Friday, July 22, 2016

Derek Jeter's undies endorsement flummoxes chancery court

By Anne Sherry, J.D.

A governance-based endorsement deal between Derek Jeter and sports-underwear maker RevolutionWear soured, prompting the Delaware Court of Chancery to warn about "the mixing of roles in a corporate-governance setting." The so-called reverse endorsement installed Jeter on the RevolutionWear board as a means of indirect promotion. But Jeter, wary of disturbing his existing contract with Nike, allegedly refused to approve a press release touting the endorsement. The court granted parts of Jeter's motion to dismiss RevolutionWear's fraud, breach of contract, and breach of fiduciary claims, but most will proceed to trial (Jeter v. RevolutionWear, Inc., July 19, 2016, Glasscock, S.).

According to RevolutionWear, Jeter induced the company to ink the deal by insisting that his arrangement with Nike wouldn't pose a conflict. In 2011 the parties entered into a director's agreement, which entitled RevolutionWear to issue a press release disclosing Jeter's leadership role in the company, subject to Jeter's prior approval. Jeter procrastinated and eventually outright declined to give that approval, citing the Nike contract. Instead, he allowed a statement expressing his excitement about RevolutionWear's underwear product and saying he looked forward to seeing its continued progress—a statement that, in RevolutionWear's view, fell short of the contemplated disclosure. Jeter began the litigation by suing for a declaratory judgment and other relief, but the Delaware Chancery Court's judgment concerns counterclaims by RevolutionWear for fraud, breach of the director's agreement, and breach of fiduciary duty.

Breach of contract. The director's agreement did not condition Jeter's ability to give or withhold approval of a press release. However, RevolutionWear argued that the provision contained an implied covenant of good faith and fair dealing. Jeter conceded at oral argument that there was an implied requirement that he would not withhold his approval unreasonably. This concession sank his motion to dismiss on that aspect of the breach of contract claim: the court found that it was reasonably conceivable that Jeter's refusal to approve the proposed press release was not reasonable and thus breached the agreement.

Breach of fiduciary duty. To the court, the breach-of-duty allegations "illustrate the difficulties that may arise in the fiduciary duty context when a corporation expects its directors to perform acts outside of their traditional fiduciary role." Jeter's membership on the board was, essentially, a marketing move, and the director's agreement contained provisions to further the reverse endorsement strategy that went beyond Jeter's fiduciary obligations. "While such contractual obligations may give rise to breach-of-contract claims, they do not alter the fiduciary obligations of the director," the court wrote. Accordingly, it dismissed all but the claim that Jeter falsely promised investors that he would publicly announce his role.

Jeter was protected by an exculpatory provision, so RevolutionWear needed to make the case that Jeter breached the non-exculpated fiduciary duty of loyalty. RevolutionWear alleged that Jeter, while acting as a fiduciary, made statements that were knowingly false and caused investors to invest. Investors lost faith in RevolutionWear when they discovered Jeter's statements were false, thereby limiting the company’s ability to raise capital. Assuming the truth of these allegations for purposes of the motion to dismiss, the court concluded that Jeter acted in bad faith by acting with a purpose other than that of advancing the best interests of the company.

Fraud. The court denied the motion to dismiss the fraudulent inducement and fraudulent concealment claims. Although there was an argument that the statute of limitations had run, it depended on a factual finding that the court could not make at the motion to dismiss stage. RevolutionWear's counterclaim pleaded falsity sufficient to survive the motion. However, the court dismissed the standalone fraud claim, as it was subsumed by the two other claims sounding in fraud.

The case is No. 11706-VCG.

Thursday, July 21, 2016

In absence of scienter, Crocs auditor walks away

By Rodney F. Tonkovic, J.D.

A Tenth Circuit panel has affirmed a district court judgment giving the boot to a complaint against the auditor for Crocs, Inc. The complaint, which the district court dismissed for failure to state a claim, alleged that Crocs's reports fraudulently represented the value of its inventory and the adequacy of its internal controls over financial reporting, and that the auditor was complicit in the fraud. While Crocs' inventory was problematic, the complaint failed to show that the auditor knew of, or refused to see, any warning signs, and the more compelling inference was one of negligence (Sanchez v. Crocs, Inc., July 19, 2016, Holmes, J.)

According to the complaint, shoe-maker Crocs experienced rapid growth between its formation in 2002 and 2006. Despite this, Crocs did not use modern inventory control software or procedures, causing a host of problems with its inventory. As a result of unreliable data, the company had in its inventory too many poor-sellers and too few best-sellers, and retailers were frequently sent the wrong orders. The investors alleged further that one of the company's overseas manufacturers was producing poor quality goods, resulting in a rise in returns.

By 2008, Crocs's inventory had ballooned. While management recognized that demand was decreasing, it believed that demand would rebound, and the company sustained its high production. Despite these issues, Crocs valued its inventory at cost in its 2006 and 2007 Form 10-Ks, and Deloitte & Touche, the company's auditor, issued unqualified audit opinions in both years. In April 2008, Crocs announced a three-month inventory increase of between 5 and 10 percent in three months, resulting in a 45 percent drop in its stock's price. In November 2008, Crocs wrote down the value of its inventory by over seventy million dollars.

Procedural history. Even before the write-down, several plaintiffs had filed securities fraud class action lawsuits against Crocs. The complaints were consolidated and the lead plaintiff, the Sanchez Group, filed the complaint at issue in this case. According to the complaint, Crocs knew that the bulk of its inventory was unsalable, but materially overstated the value of the inventory in its Forms 10-K. Deloitte, as Croc's auditor was complicit in the fraud, and knew of, or recklessly disregarded, various warning signs.

In February 2011, the district court dismissed the complaint for failure to state a claim. The plaintiffs then appealed, but, in the interim, a settlement was reached with the Crocs defendants.

The only remaining defendant on appeal is Deloitte. The district court found that the complaint failed to allege to allege that Deloitte acted with scienter and, at most, established negligence. According to the court, the allegations that Deloitte had access to confidential material and was aware of red flags were too general. On appeal, the investors argued that the complaint adequately set forth Deloitte's false and misleading statements and that the allegations gave rise to a strong inference of scienter.

Mere negligence. The panel concluded that the complaint failed to allege a strong inference that Deloitte acted recklessly in auditing Crocs's finances and internal controls. The complaint alleged that Deloitte knew of, or recklessly disregarded, obvious red flags, including Croc's "primitive" inventory system and the inventory build-up. According to the panel, the complaint insufficiently demonstrated that Deloitte knew about the red flags. The complaint failed to identify any particular document or statement that would have alerted Deloitte to Croc's error-prone inventory.

The complaint also failed to show that any warning signs were so obviously indicative of fraud that Deloitte's failure to see them constituted willful blindness. Neither the flawed inventory system nor the inventory build-up would have ineluctably led to the conclusion that the value of Crocs's entire inventory should have been written down, and far more blatant misconduct would be necessary to infer that Deloitte refused to see the obvious, the panel said. In sum, the more compelling inference was one of negligence on Deloitte's part.

The case is No. 11-1116.

Wednesday, July 20, 2016

CII seeks stronger clawback language in incentive-based compensation proposal

By John Filar Atwood

The Council of Institutional Investors (CII) expressed wide support for the proposed rule on incentive-based executive compensation, but asked the sponsoring entities to consider adding instances where clawbacks would be mandatory. CII expressed its views in a comment letter to the agencies that developed the proposal, which are the SEC, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corp., the Federal Housing Finance Agency, and the National Credit Union Administration.

The proposal would implement Section 956 of the Dodd-Frank Act, which requires that the agencies jointly issue regulations or guidelines prohibiting incentive-based payment arrangements that the agencies determine encourage inappropriate risks by certain financial institutions by providing excessive compensation or that could lead to material financial loss. It also requires the financial institutions to disclose information concerning incentive-based compensation arrangements to the appropriate regulator.

CII said in its comment letter that it believes that the proposed rule represents a meaningful response to some of the lessons learned from the financial crisis. The proposal preserves a role for incentive-based compensation at financial institutions, CII noted, but with a greater emphasis on risk management and long-term outcomes.

CII said that it supports the proposed rule’s over-arching requirements that incentive-based compensation arrangements at covered financial institutions appropriately balance risk and reward, and bar arrangements that could encourage inappropriate risks. CII also approves of the rule’s recognition that the board should oversee incentive-based compensation programs.

Clawback mechanism. The proposed rule would require systemically important financial institutions to adopt clawback mechanisms by which they could seek to recover incentive-based pay for seven years after such compensation has vested. The policies would provide for optional recovery in the event of misconduct resulting in significant financial or reputational harm, fraud or intentional misrepresentation of information used to determine incentive-based pay.

CII notes that the proposed rule does not identify any circumstances in which forfeiture, downward adjustment or clawback is mandatory. In light of the failure of some compensation committees to seek appropriate clawbacks in the past and the importance of systemic risk posed by covered financial institutions, CII urged the agencies to consider identifying in the final rule some circumstances when forfeiture, downward adjustment or clawback of incentive-based compensation is mandatory, while preserving discretion for less conclusive situations.

In addition, CII does not view seven years after vesting as an unreasonable period to adopt, but notes that CII policies provide that all incentive-based compensation should remain subject to recovery for at least three years following discovery of the basis for recovery.

Risk takers. The proposed rule applies to senior executive officers at financial institutions holding at least $1 billion in average total consolidated assets, and significant risk takers at financial institutions holding at least $50 billion in assets. CII expressed concern that under the proposed definition, employees that are not senior executive officers but place billions of dollars at risk at systemically important financial institutions would avoid automatic significant risk taker status. CII said that the final rule would better serve investors if the significant risk taker definition were revised to more broadly cover non-executive significant risk takers.

Risk/reward balance. The proposed rule provides that incentive-based compensation will not be considered to balance appropriately risk and reward unless three conditions are met: (1) inclusion of financial and non-financial measures to measure performance; (2) allowance of non-financial measures to override financial measures when appropriate, and (3) permission to make any amount awarded subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures. CII stated that while the three conditions do not ensure a balance of risk and reward, CII is satisfied that the guidance increases the likelihood of an appropriate balance.

Deferrals of pay. For systemically important financial institutions, the proposed rule mandates deferral of 40 percent to 60 percent of incentive-based pay, with short-term incentive-based pay requiring longer deferral than long-term incentive-based pay. CII said that it supports revisions to the proposed rule that would further increase the percentages of annual incentive-based compensation subject to mandatory deferral.

CII said that it opposes hedging by executives and discourages companies from allowing other employees to hedge equity-based awards or other stock holdings. Accordingly, CII supports the proposed rule’s provision preventing covered institutions from hedging on employees’ behalf to limit their risk associated with incentive-based compensation. However, CII believes that rule could be improved if it also barred senior executive officers and significant risk takers from directly engaging in hedging activity to offset risk connected with their incentive-based compensation.

Tuesday, July 19, 2016

Massachusetts guides IAs who use robo-advisers

By Jay Fishman, J.D.

The Massachusetts Securities Division has issued regulatory guidance for its state investment advisers who use third-party robo-advisers to provide advisory services to clients. The need for guidance arose from the Division’s discovery during its application review process that advisers were stepping up their use of robo-advisers to service clients.

Policy statement. The Division issued a policy statement in April 2016 proclaiming that because automated robo-advisers, unlike traditional human investment advisers, cannot provide fiduciary duties to clients, the Division would evaluate their Massachusetts registration applications on a case-by-case basis.

Regulatory guidance. Now, following the increased use of robo-advisers, the Division has issued this regulatory guidance for its state investment advisers. The guidance tells state investment advisers who use robo-advisers to provide their clients with asset-allocation and trading functions that, at a minimum, the advisers:
  • Must clearly identify any third-party robo-advisers with which they contract; must use phraseology that clearly indicates that the third party is a robo-adviser or otherwise utilizes algorithms or equivalent methods in the course of providing automated portfolio management services; and must detail the services provided by each third-party robo-adviser;
  • If applicable, must inform clients that investment advisory services could be obtained directly from the third-party robo-adviser;
  • Must detail the ways in which they provide value to a client for their fees, in light of the fiduciary duty they owe the client;
  • Must detail the services that they cannot provide to the client, in light of the fiduciary duty they owe the client;
  • If applicable, must clarify that the third-party robo-adviser may limit the investment products available to the client (such as exchange-traded funds, for example); and
  • Must use unique, distinguishable, and plain-English language to describe the adviser’s and the third-party robo-adviser’s services, whether drafted by the adviser or by a compliance consultant.

Monday, July 18, 2016

Amicus backing Rabobank LIBOR defendants: no misrepresentation, no fraud

By Anne Sherry, J.D.

Rabobank employees were wrongly convicted of LIBOR manipulation, argues an amicus brief filed in the Second Circuit by the New York Council of Defense Lawyers (NYCDL). By ruling on a defense motion that the relevant issue was the defendants' intent rather than the accuracy or inaccuracy of the LIBOR submissions, the district court "improperly dispensed with an essential element of fraud liability." Adopting such an expansive theory of wire fraud would erode fair notice and due process, amicus argues (U.S. v. Allen, July 13, 2016).

Conviction based on intent. Rabobank derivatives traders were convicted of wire fraud, conspiracy, and bank fraud in the Southern District of New York for allegedly manipulating U.S. dollar and yen LIBOR rates. The amicus brief highlights that the court instructed the jury it could convict if the defendants submitted rate estimates "reflecting, at least in part, an intent to benefit Rabobank's trading positions and thereby obtain profits that Rabobank might not otherwise realize." Denying the defendants' motion for acquittal, the district court explained that "the relevant issue was not the accuracy or inaccuracy of defendants' LIBOR submissions, but the intent with which these submissions were made."

The court reasoned that the defendants effectively represented that they acted in good faith in submitting LIBOR estimates. The NYCDL argues that this rationale depends on intent substituting for an actual misrepresentation. Furthermore, the Council argues, it rests on a flawed assertion that lack of good faith "could consist merely of Defendants' seeking to promote the financial interests of their employer in transactions with parties to whom no fiduciary duty was owed." Such a rule would subject executives and employees to criminal liability for their opinions and estimates simply because they were in part influenced by their employers' financial interest—even if the opinions and estimates were reasonable, accurate, and honestly believed.

Fraud liability requires misrepresentation. The sole statement made in the LIBOR submissions was an answer to the question: "At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11am?" NYCDL asserts that the rates provided in answer were estimates or opinions, not statements of historical fact. As such, they stand on a different footing in a falsity analysis. To be actionable as fraud, the Council continues, a statement of opinion must lack a reasonable basis, and the speaker must subjectively disbelieved it. Neither of these facts was proven at trial, allowing defendants to be convicted of fraud without proof of the most basic element: a misrepresentation.

The brief quotes the Second Circuit's recent Countrywide decision, in which it rejected the Government's argument that fraudulent intent was sufficient to show fraud. "Freestanding 'bad faith' or intent to defraud … is not actionable under the federal fraud statutes," the court wrote; "the statutes apply to 'everything designed to defraud by representations as to the past or present, or suggestions and promises as to the future.'" NYCDL argues the government's theory of fraud in the LIBOR case invalidly relied on evidence of intent alone, without connecting that intent to a misrepresentation. Even worse than in Countrywide, the district court's theory of fraud equated an intent to benefit Rabobank with an intent to defraud. "Employees are supposed to promote their employer's financial interests, and indeed have a fiduciary obligation to do so," the brief asserts.

Expanding criminal liability. In NYCDL's view, the district court's interpretation of the wire fraud statute is antithetical to the principle that criminal statutes must be written and interpreted in such a way that ordinary people can understand what conduct is prohibited. Furthermore, the "creative interpretation" runs afoul of the principle that because of the seriousness of criminal liability and penalties, legislatures, not courts, should define criminal activity.

The case is No. 16-898(L).

Friday, July 15, 2016

SEC’s Investor Advisory Committee considers current state of sustainability reporting

By Jacquelyn Lumb

The SEC’s Investor Advisory Committee heard presentations on sustainability reporting from former SEC general counsel and former PCAOB member Daniel Goelzer, and representatives of the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), the International Integrated Reporting Council (IIRC), and General Electric Company. SEC Chair Mary Jo White noted that she recently addressed sustainability in remarks to the International Corporate Governance Network, and repeated her message that the issue has the agency’s attention.

Evolution of sustainability reporting. Goelzer presented a historical overview of the issue dating back to the 1970s when he joined the Commission. At that time the SEC concluded that the disclosure of social responsibilities was based on whether it was necessary or appropriate to influence investment decisions or proxy voting and that it should be economically significant to investors. The MD&A requirements have sharpened up a bit since then, he said, with the disclosure of known trends, events and uncertainties likely to have a material effect on the issuer’s operations and as part of the risk factors. Still, he noted that the current level of disclosure is fairly limited and pretty general.

GRI standards. Christianna Wood reported that GRI is the mostly widely used sustainability reporting network which is referenced in the regulations of 41 countries. GRI urges the SEC to encourage companies to expand their sustainability reporting and to take action to ensure a consistent approach, preferably based on GRI standards, she said.

SASB standards. Jean Rogers, the founder and CEO of SASB, cited boilerplate language as the current problem with the disclosure in companies’ Forms 10-K, and said there is no way to benchmark or compare performance based on current disclosure or to understand the magnitude of a company’s risk. The problem with current sustainability reports is that the information is largely immaterial, it is not comparable, and it is biased. Some shareholders seek information directly from companies through questionnaires, but Rogers said this process imposes a cost burden and results in selective disclosure. In addition, the questionnaire process favors large investors and poses a danger of running afoul of Regulation FD. In SASB’s view, industry-specific standards are required, but not line item disclosures given the differences among industries.

IIRC framework. Lisa French, on behalf of the IIRC, noted that her organization is looking at a somewhat broader bandwidth than GRI or SASB, but encourages companies to look at those frameworks. IIRC sees a disproportionate focus on past performance in current reporting and believes there is a greater need for information about a company’s strategy, outlook and the long-term viability of its business model. The volume and complexity of disclosure has increased, but so too has the use of boilerplate and legalese, she explained. IIRC has developed principles-based guidance to promote integrated reports that provide better decision-useful information to the capital markets.

White asked how the work of SASB, GRI and IIRC fit together. Wood noted that first you need to have something to integrate, such as GRI’s standards. Rogers said, if information is material, it belongs in the Form 10-K. She said SASB’s standards relate to information that is relevant to decision-making. She added that consistency in reporting material information is critical. Companies currently do not know how much to report and do not want to be the first to report, according to Rogers, which is why market standards would be useful.

Caution about third party standards. IAC member Joseph Carcello, a professor at the University of Tennessee, agreed that sustainability reporting is important, investors are using it, and there currently are at least two sets of standards on which they could rely. There is precedent for the SEC relying on standards from outside groups, such as FASB and the PCAOB, he said. However, before the SEC recommends the standards developed by SASB or GRI, he reminded that there have also been notable failures in relying on third parties.

One of the concerns with international financial reporting standards, for example, was the source of funding, so he said that area should be examined. In addition, he noted that SASB’s comment letter to the SEC in response to its concept on Regulation S-K disclosure reported that the organization has a staff of 30. Of that group, issuers and those who serve issuers make up over 50 percent of the staff. Carcello said he is adamantly opposed to giving such a majority the power to set industry-specific standards.

General Electric’s counsel, when asked if GE uses either GRI or SASB standards in its reports, said it uses more of a custom approach based on materiality. The materiality standard works and it is self-adjusting, he explained. Now it is up to the SEC, he said.

Thursday, July 14, 2016

Alleged 'spoofer' escapes injunction, but trading restricted until trial

By Anne Sherry, J.D.

A court declined the CFTC's request to preliminarily enjoin a trader's "spoofing" behavior, electing instead to restrict the defendants' trading to ensure compliance until the charges go to trial. 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. Despite the "troubling" evidence of spoofing, the Northern District of Illinois imposed a number of reporting and compliance requirements and ordered the principal to attest to compliance every month until the end of trial (CFTC v. Oystacher, July 12, 2016, St. Eve, A.).

In a prior order, the court denied the CFTC's bid to disqualify the defendants' expert, University of Chicago law professor and Compass Lexecon president Daniel R. Fischel. One of the CFTC's own experts, Arizona State University professor Hendrik Bessembinder, entered into a consulting agreement with Compass, but the court determined that this did not rise to the level of "side-switching" that would justify such an extreme sanction. Nevertheless, Professor Fischel's testimony did not sway the court's judgment on the preliminary injunction motion. Despite Fischel's assertions that confirmation, selection, and aggregation bias clouded Bessembinder's findings of spoofing, the court was satisfied with Bessembinder's rebuttals.

Instead, the court deferred to nine restrictions imposed on the individual defendant by 3Red's chief compliance officer. The CFTC presented no evidence or argument that the principal was not complying with those self-implemented restrictions, nor did it identify any motivations that might undercut the CCO's credibility or the legitimacy of the measures. In addition to the nine tools, the court noted that the trial date is only six months away; the order imposes additional limitations and requirements to ensure compliance until the trial; and the principal currently trades on only two exchanges. The totality of the circumstances did not warrant a preliminary injunction, the court concluded.

The order formalizes the nine internal requirements and requires the CCO to monitor the individual defendant's compliance. It also restricts trading to the two markets in which the principal currently trades. He must file a sworn affidavit attesting to compliance on the first of every month until the conclusion of trial.

The case is No. 15-CV-9196.

Wednesday, July 13, 2016

Fair value of DFC shares higher under revised valuation method

By Amy Leisinger, J.D.

In this appraisal action, the Delaware Court of Chancery found that neither the specific valuation methodology proposed by dissenting shareholders following a merger nor that proposed by the company itself is inherently reliable. Instead, the court determined that calculating the fair value of the company’s shares involves three separate pieces: a discounted cash flow model, a comparable company analysis, and the transaction price. The company sold its shares to a private equity buyer for $9.50 per share in June 2014, but, under the more appropriate valuation framework, the fair value was $10.21 per share when the transaction closed, the court found (In re Appraisal of DFC Global Corp., July 8, 2016, Bouchard, A.).

Merger transaction. In 2013, DFC Global Corp. was operating its payday lending business in ten countries through more than 1,500 retail storefront locations and online platforms. It faced significant competition and was subject to differing regulations in each jurisdiction that could increase the cost of doing business. As various regulatory changes came into play, DFC was forced to cut earnings guidance and provide adjusted EBITDA guidance but stated that it was “hopeful” its market share would increase as competitors with difficulties operating under stricter regulations exited the market and noted its past success in adapting to regulatory change.

During this time, DFC retained a firm to investigate selling the company to a financial sponsor and received non-binding indications of interest from two companies. After revised projections and citing regulatory uncertainty, the acquiring private equity firm lowered its offering price to $9.50 per share, and DFC’s board approved the transaction.

Share price battle. Former DFC shareholders petitioned the court to appraise the fair value of shares they held when the company was sold, alleging that the sale occurred at a discount during a period of regulatory uncertainty that temporarily depressed the company’s market value. Using a discounted cash flow model based on management’s most recent five-year projections, the shareholders’ expert calculated a fair value of $17.90 per share. The company’s expert, however, used a blended discounted cash flow model and a multiples-based comparable company analysis and found a lower fair value of $7.94 per share.

Appraisal method. The court noted that it will often defer to a transaction price negotiated in an arm’s-length process but found that a price is reliable only when the market conditions leading to the transaction are conducive to fairness. The DFC transaction was negotiated and consummated during a period of turmoil and uncertainty, the court found, and this raises questions regarding both transaction price and financial projections. However, neither of the metrics proposed to value DFC is completely reliable, according to the court. As such, the court stated, the most reliable determinant of DFC’s fair share value is a blend of three “imperfect” approaches: a discounted cash flow model incorporating certain methodologies made by each expert; the comparable company analysis performed by the company’s expert; and the final transaction price.

The court noted that the experts disagreed on numerous points regarding construction of a discounted cash flow valuation of DFC, including, among other things, factors used to calculate the weighted average cost of capital, the method of unlevering and relevering beta, the appropriate premium for company size, and the applicable tax rate. In its analysis to calculate beta, the court used Bloomberg five-year smoothed betas for the six peer companies the experts agreed on and for DFC itself and accounted for the negative reaction to earning reductions and adjustments in connection with the size premium. The court accepted the firm’s expert’s comparable company methodology and its valuation of $8.07 per share and took note of the deal price of $9.50 per share.

Determining that all three valuation metrics provide equally meaningful insight into DFC’s value, the court concluded that the fair value of DFC at the time of the transaction was $10.21 per share. The shareholders are entitled to this amount, as well as interest accruing from June 13, 2014, at the rate of 5 percent over the Federal Reserve discount rate, the court stated.

The case is No. 10107-CB.

Tuesday, July 12, 2016

Agency officials discuss developments post-Newman, commodities insider trading

By Lene Powell, J.D.

In a Practising Law Institute program, a panel of SEC, CFTC, and DOJ enforcement officials discussed the impact of the Second Circuit’s decision in U.S. v. Newman on current insider trading cases. Joon H. Kim, Deputy U.S. Attorney for the Southern District of New York, said in the Southern District’s view, Newman was wrongly decided and inconsistent with Supreme Court precedent. However, he noted that the high court will consider the issue of personal benefit in Salman v. U.S. this fall.

CFTC Chief Trial Attorney Candice Aloisi and Stephanie Avakian, SEC Deputy Director of Division of Enforcement, also discussed the impact of Newman on insider trading actions. Aloisi also gave an overview on commodities insider trading law following an expansion of the CFTC’s authority under the Dodd-Frank Act.

Insider trading after Newman. Kim said the Southern District’s view on Newman, set forth in court filings, is that Newman is inconsistent with precedent, in particular Dirks. It carves out, or leaves beyond scope of prosecution, culpable conduct that has always been thought to be illegal. If the tipper needs to have received some type of pecuniary benefit, it is now hard to prosecute a case where the tipper doesn’t expect payment, said Kim. For example, a CEO of a major company, a billionaire who doesn’t need particularly need more money, could tip his son or fraternity brother or golf buddy and not receive any pecuniary benefit.

Kim observed that although the Supreme Court denied the government’s petition for certiorari in Newman, the question presented in Salman v. U.S. is exactly the question of whether the definition of “personal benefit” is correct, so the court will effectively review Newman. In Salman, an investment banker at Citibank tipped family members about classic material nonpublic information (MNPI). His personal view is that the facts in Salman are good for the government. For the markets to work and to be fair, the type of information investment banks are privy needs to be kept secret, without friends and family members being able to trade on it. Otherwise, the market will have two categories of investors: regular people and people who are friends and families of insiders, said Kim.

Avakian agreed. In Salman, the testimony was unambiguous—there was intent to benefit, there was knowledge that there was going to be trading, and there was intent that there should be trading. She believes Salman is a “very strong case” for the government and tees up the personal benefit issue well.

“I can’t imagine that someone would look at that set of facts and say that’s okay,” said Avakian.

Effect on current enforcement actions. Avakian said that Newman has “certainly had an effect” on SEC insider trading actions. It hasn’t slowed down the SEC in terms of the number of insider trading cases brought, but it has resulted in a more intense focus on the issue of personal benefit. However, she believes that district courts in the Second Circuit have largely been limiting Newman to its particular facts.

For example, Avakian noted that in the Payton v. Durant jury trial in February 2016, personal benefit was squarely the issue, and the SEC won that case. In a pre-trial ruling, the court found the SEC had sufficiently alleged a personal relationship sufficient to satisfy the personal benefit requirement. The tipper and tippee were roommates who shared housing expenses, the tippee had previously assisted the tipper with a criminal matter, and the tipper said he was happy the tippee had profited, because the tippee had helped him. Avakian said other cases in the Second Circuit have also limited the Newman ruling, as for example in the Gupta case, where Judge Rakoff said that a personal benefit did not necessarily need to be pecuniary.

Regarding the effect of Newman on CFTC insider trading cases, Aloisi said the securities cases are significant and relevant to the CFTC because they’re interpreting provisions on which the commodities insider trading provisions are based. The Commission’s guidance is that the Commission will be guided—but not controlled—by judicial precedent applying comparable language under the SEC rules.

Commodities insider trading. Aloisi gave an overview of commodities insider trading provisions. Historically, there has long been a reluctance to extend insider trading prohibitions to the commodities space, she said. This is because commodities end users legitimately use the commodities markets for hedging, and this should not be discouraged. For example, a farmer who has inside information about the state of his crops trades agricultural futures, and the farmer should have the freedom to do that.

Before Dodd-Frank, said Aloisi, the Commodity Exchange Act did regulate some forms of insider trading-type conduct, but the provisions were limited to certain actors, products, and fact patterns. In particular, Section 9(e) prohibits employees and governing members of self-regulatory organizations from trading on or disclosing MNPI. She said the CFTC is currently litigating a case against NYMEX and some of its former employees for this type of violation. A similar rule applies to Commissioners and CFTC staff. In addition, Section 4b provides a prohibition against fraud committed in connection with another person, which can cover a broker’s misappropriation of a client’s information, for example.

Dodd-Frank expanded the CFTC’s authority over insider trading, Aloisi explained. Section 9(e) was expanded to cover swap data repositories and swaps trading. Further, a new rule covers federal employees with access to MNPI and anyone who obtains information from a federal source. For example, a trading on a nonpublished Department of Agriculture report would not have been illegal before Dodd-Frank, but now would be. This is informally known as the “Eddie Murphy rule” from the movie “Trading Places,” said Aloisi.

Finally, Section 6(c) and Rule 180.1 are catchall fraud rules modeled “very closely” after Exchange Act Section 10(b) and SEC Rule 10b-5, said Aloisi. These new provisions apply to any person, not just the limited actors of the pre-Dodd Frank rules. The Commission’s guidance is that these provisions prohibit trading:
  • on the basis of MNPI in breach of a pre-existing duty established by another rule, law, agreement, understanding, or some other source; or
  • on the basis of MNPI obtained through fraud or deception.
Motazedi case. Turning to the Motazedi case settled by the CFTC in December 2015, Aloisi said the case involved a natural gas futures trader who traded a proprietary account for a large publicly traded energy company. He traded for both his employer and for his personal accounts. At times, he traded in his personal accounts ahead of orders he placed for his employer, essentially front-running his employer. Because he knew the timing, amounts, and the pricing of trades for his employer, he was able to take advantage of the anticipated price change from the employer trades.

Aloisi observed that a fact pattern of front-running is not new, but the charges are unique and new for the CFTC. Motazedi was charged with violating Sections 4b, 4c, and 6(c)(1) and Rule 180.1. This was the first time Section 6(c)(1) and Rule 180.1 have been used in a misappropriation of information fraud scenario. He paid a penalty, restitution to the employer, and was banned from trading and registering with the CFTC.

Aloisi added that the CFTC has seen an increase in whistleblower tips relating to insider trading, as word gets around that the CFTC is now in the insider trading space.

Monday, July 11, 2016

Court affirms judgment against attorney who wrote false opinion letter

By Kevin Kulling, J.D.

The Second Circuit Court of Appeals has affirmed a district court’s determination that an attorney violated Section 5 of the Securities Act when she produced an attorney opinion letter supporting an exemption from registration that contained false statements. The court also upheld the lower court’s finding that the attorney was liable for aiding and abetting violations of Section 10 and Rule 10b-5 (SEC v. Sourlis, July 8, 2016.)

Attorney opinion letter. The action arose out of the distribution of unregistered shares of Greenstone Holdings, Inc., which sent to its stock transfer agent legal opinion letters that supported an exemption from registration under Rule 144(k).

The defendant, attorney Virginia Sourlis, wrote one of the opinion letters in which she concluded that Greenstone shares could be issued without a legend. In her letter, Sourlis represented that the shares could be issued in exchange for convertible promissory notes that had been issued by a predecessor before January 2004. Sourlis wrote that the original convertible notes had been held for at least two years prior to the assignment and that none of the vendors were affiliates of the company under Rule 144. The district court granted the SEC’s request for summary judgment after concluding that the convertible notes did not even exist and representations made by Sourlis were false.

Section 5 liability. The appellate court said that it saw no error in the district court’s conclusion to grant summary judgment on the Section 5 violation. It was undisputed that the Greenstone shares were not registered, the court said. It was also established that Sourlis opined that shares could lawfully be issued as unrestricted shares to recipients who were acquiring them in exchange for certain convertible notes, the court said.

Sourlis wrote that she was relying on “information and representations furnished by the Original Note Holders to me,” and that “I have been informed by the Original Note Holders” that none of them were affiliated with the issuer and that the Original Note holders had owned the notes for at least two years.

The Second Circuit said that on the basis of her letter, shares were issued as unrestricted shares allowing them to be sold to the public despite that fact that they were unregistered. The appellate court agreed with the district court’s determination that her role “satisfied the requirement” that she directly or indirectly offered to sell securities. The transfer agent, who required a legal opinion letter providing the authority to issue the unregistered shares without a restrictive legend, would not have issued the shares without Sourlis’ letter. This, the court said, was sufficient to hold an attorney liable under Section 5.

Aiding and abetting. The appellate court also upheld the district court’s finding that Sourlis was liable under Section 20 of the Exchange Act because her letter aided and abetted violations of Section 10 and Rule 10b-5.

On appeal, Sourlis argued that she had no actual knowledge that her letter would be used for the issuance of unrestricted stock a year later. But the appellate court found no error in the district court’s rejection of Sourlis’ arguments. The letter itself made clear that its purpose was to state whether unrestricted stock could be issued in exchange for the supposed notes, the court said. Its misrepresentations underlying its conclusion that such shares could be issued without a restrictive legend plainly enabled the transfer agent to issue, in exchange for nonexistent notes, unrestricted stock that was then sold by the recipients, according to the court.

The court also said that the requirements of Section 20 had been met because Sourlis elected not to insist on seeing the notes discussed in her letter, which was at the very least reckless, and her misrepresentations that she had spoken to the original note holders were misrepresentations as to her knowledge and hence were knowingly false.

Relief affirmed. The appellate court also upheld the district court’s order of relief that included an order that Sourlis pay $57,284 as a civil penalty, disgorgement, and be permanently barred from participating in penny stock offerings. Sourlis was also suspended as an attorney for a time. The appellate court saw no abuse of discretion, given what it called her lack of concern as to whether her representations of fact were true or false and her continued manifestation of a lack of concern for her responsibilities under the securities laws.

The case is No. 13-3191-cv.

Friday, July 08, 2016

Deutsche’s closed-end funds may not omit shareholder proposals seeking declassified boards

By Jacquelyn Lumb

The Division of Investment Management has advised closed-end funds Deutsche Strategic Income Trust and Deutsche Multi-Market Income Trust that it does not concur with their view that they may omit a shareholder proposal which seeks the declassification of their boards of directors. Western Investment, LLC submitted an identical proposal to both funds in which it sought the annual election of directors to improve board accountability and fund performance. The funds sought to omit the proposals on the basis that the supporting statements contained materially false and misleading information. The staff was unable to conclude that the funds had objectively demonstrated that the cited portions of the supporting statements were false and material in violation of Exchange Act Rule 14a-9.

Staggered boards and majority votes. The boards of both funds are currently divided into three classes that serve staggered three-year terms. Western said that a classified board protects incumbents, which limits their accountability to shareholders. Western also maintained that, in addition to requiring a near impossible absolute majority of shares outstanding to elect directors rather than a majority of the shares voting, the funds used other undemocratic tactics, including the failure to hold timely annual meetings.

The current investment manager has overseen significant losses at the two funds and their other sister funds, according to Western, six out of seven of which have or are scheduled to be liquidated or converted to open-end funds. If the proposal is adopted by the board, all of the directors would be subject to annual elections after the phase-in period, so that unexpired terms would not be affected.

The funds accused Western of attempting to impugn the character, reputation, and integrity of the investment manager by suggesting that the investment manager blocked shareholder rights with the absolute majority voting requirement. The funds noted that the by-laws establish the voting requirements, not the investment manager, and they also took issue with Western’s view that obtaining an absolute majority of shares is nearly impossible, claiming it has no basis.

Western noted that the investment manager has selected each of the board members, which are the same individuals for many Deutsche-sponsored funds. The investment manager has accepted the by-laws during its many years of operating the funds. Western also noted that in contested elections where discretionary voting by brokers is not permitted, obtaining a quorum can be difficult, let alone receiving a majority of outstanding votes.

Western noted that its proposal to declassify the board at another Deutsche fund passed with 68 percent of the vote in 2010, but the board took no action. After a no-confidence vote by shareholders at another of the funds in 2008, the fund declined to hold an annual meeting in 2009. This fund did not schedule a shareholder meeting in 2010 until Western compelled it to do so by filing a lawsuit. The majority vote standard at the Deutsche funds is designed to make contested elections fail, in Western’s view, and are also in contradiction to ISS corporate governance standards.

The funds also stated that it was materially misleading of Western to imply that by reclassifying the board, the net asset value and/or market value of the funds would increase, citing a lack of evidence to support its statement. Western advised that it was referring to the level of discount and the net asset value in its statement. In Western’s view, there is ample evidence that shareholder engagement and influence can lead to a more optimal valuation.

Staff response. The staff said it was unable to assure the funds that it would not recommend enforcement action if they omit the proposals or portions of Western’s supporting statements from their proxy materials in reliance on Rule 14a-8(i)(3).

Thursday, July 07, 2016

Coming to terms with U.K. leave vote

U.K.-based consultant Steve Blackbourn discusses the initial shock of Britain’s decision to leave the European Union with an eye to the many unanswered questions about how the "Brexit" will occur over time. These questions center on the Bank of England’s monetary policy, derivatives regulations, and directives applicable to alternative investment funds. Blackbourn also takes a closer look at some key financial regulations and the road ahead for these regulated businesses. Blackbourn is a frequent contributor to Wolters Kluwer Financial Services’ Compliance Resource Network, where his latest Brexit analysis first appeared.

To view the full text of Blackbourn’s analysis, please click the following:

Wednesday, July 06, 2016

Fixed indexed annuities are not securities under the Illinois Securities Law

By R. Jason Howard, J.D.

An Illinois appellate court has affirmed the judgments of the lower court, determining that fixed indexed annuities (FIAs) are insurance products and not securities under the Illinois Securities Law of 1953 (Babiarz v. Stearns, June 30, 2016, Cobbs, C.).

The plaintiff purchased three annuities but was dissatisfied with the annuities as an investment vehicle and instead filed a complaint in the circuit court of Cook County alleging breach of fiduciary duty, negligent misrepresentation, violation of the Consumer Fraud and Deceptive Business Practices Act, violation of the Illinois Securities Law, common-law fraud, breach of contract to confirm annuities were suitable, breach of contract to investigate plaintiff’s complaints, and negligent suitability review.

The consumer fraud claim proceeded to a bench trial at which the court granted a directed verdict in defendants’ favor. The remaining claim for breach of contract to confirm the annuities were suitable was disposed of at a jury trial, at which the jury found in defendants’ favor. This appeal followed.

Appeal. On appeal, it was the plaintiff’s contention that the trial court erred in granting summary judgment on her breach of fiduciary duty, Illinois Securities Law, negligent misrepresentation, and common law fraud claims because the annuities at issue in this case were securities, not insurance products.

Fixed index annuities. Focusing on the primary issue, the court addressed whether an annuity is an insurance product or a security. The court explained that in analyzing what constitutes a security, federal courts have explained that the definition is broad and includes virtually any product sold as an investment. But federal courts have observed that FIAs, such as the annuities at issue in this case, share characteristics of both investments and insurance products.

The court noted that FIAs were first offered in the 1990s by insurance companies and, by default, have been regulated by state insurance codes and, like traditional fixed annuities, FIAs must provide the base-line protections to consumers that those codes require. Unlike traditional fixed annuities, however, FIAs base their interest rates on a financial market index and, consequently, similar to a security, if the financial market does well, an FIA could have increasingly higher interest rates resulting in a greater account balance. Unlike most securities, however, FIAs have guaranteed minimum interest rates. Thus, no possibility of loss from the unpredictability of the financial market exists. Nevertheless, the court explained that FIAs subject purchasers to more risk than traditional annuities because their interest rates will always be uncertain and purchasers can lose principal if they withdraw their money prior to a specified date and incur surrender charges.

The court continued, saying that despite the fact that FIAs have been regulated by state insurance codes, their hybrid nature has led to confusion regarding whether they would be more appropriately regulated under securities laws.

On the question of whether FIAs are exempt from the Illinois Securities Law, the court turned to the Illinois Insurance code which classifies “annuity contracts” as insurance products and regulates annuities as insurance products in various provisions throughout the Insurance Code, although the code does not refer specifically to FIAs. The Illinois Department of Insurance issued a bulletin declaring that it governs FIAs and advises on its website that “[w]hen you buy an equity-indexed annuity you own an insurance contract. You are not buying shares of any stock or index.” Additionally, FIAs are registered as insurance products with the Illinois Department of Insurance. They are not registered with the Illinois Secretary of State under the Illinois Securities Law.

Moreover, “Illinois case law suggests that FIAs are insurance products. Although this court has not ruled on whether FIAs are insurance products, we have previously held that an ‘annuity’ is an insurance product,” said the court. Additionally, although the Illinois Securities Law does not contain the term “fixed indexed annuity,” the law further supports the conclusion that FIAs are insurance products.

The court, taking all the evidence into account, said that in sum, although the Illinois Securities Law and the Insurance Code did not specifically mention FIAs, they generally refer to annuities as insurance products and, accordingly, held that FIAs are insurance products exempt from the Illinois Securities Law.

The court then addressed several other arguments briefly and determined that the lower court did not err in granting summary judgment on plaintiff’s claims.

The case is No. 1-15-0988.

Tuesday, July 05, 2016

'33 Act class actions belong in federal court, say SIFMA, Chamber

By Anne Sherry, J.D.

SIFMA, the Chamber of Commerce, and the National Venture Capital Association are urging the Supreme Court to decide whether states retain concurrent jurisdiction over Securities Act class actions. California state courts are now a "magnet" for '33 Act class actions following the 2011 Countrywide decision, the groups argue in an amicus brief. This shift to state courts "is exactly what Congress sought to prevent when it enacted SLUSA" (Cyan, Inc. v. Beaver County Employees Retirement Fund, June 27, 2016).

Cyan, Inc. petitioned the Supreme Court for a writ of certiorari last month after a California trial court held that it has jurisdiction over a class action against Cyan. (Cyan also exhausted its state-court appeals.) The action, which involves weaker-than-expected results following the company's IPO, alleges only federal claims under the Securities Act. The trial court explained that it is bound by Luther v. Countrywide Financial Corp. (Cal. App. 2011), which held that the Securities Litigation Uniform Standards Act continued, rather than withdrew, state-court jurisdiction over covered class actions.

Amicus support. The industry groups support Cyan's effort to get the case in front of the High Court. The case squarely presents the question of whether state courts have jurisdiction over Securities Act covered class actions, a purely legal and fully dispositive issue. This is a rare opportunity to decide an important federal question, amici argue, because when the issue has been addressed in federal district court, procedural or practical roadblocks have prevented appeal.

In the groups' view, the California decision conflicts with the plain language and purpose of SLUSA. The court read a jurisdictional amendment's exception to concurrent jurisdiction as excepting only state law claims precluded and removable under two Securities Act provisions—but the cited provisions already have that effect. The court's statutory interpretation is erroneous because it would render the exception superfluous.

Countrywide, if left unchecked, will harm capital markets, amici continue. They note that 38 Securities Act class actions have been filed in California state courts since the decision, and nearly all of these have named underwriters as defendants. Prior to Countrywide but after SLUSA, only six such class actions were filed in 12 years. The groups cite the uncertainty about which jurisdiction governs market conduct as a major contributing factor to corporations' taking their business overseas. The amicus brief suggests that state courts are less likely to dismiss class actions and that discovery in state court drives up litigation expenses. Under the Countrywide decision, nothing stops plaintiffs from pursuing parallel class actions in state and federal court—and the costs of duplicate defenses are borne by the marketplace.

The case is No. 15-1439.

Friday, July 01, 2016

PCAOB’s Harris raises alarm about increase in Big Four firms’ consulting and advisory services

By Jacquelyn Lumb

PCAOB member Steve Harris raised alarms about the emerging threat to auditor independence posed by the rise in consulting and advisory services offered by public accounting firms. In remarks to the International Corporate Governance Network, Harris described the growing consulting and advisory services among the Big Four U.S. accounting firms, which he said now dominate the consulting market. This trend is important, he explained, because the last time it occurred was before the SEC’s adoption of new independence rules and the enactment of the Sarbanes-Oxley Act, both in response to accounting firms’ unsuccessful attempts to serve dual roles.

Harris noted that auditor independence violations continue to occur 16 years after the adoption of the SEC’s independence rules. All of the global networks or their affiliates have either settled enforcement actions related to independence violations or have resigned from an engagement because they provided prohibited services, according to Harris. The Board continues to see independence violations and its concerns are shared by its international counterparts, he advised. These continuing violations raise questions about the effectiveness of firms’ controls to prevent the cross-selling and marketing of prohibited services, Harris advised.

Harris characterized the profession’s use of words such as “strategic partners” or “trusted advisers” in describing their relationships with clients as red flags that raise questions about whether the amount or types of services being offered are appropriate for audit clients. Some in the profession are calling for a modernization of the independence rules, he added, which he sees as code for relaxing the independence rules.

The PCAOB is analyzing the business models of auditing firms to determine whether they pose risks to auditor independence and audit quality. Harris said the Board will continue to address its concerns with firm leaders, but also encouraged others to pay close attention to whether the increase in consulting and advisory services may reduce firms’ focus on audit quality and investor protection.

Going concern. Harris reviewed the Board’s initiatives on naming the engagement partners and other participants in an audit and proposed revisions to the auditor’s reporting model, and also discussed going concern. The Board is considering whether revisions are needed to the going concern standard given FASB’s new requirements for management to disclose going concern matters. Harris said that if FASB’s disclosure threshold was applied for the audit, even fewer going concern opinions would be issued than during the past crises.

Harris cited FASB member Lawrence Smith’s dissent when the revisions were adopted, in which Smith said the increased threshold will result in a decrease in the number of going concern disclosures compared to current practice. This is an important transparency issue on which to focus, in his view, and he urged investors to increase their involvement during the Board’s comment process.

Diversity, governance, sustainability. Harris closed with a few thoughts on diversity, audit firm governance, and sustainability reporting. Diverse audit engagement teams result in better audits, he said, just as a diverse board of directors improves shareholder value. He said the profession should be encouraged to continue its efforts to attract and retain talented minorities.

Harris also called on the major accounting firms to increase their board governance diversity by increasing the number of independent individuals who serve on their managing boards. More independent board members will help focus the firms on improving audit quality and preventing potential conflicts, in his view.

With respect to sustainability reporting, Harris said it is currently a voluntary effort in the U.S., other than climate change disclosure, which is required, but is largely presented in a boilerplate manner. He applauded the SEC’s concept release on disclosure reform which includes 11 pages of discussion on sustainability. Harris believes that higher quality disclosure on environmental, social, and governance issues is inevitable, and added that it raises the question of whether it should be subject to independent verification. Sixty-nine percent of the respondents to a CFA Institute survey supported verification measures, he advised.

Thursday, June 30, 2016

Texas diverges from SEC on portal handling of investor funds

By Jay Fishman, J.D.

While the SEC prohibits crowdfunding portals from handling investor funds, the Texas State Securities Board has proposed to amend its crowdfunding exemption to relax this prohibition. As proposed, a Texas crowdfunding portal could create a segregated account to handle investor funds. The portal would disclose the segregated account to prospective purchasers and investors, along with a statement that the portal must: (1) prudently process, safeguard, and account for funds the issuer and investors entrust to it; (2) act in the issuer’s and investors’ best interests and advantage; and (3) ensure that all requirements of the account agreement between the portal and issuer are met before any funds are disbursed from the segregated account.

A “segregated account” is an account created by a registered general dealer or a Texas crowdfunding portal under a written agreement with the issuer, which provides that the registered dealer or portal will act on the issuer’s and investors’ behalf to hold funds raised from investors for a specific securities offering until the time that those funds can be disbursed accordingly. The account agreement must identify the bank or other depository institution and account number where the funds are being held. All signatories on the segregated account must be persons registered with the Texas securities commissioner.

Wednesday, June 29, 2016

Timbervest proceeding remanded to SEC to hear additional evidence

By Amanda Maine, J.D.

The D.C. Circuit has remanded proceedings against Timbervest LLC to the SEC for the purpose of hearing additional evidence relating to the SEC’s original disgorgement order; in particular, an agreement of settlement Timbervest made with the aggrieved party. The SEC had not opposed remand, but objected to Timbervest’s request that the SEC’s order be vacated (Timbervest, LLC v. SEC, June 24, 2016, per curiam).

Commission’s order. The SEC brought proceedings against Timbervest and several executives alleging that they defrauded AT&T, one of their pension fund clients, by selling one of AT&T’s assets at a below-market rate to another Timbervest client without disclosing the conflict of interest their role in the transaction created. An SEC administrative law judge concluded, and the Commission agreed, that the Timbervest respondents were unjustly enriched, and ordered disgorgement.

Timbervest motion. Timbervest moved to vacate the SEC’s order on several grounds, including that Timbervest had since reached a settlement with AT&T to pay in complete satisfaction all claims relating to the disposition fee paid by AT&T, which was the amount used to determine disgorgement in the SEC’s final order. Under the recently decided case SEC v. Graham (11th Cir.), disgorgement and forfeiture are “effectively synonymous” and thus barred by the five-year statute of limitations in 28 U.S.C. 2462 because it goes beyond remedying the damage caused to the harmed parties by the respondents’ action.

Remand, not vacate. The SEC did not oppose the request to remand the proceedings for the purpose of taking additional evidence on the settlement. However, the SEC argued that Timbervest’s claim that the original order has been materially altered by the settlement means that the district court may not consider it because those material facts were not before the Commission, and under the SEC’s statutory review scheme, the Commission, not the courts, must first be given an opportunity to adduce the new evidence.

Circuit court’s order. In a one-page order, a panel of the D.C. Circuit ordered that the record be remanded to the Commission for the “limited purpose of allowing the Commission to consider additional evidence” that Timbervest cited in its motion to determine its effect, if any, on the Commission’s original order. The panel also ordered that Timbervest’s appeal be held in abeyance pending further court action.

Other issues remain. Timbervest’s brief to the D.C. Circuit had cited several other issues it felt the court should consider, including the unconstitutionality of the SEC’s administrative forum, equal protection rights afforded to respondents under the SEC’s in-house regime, and evidentiary failures resulting into unwarranted sanctions. The SEC’s administrative regime has come under fire over the last year, with litigants bringing suit in various federal courts. Most challenges to the regime have so far been unsuccessful.

The case is No. 15-1416.

Tuesday, June 28, 2016

Tax condition lets oil company out of unfavorable merger

By Anne Sherry, J.D.

The inability to procure a legal opinion allowed Energy Transfer Equity, L.P. (ETE) to back out of an unfavorable merger with The Williams Companies, Inc. The energy market tanked after the parties agreed to the merger, rendering it a bad deal for ETE, which would have had to borrow $6 billion against its devalued assets to pay the fixed cash price. The Delaware Chancery Court took a skeptical view as a result, but observed that "motive to avoid a deal does not demonstrate lack of a contractual right to do so" (The Williams Companies, Inc. v. Energy Transfer Equity, L.P., June 24, 2016, Glasscock, S.).

Merger mechanics. Both Williams' stock and ETE's common units trade on the NYSE. The deal was structured so that Williams shareholders would retain publicly traded stock post-closing and receive a substantial cash payment. ETE created a new limited partnership, taxable as a corporation, into which Williams would merge. The new entity would then transfer 19 percent of its own stock, in addition to the former Williams assets, to ETE in exchange for partnership units and $6 billion in cash. The cash would be distributed to the former Williams stockholders.

ETE pursued the deal "assiduously," and the parties negotiated heavily to come to an agreement that they executed on September 28, 2015. The merger's potential tax ramifications were a particular concern. Although the deal does not give ETE a financing or solvency out, a condition precedent to consummation of the merger is that ETE's tax attorneys, Latham & Watkins, issue an opinion that a specific transaction "should" be treated as a tax-free exchange under the Internal Revenue Code. Latham has been unable to issue that opinion, and that is unlikely to change before June 28, the outside date for consummating the merger.

Contract trumps motive. Williams maintained that ETE was estopped from leveraging the condition precedent because it breached the merger agreement by failing to use "commercially reasonable efforts" to secure the legal opinion. This is an equitable argument, and the court observed that Delaware law, which governed the agreement, is "strongly contractarian." Using equity to consummate the merger would force ETE to accept the potential tax risk without the comfort of a tax opinion from Latham.

Latham's good faith. The court examined the various interests that colored its interpretation of the facts. The sophisticated parties negotiated a condition precedent that required a subjective opinion and assigned that determination to ETE's tax lawyer rather than a neutral third party, the court noted. It was not appropriate to substitute the court's judgment on the tax issue for that of Latham; the court's role was to determine whether the refusal to issue the opinion is in good faith. On the other hand, the court had to look at Latham's decision—which favored its client—"with a somewhat jaundiced eye." Latham was originally prepared to issue the opinion, but reconsidered after the market stacked the deal against ETE. However, Latham is a large, international firm whose interests are larger than those of this particular representation. Clients generally want their deals to go through; Latham's deal-breaking conclusion was counter to the firm's reputational interest going forward.

The court found that Latham made its determination in good faith and that a condition precedent to the consummation of the merger has not been met. Under the relevant Internal Revenue Code provision, a contribution of property for an interest in a partnership is not a taxable event. But the merger included another exchange, of $6 billion in cash for shares of the new LP. The drop in value of ETE units meant that the cash transaction represented a payment of $6 billion for between $2 and $3 billion worth of stock. The tax authorities could consider the overpayment to be part of a hidden sale of assets, which would trigger tax liability. At the time the agreement was executed, the cash transaction involved assets of equivalent value, and Latham was able to give an opinion that the transaction should be considered a tax-free event. But the drop in the shares' value, relative to the fixed cash payment, changed that. ETE hired Morgan Lewis attorneys and a professor to examine the transaction; both also concluded that it was likely to trigger tax liability.

ETE did not breach. The merger agreement required ETE to use "commercially reasonable efforts" to obtain the legal opinion, but it did not define the phrase. This was an objective standard, the court determined. But Williams could point to no commercially reasonable efforts that ETE could have taken to cause Latham to issue the legal opinion in good faith. Whatever ETE's motivations, there was no material breach on the facts before the court.

The case is No. 12168-VCG.

Monday, June 27, 2016

House Agriculture leaders warn proposed CFTC energy order would cause inconsistency

By Lene Powell, J.D.

The leaders of the House Agriculture Committee wrote to CFTC Chairman Timothy Massad to express concern about a proposed CFTC order that would recognize a private right of action for market manipulation involving certain transactions in the electricity markets. The transactions were largely but not completely exempted from the Commodity Exchange Act (CEA) by a previous CFTC order, creating uncertainty whether private actions involving the excluded transactions were permitted. According to the legislators, allowing private lawsuits in this area would upset the existing division of authority between CFTC and the Federal Energy Regulatory Commission (FERC) and lead to legal inconsistency.

“We recognize the harm to consumers of fraud and market manipulation in electricity markets, and value the CFTC’s rigorous work to police these shared markets,” wrote the lawmakers. “However, to uphold the Congressional intent expressed in Section 720(a) of the Dodd-Frank Act, and to ensure that FERC and the CFTC are able to continue their effective and cooperative monitoring of the energy markets, we urge you to consider the possibility that the proposals will result in widespread, inconsistent judicial interpretations of the CEA.”

The letter was signed by Chairman Michael Conaway (R-Texas) and Ranking Member Collin Peterson (D-Minn), as well as Austin Scott (R-Ga) and David Scott (D-Ga), chairman and ranking member of the Subcommittee on Commodity Exchanges, Energy, and Credit.

Transactions excluded. In 2012, a group of Regional Transmission Organizations (RTOs) and Independent System Operators (ISOs) petitioned the CFTC to exempt specified electricity transactions from the CEA and CFTC regulations. The following year, the CFTC issued a final order that exempted the purchase or sale of defined “financial transmission rights,” “energy transactions,” “forward capacity transactions,” and “reserve or regulation transactions” offered or sold in a market administered by one of the petitioning RTOs or ISOs under a tariff or protocol approved or permitted to take effect by FERC or the Public Utility Commission of Texas (PUCT). The exemption was subject to conditions, and the transactions remained subject to the CFTC anti-fraud and anti-manipulation authority and scienter-based prohibitions.

In a subsequent private action that alleged market manipulation in the Texas electricity markets, a federal district court in Texas interpreted the 2013 order as prohibiting private actions involving the excluded transactions. The Fifth Circuit affirmed the decision of the district court (Aspire Commodities v. GDF Suez Energy North America).

Private right of action. In May 2016, the CFTC proposed to revise the 2013 order to explicitly provide that the order does not exempt covered entities from the private right of action in CEA Section 22 with respect to the excluded transactions. Chairman Timothy Massad explained that although regulatory certainty is important, private actions play an important role in protecting market participants and the public interest. Commissioner J. Christopher Giancarlo dissented from the proposal, noting that the covered entities are extensively regulated and monitored by the Federal Energy Regulatory Commission, lessening the policing role of private suits involving these markets. The comment period for the proposal closed June 15, 2016.

Aspire Commodities, the trading firm that brought the market manipulation action, supported the proposal. According to Aspire, private actions are needed to prevent market manipulation because the RTOs and ISOs do not adequately police the markets and the CFTC does not have the resources or knowledge to do so either. But FERC and PUCT joined energy trade associations in opposing the proposal, saying it could upset the Congressionally-mandated balance of overlapping jurisdiction between the CFTC and FERC.

House Agriculture opposition. Led by Chairman Conaway, the leadership of the House Agriculture Committee pointed out that Congress specifically intended to avoid uncertainty in the electricity markets by requiring the CFTC and FERC to enter into a Memorandum of Understanding (MOU) delineating oversight between the two agencies. A private right of action would open market rules to judicial interpretation, likely resulting in inconsistent determinations across the country. This would undermine the ability of the carefully negotiated MOU to provide a consistent, efficient, and effective framework for energy producers and market participants, the lawmakers warned.

Friday, June 24, 2016

IDC warns against fund proposals pushing managerial tasks onto boards

By Amy Leisinger, J.D.

The Independent Directors Council filed a supplement to its comment letters on the SEC’s proposals regarding liquidity risk management and funds’ derivatives use. According to the IDC, both proposals raise issues regarding the fund boards’ oversight role and the responsibilities of independent directors, and the SEC should hold a roundtable to provide a forum for a full discussion of fund governance and appropriate parameters for directors’ oversight responsibilities. The Commission must be cautious against imposing management functions on directors that contradict their stated duties, the group stated.

Liquidity risk management proposal. The SEC proposed a new rule and amendments to promote effective liquidity risk management and to reduce the possibility that funds will be unable to meet redemption obligations and mitigating dilution of the interests of fund shareholders. The Commission proposed new Rule 22e-4, which would require each registered open-end fund, including open-end exchange-traded funds but not including money market funds, to establish a liquidity risk management program. The SEC also proposed to permit a fund, under certain circumstances, to use swing pricing and to change disclosure requirements to give investors, market participants, and Commission staff improved information on fund liquidity and redemption practices.

Derivatives use proposal. The SEC proposed rules to enhance regulation of the use of derivatives by registered investment companies. Specifically, the proposal would require each fund to comply with limitations on the amount of its leverage derivatives and other transactions and to manage risks associated with derivatives transactions by segregating assets in an amount sufficient to enable the fund to meet its obligations under stressed conditions. A fund that engages in more than a limited amount of derivatives transactions would also be required to establish a formalized derivatives risk management program under the rule. The proposed reforms would also address funds’ use of financial commitment transactions by requiring funds to segregate certain assets to cover their obligations.

IDC on directors’ role. According to the IDC’s comments, directors are most effective when they can provide an independent perspective regarding management decisions without direct day-to-day involvement in the process. Board members need to focus on the oversight of forest, not the individual trees, the group continued, and participation in daily management matters is not where they can add value.

The SEC needs to consider which obligations can be appropriately imposed on independent directors and which activities go too far into management function, the IDC explained. In the past, the Commission has imposed specific responsibilities on independent directors when a matter involves a conflict of interest, the group noted, but the two proposals do not present conflicts that warrant independent scrutiny. In fact, according to the IDC, the interests of a fund’s adviser and the fund are typically aligned in matters of liquidity management and limitations on derivatives use. In addition, under the proposals, directors would have to develop deep understanding of technical matters, which could divert their focus from the matters most important to shareholders, the IDC stated.

According to the group, imposing specific managerial obligations could also set directors up for failure in making on-the-ground managerial decisions and increase the potential for liability. Moreover, managerial responsibilities on board members could lead to overemphasis on directors with subject-matter expertise, thereby limiting the pool of qualified candidates. The SEC should consider how the existing Rule 38a-1 oversight framework for boards addresses the proposals’ concerns and whether the proposed changes would create uncertainty in relation to current compliance programs, the IDC said.

The Commission must clearly draw the line between board oversight and day-to-day management, the IDC concluded.