Saturday, March 28, 2015

SEC Investor Advocate to Keynote NASAA’s Public Policy Conference

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

NASAA has announced that SEC Investor Advocate Rick Fleming will keynote NASAA’s 30th Annual Public Policy Conference next month in Washington, D.C. This year’s conference, "Progress Through Innovation," will focus on the steps that states and Canadian provinces are taking to protect investors while fostering local entrepreneurial initiatives and economic growth.

Appointed to the position last year by Chair Mary Jo White, Fleming became the first person to lead the SEC’s Office of the Investor Advocate, which was created under the Dodd-Frank Act. Immediately prior to his current appointment, Fleming had served as NASAA’s Deputy General Counsel from 2011 to 2014. Fleming has also been General Counsel for the Office of the Kansas Securities Commissioner. A native of Kansas, Fleming holds degrees from Washburn University and Wake Forest School of Law.

In addition to the luncheon featuring Fleming’s keynote address, the conference will feature two panel discussions with financial and regulatory experts. The first panel, "Laboratories of Capital Innovation," will examine the innovative local solutions provided by NASAA member jurisdictions to spur capital formation. The second panel, "Balancing the Risks and Rewards of Technological Financial Innovation," will explore how technological financial innovation and investor protection can coexist to fully benefit investors and firms alike.

The conference will be held on Tuesday, April 14, at the Mayflower Renaissance Hotel in Washington, D.C. Prospective attendees may register on NASAA’s website.

Friday, March 27, 2015

CFTC Commissioner Bowen Addresses Risk Management

[This story previously appeared in Securities Regulation Daily.]

By R. Jason Howard, J.D.

CFTC Commissioner Sharon Y. Bowen spoke before the 17th Annual OpRisk North America on March 25th to discuss operational risk, an issue she described as being very near to her heart.

In her speech she lays out the major trends in operational risks that she believes the market is facing at present. She also provided some thoughts on what needs to be done to address those risks. She also provided some specific insights into a major CFTC rule and explained how she views the CFTC's new regulation governing the risk management practices of swap dealers and major swap participants.

Cybersecurity. Commissioner Bowen began the discussion on cybersecurity by first reminding the audience that “trading is effectively entirely electronic.” Even when two traders are booking a deal over the phone, it is being logged and finalized via electronic communications, she said. The result, she continued, is that financial actors have become storehouses for massive amounts of sensitive data, from information about trading strategies to client’s social security numbers. Intuitively, the damage that could be done via a major cyberattack on an exchange, clearinghouse, Swap Execution Facility (SEF), or systemically important financial institution is almost incalculable.

At the end of the day, the Commissioner explained, regulators and the industry are allied in the fight to prevent and mitigate cyberattacks. We have to be working together. Because this threat is constantly changing and new entities are continually developing new strategies, we all need to adopt a stance of constant improvement.

Technology. The trend of technology breaking was Commissioner Bowen’s second risk trend topic. As finance has become an industry that is really housed in cyberspace, she explained, there is a risk that these new technologies may not fully be understood by the people who are using them, particularly with regard to high frequency trading. An example she cited was the ‘flash crash’ of 2010, which was an accident but, she continued, the risk of massive technological failure affecting clearinghouses is not going away. Therefore she thinks that entities that are using, for instance, high frequency trading algorithms in the futures market should at least be required to inform the CFTC that they are using those technologies, just as other registrants often inform the CFTC if they are implementing major new technological changes; doing so she says, will help ensure that industry participants fully understand the tools that they are using to trade.

For now, she explained, she wants to encourage consideration of the dangers that technologies could fail or malfunction and suggest that be part of overall risk management. That includes getting a fulsome grounding in how the technology works and getting the input of technical experts on the flaws in the present technology being used.

Culture. Culture, the Commissioner explained, is a trend that has received a lot of attention lately as she has witnessed a significant number of settlements and alleged violations of our laws and regulations in just the last nine months and, all too often, she continued, those settlements and alleged violations are coming from large actors who have previously run afoul of the rules, endangering the reputation of those actors and the trust that undergirds the larger financial system.

On this topic, the Commissioner encouraged all attending to do what they can both to assess their risks of having a bad culture and to improve their organization’s culture as fast as they can. Unlike cybersecurity, she stated, this is a problem that can be solved by each individual firm.

Lack of regulatory clarity. This was the fourth risk trend that Commissioner Bowen spoke about, saying that this topic is typically talked about in the context of the risk that regulators will change previously finalized rules without giving sufficient notice to industry but it also applies to situations where rules required by Congress remain unfinished for long periods of time and therefore in a state of flux, as well as applying to situations where a regulator relies too much on issuing guidance and no-action letters for previously finalized rules. To this she said that she believes regulations should be changed, as much as possible, via the ordinary process of notice and comment and resist the temptation to craft a regulatory regime primarily through no-action letters.

Risk management policies. Here, Commissioner Bowen discussed the final rule the CFTC released a few years ago: the CFTC regulation requiring risk management programs for swap dealers and major swap participants, known as Section 23.600. The rule states that each swap dealer and major swap participant needs to establish and enforce a system of risk management policies associated with its swaps activities.

Commissioner Bowen explained that the written policy needs to be approved by the governing body of the swap dealer or major swap participant and it has to be provided to the Commission; the swap dealer or MSP also has to establish and maintain an independent risk management unit that will carry out the risk management program and it has to report directly to senior management; the program has to cover, among other things, a number of risk categories: market risks, credit risks, legal risks, and, of course, operational risk; and the program also must include a policy for identifying and taking into account the risks of new products before they are used in transactions.

List of risks not all-inclusive. Because CFTC Section 23.600 is a “dense regulation,” Commissioner Bowen explained that the list of risks to be considered is not all-inclusive and the items that swap participants must consider are not “check-the-box” exercises, rather, it states only the risks that must be included in the risk management programs. Those plans that deal only with the explicit requirements, said Commissioner Bowen, should not be viewed as complete and she went on to suggest that “systemic” risk would be an appropriate category to include.

Risk categories not all-inclusive. The Commissioner’s second point about Section 23.600 was that the risk categories themselves are not all-inclusive. In the case of each category, she continued, the rule states that programs and policies to address a specific risk shall include two or three explicit risks, among other things. Her example was on operational risk, where the CFTC has explicitly stated that a risk management program has to take into account secure, reliable, and independent operating systems, safeguards against deficiencies in operation and information systems, and reconciliation of all data in operating systems. This, the Commissioner believes, only begins to scratch at the surface of operational risk.

Senior management involvement. Third, Commissioner Bowen said that the implementation and enforcement of the risk management plan is to be carried out by an independent unit that has direct access to senior management. Senior management, she continued, needs to really consider and engage with the process of creating and updating the risk management plan so that senior management has a vested interest in the success and usefulness of the risk management program.

Independent. The Commissioner’s fourth point was that the risk management unit needs to be truly independent, the Commissioner said. Ideally, she explained, each risk management program would have a majority of people in it who, when they arrive at the risk management unit, have no prior work experience in the company. Moreover, she continued, suggesting that distance will help ensure that the unit looks at issues with fresh eyes and reduce the risk that the risk management unit simply ratifies prior analyses without really considering the costs and benefits of doing so.

The Commissioner suggested that the plans be dynamic and she encouraged the attendees “seriously rethink everything about your overall risk management plans with some frequency.”

Operational risk critically important to finance. Commissioner Bowen reiterated her thoughts from earlier in the speech, saying that she thinks operational risk is a critically important part of finance. “It’s by considering operational risk in advance, she explained, that a smart company is able to be flexible in a tough market or weather a storm...and while there will always be black swan events that do come out of nowhere, the more companies take into account as many of their real risks as is possible, the better each individual company and our financial system generally will be able to withstand unforeseen events.”

Conclusion. Commissioner Bowen concluded by saying that major financial actors need to fully implement requirements regarding risk management programs, sufficient protections need to be in place to prevent against hacking and cyberattacks, and major financial institutions need to change their culture so that there are far fewer violations of our laws and regulations.

Thursday, March 26, 2015

NYC Comptroller Urges Fiduciary Transparency Law

[This story previously appeared in Securities Regulation Daily.]

By Mark S. Nelson, J.D.

New York City Comptroller Scott M. Stringer announced his plans to ask state legislators to enact a law that would help consumers to better grasp the standard of care their financial advisers must live up to. The debate over whether federal regulators should do the same has been ongoing since Congress authorized the SEC to adopt a uniform fiduciary standard under a provision in the Dodd-Frank Act. But the issue persists because advisers subject to the Investment Advisers Act are treated as fiduciaries, while broker-dealers are held to the lower suitability standard.

Stringer’s proposal is essentially a disclosure requirement. According to a press release, the proposed law would require any financial adviser who abides by the suitability standard to explicitly state to their customers that they are not a fiduciary and can still recommend investment options that are not in the customer’s best interest.

Stringer emphasized the harms possible under the current dual system of advisers who are fiduciaries and those who are not. “Hard-working New Yorkers should not be penalized by a system that doesn’t adequately address potential conflicts of interests and financial mismanagement.” He also cited a report by his office that details changes in the marketplace that can result in consumer confusion over the roles played by different types of financial advisers.

But Stringer noted a few signs of change, including recent efforts by the Department of Labor to define “fiduciary” under the Employee Retirement Income Security Act of 1974. He also noted some movement by SEC Chair Mary Jo White toward a uniform fiduciary standard.

White said in her testimony to the House Financial Services Committee yesterday that the SEC had provided “technical assistance” to the DOL regarding the definition of fiduciary. She also suggested that she may put the SEC on a path similar to the one the DOL has taken.

“After significant study and consideration, I believe that broker-dealers and investment advisers should be subject to a uniform fiduciary standard of conduct when providing personalized securities advice to retail investors,” said White. But she also noted some barriers to implementing a uniform standard, including how to define the standard, what guidance to give about permitted and banned practices, and how to enforce a new standard.

Wednesday, March 25, 2015

Bad-Actor Bill Would Mitigate ‘Too-Big-to-Bar’

[This story previously appeared in Securities Regulation Daily.]

By Anne Sherry, J.D.

Representative Maxine Waters (D-Cal) has released draft legislation that would require the SEC to overhaul its process for waiving bad-actor disqualifications. The congresswoman, who has been critical of the lack of accountability for individual wrongdoers at big banks, said the Commission’s seemingly automatic waiver process “enshrines a policy of ‘too-big-to-bar.’”

Waivers for bad actors. Nine provisions across the securities laws disqualify wrongdoers from eligibility for certain exemptions and safe harbors. But these “bad actors” may apply for waivers, which proceed to review by the staff of the Division of Corporation Finance or Investment Management. Representative Waters maintains that these waivers are seemingly automatic at times and disproportionately benefit large financial firms, many of whom are recidivists. She notes that, as Commissioner Stein pointed out, one large financial firm received over 22 waivers in a 10 year period, yet maintained in its waiver applications that it has a “strong record of compliance with federal securities laws.”

Commissioners’ views. Commissioner Stein objected to the waiver process during a vote at the Commission level on whether to grant Royal Bank of Scotland a waiver despite its subsidiary’s role in manipulating LIBOR. (The waiver was approved over her dissent.) But Chair Mary Jo White defended the waiver process earlier this month, calling it a “thorough, rigorous, and principled application of the law.” She denied that the SEC routinely grants waivers without rigorous analysis and said that it should not be surprising that large financial firms have sought multiple waivers, given that corporate liability can be triggered through the act of a single employee. On the heels of these remarks, the Division of Corporation Finance issued a policy statement concerning the factors it will consider in granting waivers from disqualification under Regulations A and D.

Discussion draft. White also acknowledged that the numbers and public record to not reflect the “extensive and exacting work” of the SEC staff in analyzing waiver requests. This lack of transparency would also be addressed through Rep. Waters’ bill.

The legislative proposal was timed to coincide with Chair White’s testimony today before the House Financial Services Committee, of which Rep. Waters is ranking member. The Bad Actor Disqualification Act of 2015 would require the SEC to conduct and vote on its waiver process at the Commission, rather than staff, level; require the Commission to consider whether granting a waiver would be in the public interest, protect investors, and promote market integrity; provide a public notice and comment period and the opportunity to request a hearing; and require SEC staff to keep public records of all waiver requests and denials along with a public database of bad actors.

Tuesday, March 24, 2015

Shareholder Support for Directors and Pay Plans Fell in 2014

[This story previously appeared in Securities Regulation Daily.]

By Matthew Garza, J.D.

Investor communication firm Broadridge Financial Solutions and PricewaterhouseCoopers have released an analysis of the 2014 proxy “mini-season,” which included data from 1,077 public company shareholder meetings held between July 1 to December 31, 2014, and provided a preview of the 2015 proxy season in a new edition of the ProxyPulse newsletter.

Ownership. The firms reported that institutional shareholders owned 59 percent of “street name” shares, up three percent from 2013, while retail shareholders held 41 percent. Institutional shareholders voted 83 percent of the shares they owned, but retail shareholders voted only 28 percent of their shares. There was also a wide gap in voting participation based on the company’s capitalization. Institutions voted 88 percent of their shares at mid-cap companies, but only 55 percent at micro-caps. Retail shareholders voted 34 percent of their mid-cap shares and 24 percent of their micro-cap shares.

Director support. The number of directors failing to receive the support of a majority of shareholders increased 26 percent over the 2013 mini-season, with 125 directors at 45 different companies failing to receive majority support, and 344 directors failing to receive 70 percent support. Ninety-nine directors at 53 different companies failed to attain majority shareholder approval in 2013. One-third of the companies that had a director fail to attain majority support in 2013 also had a director fail to obtain majority support in 2014, the report pointed out.

Chuck Callan, senior vice president of regulatory affairs for Broadridge said “The 70 percent ‘support’ benchmark is important to many companies and proxy advisors. At the same time, retail shareholders were not broadly engaged in voting and their ‘un-voted’ shares amounted to 29 percent of street shares outstanding.” The report said over 22 billion retail shares in total were not voted, which presented an opportunity for greater company engagement with shareholders.

Say-on-pay. The average level of shareholder support for pay plans declined from 83 to 80 percent from 2013 to 2014, with the declines most pronounced at large caps. Six large-cap companies failed to achieve at least 70 percent support for pay plans, compared to only one in the 2013 mini-season. Support for say-on-pay increased at micro-caps, however, from 71 percent to 80 percent. Overall, 35 out of 471 companies failed to obtain majority support in their say-on-pay votes. The firms again said the 2014 results for particular companies followed 2013 results, with almost half of all companies whose pay plans fell short of 70 percent shareholder support in 2013 showing the same result in the 2014 mini-season.

2015. Looking ahead to 2015, the report predicted that proxy access will remain a hot issue, especially after SEC Chair Mary Jo White directed her staff to review Rule 14a-8(i)(9) following the controversy over proxy access at Whole Foods. Cybersecurity disclosures are likely to get increased scrutiny by shareholders in 2015, and the new “scorecard” approach to evaluating independent chair and equity plan shareholder proposals at ISS could impact voting. The adoption of fee-shifting bylaws at some companies will also garner attention in 2015, the firms predicted.

Monday, March 23, 2015

Bill Takes Aim at SEC’s ‘Revolving Door’

[This story previously appeared in Securities Regulation Daily.]

By Matthew Garza, J.D.

Congressman Stephen F. Lynch (D-Mass) has introduced a bill that would prevent SEC staff members from seeking employment with companies they recently targeted in enforcement actions until a year after leaving the agency. The bill was introduced prior to testimony by SEC Enforcement Director Andrew Ceresney yesterday morning in front of the Financial Services Committee’s Capital Markets Subcommittee. “As Director Ceresney highlights the enforcement office’s priorities in the coming year at today’s hearing, I want to emphasize the need to end the revolving door at the SEC, which poses increasing risks to the agency’s effectiveness and ability to keep enforcement actions fair and transparent,” said Lynch.

H.R. 1463, the SEC Revolving Door Restriction Act of 2015, would bar staffers for a year from seeking employment with companies against which they participated in enforcement actions in the preceding 18 months. Enforcement actions are defined as court actions, administrative proceedings, or Commission opinions. Former staffers must seek an ethics opinion from the SEC if they wish to seek employment with a recently targeted company within a year of their termination.

Delaying staffers’ employment in the private sector would affect a significant number of SEC employees, who have a long tradition of leaving government service to join the defense bar. At the 2015 SEC Speaks conference, when current and former agency staff members were asked by Chair Mary Jo White to stand, at least two thirds of the room took to their feet. Chair White has been affected by entering the revolving door in the opposite direction, having recused herself from numerous enforcement matters after coming to the SEC from years in private defense practice.

A study on the risk of “regulatory capture,” conducted by the Project On Government Oversight (POGO) and covered in Securities Regulation Daily on February 12, 2013, found that 419 ex-SEC officials and staffers filed more than 1,900 disclosure statements saying they planned to represent clients or new employers in matters pending at the SEC between 2001 and 2010.

POGO makes the data available online in the “SEC Revolving Door Database.” Some former staffers have gone on to successfully seek waivers for companies charged with wrongdoing by the SEC.

POGO’s Executive Director Danielle Brian called for bipartisan support for the bill, saying that “When an enforcement attorney leaves the SEC on Friday, and shows up on Monday requesting favorable treatment for a bank charged with wrongdoing, it can greatly damage the integrity of our regulatory system.” Congressman Lynch said that he believes the proposed legislation “will improve confidence in the agency’s ability to investigate suspected wrongdoing and continue the SEC’s recent efforts to strengthen their enforcement function.”

Friday, March 20, 2015

ESMA Report Offers New Way to Monitor Hedge Fund Industry Systemic Risk

[This story previously appeared in Securities Regulation Daily.]

By John Filar Atwood

The European Securities and Markets Authority’s (ESMA) semi-annual report on trends, risks, and vulnerabilities in the European Union securities markets provides a new method for monitoring systemic risk in the hedge fund industry. The report claims that the methodology works for the entire global hedge fund industry and can be applied to other parts of the fund industry with only limited adjustment, making comparable indicators available for systemic risks in different fund sectors.

The report, which covers July to December 2014, examines the performance of EU securities markets to develop a comprehensive picture of systemic and macro-prudential risks in the EU. The report is designed to help member states and EU regulators in their risk assessments.

In a press release, ESMA said that market conditions in the EU generally remained tense, with high asset valuations, stable asset prices over time but with rising short-term price volatility across key markets. There were strong price movements in foreign exchange and commodity markets, while capital-market issuance for corporate funding continued to increase.

The report identified several sources of market uncertainty, including the low-interest-rate environment, public debt policies in EU member states, and strong swings in exchange rates and commodity markets. Political and geopolitical risks in the EU’s vicinity also helped to drive increased levels of liquidity and market risk.

Hedge fund systemic risk. The new system for monitoring systemic risk in the hedge fund industry is based on sector-wide aggregated individual interdependencies of performance rates between individual hedge funds and the entire industry. The information is extracted by using a large set of fund-individual regression analyses and aggregating significant coefficients found across the industry. According to the report, when tested, the new method was able to identify successfully almost all financial crises included in the reporting sample, which was January 1995 through October 2013. The report claims that the results were robust with respect to variations in model specification, which increases the econometric reliability of the proposed measures.

Future vulnerabilities. The report includes ESMA’s findings on market developments that may present future vulnerabilities. One potential issue is the growth of funds investing in loans. ESMA acknowledged that this does offer a portfolio diversification opportunity, but it also creates exposure to credit and liquidity risk. The report concludes that while loan origination funds contribute to SME financing, the resulting financial stability risk should be carefully monitored.

A second area that could create future market vulnerability is the rapid growth of alternative index products. These products minimize certain weaknesses of traditional market capitalization-based indices, but they also expose investors to sector volatility and other risks. ESMA notes that alternative index products are not necessarily more risky than traditional models, but are often more opaque. A low level of transparency makes it difficult for investors to understand the risk-return profile of alternative indices, the report states.

Systemic stress. The report identifies trends in other areas, such as systemic stress. It finds that systemic stress showed higher volatility than in the previous reporting period, driven mainly by the equity markets. The report warns that, as evidenced by the higher implied fixed income volatilities, the potential for market corrections is high. Drivers of such a correction include weaker-than-expected economic recovery, persistent down-side influences including geopolitical tensions, pockets of stress in debt markets, expectations of divergent monetary policies, commodity prices and exchange rates dynamics, and the increasing emergence of vulnerabilities in market functioning, ESMA said.

Thursday, March 19, 2015

Members of Congress Urge SEC to Adopt Pay Ratio Rule

[This story previously appeared in Securities Regulation Daily.]

By Amanda Maine, J.D.

Fifty-eight members of Congress signed a letter sent to SEC Chair Mary Jo White calling on the Commission to adopt a rule requiring that companies disclose their CEO-to-worker pay ratio. Section 953(b) of the Dodd-Frank Act mandated that the SEC undertake a rulemaking to require publicly traded companies to disclose the ratio of the compensation of their CEOs to the compensation of their median worker. The SEC issued a proposing release in September 2013, but has yet to implement a final rule.

In the letter, the representatives said that adoption of the pay ratio rule is long past due. This information will be useful to boards of directors, investors, and others in assessing and understanding CEO compensation. According to research cited in the letter, the higher the CEO-to-median worker pay ratio, the more likely that CEO is to pursue the kind of risky investment strategies that contributed to the global financial crisis. The letter also cited a Center for Audit quality survey that found that 46 percent of investors consider CEO compensation in their decision making.

Advocacy group Public Citizen issued a press release applauding the representatives’ letter to White. The organization pointed out that more than 100,000 commenters have asked that the SEC finalize the pay ratio rule. According to Public Citizen, of the 400 rules mandated by Dodd-Frank, the pay ratio rule is the simplest. The press release scoffed at claims by major companies that calculating the number would be difficult and costly, describing as “ludicrous” Exxon’s claim that it would cost $100 million to identify its median paid employee.

Wednesday, March 18, 2015

SEC Charges 8 with Failing to Update Disclosures After Taking Companies Private

[This story previously appeared in Securities Regulation Daily.]

By Rodney F. Tonkovic, J.D.

The SEC has charged eight corporate insiders for failing to update Schedule 13D disclosures to reflect material changes, including going private transactions. The Commission found that the respondents had each taken significant steps to effect going private transactions that resulted in material changes from the disclosures previously made in their Schedule 13D filings. Each of the respondents settled the proceedings against them by paying civil penalties, without admitting or denying the Commission's allegations.

Andrew J. Ceresney, Director of the SEC’s Division of Enforcement, said that investors are entitled to current and accurate information. He added: “Stale, generic disclosures that simply reserve the right to engage in certain corporate transactions do not suffice when there are material changes to those plans, including actions to take a company private.”

First Physicians Capital Group transactions. Six of the orders relate to steps taken by the respondents in 2014 to take First Physicians Capital Group, Inc. (FPCG) private. The Ciabattoni Living Trust and Anthony and Jane Ciabattoni failed to amend their respective disclosures until June 20, 2014. The Trust and the Ciabattonis also engaged in 12 transactions acquiring or disposing of their beneficial ownership of FPCG securities between 2010 and 2014, but did not report any of these transactions until June 20, 2014. The Trust and the Ciabattonis were jointly and severally ordered to pay a civil money penalty in the amount of $75,000.

SMP Investments I, LLC and Brian Potiker waited approximately three months to update their Schedule 13D disclosure after taking steps to further the FPCG transaction. The Commission also found that SMP and Potiker violated Section 16(a) by failing to report material transactions in FPCG shares until months or years later. SMP and Potiker were jointly and severally ordered to pay a civil money penalty in the amount of $63,750.

Finally, William Houlihan waited approximately five months before amending his previous Schedule 13D after taking a series of steps to effectuate a going private transaction for FPCG. He also violated Section 16(a) by waiting more than five months to report a material transaction in FPCG shares. Houlihan was ordered to pay a civil money penalty of $15,000.

Shuipan Lin. Next, Shuipan Lin, Chairman and CEO of Exceed Company Ltd., failed to timely amend his Schedule 13D report after taking steps to take Exceed private. According to the Commission, Lin took steps to effectuate a going private transaction beginning in October 2012, but waited until August 20, 2013, to file an amendment to report that his plans or proposals concerning Exceed's shares had materially changed. Additionally, Lin did not file his initial Schedule 13D report until May 2011, even though his filing obligation began in October 2009, and he failed to report a subsequent acquisition of Exceed shares. Lin agreed to pay a civil penalty of $30,000.

Berjaya Lottery Management. Finally, Berjaya Lottery Management (H.K.) Ltd. violated its beneficial-ownership disclosure requirements in connection with actions it took to further a going private transaction for International Lottery & Totalizator Systems, Inc. (ILTS). Berjaya, a majority holder of ILTS securities, took steps to take the company private in July 2013, but did not amend its Schedule 13D to reflect this material change until March 2014. Berjaya was ordered pay a civil money penalty in the amount of $75,000.

The releases are Nos. 34-74497; 34-74498; 34-74499; 34-74500; 34-74501; 34-74502; 34-74503; and 34-74504.

Tuesday, March 17, 2015

Staff Reverses Position After GE Adopts Proxy Access Bylaw

[This story previously appeared in Securities Regulation Daily.]

By John Filar Atwood

In the latest chapter in what has been a controversial year for proxy access proposals, the staff of the Division of Corporation Finance has advised General Electric that it may omit a shareholder proposal after the company “substantially implemented” the proposal by adopting a proxy access bylaw. The staff originally denied GE’s request for omission in December. It is the first time that the staff has reversed its course on a proxy access proposal where the company’s adoption of a new policy rendered the shareholder proposal moot.

Proponent’s request. The proposal was submitted to GE by Kevin Mahar and requested that the company allow shareholders that have owned three percent of GE’s shares continuously for at least three years to include the names of their board nominees on the company’s proxy statement. Mahar’s proposal included the provision that the number of shareholder-nominated candidates could not exceed 20 percent of the number of directors then serving.

In December, the staff advised GE that it may not exclude Mahar’s proposal from its proxy materials under Rule 14a-8(b). GE had argued that it did not have to include the proposal because Mahar had failed to document that he owned the requisite number of GE shares. The staff denied GE’s request, noting that Mahar provided a written statement regarding his intent to hold GE’s common shares through the date of the meeting as required by Rule 14a-8(b).

GE’s new bylaw. In early February, GE amended its bylaws to put in place its own proxy access procedure. As reported in an earlier Securities Regulation Daily story, GE’s new bylaw permits a shareholder, or a group of up to 20 shareholders, owning three percent or more of the company’s outstanding common shares continuously for at least three years to nominate and include in the company’s proxy materials directors constituting up to 20 percent of the board.

In light of its new bylaw, GE wrote again to the SEC asking that it be allowed to omit Mahar’s proposal on the grounds that the company had already implemented it. The staff agreed, stating in its letter to GE that the company’s new proxy access bylaw addresses the essential objective of Mahar’s proposal.

Monday, March 16, 2015

Commissioner Piwowar Asks for Markets Input from Academics

[This story previously appeared in Securities Regulation Daily.]

By Mark S. Nelson, J.D.

SEC Commissioner Michael S. Piwowar told a group of financial academics today that he wants them to be more engaged in policy debates over securities regulations. Piwowar spoke about how academic research may aid the SEC’s nascent efforts to study equity market microstructure in a presentation to the Center for the Study of Financial Regulation at the University of Notre Dame’s Mendoza College of Business.

Piwowar lamented the SEC’s being slow to address market structure issues after last year’s “unsolicited prompting by a bestselling author” (a likely reference to Michael Lewis’s book Flash Boys, which prompted Congressional hearings about high-frequency trading and market structure after Lewis appeared on CBS’s 60 Minutes and said the U.S. stock market is “rigged”). Chair Mary Jo White has noted since that the SEC has brought its first cases against high-frequency trading firms, and has said the markets are neither "fundamentally broken" nor "rigged."

According to Piwowar, market microstructure academics can help the SEC to better understand market dynamics by evaluating the impact of the agency’s tick size pilot for small companies, and by following the activities of the new Market Structure Advisory Committee. But Piwowar said the agency needs to do more to push these initiatives forward. Piwowar said one step would be for the SEC to hold the roundtable he has asked Chair White to arrange so the Commission can review the Self-Regulatory Organizations’ assessment of the tick size pilot’s impact.

How else might academics aid the SEC’s market structure inquiries? Piwowar said academics can design their research to consider policy implications from the start, and not just as addendums to papers soon to be published. He also urged academics to submit public comments on rulemakings, especially the “data-driven” kind they alone can make.

But he worried that academics now submit too few comments. As an example, Piwowar observed in a footnote to his prepared remarks that only 10 academics (about 4 percent of all commenters) had offered their views on the SEC’s Concept Release on Equity Market Structure, which the agency published in 2010.

Piwowar said another way academics can get more involved in market policy is to mine the data published by the SEC from its Market Information Data Analytics System, or MIDAS. Still other possibilities include contacting regulators and other policymakers directly, and making sure to reply when these officials reach out to the academic community.

Friday, March 13, 2015

NASAA Questions Value, Viability of Venture Exchanges

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

NASAA has asked Congress to examine more closely the policy rationale behind any legislation that would establish “venture exchanges” for small and unestablished companies. In a written statement this week to the Senate Subcommittee on Securities, Insurance, and Investment, NASAA President William Beatty questioned the need for opaque and volatile venture exchanges, given the many existing ways that new and growing businesses can access investment capital.

Viability. Beatty questioned whether the enactment of new legislation would even result in the creation, let alone the success, of any venture exchanges. He noted that over the past 80 years, more than 20 regional stock exchanges have either have gone out of business or have been forced to merge with other exchanges to remain viable. The fact that a “venture exchange” does not already exist may be due to financial viability as opposed to regulation, Beatty said.

Low listing standards. NASAA also fears that facilitating the creation of exchanges with low listing standards may facilitate fraud at the expense of retail investors. The key to success, NASAA believes, will be to scale listing standards to the size of the enterprise while mainitaining adequate investor protections. The protections would include, at a minimum, a baseline standard that requires investor qualifications for participation.

Beatty emphasized that foreign venture exchanges are not unregulated marketplaces. These exchanges explicitly acknowledge that regulation is the key to success for both the exchange and the companies that trade on them. In NASAA's view, any “venture exchange” legislation should be based on a study of those markets and their successes and failures.

Preemption of state review. NASAA opposes the preemption of state review of offerings of securities listed on an exchange lacking rigorous listing standards. Beatty urged the lawmakers to maintain the regulatory balance struck by the National Securities Markets Improvement Act of 1996 and not extend exempt, “covered security” status to less stringent exchanges. Where an exchange does not qualify for “covered security” status, manual exemptions and other exemptions are available in a majority of states to facilitate secondary trading while providing for important investor protections, Beatty stated.

Regional diversity. Beatty also observed that prior regional exchanges often became focused on a particular industry or region, thereby magnifying economic downturns in those markets or regions. One way to avoid this risk in any future legislation, NASAA believes, would be to prohibit venture exchanges from denying a listing based on a company’s business location within the United States or based on the company’s industry of operations. This would help to create a diversity of listings that would better ensure the success of those exchanges, Beatty said.

Thursday, March 12, 2015

Futures Industry Girds for Cybersecurity Threats

By Lene Powell, J.D.

Former Senator Saxby Chambliss warned a futures industry conference that “nobody is immune” from cyberattacks, however big or small the firm, and that the enemy is very sophisticated. “You’d better have legal and technical advice” both before and in the aftermath of an attack, he advised. “Be prepared.”

In 2013, there were over 10 million cyber intrusions per day, resulting in a global cost of $445 billion, said Chambliss. The average cost to a firm of a cyber breach was $3.5 million.

As former Vice Chairman of the Senate Select Committee on Intelligence and Chairman of the Senate Agriculture Committee, Chambliss is uniquely positioned to advise the futures and derivatives industry of threats in this area. He is currently a partner at DLA Piper.

Cyberattacks. For a good overview, Chambliss said firms should read the most recent report by Mandiant, the cybersecurity firm. He also recommended a recent New York Times article about a massive bank robbery investigated by the Russian cybersecurity firm Kaspersky. In that crime, the criminals inserted malware into bank systems and patiently collected data over the course of many months, leading up to a synchronized attack in which ATM machines suddenly began pouring out cash, which was then collected by the criminals. They also adjusted bank accounts to reflect much higher balances for a short period of time, then sucked the money out of the accounts. The heist affected over 300 financial institutions in 50 to 60 countries, and the losses are approaching $1 billion, Chambliss said.

Ill-gotten gains are not always the aim of cyberattacks, Chambliss noted. The recent North Korean attack on Sony and Iranian attack on the Sands Hotel in Las Vegas were game-changers, because these attacks were the first time that attackers sought to inflict intentional damage on computer systems. These attacks came close to an act of war, and the parameters of what constitutes an act of war need to be defined.

Government response. According to Chambliss, forty-seven states have breach notification laws—and strict penalties for not following them. Federal legislation on information-sharing is needed, and he and Senator Dianne Feinstein had agreed on a bill, but it was not taken up by the last Senate. 

Chambliss said that a successful bill concerning information-sharing needs the following components to work:
  • Information-sharing must be voluntary;
  • Information must be available regardless of size of firm;
  • The framework must mesh with the framework established by the National Institute of Standards and Technology (NIST);
  • There must be a portal at the Department of Homeland Security, capable of processing data in real time;
  • There must be liability protection. If a firm acts in good faith, they must be protected from litigation;
  • Sharing must be permitted not only between the private sector and the federal government, but also between private firms, with no antitrust liability;
  • The system must be flexible.
Asked about “backdoors” introduced by our own government, Chambliss said a system with no backdoors is a mistake. The U.S. government needs to know what the bad guys are doing, without looking into the systems of the good guys any more than it needs to. The U.S. government has done a good job of that. The Chinese government is not necessarily as constrained, however, as it “wants to know everything.” 

As to whether there should be some kind of FDIC-type system to indemnify or reimburse market participants for breaches that occur as a result of government-created backdoors, Chambliss said that was an interesting concept, but he has not heard any discussion about it.

CFTC approach. In a later session, CFTC Chairman Timothy Massad said the agency is “keenly” focused on cybersecurity and has incorporated it into core principles and made it a priority in examinations. 

Massad said the CFTC cannot directly test firms’ systems due to limited resources, adding that many financial institutions spend more on cybersecurity than the agency’s entire budget. However, they are looking at whether the private companies that run core infrastructure, including exchanges and clearinghouses, are themselves adequately testing their cyber protections. The CFTC is holding a public staff roundtable on cybersecurity next week.

Exchange perspective. According to Jeffrey Sprecher, head of IntercontinentalExchange, a network of exchanges and clearinghouses including ICE and NYSE, it’s important to thoroughly test systems. One issue that comes up is how to handle system backups, because if you have a bug and you back up your system, you’ve just infected all your legacy data.

IntercontinentalExchange pays particular attention to risks posed by employees, going so far as to dock an employee’s pay if they fail a cybersecurity test.

“Your employees are keys, and they’re walking out the door every night,” said Sprecher.

Wednesday, March 11, 2015

Manhattan U.S. Attorney Still Feeling Effects of Newman

[This story previously appeared in Securities Regulation Daily.]

By Mark S. Nelson, J.D.

The U.S. Attorney’s Office in Manhattan recently filed a letter with federal Judge Valerie E. Caproni in the insider trading case of John Johnson to clarify that Johnson’s allocution and guilty plea from two years ago is no longer sufficient in light of the Second Circuit’s Newman opinion. Still, the government said it is ready to go to trial in Johnson’s case, or to have the court let him amend the allocation and re-plead. Judge Caproni had asked the government for its views last month (U.S. v. Johnson, March 6, 2015).

Johnson agreed to be prosecuted by a March 2013 information (rather than indictment) accusing him of conspiracy and with engaging in insider trading in violation of Exchange Act Section 10(b). According to the U.S. Attorney’s letter to Judge Caproni, Johnson’s testimony in another criminal case suggested that he chose not to find out key details about a tipper’s source of information concerning the expected acquisition of Foundry Networks, Inc. by Brocade Communications Systems, Inc. This showed Johnson’s attempt to create “a plausible level of deniability” about his trading, said the government.

Johnson, a second-degree tippee, had testified in the government’s case against David Riley. In that case, Judge Caproni last week denied Riley’s bid for judgment of acquittal or for a new trial based on the strength of the evidence against Riley, despite the Newman opinion. The judge was unpersuaded by Riley’s argument that Johnson could not have committed a crime under Newman. But the judge did acknowledged Newman would have influenced the wording of the jury instructions in Riley’s case had the Second Circuit issued its opinion earlier.

In Riley, Judge Caproni also rejected Riley’s argument that Johnson’s plea deal inadequately showed Johnson’s personal knowledge that the initial tipper got a benefit. Put another way, the judge in Riley said Johnson’s credibility as a witness who said he got material, nonpublic information and had pleaded guilty was unaffected by any conceivable post-Newman shift in Johnson’s motivation to testify favorably to the government. As a result, there was no plain error or prejudice to Riley from Johnson’s testimony.

The Newman case has brought renewed national attention to what until now has been a highly successful insider trading strategy pursued by Manhattan U.S. Attorney Preet Bharara, whose office has vigorously objected to the Newman panel’s outcome. The government currently seeks panel or en banc rehearing by the Second Circuit. The SEC also has urged the Second Circuit to upend Newman. Meanwhile, several other individuals who entered pre-Newman insider trading guilty pleas recently won a reprieve in another case from a federal judge who vacated their earlier pleas and instead entered pleas of not guilty based on Newman.

The case is No. 13Cr190.

Tuesday, March 10, 2015

Republicans Request Proof of SEC/DOL Coordination on Fiduciary Rulemaking

[This story previously appeared in Securities Regulation Daily.]

By John Filar Atwood

Two Republican lawmakers have written to Department of Labor (DOL) Secretary Thomas E. Perez requesting that he produce by March 18 documents that prove there has been coordination between the DOL and the SEC on the DOL’s rulemaking to expand the definition of fiduciary. Representative John Kline (R-Minn.), Chairman of the House Committee on Education and the Workforce, and Rep. Phil Roe (R-Tenn.), Chairman of the Subcommittee on Health, Employment, Labor and Pensions, said they were prompted to write by recent claims by SEC Commissioner Daniel Gallagher that DOL’s efforts to engage the SEC were a mere “check the box” exercise.

DOL rulemaking. DOL is working on a re-proposal to amend the definition of the term “fiduciary” to more broadly define as fiduciaries, employee benefits plans, and individual retirement accounts (IRAs) those persons who render investment advice to plans and IRAs for a fee. DOL initially proposed the rule in 2010, but withdrew it after the proposal drew criticism. DOL is now planning to move forward again with the rulemaking.

In their letter to Secretary Perez, Kline and Roe said that they remain concerned that the project could conflict with SEC rulemakings authorized by the Dodd-Frank Act. Specifically, Dodd-Frank Section 913 directs the SEC to study the standard of care for investment advisers and broker-dealers, and authorizes the SEC to promulgate rules based on the results.

Kline and Roe noted that policymakers have consistently warned that DOL’s approach could conflict with the SEC’s rulemaking, leading to uncertainty, higher costs, and less financial information for investors. Coordination between the agencies is necessary, they said, but it is not clear that it is occurring. As a result, they have requested documents and communications demonstrating the coordination between DOL and the SEC on the project.

Gallagher’s remarks. The lawmakers said that they were alarmed by Gallagher’s recent statement that to his knowledge DOL has not formally engaged the SEC commissioners on its rulemaking effort. Any efforts by DOL, he claimed, were merely designed to “legitimize the runaway train that is their fiduciary rulemaking.”

Kline and Roe stated that a revised notice of proposed rulemaking should not be issued until after Congress is satisfied that sufficient coordination has occurred between the SEC and DOL. They asked Secretary Perez to furnish all communications after September 19, 2011 between DOL and the SEC regarding the rulemaking. They also requested all documents and materials addressing how DOL has considered, adopted or discarded any concerns raised by the SEC as it revised its regulatory proposal.

The lawmakers asked Secretary Perez to provide the requested information by March 18, or to inform the committee in writing as to why he cannot meet the deadline and the date by which he will provide the requested information.

Monday, March 09, 2015

In Memoriam: Jim Hamilton



It is with great sadness that we share news of the passing of Jim Hamilton, a colleague and friend to those within Wolters Kluwer and, for nearly 40 years, a source of insight for the broader “World of Securities Regulation.”

Jim was Principal Analyst for Securities Law at Wolters Kluwer Law & Business. One of the nation’s most respected thought leaders in the securities arena, Jim was dedicated to his profession, to his colleagues, and especially to his readers. Over the course of his illustrious career tracking, analyzing, and explaining securities law, Jim authored countless reports, books, and articles relied on by practitioners both nationally and globally. This very blog was one of the company's first forays into social media. Jim held it to the highest of standards, and as a result the blog is one of the most widely read and cited in the industry.

Jim's expert insights, first recognized in his analysis of legislation in the 1980s, brought him fully into the spotlight when he was cited as an authority in the U.S. Senate Banking Committee report of the Dodd-Frank Act. His analysis of that legislation was — and remains — definitive. His commitment to accurate and impartial discussion of securities law has helped thousands of attorneys navigate the intricacies of this complex practice area.

For those of us who knew him, it was on a personal level that Jim will be most remembered. He was supremely generous: mentoring others (including many contributors to this blog), volunteering for countless writing assignments on short notice, and helping with sales presentations. Yet for all his knowledge, he was remarkably humble, always preferring to shine the spotlight on someone else's achievements even though his were, in many ways, without equal. Jim simply wanted the best for his company, his colleagues, and his readers.

By those privileged to know him, as well as those in the industry who benefitted from his extraordinary insights, Jim will be truly missed.

"Being neutral in discussing the material does not preclude being passionate about it. Even in my blog I try to be right down the line with everything, which has helped me maintain my credibility. Our customers need information that is objective and accurate so that they can form their own opinions." —Jim Hamilton.

* * * * *

Jim's colleagues share his passion, expertise, and commitment to excellence. This blog is part of Jim's legacy; as such it will continue to be published under his name, and will continue to serve practitioners as a source of insight, guidance and inspiration.

FSOC Official Spotlights Efforts to Evaluate Asset Management Risks

[This story previously appeared in Securities Regulation Daily.]

By Amy Leisinger, J.D.

In remarks at the Investment Adviser Association’s 2015 Compliance Conference, Treasury’s Deputy Assistant Secretary for the Financial Stability Oversight Council (FSOC) Patrick Pinschmidt discussed the organization’s work and recent changes to its nonbank-designation process, as well as its consideration of potential risks related to asset management products and activities. In his speech, the official noted that FSOC was designed to bring regulators together to look at the entirety of the financial system for potential risks to financial stability, to take a broad view in order to mitigate or even prevent a future financial crisis. “[R]isks are not always neatly packaged within particular asset classes or institutions and they don’t always align within the contours of our regulatory system,” he explained.

FSOC activities. Pinschmidt noted that FSOC’s primary role is to look across regulatory and industry-specific silos to assess and respond to vulnerabilities by means of interagency cooperative efforts. The council has established separate committees to conduct regular, focused discussions on market developments and emerging risks and, most recently, has considered issues surrounding market volatility, interest rate risk, benchmark reforms, and cybersecurity threats. FSOC’s annual report to Congress provides the council’s views with respect to particular risks throughout the financial industry and how those risks might be transmitted to the system as a whole, according to Pinschmidt. In addition, the official stated, FSOC makes recommendations as to how those risks could be addressed or mitigated that serve as guidance for the council’s agenda in the year ahead.

Asset management. Recently, FSOC has been more closely analyzing whether risks within the asset management industry could affect U.S. financial stability. To gather as much information as possible, Pinschmidt explained, the council has held public conferences and directed staff to study industry-wide products and activities to assess potential risks. FSOC is engaged in an ongoing dialogue with the industry, as high-quality information is central to FSOC’s efforts, the official stated, but more data is still needed to better understand the nature and impact of potential risks. “There is no universally accepted, bright-line definition for what constitutes a potential threat to financial stability,” he explained.

Pinschmidt also clarified that FSOC is not aiming to regulate the day-to-day operations of asset managers but instead is striving to assess potential financial-stability risks. In its request for comments on asset management and key risks, FSOC is seeking input on liquidity and redemption risk, leverage, operational risk, and resolution. Specifically, the official noted, the council wants to understand whether the structure of pooled investment vehicles fosters a “first-mover advantage” and how redemption rights and liquidity-management practices may affect investor incentives. FSOC also requests information as to the degree to which leverage use may increase the potential for forced asset sales and expose others to losses or unanticipated risks, according to Pinschmidt. As to operational risk, FSOC seeks input on the potential risks associated with significant transfers of client accounts or assets and asks whether asset managers’ reliance on service providers for key functions could have a negative impact in the case of serious service disruptions. The council also requests comment on various financial interconnections that could affect or complicate a resolution.

“[T]here is no predetermined outcome, and no final decisions have been made in terms of potential risks relating to asset management products and activities,” the official noted, and “it is premature to speculate on any particular course of action the [c]ouncil may take.”

Since the enactment of the Dodd-Frank Act, consumers are more informed, markets are more resilient, and regulators are more apt at identifying and responding to potential concerns, but “we must remain vigilant to potential threats, and that requires us to keep an eye on the full breadth of the financial markets,” Pinschmidt concluded.

Thursday, March 05, 2015

Venture Exchanges Could Boost Capital Formation for Small Companies, Proponents Say

[This story previously appeared in Securities Regulation Daily.]

By Lene Powell, J.D.

One-size-fits all stock trading has disadvantaged small companies and led to a significant decline in the number of listed companies and IPOs since the late 1990s, said investment banker David Weild in a meeting of the SEC Advisory Committee on Small and Emerging Companies. One possible solution, supported by Commissioner Daniel Gallagher, is to allow the formation of “venture exchanges” that have tailored periodic reporting and listing requirements more appropriate for small businesses.

Decline in IPOs. According to Weild, IPOs and the overall number of listed companies have been in serious decline. From 1998 to the present, listed companies in the U.S. fell from 9,000 to 5,000. IPOs fell from 500 per year to 150 per year, with the ranking falling from 1 to 2 in large IPOs and 1 to 12 in small IPOs. This has led to a decline in employment and innovation.

The reason for this is a one-size-fits-all market structure, which works for naturally liquid large and mid-cap stocks, but fails small, illiquid stocks, Weild said. Changes in order handling rules, Regulation ATS, Regulation NMS, and Sarbanes-Oxley have all played a role in this.

Venture exchange structure. The solution is to charter member-owned venture exchanges that permit listings of up to $2 billion in market value, said Weild. The exchanges and the companies they list would be exempt from order handling rules, Regulations ATS and NMS, unlisted trading privileges (Rule 12f-2), decimalization, Sarbanes-Oxley, and state blue sky laws. To create a pro-growth environment, they would be subject to SEC but not state review, SEC scaled disclosure, or JOBS Act research rules.

To support the exchanges, the SEC along with FINRA and DTCC should establish a “Venture Exchange Division.” This would institutionalize knowledge about venture exchanges and the small and emerging companies they list, Weild said.

Commissioner Gallagher said he is in favor of the rule changes necessary to allow venture exchanges, saying they are a “vital bookend” to JOBS Act rulemaking on Regulation A+. “We must depart from the failed policies and feeble ideas of the past, in order to pursue critically-needed innovation like Venture Exchanges. I believe this Commission has the courage and leadership to do so,” he stated.

Concerns. In a statement, Chair Mary Jo White agreed that one market structure might not fit all, and that the Commission must concretely focus on how to enhance the market structure for smaller companies. However, she noted that some early venture exchanges were not successful, and the reasons for this need to be carefully studied.

Commissioner Aguilar concurred, saying that venture exchanges are a possible solution to the “coming tsunami” of unregistered and unlisted shares of small businesses expected to come on the market due to new rules under Regulation A-plus, crowdfunding, and Rule 506(c) of Regulation D. But prior efforts to establish them in the U.S. have fared poorly, and a thoughtful and prudent approach is needed that carefully examines why the prior attempts failed, he said.

For example, the American Stock Exchange’s Emerging Company Marketplace (ECM) thrived for some time due to lower transaction costs, but the exchange eventually succumbed to a number of serious design flaws. Because profitable firms that joined the ECM eventually graduated to the American Stock Exchange, this created the impression that the ECM was populated only by unsuccessful companies. The exchange failed to properly screen firms and scandals led to the exchange’s reputation as a lawless Wild West. Also, narrow bid/ask spreads might have dissuaded broker-dealers from making markets for the stocks and distributing research on the companies, which may have decreased liquidity, said Aguilar.

To address these concerns, the SEC needs to look at specific questions of structure including dealer vs. auction markets, batch auctions vs. continuous trading, and possibly larger tick sizes, Aguilar said. Apart from these specific issues, though, it’s important for investors to understand that venture exchanges generally may have low liquidity and high volatility, meaning that investors could lose a lot of money quickly and could have trouble selling their shares in a downturn. And, in looking for the next Apple, Google, or Facebook, investors may not comprehend that venture exchanges tend to have a high proportion of small, early stage companies in high-risk business sectors, resulting in a higher risk profile than firms on traditional exchanges. The SEC needs to make sure investors understand these risks, cautioned Aguilar.

Senate Banking to examine. The topic of venture exchanges and small-cap securities will be examined at a Senate Banking Committee subcommittee hearing on March 10. Scheduled to testify are Stephen Luparello, Director of Division of Trading and Markets, as well as representatives from NYSE and NASDAQ OMX.

Wednesday, March 04, 2015

Staff Issues Guidance on Volcker Rule’s Covered Fund Exemption

[This story previously appeared in Securities Regulation Daily.]

By Jacquelyn Lumb

Commissioner Kara Stein last month spoke in Tokyo, Japan, about the changes the Dodd-Frank Act’s Volcker rule brought to the U.S financial system. In written remarks, which were recently posted by the SEC, Stein spoke about the rule’s value for enhancing systemic resilience and its broad global coverage. While Japan’s banks did not need a bailout in the 2008 financial crisis, Stein said its economy was affected by the global recession.

Stein’s guidance recommendation. The Volcker rule is in the process of being implemented and Stein recognized the need for meaningful guidance and responses to questions in a timely and transparent manner. Regulators cannot answer every question, she said, but that is no reason to delay the implementation of the rule. She recommended that the Volcker rule working group establish a deadline for responding or choosing not to respond to a question. She said it would be helpful for everyone to know the types of questions that are being asked before they are answered. Providing clarity and transparency around the guidance process will help the industry comply while also speeding up the effective implementation of this important financial reform.

Staff FAQ. The SEC’s Division of Trading and Markets, on February 27, updated its guidance under Section 13 of the Bank Holding Company Act, known as the Volcker rule, as it relates to the exemption for hedge fund or private equity fund activities that occur solely outside the U.S. (SOTUS). The guidance responds to whether the marketing restriction under the rule applies only to the activities of a foreign banking entity that is seeking to rely on the SOTUS covered fund exemption or whether it applies more generally to the activities of any person offering or selling ownership interests in a covered fund. According to the guidance, the regulatory agencies believe the marketing restriction applies to the activities of a foreign banking entity, including its affiliates, which seek to rely on the SOTUS covered fund exemption.

Marketing restriction. The marketing restriction provides that no ownership interest in a covered fund will be offered or sold to a resident of the U.S. –that is, the offer does not target U.S. residents. The staff notes that the marketing restriction constrains the foreign banking entity in connection with its own activities with respect to covered funds, which ensures that in seeking to rely on the SOTUS covered fund exemption, it does not engage in an offering of ownership interests that targets residents of the U.S.

If the marketing restriction were applied to the activities of third parties, the staff explained, such as the sponsor of a third-party covered fund, the SOTUS covered fund exemption may not be available in certain circumstances, such as where the risks and activities of the foreign banking entity with respect to its investment in the covered fund are solely outside the U.S.

A foreign banking entity or its affiliates that seek to rely on the SOTUS covered fund exemption must comply with all of the conditions of the exemption, including the marketing restriction. A foreign banking entity that participates in an offer or sale of covered fund interests to a resident of the U.S. cannot rely on the SOTUS covered fund exemption with respect to that covered fund.

The staff added that, where a banking entity sponsors or serves, directly or indirectly, as the investment manager, investment adviser, commodity pool operator, or commodity trading adviser to a covered fund, that banking entity will be viewed as participating in an offer or sale of the covered fund ownership interests. Accordingly, the foreign bank entity would not qualify for the SOTUS covered fund exemption if that covered fund offers or sells ownership interests to a resident of the U.S.

Tuesday, March 03, 2015

Corporations Are Not People in Delaware Courts, Cannot Be Expert Witnesses

[This story previously appeared in Securities Regulation Daily.]

By Joanne Cursinella, J.D.

Only a biological person can be an expert witness in Delaware under its Rules of Evidence, so the defendants in a shareholder litigation could not designate a corporation as their expert witness on the subject of a company’s value at the time of the transaction in question (In re Dole Food Co. Inc. Securities Litigation, February 27, 2015, Laster, J.).

Background. This action stems from the ligation of a breach of fiduciary duty claim that was coordinated with an appraisal proceeding (see Securities Regulation Daily Wrap up for December 10, 2014 for more on the appraisal action). Both actions arose from a take-private transaction involving Dole Food Company, Inc.

The defendants identified Stifel, Nicolaus & Company, Incorporated (Stifel), as their “expert witness” on the subject of Dole’s valuation and served an opening expert report that identified the corporation as its author. They served a rebuttal expert report that also identified Stifel. The actual humans who signed the reports were Seth Ferguson, a Stifel managing director, and Michael Securro, another Stifel employee. Neither signed in his official capacity, the court said, but rather as an authorized representative of Stifel.

When the plaintiffs noticed a deposition of the corporation, Stifel produced Ferguson as the biological person most knowledgeable about the reports. During this deposition, the plaintiffs attempted to ascertain if the defendants were really attempting to designate the corporation as their expert. When Ferguson claimed to have written the reports, defense counsel objected, claiming that Ferguson was not the expert—Stifel was.

Expert witnesses. Under Delaware Rules of Evidence, an expert witness must first be capable of serving as a witness. Rule 601 says that “[e]very person is competent to be a witness except as otherwise provided in these rules.” The plaintiffs focused on the word “person” here to claim that only biological persons were meant.

The court noted that statutory construction under the Delaware Code would appear to mandate the opposite result, that is, when a provision refers to a “person,” the term presumptively includes “corporations,” among other entities. But notwithstanding this, the Rules of Evidence make it clear that a witness must be a biological person, the court said. The court provided several examples of this, such as rules requiring that a witness must be able to testify from personal knowledge and that that a witness must be able to take an oath or make an affirmation.

A corporation is an artificial being, the court said, and having no mind, it must rely on the facilities of natural persons. Lacking a voice, the court continued, a corporation cannot testify. Lacking a mind , it cannot possess personal knowledge. Without a conscience, it cannot take an oath. “And because of its incorporeal nature, it cannot even meet Delaware’s statutory requirement that a person taking an oath do so ‘with the uplifted hand,’” the court concluded.

The court went on to say that these deficiencies cannot be finessed by testifying through an agent, as Stifel tried to do here. The court also said, however, that the inability of a corporation itself to testify does not mean that the testimony of biological persons who are agents or decision-makers of the corporation will not bind the corporation. But, given the requirements of the rules of evidence, the court concluded that a corporation could not, itself, serve as an expert witness.

Result. The court said that since a corporation cannot serve as an expert witness, Stifel cannot testify at trial. But as long as Ferguson confirms that he has adopted Stifel’s expert reports, then he will be allowed to testify about their contents. Ferguson has a body and brain, the court said, and if he is otherwise qualified, he can serve as an expert witness. Stifel has neither and cannot.

The case is C.A. No. 8703-VCL.