaries of delegated authority. The congressional findings and statement of purpose with regard to the Commodity Exchange Act satisfy all three requirements with respect to the spoofing statute.

The case is No. 15-CV-9196.

Wednesday, August 24, 2016

'Deplorable’ conduct will cost shady CEO $7.M in rival’s attorney fees

The Delaware Court of Chancery has ordered the CEO of TransPerfect Global, Inc. to pay over $7.1 million in sanctions to his former girlfriend and business partner. The court found that the CEO made false statements in response to interrogatories and in testimony, recklessly failed to safeguard evidence, and intentionally sought to destroy other evidence he had been ordered to make available in an ongoing action concerning the dissolution of the parties’ highly profitable company. While agreeing to sustain certain of Shawe’s objections to the total payment requested, the court found that Shawe’s “deplorable behavior” warranted redress in the form of attorney fees paid in addressing his deceit and attempts at concealment (In re Shawe & Elting LLC, August 19, 2016, Bouchard, C.).

Contentious relationship. TransPerfect, one of the world’s leading providers of translation, website localization, and litigation support services, is owned and operated by Elizabeth Elting and Philip Shawe, who started the company in a college dorm room over 20 years ago. Nearly five years ago, disputes between Shawe and Elting became a regular occurrence. They argued over business and personal expenditures, hiring and firing of employees, and methods by which to cover tax liability. The tumultuous relationship continued over time, and several attempts to compromise failed.

Dissolution. Elting moved for dissolution of TransPerfect and the appointment of a custodian to sell the company and to resolve the deadlocks between Shawe and Elting. The court granted the motion for dissolution, noting that, the business of a profitable corporation may be suffering from an “irreparable injury” when the directors’ approaches are so diametrically opposed that they are unable to govern. The company has already suffered from dysfunction and is threatened with much more grievous harm if the issues are not addressed, the court stated.

Sanctions. In an opinion last month, the court found that Elting had presented clear evidence that Shawe acted in bad faith during the course of the proceedings. Litigation hold notices were provided to TransPerfect staff by both Shawe and Elting, but Shawe twice intentionally deleted computer files to thwart the discovery process (even after being ordered to provide his laptop for forensic analysis) and was, at best, reckless in failing to safeguard evidence on his phone, according to the court. The court also found that the evidence showed that Shawe provided false interrogatory answers and deposition testimony and lied during the merits trial to cover up his deletions and his extraction of information from Elting’s computer. These actions obstructed discovery and “needlessly complicated and protracted these proceedings to Elting’s prejudice, all while wasting scarce resources,” the court stated.

Delaware courts typically follow the “American Rule,” which generally prevents the award of attorney fees to prevailing parties in litigation, the court stated. However, an exception is made when a party has “acted in bad faith, vexatiously, wantonly, or for oppressive reasons” and has displayed “unusually deplorable behavior,” and Shawe’s conduct meets all of these standards, the court concluded. As such, the court ordered Shawe to pay Elting 33 percent of her attorney fees and expenses incurred in connection with the litigation of the merits trial and 100 percent of her fees and expenses in connection with the sanctions hearing.

In its final order, the court made a downward adjustment to the amount proposed and documented by Elting, citing a lack of direct connection of some items to the trial and the hearing.

The case is No. 9661-CB.

Tuesday, August 23, 2016

Commission reverses ALJ on short-selling customer’s fraud liability

By Amanda Maine, J.D.

By a unanimous vote, the Securities and Exchange Commission imposed penalties, disgorgement, and a cease and desist order on a broker-dealer for its role in a complex short-selling scheme. However, the commissioners disagreed with the initial decision of the administrative law judge regarding alleged violations by a retail customer of the broker-dealer, finding that the Enforcement Division had not presented sufficient evidence that the customer had committed securities fraud. The Commission also again rejected constitutional challenges to its in-house administrative court system (In the Matter of optionsXpress, Inc., Release No. 33-10125, August 18, 2016).

Regulation SHO and fraud charges. In April 2012, the SEC charged optionsXpress, Inc., an online brokerage and clearing agency, with violating Rules 204 and 204T under Regulation SHO. The SEC had alleged that optionsXpress failed to satisfy its close-out obligations by engaging in a series of sham transactions designed to give the appearance of having purchased shares to close out an open failure-to-deliver position without actually doing so. The firm allegedly relied on buy-writes (paired stock and options transactions) to address its fail to deliver positions, and the buy-writes did not timely close out optionsXpress’s fails.

An optionsXpress customer, Jonathan I. Feldman, was also charged with fraud for executing 390 buy-writes while knowing that he had no intention of fulfilling his obligations under the options contracts, according to the SEC. An administrative law judge agreed with the Enforcement Division’s allegations and imposed penalties, disgorgement, and cease-and-desist orders on both respondents. The respondents petitioned the Commission for review of the ALJ’s initial decision.

optionsXpress. The Commission agreed with the ALJ that optionsXpress’s reliance on the buy-writes to satisfy its delivery and close-out obligations under Regulation SHO was improper. The firm argued that the Division could not present evidence of harm to any specific investors by its conduct, but the Commission pointed out that persistent fails to deliver undermine market integrity, even without identifying a particular individual or entity harmed.

The Commission noted that while it is not by itself unlawful for a broker-dealer to have a fail to deliver, the broker-dealer is required to close out its fail to deliver position by borrowing or purchasing securities of like kind and quantity. Shares of the securities at issue were not being delivered in sufficient quantities to close out optionsXpress’s failures to deliver, the Commission advised. By relying on its customers’ buy-write transactions, optionsXpress perpetuated and maintained its original fail position. The Commission also cited pre-Rule 204 guidance on fails and close-outs, settled enforcement actions, and guidance accompanying the adoption of Rules 204 and 204T in support of the argument that participants cannot employ combined purchase-and-sale transactions to circumvent those rules.

The Commission also upheld the ALJ’s sanctions on optionsXpress. A cease-and-desist order was proper due to the repeated and serious nature of the violations, the risk that the firm could commit future violations, and its failure to accept responsibility for its conduct. Disgorgement in the amount of $1.5 million was reasonable as the approximate commissions earned by optionsXpress in executing the buy-writes. Finally, third-tier civil penalties were appropriate due to optionsXpress’s “deliberate and reckless disregard of regulatory obligations over a prolonged period.” Finding that optionsXpress violated Rules 204 and 204T approximately 1,200 times, the Commission imposed a civil monetary penalty of $2 million.

Feldman. The commissioners disagreed with the ALJ’s findings holding Feldman liable for fraud. The Division’s contract-based fraud theory was that Feldman sold call options with no intention of fulfilling the resultant delivery obligations when the options were exercised. The Commission pointed out, however, that Feldman did not have any obligation to do so. Broker-dealers like optionsXpress have the obligation and ability to deliver shares, not retail customers like Feldman. There was also no evidence that Feldman secretly intended not to deliver the shares, and in fact was very open about his trading strategy.

The Division also alleged that Feldman’s repeated use of buy-writes deceived market participants about the timely delivery of their shares, effectively amounting to market manipulation. The Commission disagreed, finding fault with the Division’s evidence of scienter, which was primarily Feldman’s statements that he did not want to settle his position. This argument, according to the Commission, “conflates the concept of ‘delivery’ applicable to broker-dealers and that applicable to customers.” The Commission also pointed out that Feldman’s profits were not affected by whether optionsXpress actually delivered the shares. In addition, the Commission noted that Feldman was given assurances from optionsXpress that his use of buy-writes was not inappropriate under SEC regulations.

Constitutional arguments. Finally, the Commission rejected the respondents’ arguments that its ALJ regime is unconstitutional, which is a position it has taken in the recent past (see, e.g., Raymond J. Lucia, John J. Aesoph), as well as a position bolstered by a recent D.C. Circuit opinion. The respondents challenged the appointments of the SEC’s ALJs as unconstitutional under the Appointments Clause, arguing that they are “inferior officers” like the special trial judges of the Tax Court in Freytag v. Commissioner. The Commission reiterated its opinion that SEC ALJs have fewer powers than special trial judges, and instead are employees similar to the FDIC’s ALJ’s under Landry v. FDIC.

The Commission also disagreed with the respondents’ contention that dual for-cause removal restrictions on its ALJs are unconstitutional under Free Enterprise Fund v. PCAOB. The Commission pointed out that Free Enterprise specifically did not address ALJs. It also observed that the nature of the duties of ALJs is dramatically different from the PCAOB in that ALJs perform adjudicative rather than enforcement or policymaking functions. In addition, ALJs have less independence than the PCAOB, the Commission stated; ALJs merely take the cases assigned to them rather than possessing the independence of the PCAOB, which determines its own priorities and can interfere in the affairs of regulated firms without Commission preapproval. Finally, the Commission noted that the ALJ system, unlike the PCAOB, is not novel and has worked effectively for over 70 years.

The release is No. 33-10125.

Monday, August 22, 2016

SEC approves FINRA’s capital acquisition broker rules

By John Filar Atwood

The SEC has issued an order approving a new set of rules drafted by the Financial Industry Regulatory Authority, Inc. (FINRA) to apply solely to firms that meet the definition of “capital acquisition broker.” FINRA created the separate rules because it believes that capital acquisition brokers do not engage in many of the types of activities typically associated with traditional broker-dealers.

Capital acquisition brokers. According to FINRA, capital acquisition brokers are firms that are solely corporate financing firms that advise companies on mergers and acquisitions, advise issuers on raising debt and equity capital in private placements with institutional investors, or provide advisory services on a consulting basis to companies that need assistance analyzing their strategic and financial alternatives. The firms often are registered as broker-dealers, FINRA noted, because of their activities and because they may receive transaction-based compensation as part of their services.

FINRA initially published the rules for comment in December 2015, and the SEC received 18 comment letters on the proposal. In response to the comments, FINRA amended the rules In March to clarify that the definition of “capital acquisition broker” does not include any broker or dealer that effects securities transactions that would require the broker or dealer to report the transaction under the FINRA Rules 6300 Series, 6400 Series, 6500 Series, 6600 Series, 6700 Series, 7300 Series or 7400 Series.

Another amendment. After the amendment, the rules were published again for public comment, and the Commission received one letter on the amended version of the rules. In response, FINRA amended proposed CAB Rule 016(c)(1)(F) regarding a CAB’s authority to engage in qualifying, identifying, soliciting, or acting as a placement agent or finder in connection with unregistered securities transactions.

The order granting approval covers the version of the rules that includes both FINRA amendments. FINRA said that the rules subject capital acquisition brokers to the FINRA bylaws, as well as core FINRA rules that FINRA believes should apply to all of its members. The new rules also include other FINRA rules that are tailored to address capital acquisition brokers’ business activities.

Friday, August 19, 2016

Industry worries about incomplete Treasury trade reporting

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

Securities industry groups have expressed concerns about the scope of FINRA’s recent proposal to require members to report secondary market transactions in U.S. Treasury securities to the Trade Reporting and Compliance Engine (TRACE). In separate comment letters to the SEC, the Securities Industry and Financial Markets Association (SIFMA) and the Investment Company Institute (ICI) offered general support for the proposal, stating that expanding TRACE reporting to Treasuries would provide greater clarity to regulators while helping to ensure an efficient and competitive market for all investors. The organizations each expressed concern, however, that the proposal may result in an incomplete view of the secondary Treasury market because FINRA’s rules by themselves cannot capture transactions executed by market participants that are not registered as broker-dealers.

FINRA proposal. In the wake of the "flash crash" in Treasury securities in October 2014, an interagency working group led by the Treasury Department analyzed the conditions that contributed to the unusual volatility as well as the structure of the overall Treasury securities market. After the Treasury Department solicited public comments on the need for structural changes, the Treasury Department and the SEC asked FINRA to consider a proposal to require member broker-dealers to report Treasury cash market transactions to a centralized repository.

FINRA’s proposal would amend the TRACE rules to require the reporting of transactions in all Treasuries with the exception of savings bonds, generally on a same-day basis. In response to public comments, however, FINRA proposed to add transactions in U.S. Treasury Securities to the list of transactions for which information will not be disseminated to the public.

SIFMA’s comments. SIFMA noted that the recent evolution of the Treasury market has included significant participation by entities that are not subject to FINRA’s reporting requirements, such as unregistered principal trading firms (PTFs), banks, and unregistered trading platforms. Without reported transaction-level data from these entities, any analysis of the U.S. Treasury market would be necessarily limited and incomplete. As a result, SIFMA expressed concern that the current proposal will not give regulators a complete picture of the current Treasury market. Accordingly, SIFMA believes that the Treasury Department and other agencies should determine the most efficient and cost effective way to develop a consistent reporting regime that encompasses all relevant market participants—including unregistered PTFs.

SIFMA also expressed concern that any analysis concerning the benefits of public dissemination of the data will be undertaken while incomplete data on the market is available. SIFMA suggested that the Treasury and the other agencies continue to engage in discussions with the full spectrum of market participants and other stakeholders before any decisions are made on public dissemination. SIFMA also urged Treasury and other official sector stakeholders to carefully consider and balance any potential benefits of public dissemination against its potential costs, including costs related to overall market liquidity.

ICI’s comments. The ICI echoed SIFMA’s comments, saying that the proposal will provide the official sector with only partial information about the U.S. Treasury cash market because not all intermediaries in the market are FINRA members. In addition, some significant intermediaries, including certain unregistered PTFs with potentially high levels of trading activity, face little or no regulation. The ICI cautioned regulators against using the data acquired through TRACE reporting to develop rules that would change the structure of the Treasury market. In the ICI’s view, fundamental changes to market structure such as trading halts, circuit breakers or the public dissemination of trading data have the potential to disrupt the operation of the market if they are implemented prematurely or unnecessarily.

Thursday, August 18, 2016

Former enforcement director asks SEC to limit retroactive application of penalty increases

By John Filar Atwood

Three WilmerHale attorneys, including former SEC Enforcement Division director William McLucas, have written to the SEC to urge it to restrict the application of its civil penalty increases to violations that occur after November 2, 2015. The attorneys said that the SEC’s language in announcing the penalty increases was unclear, but that retroactive application of any increases to violations that occurred prior to November 2, 2015 exceeds the Commission’s authority.

Background. On July 1, the SEC adopted an interim final rule to implement the Federal Civil Penalties Inflation Adjustment Act Improvements Act of 2015. The interim final rule adjusts for inflation the maximum amount of civil monetary penalties under the federal securities statutes. By law federal agencies are required to adjust for inflation their maximum civil monetary penalties at least once every four years.

Wilmer’s concerns. In a comment letter to the Commission, the WilmerHale attorneys noted that the release announcing the SEC’s penalty increases stated that the adjustments apply to all penalties imposed after the effective date of the interim final rule, “including to penalties imposed for violations that occur before the effective date of the amendment.” The attorneys expressed concern that this language could indicate the SEC’s intention to apply the penalty increases to violations that occurred before November 2, 2015.

The attorneys noted that the statute authorizing the penalty increases became law on November 2, 2015. It directed agencies to adopt catch-up penalty increases effective no later than August 1, 2016. Although the statute provided that penalty increases could apply to violations predating the regulation increasing the penalty, the attorneys stated, it did not specify whether the penalties apply to violations predating the November 2, 2015 passage of the statute.

The attorneys argued that the statute’s silence on this question is important given the holding in Landgraf v. USI Film Products that a statute does not apply retroactively to conduct prior to the passage of the statute unless the statutory language “requires this result.” The attorneys also cited the Supreme Court’s observation that it has never “read a statute substantially increasing the monetary liability of a private party to apply to conduct occurring before the statute’s enactment.”

Other agencies’ approach. The attorneys advised the Commission that most other federal agencies, including the Department of Justice, are not applying their penalty increases to violations that occurred prior to November 2, 2015. This demonstrates that the statute does not “require the result” the SEC is proposing, the attorneys noted, and they urged the Commission to restrict the application of its penalty increases to violations after November 2, 2015.

Wednesday, August 17, 2016

Comment period closes on PCAOB’s reproposal to revise the auditor’s reporting model

By Jacquelyn Lumb

The comment period has closed on the PCAOB’s reproposed standard to revise the auditor’s reporting model to include communications about critical audit matters (CAMs) that arose during the audit of a company’s financial statements. The project began with a concept release in 2011 in which the PCAOB received 155 comment letters, followed by a proposal in 2014 that resulted in 248 responses, and a reproposal that garnered an additional 51 comment letters. In the PCAOB’s reproposal, it included materiality in the definition of what constitutes a critical accounting matter, partly to ensure that the auditor would not be the original source of information that appears in the report.

Center for Audit Quality. The Center for Audit Quality does not believe the revised definition fully aligns with the Board’s intent, and proposed a further revision to the definition so that a CAM is defined as any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee, is material to the financial statements taken as a whole, and involved especially challenging, subjective or complex auditor judgment.

Another measure to help ensure that auditors are not the original source of information for a company is to revise the factors with respect to their most challenging, subjective, or complex judgments, according to CAQ, and it proposed a number of tweaks to those factors. CAQ also suggested revisions to the Board’s illustrations to ensure that auditors do not interpret the examples as requiring detail beyond the principal considerations and the principal way in which the CAMs were addressed.

Enhanced auditor reporting will inevitably increase the risk of litigation, CAQ noted, and the Center said it is concerned that the requirement to describe how CAMs were addressed may significantly increase that risk. The auditor must not be required to include information in the report when the source should be the company to prevent an increased risk of liability, CAQ advised.

Because it does not see a correlation between auditor tenure and audit quality, CAQ said it does not support including that disclosure in the auditor’s report. If the audit committee believes the information is important to users of its financial statements, the audit committee report is the appropriate place for the disclosure, in CAQ’s view.

CAQ supports the application of the standard to emerging growth companies, and recommended a two-phased adoption of the proposal, the first of which would apply to large accelerated filers for audits ending two years after the approval of the final standard, and for the others, one year after that. This approach would enable the PCAOB to share its inspection observations and provide insight to assist the phase two adopting issuers.

Deloitte & Touche LLP. Deloitte & Touche LLP wrote in support of the PCAOB’s proposal, but does not believe disclosure about auditor tenure should be included in the auditor’s report. The firm said the disclosure should appear in new form AP instead, with the ability to provide supplementary contextual information if needed. Communication about CAMs should not be required for audits of brokers and dealers, investment companies other than business development companies, or benefit plans, while allowing for the voluntary inclusion of CAMs for these entities. Deloitte said there is no basis for exempting the audits of emerging growth companies from the standards.

As for auditor liability concerns, Deloitte raised the possibility that plaintiffs may use descriptions of the auditors’ procedures in their CAM disclosures to ty to “plead around” the strict requirements of the Private Securities Litigation Reform Act. However, Deloitte concluded that concerns over auditor liability should not stand in the way of the PCAOB moving forward.

AFL-CIO. The AFL-CIO expressed concern about adding a materiality threshold in the definition of CAMs and urged the Board to look to the IAASB’s definition of key audit matters (KAMs) which requires auditors to select the most significant matters in the audit for discussion in the auditor’s report. The IAASB’s approach avoids reliance on the auditor’s determination of whether a matter was especially challenging, subjective, or one involving complex judgment.

The AFL-CIO supports the inclusion of the auditor’s tenure in auditor’s reports and noted that its own proxy voting guidelines recommend that voting fiduciaries consider voting against the ratification of an auditor when a company has had the same audit firm for more than seven years. While many companies have begun to provide this information voluntarily, the AFL-CIO believes that investors should be able to access it in a standardized location.

Institut der Wirtschaftsprufer. Institut der Wirtschaftsprufer wrote that it is in the process of revising its auditing standards to reflect the revised international standards on auditor reporting, and repeated its previous comments urging the Board to strive for maximum global consistency in auditor reporting. The reproposal represents an improvement, but the Institut perceives a lack of conviction by the Board with respect to the importance of international comparability. The Institut found no discussions in the release that justify the differences for matters to be reported as CAMs or KAMs, and urged the Board to carefully consider the need for international comparability as it moves forward.

Tuesday, August 16, 2016

Time limit established for actions by NCUA as conservator or liquidating agent

By R. Jason Howard, J.D.

The Ninth Circuit has vacated and remanded a case in which the lower court narrowly construed the Extender Statute contained in the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and determined that claims brought by the National Credit Union Administration Board (NCUA) were time-barred (National Credit Union Administration Board v. RBS Securities, Inc., August 15, 2016, Nelson, D.W.).

NCUA. The NCUA is an independent federal agency responsible for chartering and regulating federal credit unions, regulating federally insured state-chartered credit unions, and administering the Share Insurance Fund. When an insured credit union is in danger of failing, the NCUA has the authority to step in as a conservator to preserve the credit union’s assets and to protect the insurance fund.

Before its failure, Wescorp was the second largest corporate credit union in the United States and, like many financial institutions before the collapse of the housing market, Wescorp invested in RMBS, which are securities backed by thousands of individual residential mortgages. Wescorp failed after suffering heavy losses on its RMBS investments.

Pursuant to its statutory authority, the NCUA placed Wescorp into conservatorship, and later into liquidation. After assuming control of Wescorp, the NCUA determined that offering documents for RMBS issued by Wachovia Mortgage Loan Trust, LLC (Wachovia) and Nomura Home Equity Loan, Inc. (Nomura) and purchased by Wescorp in 2006 and 2007 contained certain statements and omissions that the NCUA believed materially misrepresented the quality of the residential loans underlying the RMBS.

Securities Act. Section 13 of the Securities Act states that a private investor pursuing a claim under Section 11 or Section 12(a)(2) ordinarily must bring suit: (1) within one year after discovering a violation; and (2) within three years after the security was offered or sold.

The Supreme Court has explained that the second requirement is a statute of repose and, unlike a statute of limitations, which begins to run when a claim accrues and may be subject to equitable tolling, “[a] statute of repose bars any suit that is brought after a specified time since the defended acted . . . , even if this period ends before the plaintiff has suffered a resulting injury,” making the statute of repose essentially a cutoff and an absolute bar on a defendant’s temporal liability.

FIRREA. In response to the savings and loan crisis, Congress enacted FIRREA, which contains special provisions concerning the failure of financial institutions, including the Extender Statute, which establishes “the applicable statute of limitations with regard to any action brought by [the NCUA] as conservator or liquidating agent.” It requires that tort claims be brought within the longer of: (1) the 3-year period beginning on the date the claim accrues; or (2) the period applicable under state law. Accordingly, a claim accrues the later of: (1) the date of appointment of the NCUA as conservator or liquidating agent; or (2) the date on which a cause of action accrues.

District court. In interpreting the Extender Statute, the district court found that it supplanted only the one-year “statute of limitations” and not the three-year “statute of repose” contained in Section 13 of the Securities Act. The NCUA placed Wescorp into conservatorship on March 20, 2009, and filed its original complaint less than three years later, on July 18, 2011. Because the NCUA did not file suit within three years after the securities at issue were offered or sold (as the statute of repose ordinarily requires), the district court dismissed the NCUA’s claims against Wachovia and Nomura as time-barred.

Ninth Circuit holding. The court explained that the Extender Statute establishes a universal time limit for all actions by the NCUA as conservator or liquidating agent and that the district court erred in holding that FIRREA’s Extender Statute does not displace the Securities Act’s statute of repose in actions by the NCUA as conservator or liquidating agent and said, “We hold that the Extender Statute replaces all preexisting time limitations—whether styled as a statute of limitations or a statute of repose—in any action by the NCUA as conservator or liquidating agent. We also hold that the Extender Statute’s scope—“any action brought by the [NCUA]”—includes actions such as this one, in which the NCUA asserts statutory claims rather than common law tort or contract claims. In sum, we conclude that the NCUA’s claims were timely filed.”

The case is No. 13-56620.

Monday, August 15, 2016

SROs’ upcoming rules changes will address trading halts

By Mark S. Nelson, J.D.

Bats Global Markets, Inc., Nasdaq, and NYSE Group announced they will submit a series of related rule changes to the SEC as part of a larger effort to revise the National Market System Plan to better handle periods of market volatility. Several highly publicized “flash” crashes during the past few years underscore the need for limit up/limit down (LULD) requirements and for additional fine-tuning of these rules regarding the resumption of trading after halts.

Market solution. The exchanges’ proposals seek to: (1) avoid periods where LULD bands are absent; (2) create markets with fewer trading pauses; (3) establish a standardized mode of re-opening after a pause; and (4) obviate the need for the clearly erroneous execution rules, at least while LULD bands are in effect. The exchanges also plan systemic changes to reduce halts and price distortions that can result from “leaky” LULD bands.

EMSAC sees promise, pitfalls. SEC Chair Mary Jo White, in opening remarks to the August meeting of the Equity Market Structure Advisory Committee (EMSAC), said she was pleased the committee would address industry harmonization efforts along with defects in the current LULD reopening auction process.

The EMSAC’s Market Quality Subcommittee’s recommendation noted that although LULD bands’ primary function is sound, the re-opening process is flawed. While the subcommittee acknowledged, and praised, industry efforts to improve the LULD mechanism, members expressed some doubt as to whether these changes alone will fix the re-opening auction process.

Previously, Commission staff issued a study regarding trading pauses for the SEC’s Division of Economic and Risk Analysis. Staff from the Division of Trading and Markets also published a research note that includes an extensive discussion of LULD halts.

Friday, August 12, 2016

FCM let off the hook for not recording customer's phone call

By Anne Sherry, J.D.

The failure of futures commission merchant TransAct to record a customer's phone instructions did not give rise to a presumption in favor of the customer. The customer said that he told TransAct to cancel all of his working orders, but TransAct said it was told to cancel only some of them. The Seventh Circuit observed that TransAct had no legal or contractual obligation to record the phone call, and it deferred to the CFTC's credibility assessment finding TransAct's side of the story more plausible (Witter v. CFTC, August 10, 2016, Wood, D.).

Dispute over phone call. The customer was a mortgage broker, but the TransAct trades were his first foray into commodities trading. He contended that he called TransAct's customer support desk with instructions to (1) place a stop-loss order on his open position in the E-Mini S&P; and (2) cancel all seven of his working orders. According to the customer support representative, however, the instruction was to cancel three of the seven orders—those for Treasury and Dow Index futures contracts, but not the orders for E-Mini S&P contracts. The customer noticed the following day that his account value had dropped by $23,000, alerting him to the fact that his working orders had not been canceled.

Procedure before CFTC. The judgment officer in the CFTC's summary proceeding dismissed the customer's complaint, having found the TransAct representative's testimony more plausible and noted that the customer tended to confuse trading terms, like "position" and "order." The customer appealed to the full Commission, which remanded for further discovery on whether TransAct had actually recorded the call. Although TransAct conceded that it had the technology to record multiple calls, it explained that redirected calls did not get recorded and that this was the fate of the call in question. The judgment officer declined to draw an adverse inference from TransAct's inability to produce a recording and dismissed the complaint based on his original credibility assessment; the CFTC affirmed.

Customer not entitled to inference. In his appeal to the Seventh Circuit, the customer argued that he was entitled to an inference from TransAct's failure to produce a recording of the telephone call because TransAct was legally and contractually required to record the call. These contentions, however, were incorrect: no regulation requires an FCM to record phone instructions to cancel previously authorized orders to buy or sell. Furthermore, while TransAct's customer agreement secured consent to record calls, it did not require TransAct to do so.

TransAct testimony more credible. The Seventh Circuit also stood by the judgment officer's credibility assessment, which could be overturned only in extraordinary circumstances. On the contrary, the record amply supported the credibility ruling. Although the judgment officer found both sides' testimony to be sincere, "but leavened with a bit of self-interest," he noted that the customer tended to mix up trading terms. This was relevant, the appeals court wrote, to what the TransAct representative understood the customer to be asking of him. The terms the customer conflated at the hearing were directly related to the disputed call, and the judgment officer cited other reasons for finding TransAct's explanations more plausible, such as the fact that the customer support representative wrote his affidavit shortly after the disputed call and was more familiar with the telephone recording system.

The case is No. 15-3535.

Thursday, August 11, 2016

NIRI urges SEC to focus on materiality of business and financial disclosure

By Jacquelyn Lumb

The National Investor Relations Institute urged the SEC to keep in mind Congress’s intent that disclosure reform of Regulation S-K should focus on the reduction of costs and burdens on issuers while still providing all material information. NIRI, which represents corporate officers and investor relations consultants, advised that many investors and issuers have complained that disclosure overload has become worse due to new disclosure mandates imposed by Congress. Some of these new reporting requirements have cost millions of dollars to implement while providing non-material information to investors. Fear of shareholder litigation also leads many companies to include generic or boilerplate risk factors, according to NIRI, and it remains in their filings for years. NIRI asked the SEC to consider the voluntary disclosure improvement efforts underway in response to investor demands before mandating any new disclosures.

Voluntary disclosures. Many companies no longer rely solely on their Exchange Act reports to provide information to analysts and investors. In addition to investor day events, non-deal roadshows, and industry conferences, NIRI noted that many companies have created websites to provide information about their operations, financial metrics, stock performance, and earnings guidance. Investor relations professionals seek feedback from investors, analysts and other stakeholders in order to refine their websites and presentations, according to NIRI.

Materiality. In NIRI’s view, the SEC should avoid any new market-wide disclosure requirements that do not meet the materiality standard outlined in the Supreme Court’s TSC Industries v. Northway decision. NIRI quoted Commissioner Michael Piwowar’s remark that this materiality standard is an objective legal standard rather than a subjective political one. The “reasonable investor” standard is well known and flexible enough to allow the SEC to provide new guidance as investor priorities change, according to NIRI, and it should continue to guide the SEC’s materiality determinations.

Company profiles. NIRI supports recommendations by Davis Polk and other commenters that the SEC should allow companies to create online business profiles for information that is unlikely to change from quarter to quarter, and provide annual updates. Companies then could provide shorter periodic reports that would focus on recent financial results, material changes to risk factors, and other new developments. This approach would allow for the elimination of Item 101(a), which requires a description of the general development of an issuer’s business over the past five years, NIRI explained.

Additional disclosure on the impact of environmental regulation should not be required since many companies already disclose pertinent information outside of their SEC reporting and they should retain that flexibility, NIRI wrote.

NIRI also urged the SEC to make clear that companies need only disclose industry and company-specific risks, with a safe harbor for the failure to disclose common risks. The SEC should eliminate the duplication of risk factors within periodic filings.

There is no consensus with respect to changing the quarterly frequency of financial reporting but NIRI said that most of its members do not favor a change in the rules, and believe the need for quarterly information may be greater for small or emerging issuers.

Use of technology. NIRI encouraged flexibility in issuers’ use of technology to improve the readability and navigability of their disclosures, including the use of cross references, incorporation by reference, and hyperlinks to reduce duplication and disclosure overload. The SEC should resist calls for an expansion of XBRL reporting requirements, in NIRI’s view, until it examines whether a significant number of investors use XBRL and whether the benefits outweigh the compliance costs.

NIRI listed a number of specific disclosure requirements that should be removed because they are duplicative or have become outdated, including the number of equity holders under Item 201(b)(1), supplemental financial information in Item 302, and the use of proceeds from registered securities in Item 701(f).

Wednesday, August 10, 2016

Swisher Hygiene folds in wake of accounting fraud

By Anne Sherry, J.D.

Swisher Hygiene will dissolve, capping an accounting-fraud scandal that led to the indictments of several executives and the company's commitment to a $2 million penalty. The SEC's Division of Corporation Finance confirmed that Swisher can stop filing periodic reports while the dissolution and liquidation is in process. CorpFin's no-action response sheds some light on the factors it looks for when granting such a request.

Accounting fraud and aftermath. The alleged fraud, which took place in 2011 and 2012, was meant to ensure that Swisher met or exceeded management forecasts. A 2015 indictment of Swisher's former CFO and its director of external reporting indictment maintained that the co-conspirators created fraudulent accounting entries and provided false or misleading information to Swisher’s outside auditor, its lender (Wells Fargo), and the public. Those defendants allegedly concealed their fraud and lied to the investigators in an internal investigation. Swisher's former director of financial planning pleaded guilty for his role in the fraud, and Swisher agreed to pay a $2 million penalty as part of a deferred prosecution agreement.

The fraud also led to private litigation by stockholders in connection with Swisher's M&A activity. A district court in North Carolina dismissed a private suit related to the acquisition of Choice Environmental Services. But two stockholder suits were filed in connection with Swisher's sale of a subsidiary to Ecolab; one of those suits is still pending.

The no-action request. Swisher asked CorpFin for relief from reporting requirements while it liquidated its assets and dissolved the corporation. The company filed a certificate of dissolution with Delaware in May 2016, closed its stock transfer books, and promised not to issue any new stock certificates. As a result of completing the sale transaction to Ecolab, Swisher has no remaining operating assets and generates no revenue. Relief from Exchange Act reporting requirements would save the company $150,000 per 10-Q and $350,000 per 10-K, the no-action letter estimates.

No-action relief. CorpFin agreed that Swisher can stop filing periodic reports pending its liquidation and dissolution, on the conditions stated in its no-action letter. Specifically, the Division gave a roadmap of sorts by highlighting the following representations that led to its no-action relief:

  • Swisher Hygiene's stockholders approved and adopted the Plan of Dissolution;
  • Swisher Hygiene will file reports on Form 8-K to disclose any material events relating to its winding up and dissolution, including the amounts of any liquidation distributions, payments and expenses;
  • Swisher Hygiene will file a final report on Form 8-K and a Form 15 when the dissolution is complete;
  • Swisher Hygiene is current in its reporting obligations under the Exchange Act;
  • Swisher Hygiene filed its Certificate of Dissolution with the Delaware Secretary of State and the effective date of the dissolution was May 27, 2016;
  • There is no trading in Swisher Hygiene's securities; and
  • Swisher Hygiene's transfer agent has closed Swisher Hygiene's stock transfer books and discontinued recording transfers of Swisher Hygiene's stock.

Tuesday, August 09, 2016

Private action plaintiffs urge court to deny Kraft request for interlocutory appeal

By Lene Powell, J.D.

Plaintiffs in a private action alleging commodity price manipulation and antitrust violations by Kraft Foods urged a federal district court to reject Kraft’s request to certify three questions for interlocutory appeal. Pointing to the recent denial of interlocutory appeal in a similar case brought by the CFTC, the plaintiffs argued that the questions, involving the elements of manipulation and monopoly power, were not contestable or controlling and would not expedite the case (Ploss v. Kraft Foods Group, Inc., August 5, 2016).

Two cases against Kraft. In April 2015, the CFTC brought an enforcement action alleging that Kraft and a subsidiary manipulated wheat prices in the cash and futures markets. The CFTC alleged that Kraft took a very large, uneconomic futures position in a type of wheat it did not use in order to depress the cash price for the type of wheat it did use, and that this constituted price manipulation in violation of the Commodity Exchange Act (CEA).

Shortly thereafter, futures trader Harry Ploss filed a private action against Kraft based on the same alleged conduct. Like the CFTC, Ploss filed in the federal district court for the Northern District of Illinois. However, the CFTC case is being heard by Judge John Robert Blakey, whereas the Ploss case is being heard by Judge Edmond Chang. Ploss also added a claim of monopolization under the Sherman Act.

Kraft subsequently lost motions to dismiss in both the CFTC and Ploss suits, and moved to certify two issues for interlocutory appeal: whether a manipulation claim required some element of misrepresentation; and whether there could be an artificial price where prices converged between the cash and futures markets. In the Ploss case, Kraft also questioned whether a defendant’s open market purchases at open market prices could support a monopolization claim. Judge Blakey denied Kraft’s motion for interlocutory appeal in the CFTC case, ruling that the issues were not contestable questions of law for which the court’s decision was likely to be reversed on appeal.

Is misrepresentation an element of manipulation? Ploss encouraged Judge Chang to follow Judge Blakey’s ruling and reject Kraft’s assertion that some sort of false communication or other misrepresentation is required to state a claim for market manipulation under CEA Sections 6(c)(1) or 9(a)(2). To require this would undermine the congressional intent in enacting the CEA to deter and redress all forms of market manipulation, said Ploss, and no judge has ever held that an explicit misrepresentation is required to state a CEA claim. Last year, the Seventh Circuit articulated a four-part test for price manipulation in In re Dairy Farmers of Am., Inc. Cheese Antitrust Litig., and that test did not include an element of misrepresentation.

Moreover, said Ploss, the question was not contestable. Kraft was attempting to extrapolate the Seventh Circuit’s ruling in Sullivan v. Long (1995) to require a “false communication” in order to state a market manipulation claim under the CEA. However, Sullivan involved the short selling of securities in violation of the Securities Exchange Act of 1934, and it would be unreasonable to extend it to commodities manipulation. The federal securities laws and CEA have different purposes and interpretations, and unlike the federal securities laws, the CEA prohibits all price manipulation. And, in order to thwart crafty manipulators, Congress, the courts, and the CFTC have purposely refused to adopt safe harbors from the definition of manipulation under the CEA. Accordingly, Sullivan is not controlling, said Ploss.

Artificial price. Kraft’s second question also should not be certified, Ploss argued. Judge Blakey found in the CFTC case that the question of whether “artificial” prices existed requires a complex fact determination, because it needs some factual predicate to know what the “true” prices were. Therefore, it was not a question of law, as required for issues certified for interlocutory appeal. In addition, the holding in Sullivan did not preclude convergence between cash wheat and futures from creating artificial prices, Ploss asserted.

Monopoly power. The question of monopoly power was also a factual rather than legal question, asserted Ploss. Without a factual record, the Seventh Circuit could not evaluate whether Kraft could have monopoly power when the purchases were made on the open market at open market prices. Also, although the monopoly question had not been before Judge Blakey, the court had previously held in a 2011 case alleging manipulation of milk futures prices that monopolization could occur by open market purchases.

Further, Kohen v. Pac. Inv. Mgmt. Co. LLC (2009), cited by Kraft, actually undermined rather than bolstered Kraft’s argument by holding that unlike a cash-settled futures market, a commodities-settled futures market (like wheat) can plausibly be cornered. In addition, that case did not suggest that a corner or a squeeze are the only means available for a defendant to monopolize a futures market. A large dominant position like Kraft’s—an 87 percent long position—could exclude competitors from taking a meaningful position in the market and thus give Kraft great influence over the prices, Ploss contended.

Not dispositive. Finally, Ploss argued that the appeal would not expedite the case. None of Kraft’s proposed three questions were dispositive, and if Kraft prevailed, the ruling would not end the two cases, but rather would require the parties to wage two contemporaneous battles, one in district court and another in the Seventh Circuit. Accordingly, Ploss urged the court to deny Kraft’s motion for certification of the issues for interlocutory appeal.

The case is No. 15 C 2937.

Monday, August 08, 2016

FINRA exam to target non-traded business development companies

By Kevin Kulling, J.D.

In connection with a FINRA targeted examination involving non-traded business development companies (BDCs), the regulator has published on its website the contents of an exam letter that will require certain firms to provide documents and information about BDCs for the period January 1, 2015 through June 30, 2016. Responses are due by September 9, 2016.

BDCs. BDCs were created by Congress as part of the Small Business Investment Incentive Act of 1980. BDCs were designed to facilitate access to capital and financing for small and growing companies. BDCs are closed-end funds that make investments in private or thinly-traded public companies in the form of long-term debt or equity capital, with the goal of generating capital appreciation and/or current income. Non-traded BDCs are not traded on a national securities exchange.

FINRA requests. The targeted exam letter requests that member firms who receive the letter provide:
  • A list of each BDC offered by the firm, including the name, SEC file number, date of offering and firm’s role in each offering;
  • For each BDC offered, a list of participating broker-dealers that have a selling agreement with the firm per each registration statement and sample copies representative of each type of selling agreement;
  • A list of all broker-dealers that sold the identified BDCs to its customers in initial or follow on offerings that includes the name of the participating broker-dealer, the total number of shares bought and sold, the total dollar value of proceeds and the number of customers purchasing the BDC; and
  • A copy of the firm’s due diligence procedures, a written description of the due diligence that the firm conducts of the BDC initially and on an ongoing basis, as well as a written description of the due diligence that the firm conducts of participating broker-dealers with which the firm has a selling agreement.
The FINRA website did not provide further details regarding which firms would receive the letter or what may have precipitated the targeted exam.

Friday, August 05, 2016

ISDA seeks delay in dissemination of security-based swap information under Regulation SBSR

By John Filar Atwood

The International Swaps and Derivatives Association (ISDA) has asked the SEC to permit a temporary delay in the public dissemination of security-based swap (SBS) information by security-based swap data repositories (SDRs) under Regulation SBSR to prevent reporting entities from having to build new delay mechanisms into their reporting architectures. Without the delay, Regulation SBSR could further delay the reporting of SBS information and negatively affect overall data quality, according to the ISDA.

Regulation SBSR allows reporting entities in an SBS transaction a 24-hour delay from reporting to an SDR after the execution of a SBS transaction. However, Section 902(a) of the regulation requires SDRs to disseminate trade information “immediately upon receipt.” Under the rule, the SDR has no flexibility to delay dissemination consistent with the 24-hour delay. As a result, ISDA said, reporting entities intending to use the 24-hour delay must independently adapt their internal reporting processes and policies to withhold transmission of trade information to the SDR, or risk the immediate public dissemination of this information.

Intended benefits. The ISDA noted that the Regulation SBSR requirements are intended to provide insight into market perspectives on the liquidity of different types of SBS transactions based on the interval at which a reporting side sent data for its SBS to an SDR for immediate public dissemination. That information could potentially form part of the data that the SEC intends to collect and analyze during the interim period to help it establish its block thresholds and reporting delays for SBS transactions (the Block Rules).

However, the ISDA claimed that the reality is that the SEC is not likely to obtain the desired information regarding SBS liquidity since reporting sides and the market infrastructure providers that facilitate reporting on their behalf (together, the reporting entities) will not be able to build sophisticated dissemination delays that take into consideration the relative liquidity of SBS transactions. Doing so would be very difficult and costly, according to the ISDA, and would create a negative commercial impact and impair market liquidity if done in an inconsistent manner.

Inconsistent with Canada. ISDA also noted in its rulemaking petition that the requirement that SDRs disseminate information immediately upon receipt is inconsistent with the existing regulatory requirements for public transaction reporting established by the CFTC and securities regulators in Canada. The rule also is inconsistent with the current functionality of SDRs that offer services in those jurisdictions, and regulatory reporting systems of all market participants in those jurisdictions.

The CFTC and Canadian regulators require reporting “as soon as technologically possible,” according to the ISDA, so reporting entities have not built internal delay mechanisms for reporting. The ISDA believes that the SDRs’ requirement under Section 902(a) effectively obligates reporting entities to build new delay mechanisms into their reporting architectures in order to prevent their SBS data from being publicly reported in advance of the 24-hour deadline for reporting allowed under Section 901(j).

The ISDA said that its members believe that that public dissemination delays are necessary to protect the stability and longevity of the SBS market. In order to avail themselves of this important protection, the ISDA added, reporting entities must build internal delay mechanisms.

Even if firms develop their own internal delay mechanism, the ISDA claimed, the process of scaling products by liquidity based on staggered reporting intervals applied on a trade-by-trade basis is a complex task that may depend on facts and circumstances of a single trade and/or more subjective views of a current market. Consequently, the ISDA expects each reporting entity to establish a single interval at which it reports its trades, which means the SEC is unlikely to obtain information on the perspectives of reporting entities on the relative liquidity of SBS to aid the establishment of its Block Rules.

Fingerprinting. Another threat to anonymity will result from differences in the intervals at which a reporting entity sends SBS to the SDR for immediate public dissemination, according to the ISDA. Since the SBS data of each reporting entity will be publicly disseminated at a consistent point of delay after execution, it argued, the identity of the reporting side would be discoverable by its counterparties who will recognize their SBS transactions against a party on the public report and would be able to deduce that other SBS disseminated at the same interval have been reported by, or on behalf of, that same reporting side. This “fingerprinting” would compromise a reporting side’s anonymity regarding its trading activity and impact its ability to hedge in a timely manner and at a fair price, the ISDA claimed.

The ISDA believes that the requirement for SDRs to comply with Section 902(a) creates a number of serious, unintended consequences that make it difficult and onerous for reporting sides to comply with Regulation SBSR, for market infrastructure providers to support SBSR and for SDRs to maintain data integrity. Firms should not have to give up their right to a public dissemination delay in order to meet their obligations to report timely in other jurisdictions and maintain data that is accurate and reconcilable, the ISDA added.

The problems caused by Section 902(a) would be entirely eliminated if SDRs were allowed to accept SBS data without disseminating it to the public immediately, the ISDA argued, and instead hold the data to be publicly disseminated per the reporting deadline in Section 901(j). The ISDA asked the SEC to amend Section 902(a) to allow SDRs to publicly disseminate a transaction report of an SBS, or a life cycle event or adjustment due to a life cycle event, upon the deadline specified in Section 901(j) or as subsequently provided in the Block Rule.

Thursday, August 04, 2016

Qualcomm's antitrust troubles don't implicate directors in derivative suit

By Anne Sherry, J.D.

A Qualcomm shareholder suing the board for its alleged failure to respond to antitrust "red flags" was thwarted by its failure to first demand that the corporation bring the claim. The pension-fund plaintiff had an uphill battle in pursuing its Caremark claim that the board breached its duty of loyalty by consciously disregarding corporate misconduct. Even assuming that antitrust settlements and foreign judgments constituted red flags, the complaint did not adequately plead that the board's response constituted bad faith (Melbourne Municipal Firefighters' Pension Trust Fund v. Jacobs, August 1, 2016, Montgomery-Reeves, T.).

Antitrust liability. According to the complaint, Qualcomm's ownership of technologies and patents essential to wireless telecommunications has allowed it to become "a toll collector for almost every smartphone manufactured." Qualcomm had acknowledged that it must offer to license its products on fair, reasonable, and non-discriminatory (FRAND) terms, but nevertheless allegedly leveraged its market power unfairly by charging unreasonably high licensing fees, bundling and tying patent licenses, demanding royalty-free licenses from licensees in return, and imposing unreasonable conditions on licensees and chip purchasers.

These allegations led to an $891 million settlement with Broadcom in 2009 and extra-U.S. proceedings in which Qualcomm was found to have violated South Korean and Japanese laws. Then, in 2013, the National Development and Reform Commission of the People's Republic of China (NDRC) notified Qualcomm that it was investigating violations of the country's anti-monopoly law. This investigation resulted in a 2015 settlement, where Qualcomm agreed to pay a $975 million fine.

Derivative allegations. The plaintiff demanded books and records from Qualcomm, received and reviewed them, and filed a derivative complaint without making a presuit demand on the board. The complaint asserts two claims for breach of fiduciary duty, against the director and officer defendants, respectively. According to the plaintiff, demand was excused as futile because a majority of the board faced a substantial likelihood of liability for breaching their duty of loyalty by failing to oversee the company's compliance with antitrust laws.

The complaint pointed to the Broadcom settlement and South Korean and Japanese decisions as red flags. These legal outcomes were disclosed in SEC filings signed by a majority of the board. According to the complaint, an absence of any indication that the board took steps to address the continuing and repeated antitrust violations in foreign markets evidenced its conscious disregard for the duty to remedy and prevent that misconduct. This bad-faith, conscious inaction resulted in Qualcomm's incurring a nearly $1 billion fine to the NDRC.

Caremark analysis. Stacking Rales (the applicable standard for assessing demand futility) and Caremark (the basis for the theory that the defendants were liable for failure to monitor compliance with the law), the court observed that demand would only be excused if the Qualcomm board acted in bad faith. In practice, plaintiffs tend to approach Caremark by pleading that the board consciously disregarded certain red flags indicating corporate misconduct.

The complaint, however, did not plead facts from which the court could reasonably infer that the board acted in bad faith. The court did not need to consider whether the settlement and decisions actually constituted red flags or whether the board's response to those alleged red flags proximately caused the damage from the NDRC decision. For purposes of evaluating whether the board acted in bad faith, the court assumed that the settlement and decisions were red flags.

Although the court assumed the existence of red flags, it assessed the severity of those red flags by way of distinguishing In re Massey Energy Co. (Del.Ch. 2011). There, bad-faith inaction was sufficient to plead a Caremark claim. But the court observed that the red flags in Massey "were far more egregious and indisputable than those alleged here."

Furthermore, the complaint conceded that the board continuously monitored each of the three alleged red flags and the NDRC decision. The board also consistently maintained that Qualcomm's business practices did not violate international antitrust law and focused on educating industry participants and government officials as to the legality of those practices. The complaint, therefore, was not that the board completely failed to respond to the red flags, but that the response was insufficient. "Red flags that rise to the severity of those in Massey may implicate an immediate duty to alter a company's culture and business practices," the court wrote. "This case, however, is not one in which the company pled guilty to criminal charges—as in Massey—or was advised by its general counsel that its business plan included potentially illegal conduct—as in [La. Mun. Police Empls' Ret. Sys. v.] Pyott" (Del.Ch. 2012).

Finding no inference of bad faith, the court dismissed the fiduciary duty claims against the director defendants. With only two of 15 officers also sitting on the board, the court also dismissed the claims against the officer defendants, as there was no possibility that a majority of the board could face liability for those claims.

The case is No. 10872-VCMR.

Wednesday, August 03, 2016

Piwowar calls for better disclosure by SEC-registered banks

By Jacquelyn Lumb

Commissioner Michael Piwowar, in remarks before the quadrilateral meeting of the Financial Markets Law Committee, the Financial Markets Lawyers Group, the Financial Law Board, and the European Financial Markets Legal Group, in London, explained his opposition to calls for prudential market regulation of the capital markets and suggested instead applying market-based prudential regulation to banks. Capital market entities are not shadow banks, he advised, and prudential market regulation of the capital markets will not work. A better approach, in his view, is to require banks to comply with the disclosure-oriented focus of market-based regulation to bring public disclosure and market discipline to the banking sector.

Piwowar said he recognizes that prudential regulators have the experience to determine the best methods to ensure that banks operate in a safe and sound manner to protect depositors, and he hopes that prudential regulators recognize that capital markets regulators have the experience to determine the best methods to protect investors, maintain fair and orderly markets, and facilitate capital formation. He opposes the calls by some prudential regulators to apply prudential market regulation to capital market entities.

Areas for additional disclosure. Piwowar noted that many investors see large banks as black boxes because of the lack of information about their assets and associated risks. He outlined five areas in which banks should provide better disclosure, beginning with their investment portfolios, but also information about the impact of their comprehensive capital analysis and review process; their resolution plans, known as living wills; their material regulatory costs; and their loan portfolios.

SEC-registered banks provide information about their loan portfolios in their financial statements, Piwowar observed, but the information is not reliable. The values are based on the initial loan amount with a reserve set aside that reflects assumptions about how likely the loans are to be repaid, rather than fair value. Investors need to know the current market value of a bank’s loans based on fair value, he said.

He also suggested applying a portfolio holdings disclosure regime to banks similar to that for investment companies. The disclosure would help investors and creditors make informed decisions and also assist the SEC in its oversight and monitoring of banks. The SEC is continuously evaluating its investment company and investment adviser disclosure requirements to reflect changes in the industry, he advised, and has proposed a comprehensive set of data reporting requirements to keep up with the development of new products and strategies in the asset management industry.

Industry Guide 3. SEC-registered bank holding companies provide much more limited information than investment companies. Piwowar called for an update to the staff’s Industry Guide 3 which assists bank holding companies in preparing their disclosure documents. The guide has not been updated in almost three decades, while the scope and nature of banking has undergone dramatic changes. Piwowar would like to see the guide broadened to include transparency about the material effects of prudential regulation since it can affect a bank’s capital structure, dividend policy, and treatment in bankruptcy.

Piwowar also noted that banking regulators have issued a rule for the living will process, in which banks must describe their strategy for a timely resolution in the event of material financial distress or failure, but the rule does not include standards for determining the will’s credibility. Since there are no standards, the market is unable to assess whether the biggest banking institutions can go through bankruptcy, he explained. The disclosure of standards for living wills would enable the market to properly assess a bank’s prospects in bankruptcy, he explained.

Piwowar concluded that by requiring banks to disclose more information, investors would have more confidence that the markets can judge a bank’s financial health, and the SEC and the bank regulators could more effectively oversee and monitor banks.

Tuesday, August 02, 2016

Comment period ends for proposal on supervising work of other auditors

By Jacquelyn Lumb

The comment period has closed on the PCAOB’s proposal to strengthen the requirements that apply to audits that involve other accounting firms and individuals other than the firm that issues the audit report. The proposed amendments are intended to improve the quality of audits and to align the requirements with the Board’s risk-based supervisory standards.

AngloGold Ashanti Limited. AngloGold Ashanti Limited, a South Africa based gold mining company, wrote in support of the PCAOB’s proposed amendments. As a foreign private issuer and a well-known seasoned issuer registered with the SEC, AngloGold said it views any audit that is not high quality to be an audit failure. However, the company raised concerns about certain unintended consequences with respect to the audit committee’s supervisory role, the increased costs, and the risk of leaking material market-sensitive information.

AngloGold supports enhancements to the lead auditor’s role, but does not support processes that refer to other auditors in the audit report, which may create an impression that the lead auditor is not to blame if the referred-to auditor’s work is in error. Instead, the company suggested that any reliance on the work of other auditors be included as a critical audit matter. If the lead auditor has concerns about the work performed by other auditors, AngloGold said it should be reported to the audit committee.

California Society of CPAs. The California Society of CPAs wrote in support of the Board’s proposal. However, in response to one specific question, the Society said it does not support a tiered audit process for emerging growth companies and seasoned issuers—the lead auditor should follow the same standard to ensure the adequacy of the audit.

The Society also strongly opposes any prohibitions on the use of a divided responsibility model and urged the Board to let the audit profession use its professional judgement in this area. The lead auditor’s communication to the audit committee should include the name of other auditors used in the engagement, their role, and whether any issues arose as a direct result of their participation, according to the Society. If any issues arose, the communication to the audit committee should include how they were resolved by the lead auditor.

The Society also echoed AngloGold’s suggestion that the need to use other auditors could be considered a critical audit matter under the PCAOB’s proposed auditor’s reporting standard. The Society recommended that the Board provide 12 to 18 months for firms to implement the requirements.

Texas Society of Certified Public Accountants. The Texas Society of Certified Public Accountants said the Board must consider the economic impact of the cost increases that will result from its proposal. For example, it is likely that both the lead auditors’ and issuers’ costs will increase. Some auditors may choose to no longer perform audits if another firm is required. If a firm chooses to do an entire audit itself, it will likely incur additional personnel, travel, and overhead costs. The pool of auditors available to smaller issuers may decrease, which will increase the costs of capital if larger firms must be used.

The Texas Society urged the Board to commission research on the issues related to shared audit responsibilities given the current lack of accessible data on international audits involving multiple firms, and recommended that the Center for Audit Quality fund research in this area. The Texas Society also recommended that auditors be given a minimum of 18 months to implement the new requirements.

Institut der Wirtschaftsprufer. The Institut der Wirtschaftsprufer urged the PCAOB to work closely with the IAASB, which has also sought comment on the use of work performed by other auditors. The Institut also raised concerns that the proposal could lead to more rules-based, rather than principles-based requirements, and suggested that the Board align the revisions with the international accounting standard rather than the proposed piecemeal changes to existing standards to avoid multiple cross-references within standards.

Federation of European Accountants. The Federation of European Accountants agreed that it would be helpful if the revised standards were compatible with IAASB standards other than where jurisdictional matters would require otherwise. The Board and the IAASB should learn from each other’s work in order to identify a common approach, in FEA’s view. FEA also urged the Board to include a reference to the other auditor’s quality control system in the proposal, given how critical these systems are within firms and across networks.

FEA said that the proposal appears to reflect a belief that lead auditors should trust no one, except when obligated to do so, which is not workable in today’s audit environment. The proposal gives insufficient emphasis to the concept of delegation, in FEA’s view.

Monday, August 01, 2016

Bankruptcy court failed to impute CEO’s intent to Lyondell

By Amy Leisinger, J.D.

The Southern District of New York has reversed a bankruptcy court’s dismissal of an intentional fraudulent transfer claim in connection with a company’s merger. According to the court, the CEO’s knowledge and intent regarding financial projections in connection with the leveraged buyout may be imputed to the firm, and the complaint plausibly alleged that the CEO acted with actual intent to benefit shareholders at the expense of creditors. The court reinstated the claim and remanded the matter for further proceedings (In re Lyondell Chemical Co., July 27, 2016, Cote, D.).

Merger. In 2006, Lyondell Chemical Co., a large petrochemicals company, became engaged in a potential acquisition. After urging rejection of the offer, Lyondell’s CEO (and board member) provided a “strategic update” suggesting large growth and increased projections, which the board accepted. Negotiations recommenced, and the merger closed in December 2007 at a share price well above the initial offer. As a result of the structure of the leveraged buyout, much of Lyondell’s debt was extinguished. One year later, Lyondell filed a petition for bankruptcy relief.

Fraud claim. The trustee filed a complaint alleging that Lyondell’s CEO knowingly presented false financial projections to the company’s board and had actual intent to defraud Lyondell’s creditors by stripping the company of assets while enriching himself, as well as other board members and shareholders. The board knew that the new projections were “inflated, unreasonable, and unachievable” and that engaging in a leveraged buyout based on false projections left Lyondell inadequately capitalized and put its creditors at risk, the trustee alleged. Through an intentional fraudulent transfer claim, the trustee sought to claw back around $6.3 billion in shareholder distributions through the LBO.

The bankruptcy court granted the shareholder defendants’ motion to dismiss, finding that the CEO’s intent could not be imputed to Lyondell and that the trustee failed to plead facts showing intent to defraud by the directors who approved the merger. The complaint also failed to show any actual intent to injure creditors as opposed to an intention to enrich others, the court found. The trustee appealed to dispute whether the fraudulent intent of the CEO may be imputed to Lyondell and what is required to plead an “actual intent” to defraud.

Imputation of intent. Under the general rule of imputation, an employee’s knowledge can be imputed to the company if the employee acquires knowledge pertaining to job duties while within the scope of employment and has authority to act, the court noted. The CEO was an agent of Lyondell, and his preparation and presentation of the questionable projections were done as part of his duties as CEO and board member, according to the court. His alleged knowledge and intent in making and disseminating false figures can be imputed to Lyondell, and the bankruptcy court erred in concluding otherwise, the court found.

Actual intent. The court noted that a debtor’s actual intent to defraud does not need to focus on a particular target, but instead may involve intent to interfere with creditors’ normal processes.

Given the difficulty of proving actual intent to defraud creditors, “badges of fraud” may support the case, the court stated. According to the complaint, the CEO knew that the projections were inflated but presented them anyway, and with the completion of the buyout, officers, directors, and shareholders (including the CEO) received substantial payouts with the majority of Lyondell’s assets were subject to liens, effectively stripping Lyondell of its assets. These contentions and related plausible inferences create disputes that cannot be resolved on a motion to dismiss, and the intentional fraudulent conveyance claim must be reinstated for consideration in the bankruptcy court, the court concluded.

The case is No. 16cv518 (DLC).

Friday, July 29, 2016

NASAA proposes concentration limits for non-traded REIT investments

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

NASAA has proposed amending its Statement of Policy Regarding Real Estate Investment Trusts to place concentration limits on investments in non-traded REITs. The proposal would also require a REIT’s sponsor and any person selling shares on behalf of the REIT to maintain records of the information obtained from shareholders to ensure compliance with the concentration limit for at least six years.

Concentration limits. Under the proposed amendments, a sponsor must establish a minimum concentration limit for persons who purchase shares in a REIT for which there is not likely to be a substantial and active secondary market. Individual investors would generally be limited to investing ten percent of their liquid net worth in a REIT, its affiliates, and other non-traded REITs, unless the state’s securities administrator determines that the risks associated with the REIT require lower or higher standards.

Liquid net worth consists of cash, cash equivalents, and readily marketable securities. The proposal also includes a carve-out for accredited investors under the income and net worth standards set forth in Rule 501 of Regulation D.

In evaluating the standards and any exclusion proposed by the sponsor, the state securities administrator may consider several enumerated factors, including:
  • complexity of the offering;
  • the REIT'S use of leverage;
  • balloon payment financing; 
  • tax implications;
  • potential variances in cash distributions;
  • relationship among potential shareholders, the sponsor and the advisor;
  • prior performance of the REIT, the sponsor and the advisor; and
  • past disciplinary or legal actions by regulators or investors.
Prospectus disclosure and recordkeeping requirements. The sponsor must disclose in the prospectus the responsibility of the sponsor and any person selling shares on behalf of the sponsor or REIT to make every reasonable effort to ensure compliance with the concentration limit based on the information provided by the shareholder. The prospectus must also disclose that adhering to the concentration limit does not satisfy independent suitability requirements under the guidelines, existing administrative rules, or the rules of a self-regulatory organization. The sponsor and any persons selling shares must maintain records of the information obtained from shareholders to ensure compliance for at least six years.

Request for comments. The deadline for comments is September 12, 2016. After the comment period has closed, NASAA will post the comments received to its website.