Wednesday, August 15, 2018

ICI, SIFMA offer recommendations on proposed Reg BI

By Amanda Maine, J.D.

Several organizations have written letters to the SEC commenting on its proposed Regulation Best Interest (Reg BI) and related proposals regarding investment advice professionals’ standards of conduct at the close of the comment period last week, including the Investment Company Institute (ICI) and the Securities Industry and Financial Markets Association (SIFMA). Both organizations were largely supportive of the SEC’s proposals, but described areas in need of improvement or clarification.

ICI. In its letter, ICI emphasized the importance of coordinating with the Department of Labor so that DOL explicitly recognize the SEC’s best interest standard once formally adopted. In addition, the ICI urged the SEC to explicitly affirm that its standards of conduct would preempt any state law standards of conduct inconsistent with the SEC’s.

ICI requested that the SEC specifically confirm that the proposed disclosure obligation on the scope and terms of a customer’s relationship with a broker-dealer and the broker-dealer’s incentives do not require the broker-dealer to separately calculate fund fees and expenses. According to ICI, funds are currently required to provide comparable, standardized fee disclosure, which is a better approach than requiring brokers to independently calculate fund fees. Not only would providing individualized cost disclosure be challenging and extremely costly for broker-dealers, this overemphasis on cost could discourage broker-dealers from recommending funds that offer investors other important benefits, ICI warned. Instead, funds should be allowed to direct customers to the detailed, standardized information about fund fees and expenses in the fund prospectus, rather than independently calculating fund fees.

ICI also advised that the SEC tailor its proposed conflicts of interest obligations on broker-dealers that recommend proprietary products to require that broker-dealers have policies and procedures reasonably designed to: (1) identify and disclose material conflicts of interest associated with such recommendations; and (2) mitigate or eliminate those material conflicts of interest that create a financial incentive for the broker-dealer representative. This approach would be consistent with that of the DOL under its now-vacated fiduciary rule and focuses on the representative’s conflict of interest, according to ICI.

In addition, ICI urged the SEC to adopt a single definition of “retail investor” for its rulemakings under Reg BI and proposed Form CRS and limit that definition to natural persons. ICI also recommended that the SEC refine its interpretation of an investment adviser’s fiduciary duty to be more consistent with existing law, including an acknowledgment that institutional advisory relationships can differ from retail advisory relationships. Finally, ICI advised that the SEC not incorporate certain broker-dealer rules into the regulatory framework for investment advisers.

SIFMA. SIFMA commended the SEC for its proposals which the Association believes will protect retail investors while preserving retail investor choice and access to the brokerage “pay as you go” advice model. However, it outlined certain changes that the SEC should incorporate into its final rulemaking. Regarding proposed Reg BI, SIFMA recommended that the definition of “retail customer” be harmonized with FINRA’s definition because the definition as proposed would result in inconsistent and redundant compliance structures.

SIFMA also urged the SEC to incorporate the “reasonable investor” definition of materiality set forth in Basic v. Levinson (U.S. 1988) into its interpretation for “material conflicts of interest” to ensure only meaningful disclosures, and not excessive disclosures that could overwhelm investors under the SEC’s proposed definition. By focusing on the significance a reasonable investor would place on withheld or misrepresented information, the SEC would promote consistency with the rest of the Exchange Act and achieve the SEC’s goal of meaningful disclosure, according to SIFMA.

In a similar vein, SIFMA stated that the conflict of interest obligations should not distinguish between financial and non-financial conflicts of interest, but instead whether the conflict is material. SIFMA feels that a distinction between the two is not meaningful, given that virtually all conflicts of interest have a financial motivation, even if attenuated.

Regarding the relationship summary under proposed Form CRS, SIFMA advised the SEC to adopt a simplified, less confusing, and more flexible approach to disclosure. Specifically, SIFMA objects to a “one-size-fits-all” Form CRS, citing concerns facing dually-registered broker-dealers/investment advisers. According to SIFMA, the proposed dual-registrant Form CRS would confuse investors by presenting information that may not be relevant to them. SIFMA’s letter includes two mockup Forms CRS reflecting possible approaches the SEC can take in making Form CRS more flexible.

While SIFMA urges the SEC to move forward without delay on finalizing its standards of conduct rules, it advised that compliance with the final rules fall under an implementation period of at least 24 months. Firms will need sufficient time to implement training programs and develop extensive infrastructure and systems to comply with whatever rules of conduct are eventually adopted, SIFMA explained.

Tuesday, August 14, 2018

SEC posts small entity compliance guide on scaled disclosure changes

By Amy Leisinger, J.D.

In anticipation of the changes to its definition of “smaller reporting company” (SRC) set to take effect on September 10, 2018, the SEC has issued a compliance guide for small entities explaining the modifications to reporting thresholds and filing requirements. The guide also provides examples concerning the potential application of the changes to the first periodic filings following effectiveness of the amendments and a chart of the specific scaled disclosure requirements available to SRCs.

Key provisions. Under the expanded smaller reporting company definition, a company with a public float of less than $250 million may provide scaled disclosures, up from the previous threshold of $75 million. A company with less than $100 million in annual revenues and either no public float or a public float of less than $700 million also may provide scaled disclosures; the definition previously restricted scaled disclosures to companies with less than $50 million in annual revenues and no public float.

A company that determines that it does not qualify as a SRC under either of these standards will remain unqualified until it determines that it meets one of two lower thresholds, set at 80 percent of the above initial thresholds: 
  • public float of less than $250 million (up from less than $50 million); and 
  • annual revenues of less than $80 million, if the company previously had at least $100 million in annual revenues; and less than $560 million of public float, if the company had at least $700 million of public float (up from less than $40 million in annual revenues and no public float). 
The Commission also amended Rule 3-05 of Regulation S-X to increase the net revenue threshold in that rule from $50 million to $100 million so that a company may omit financial statements of a business acquired or to be acquired for the earliest of the three required fiscal years if its net revenues are less than $100 million. A company required to file financial statements pursuant to the rule may apply the amended threshold in reports due after September 10, 2018.

Guidance for small entities. The guide notes that a reporting company will determine whether it qualifies as a SRC annually as of the last business day of its second fiscal quarter. A company calculates its public float by multiplying the aggregate number of shares held by non-affiliates by the price at which the common equity was last sold or the average of the bid and asked prices of common equity. A company that does not qualify under the “public float” test would determine whether it qualifies as a SRC based on its annual revenues in its most recent fiscal year completed before the last business day of the second fiscal quarter. If qualified, the company may elect to reflect its SRC status and use the scaled disclosure accommodations beginning with its second quarter Form 10-Q, and it must reflect its SRC status in its Form 10-Q for the first fiscal quarter of the next year, the staff explains.

A company that completed its initial public offering since the end of its most recent second fiscal quarter may elect to determine SRC qualification based on public float as of the date it estimated its public float before filing or as of the end of the offering based on offering price and shares sold, according to the guide.

Foreign companies meeting the applicable thresholds may use the SRC scaled disclosure accommodations if they use domestic forms instead of the separate forms for foreign private issuers and prepare financial statements in accordance with U.S. GAAP, the guide explains. However, the staff cautions, investment companies, asset-backed issuers, and majority-owned subsidiaries of a parent that is not an SRC are not eligible for SRC status.

Monday, August 13, 2018

Blockchain and the legal profession featured at Chicago-Kent law school conference

By Brad Rosen, J.D.

A conference about the law’s future titled Block (Legal)Tech, held at the Chicago-Kent College of Law, attracted an A-list collection of speakers and panelists exploring the evolving digital asset landscape and its impact on legal practice. Some 600 attendees from across the country gathered to hear from a number of industry leaders, top blockchain lawyers, educators, and law enforcement officials, including the Treasury Department’s FinCEN Director Kenneth Blanco.

Advancing innovation while protecting the integrity of the financial system. One of the highlights of the conference were the remarks of FinCEN Director Kenneth Blanco and then a follow up fireside talk. Blanco was appointed to the director position in December 2017. Some of Blanco’s main points included:
  • FinCEN is swiftly and continuously building its capabilities and understanding in the emerging technologies space to rapidly identify risks, close gaps, and support responsible innovation through clarity.
  • Suspicious Activity Reporting (SAR) reporting is of critical importance to FinCEN’s work in the virtual currency space to help identify emerging threats and typologies for the sake of the victims that are targeted, for financial institutions to better understand and effectively report on these threats, and for public trust and reliance in the good work being done in the financial innovation space.
  • FinCEN will continue to update its guidance relating to emerging technology, such as virtual currency, in close dialogue with industry, so that it improves its understanding of both the risks and the clarity that is needed to support responsible innovation.
  • FinCEN will aggressively pursue individuals and companies who do not take their obligations under U.S. law seriously, whether by targeting victims or enabling those who do. 
Below are some of the other highlights and key takeaways from the content-packed conference:

The genie is not going back into the bottle. Joshua Klayman, a leading blockchain legal thinker and founder of Klayman LLC, pointed to reports that over $10 billion has been raised in ICOs in the first half of 2018, notwithstanding the complex and sometimes contradictory regulatory framework in the U.S. Klayman noted, “In our blockchain space, the very speed of change appears to be accelerating. What we tinfoil hat wearers hoped for in 2016 is beginning to happen…Bitcoin futures exist in our present. Hedge funds are trading cryptocurrency. Governments around the globe are moving forward with blockchain technology initiatives.” Klayman also noted that blockchain developments have impacted virtually every legal practice area.

To escape the laws of gravity, it helps to understand them. Stephen Palley, a partner with Anderson Kill, who described himself as someone who sues insurance companies for a living, touched upon a number of crypto-law counsel conundrums. On the subject of considering whom to sue in the crypto space, he observed that a DAO (“decentralized autonomous organization," which might include miners, nodes, token-holders or a combination of some or all of these) sounds to him a lot like an unincorporated association, and that’s not a good thing for a DAO.

Beware blockchain’s treacherous vocabulary. Angela Walch, a professor at St. Mary’s University School of Law, implored blockchain lawyers to be the grownup in the room and continuously bring their critical thinking skills to bear in the digital assets arena. Walch bemoaned legislation passed in Arizona where “blockchain technology” was defined unartfully and which she observes will create more problems than it solves. Unfortunately, adding insult to injury, “the Arizona legislation has served as a model for other states,” observed Walch. Walch underscored the importance of lawyers’ gatekeeper role. “Lawyers play a critical role. They must force their clients to be specific and precise,” she concluded.

Hope for a brighter tomorrow. Alexandra Prodromos, a business development manager at Bloq, pointed to the explosion in ICO activity at the end of 2017 and its carry through the first half of 2018. Prodromos also optimistically pointed to the recent comments from the SEC’s Corporation Finance Director William Hinman about the ether token not being deemed a security at this time.

A word about Kent-Law School and legal technology. Chicago-Kent has historically had a strong commitment to preparing students for technological innovation and new frontiers in the legal industry. Conference organizers Professor Daniel Martin Katz and Nelson Rosario were also the instructors for one of the first Blockchain Law classes offered in the world earlier in 2018. The law school also features the Law Lab, an interdisciplinary teaching and research center focused on legal innovation and technology. The Block (Legal)Tech conference was part of the law school’s ongoing efforts to bring high quality legal education to the legal and business communities.

Friday, August 10, 2018

HM Treasury details financial services legislation approach to Brexit

By Amy Leisinger, J.D.

HM Treasury has set out its approach to financial services statutory instruments (SIs) under the EU (Withdrawal) Act. According to the ministry, during the implementation period, the UK will continue to implement new EU law that comes into effect and be treated as part of the EU’s single market and access between UK and EU markets will continue on current terms. The Act converts the existing body of applicable EU law into UK domestic law, and HM Treasury plans to delegate authority to the UK’s financial services regulators to address any deficiencies resulting from Brexit.

The publication notes that the implementation period agreed to by the UK and the EU will be in place between March 29, 2019, and December 31, 2020, providing time to introduce new arrangements, but that UK firms will need to comply with any new EU legislation during the implementation period. EU and third-country infrastructures with existing EU authorization will continue to be able to provide services to the UK to prevent disruption. A stable process for maintaining equivalent regulatory outcomes and a collaborative relationship between supervisors is crucial to protecting both UK and EU financial systems, the HM Treasury explains.

In addition to addressing the possibility of a ‘no deal’ scenario, the publication notes that the Act gives ministers the power to prevent or mitigate any failure of retained EU law to operate effectively, and HM Treasury intends to provide regulators with the ability to introduce transitional measures to phase in onshoring changes and the authority to address deficiencies or redundancies that may arise when the UK leaves the EU.

EU firms operating in the UK would broadly become subject to the same supervisory regime that the UK already applies to other countries, but the ministry acknowledges that a different approach may be necessary in certain circumstances to minimize disruption, avoid unintended consequences for service continuity, and provide protection for UK consumers.

HM Treasury intends to lay the first financial services onshoring SIs in the near future, the first providing a temporary permission regime and delegating authority to cure deficiencies to UK financial services regulators.

Thursday, August 09, 2018

Supreme Court asked to address proximate cause standard in securities cases

By Rodney F. Tonkovic, J.D.

A petition for certiorari has been filed asking the Supreme Court to address the Ninth Circuit's standard for loss causation. At issue is what the petitioner describes as a three-way split in how the appellate courts require a plaintiff to show the market's reaction to information revealing the fraudulent nature of the defendant's conduct. The petition argues that the Ninth Circuit has adopted a "dramatically less demanding" proximate cause standard for proving loss causation that is inconsistent with the Court's precedent (First Solar, Inc. v. Mineworkers' Pension Scheme, August 6, 2018).

Proximate cause. Investors in First Solar, Inc., a producer of solar panels, alleged that the company and its management concealed a manufacturing defect that reduced the performance of its products. First Solar, for its part, countered that the plaintiffs could not meet their burden to establish that the alleged concealment was the actual cause of their losses. The district court was tasked with weighing competing lines of Ninth Circuit case law on loss causation. A line of cases favoring the plaintiffs stems from In re Daou Systems, Inc. (9th Cir. 2005), and takes the position that loss causation is satisfied by drawing a causal connection between the misrepresented facts and the plaintiff's loss. In a more restrictive line urged by First Solar (following Metzler Investment GMBH v. Corinthian Colleges, Inc. (9th Cir. 2008)), an injury is not enough, and a plaintiff must show a market reaction to the fraud itself.

The district court opted to follow Daou and its progeny, but recognizing that the two lines of cases would lead to very different results, court certified a question for interlocutory appeal to the Ninth Circuit asking "What is the correct test for loss causation in the Ninth Circuit?" The Ninth Circuit panel held that the loss causation inquiry "requires no more than the familiar test for proximate cause." Here, the panel pointed to its most recent decision on loss causation, Lloyd v. CVB Fin. Corp. (decided after the district court's order) holding that "the ultimate issue is whether the defendant’s misstatement, as opposed to some other fact, foreseeably caused the plaintiff’s loss." The more restrictive cases in the Metzler line, the panel said, are simply fact-specific variants of the basic proximate cause test.

The panel then concluded that the district court applied the correct test in determining that the evidence could satisfy the proximate cause test with respect to five out of the six alleged price declines. Without reaching any other issue presented in the case, the panel affirmed the district court's judgment.

Showing loss. The petition asks whether a private securities-fraud plaintiff may establish the critical element of loss causation based on a decline in the market price of a security where the event or disclosure that triggered the decline did not reveal the fraud on which the plaintiff’s claim is based. The petitioner notes that the Court has made clear in Halliburton (2011) that loss causation may be established to the extent that a price decline is caused by the revelation of a misrepresentation to the market. At issue here is what is required to make that showing.

According to the petition, there are three approaches, and three different ways that this case could have come out, depending on where it had been filed. The First, Fourth, Seventh, and Eleventh circuits require a showing that the market learned of and reacted to information that revealed the fraudulent nature of the defendant's conduct. The Second, Fifth, Sixth, and Tenth circuits take a more permissive approach and hold that a plaintiff must show that the market learned of and reacted to the facts fraudulently concealed by the defendant, even if the fraud itself was not revealed. Finally, the Third Circuit (plus the Ninth in this decision) holds that a plaintiff can prove loss causation by "tracing" the information revealed to the market back to the facts concealed by the defendant, even if the market was ignorant at the time of both those facts and the fraud.

The petition also asserts that the Ninth Circuit's decision ignores Supreme Court precedent, the basic principles of proximate causation, and the structure of the PSLRA. The decision, the petition explains, effectively removes the established requirement that a plaintiff must prove that a price decline was the result of a revelation of a misrepresentation rather than some other intervening cause. With such a dramatically less demanding standard for proving loss causation, the Ninth Circuit, already host to a majority of securities class actions, will see those numbers grow, the petition says.

The petition is No. 18-164.

Wednesday, August 08, 2018

IAA expresses concerns about SEC’s proposed standards for financial professionals

By Amanda Maine, J.D.

The Investment Adviser Association (IAA), in a comment letter to the SEC, raised a number of concerns with the Commission’s package of proposals regarding the standards of conduct for broker-dealers and investment advisers. While IAA believes that the proposals take important steps towards strengthening the standards of conduct and reducing investor confusion, the comment letter outlines several issues that IAA would like to see addressed before the rules are finalized.

Reg BI. The letter notes that broker-dealers are excluded from the Investment Advisers Act and its fiduciary duties of both loyalty and care if the investment advice they provide is “solely incidental” to their broker-dealer business and they receive no “special compensation” for their services. IAA expressed concern about what it believes is the limited scope of the proposed standard and advised that the Commission should reconsider when broker-dealers should be able to rely on the solely incidental exclusion. The narrow scope and application of proposed Regulation Best Interest (Reg BI) could result in a gap in retail investor protection. IAA recommends that all advisory activities that broker-dealers agree to provide (such as ongoing monitoring for purposes of recommending changes in investments) should be covered by either Reg BI or the fiduciary standard under the Advisers Act.

In addition, IAA called on the SEC to “more appropriately define” what advice is considered to be solely incidental to brokerage activities. In particular, IAA recommends the position previously taken by the SEC that discretionary investment advice should not be deemed solely incidental to brokerage services. IAA’s letter notes that while the Commission’s 2005 rule relating to the Advisers Act solely incidental exclusion was later vacated, the court did not question the validity of the Commission’s interpretation on investment discretion. IAA also cited, and agreed with, a 2007 interpretive rule stating, “when a broker-dealer exercises investment discretion, it is not only the source of investment advice, it also has the authority to make the investment decision,” and warrants the protections under the Advisers Act.

However, IAA stated that it supports the proposal to require more explicit broker-dealer disclosures and recommended that the disclosures be integrated more closely with the SEC’s proposed relationship summary.

Form CRS. Regarding the SEC’s proposed Form CRS, which would require registered investment advisers, broker-dealers, and dual registrants to deliver a standalone relationship summary containing short and concise information about their advisory or brokerage relationships, IAA supports the idea of such transparency. However, IAA believes that Form CRS as proposed may exacerbate the investor confusion it was intended to address. IAA makes the following recommendations: that the SEC (1) publish the findings of its investor testing of proposed Form CRS; (2) provide the educational comparison between investment advisers and broker-dealers on its website rather than requiring firms to include disclosures about other firms’ services; (3) streamline the relationship summary to eliminate technical language and industry jargon; (4) leverage important investor disclosures, including those relating to conflicts of interest, from Form ADV brochures; and (5) provide a longer compliance date for new relationship summaries.

Title restrictions. IAA believes that the SEC’s proposed restrictions on broker-dealers using the titles “adviser” or “advisor” are a step in the right direction but recommends that the Commission take further steps toward reducing investor confusion in this space. These steps include what IAA describes as misleading marketing practices, noting as an example advertisements stating “we do it all” and other verbiage that would leave a reasonable investor with the impression that the firm will provide ongoing investment advice pursuant to a relationship of trust and confidence.

Fiduciary standard. IAA expressed its support that the SEC has reaffirmed the fiduciary duty under the Advisers Act and does not believe that is necessary for an interpretation on the fiduciary duty. IAA did, however, offer recommendations to further refine and clarify the SEC’s proposal regarding the fiduciary rule, including a more principles-based approach to the duty of care discussion, particularly related to the discussion of a client’s investment profile.

IAA also recommends that, regarding the discussion on the duty of loyalty, the SEC clarify what a full and fair disclosure of potential conflicts of interest entails, noting that such disclosure for an institutional client can differ substantially from disclosures for a retail client. IAA also asks that the SEC make clear that advisers are not required to obtain express consent but may infer consent from facts and circumstances to make an informed decision.

Tuesday, August 07, 2018

Securities Regulation Daily’s top 10 developments for July 2018

By Brad Rosen, J.D.

July saw a number of significant developments taking place that will set the tenor for the legal and regulatory environment in both the long and short terms. Let’s get to it!

Notably, President Trump chose D.C. Circuit Judge Brett Kavanaugh to replace retiring Supreme Court Justice Anthony Kennedy. While the securities bar may focus on the nominee’s track record on cases involving separation of powers and administrative law judges, commercial speech, corporate governance, SEC enforcement, and private securities suits, a major partisan battle continues to brew over the judge’s confirmation.

Matters involving virtual currencies and technology also loomed large. In a widely followed administrative determination, the SEC again rejected the Winklevoss’ Bats BZX Exchange bid to launch an exchange traded fund based on Bitcoin. Meanwhile, members of the House Ag Committee questioned an A-list group of witnesses about the appropriate oversight of new assets in the digital age. FINRA had some questions of its own as it solicited comments on the provision of data aggregation services, supervision of artificial intelligence use, and the development of a machine-readable rulebook.

The month also saw additional efforts towards further regulatory streamlining advances. In one instance, the House of Representatives passed a package of securities and banking bills that will make it easier for smaller companies to raise capital funds. Also, in July the SEC proposed rule amendments to further streamline debt offering disclosures. Meanwhile, Deutsche Bank affiliates settled an SEC enforcement action for nearly $75 million in connection with mishandling certain “pre-released” ADRs.

Things are also shaping up over at the CFTC. Commissioner nominee Dan Berkovitz testified before the Senate Agriculture Committee with flying colors. The full Senate will consider his confirmation in the near future, as well as that of Dawn Stump. During the month, CFTC Chairman J. Christopher Giancarlo again appeared before House Agriculture Committee, providing a periodic update on derivatives-related issues, including the increasingly precarious status of the existing U.S.-E.U. agreement on regulating derivatives clearinghouses and the proper role of the CFTC.

Last, but not least, the careful structuring of an “Up-C” combination by the fiduciaries over at Earthstone Energy carried the day in a legal tussle with a company stockholder, insofar as the Delaware Court of Chancery was concerned.

As summer heads into its final stretch, Securities Regulation Daily will continue bringing all the legal and regulatory news for the financial markets fit to print. As always … stay tuned.

Monday, August 06, 2018

Deal price, less synergies, best evidence of share value in fair merger process

By Amy Leisinger, J.D.

In an appraisal action resulting from a 2016 acquisition, the Delaware Chancery Court found that that the fair value of the petitioners’ shares is the deal price with a deduction for merger synergies—$53.95 per share. According to the court, the sale was completed in an open process characterized by objective indications of reliability, including many opportunities for potential buyers to bid and the work of a special committee in structuring and completing the deal. Evidence also demonstrates that the market for the stock was efficient and well-functioning, the court stated (In re Appraisal of Solera Holdings, Inc., July 30, 2018, Bouchard, A.).

Merger process. In 2015, the chairman and CEO of Solera Holdings, a provider of data and software for automotive, home ownership, and digital identity management, began to explore means by which to access financing, including a potential sale. After the executive’s efforts in testing of the waters, the Solera board formed a special committee, which determined to solicit bids from potential buyers. After a two-month outreach period and a six-week auction, Solera’s board ultimately accepted an offer from Vista Equity Partners for $55.85 per share (approximately $3.85 billion in total equity value), judged by advisors as fair from a financial point of view. Following a go-shop period, the merger closed, and Solera’s stockholders voted to approve the merger.

Seven funds that were Solera stockholders filed a petition for appraisal of their shares. Relying on a discounted cash flow analysis, the petitioners argued that fair value is $84.65 per share, and, following a recent appraisal determination in a separate matter, Solera contended that “unaffected market price” of a company’s stock should determine fair value—that is, $36.39 per share.

Deal price less synergies is fair. The court noted that, under the appraisal statute, “the stockholder is entitled to be paid for that which has been taken from him” and that courts have used different approaches to determine fair value, including comparable transaction analyses, discounted cash flow models, and final merger price. However, many decisions have found that the deal price is “the best evidence of fair value” when the sale process presents “objective indicia of reliability,” the court explained.

The Solera/Vista merger was the product of an open process conducted by an independent special committee with competent legal and financial advisors, according to the court. Many potential buyers had the opportunity to bid, the court stated, and the special committee played an active role in negotiating a fair, arm’s-length transaction, the court explained. The record also suggests that the sale process was conducted within an efficient and well-functioning market for Solera’s stock, according to the court. Declining to add merger fees to the deal price, the court found that “the deal price, minus synergies, is the best evidence of fair value and deserves dispositive weight” and stated that, as such, the petitioners are entitled to $53.95 per share as the fair value of their Solera shares of Solera, plus interest accrued since the close of the merger.

The case is C.A. No. 12080-CB.

Friday, August 03, 2018

Staff addresses soliciting materials in update to C&DIs on proxy rules and Schedules 14A and 14C

By John Filar Atwood

A soliciting party may voluntarily submit a notice of exempt solicitation even if the party is not subject to 1934 Act Rule 14a-6(g)(1) as long as the cover of the notice clearly indicates that it is being filed voluntarily, according to the staff of the Division of Corporation Finance. The staff offered advice on this topic in an update to the compliance and disclosure interpretations (C&DIs) on the proxy rules and Schedules 14A and 14C. The new C&DIs replace the interpretations published in the manual of publicly available telephone interpretations and the March 1999 supplement to the telephone interpretations.

Rule 14a-6(g)(1) requires that any person who engages in a solicitation pursuant to 1934 Act Rule 14a-2(b)(1) and beneficially owns over $5 million of the class of securities that is the subject of the solicitation to furnish or mail to the Commission a statement containing the information specified in the notice of exempt solicitation. The statement must be sent no later than three days after the date the written solicitation is first sent or given to any security holder. 1934 Act Rule 14a-103 requires the soliciting party to attach only those written soliciting materials “required to be submitted” pursuant to Rule 14a-6(g)(1).

Voluntary filing. The staff stated that it will not object if a notice of exempt solicitation is filed voluntarily provided that the written soliciting material is submitted under the cover of notice of exempt solicitation, and the cover clearly states that the notice is being provided on a voluntary basis. In the staff’s view, disclosing that the submission is being made voluntarily will make it clear to investors the nature of the submission and that it is being made on behalf of a soliciting party who does not beneficially own more than $5 million of the class of subject securities.

Rule 14a-6(g)(1) requires a notice of exempt solicitation to contain the information specified in Rule 14a-103, including the name and address of the person relying on the exemption in Rule 14a-2(b)(1). The staff advised that when submitting a notice of exempt solicitation electronically on EDGAR, the written soliciting material cannot appear in the notice before the Rule 14a-103 information is presented.

Order of presentation. According to the staff, Rule 14a-103 is designed to be a “cover” to which previously disseminated written soliciting material is “attached.” Consequently, when submitting a notice on EDGAR, whether voluntarily or to satisfy the requirements of Rule 14a-6(g)(1), all of the information required by Rule 14a-103 must be presented in the submission before any written soliciting materials. The staff noted that this applies to any logo or other graphics used by the soliciting party.

The staff advised that to the extent that the notice itself is being used as a means of solicitation, the failure to present the Rule 14a-103 information in the manner described may be misleading within the meaning of 1934 Act Rule 14a-9. Any determination about whether the presentation of information is misleading will depend upon the particular facts and circumstances, the staff added.

Thursday, August 02, 2018

Senate joins House in passage of defense bill with CFIUS reforms

By Mark S. Nelson, J.D.

The Senate passed the John S. McCain National Defense Authorization Act for Fiscal Year 2019 with its significant reform provisions for the entity charged with reviewing many business deals that involve foreign companies. Subtitle A of Title XVII of the NDAA conference report contains the Foreign Investment Risk Review Modernization Act (FIRRMA), which will change how the Committee on Foreign Investment in the United States (CFIUS) reviews mergers and acquisitions that involve foreign acquirers of U.S. businesses. The legislation passed despite objections made by a group of senators to the conference report’s removal of a provision that would have reversed President Trump’s decision to allow Chinese telecommunications company ZTE Corp to do business in the U.S. Although the Administration had objected to the ZTE provision in an earlier version of the NDAA, it otherwise backed the CFIUS reforms. The Senate voted 87-10 to adopt the NDAA conference report, while the House previously adopted the conference report by a vote of 359-54. The conference report now goes to the White House for the president’s signature.

CFIUS gets broader mandate. One of the most significant changes is the addition of new types of “covered transactions” that CFIUS can review. Specifically, the reform package adds four categories of covered transactions: (1) real estate transactions in the U.S. where a foreign person would buy or rent property near military installations; (2) investments by foreign persons in any unaffiliated U.S. business that owns or operates critical infrastructure, develops critical technologies, or maintains or collects U.S. citizens’ personal data that may be exploited in a manner that threatens national security; (3) changes in the rights regarding a foreign person’s investment in a U.S. business; and (4) any other transaction designed or intended to evade CFIUS review. The new categories of review apply to transactions proposed, pending, or completed on or after the effective dates specified in Section 1727 of the NDAA.

The revised law retains most of the existing mandate to review any merger, acquisition, or takeover that is proposed or pending after August 23, 1988 that may result in foreign control of a U.S. business, including transactions achieved via a joint venture. There are, however, some changes in phraseology; for example, the prior version of the law referred to “any person engaged in interstate commerce in the United States” whereas the revised law refers to “United States business.” The revised law also adds the reference to joint ventures.

Other provisions and reports. The reform package would extend the time for CFIUS review of a transaction from 30 days to 45 days, with the possibility of a 15-day extension in extraordinary circumstances. The CFIUS reforms further provide that any civil challenges to actions and findings made under the applicable law must be brought in the D.C. Circuit Court. The president also is directed to determine if CFIUS needs additional resources and to request funding for those resources from Congress.

Moreover, three federal departments would have to study and report on specific topics related to CFIUS’s work: (1) the secretary of Commerce must report every two years until 2026 to Congress and CFIUS on foreign direct investment transactions by Chinese entities in the U.S.; (2) the secretary of Homeland Security must report to Congress one year after enactment on investments in U.S. rail and rolling stock by state-owned or state-controlled entities; and (3) the treasury secretary must brief Congress within 60 days of enactment regarding CFIUS reviews of transactions during the past five years in which CFIUS found that the transactions would have allowed foreign persons to inappropriately influence democratic institutions and processes in the U.S. and elsewhere.

Wednesday, August 01, 2018

SEC requests comments on proxy rule revision

By Jay Fishman, J.D.

The SEC issued a statement from Chairman Jay Clayton asking investors, issuers, and other market participants to comment on whether the Commission’s existing proxy rules should be refined in advance of a fall 2018 roundtable that will discuss the matter. The SEC requests the public to submit comments about the Commission’s current proxy process before or after the roundtable in either electronic or paper form.

Reason for roundtable. Chairman Clayton remarked that the roundtable is needed to reassess the proxy process and shareholder engagement in light of the many changes that have occurred in the financial markets, corporate governance, and technology since the Commission last issued a concept release in 2010, which addressed whether the proxy process at that time met shareholder and U.S. public company expectations for accuracy, reliability, transparency, accountability, and integrity.

Potential topics. The potential topics for consideration at the roundtable could include: 
  • The proxy voting process, specifically the potential for broker-dealers to over- or under-vote the securities; the practical difficulties with confirming whether an investor’s shares have been voted according to the investor’s instructions; and the costs and challenges associated with distributing proxy materials to beneficial owners who hold in “street name”;
  • The reasons why retail shareholders typically vote a low percentage of their shares compared to institutional investors, and whether better communication, coordination among proxy participants, increased use of technology, rule changes, and investor education could boost retail shareholder participation;
  • An assessment of the current shareholder proposal process, specifically how to allow for more shareholders to submit proposals to be voted on without increasing the cost of that process;
  • An assessment of proxy advisory firms in the current proxy voting process, particularly whether investment advisers to funds and other clients over-rely on proxy advisory firms for information and voting recommendations, as well as whether issuers are provided with an opportunity to raise concerns if they disagree with a proxy advisory firm’s recommendations;
  • A determination of the benefits and consequences resulting from further reliance on, and changes in, technology, and whether technology can be used to make the proxy process more effective for participants; and
  • An assessment of the current rule requiring the use of universal proxy cards that contain all nominees’ names in contested board of director elections, which currently makes it difficult for shareholders to vote for a combination of directors from the management and dissident slates without attending the shareholder meeting in person.
Comments. Electronic commenters should use the SEC’s Internet submission form or send an email to rule-comments@sec.gov. Paper commenters should mail their comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington D.C. 20549-1090. All comments must refer to File Number 4-725 and, if email is used, the file number should be included on the subject line. The SEC will disclose the date of the roundtable at a later time.

Tuesday, July 31, 2018

Commissioner Peirce grapples with the meaning of ‘fiduciary’ versus ‘“best interest,’ and the implication for investors

By Brad Rosen, J.D.

SEC Commissioner Hester Peirce conducted a deep rhetorical dive in exploring the meaning and differences between the terms “fiduciary” and “best interest” in the context of recently proposed standards for investment advisers and broker-dealers providing investment assistance to investors. In remarks titled What’s in a Name? Regulation Best Interest v. Fiduciary, the commissioner reached the following bottom line conclusions: (1) both terms can have multiple meanings; (2) there are only two major differences in the standards implied by the terms; and (3) the impact on retail broker-dealer customers could be dire.

A fiduciary. In April 2018, the SEC considered the appropriate standards that should apply between investors and investment advisers, as well as between investors and broker-dealers. With respect to investment advisers, the Commission issued an interpretive release clarifying certain aspects of the fiduciary duty that an investment adviser owes to its clients under Section 206 of the Advisers Act. The Commission stated that the duty of loyalty component of an adviser’s fiduciary duty requires the adviser to acquire “informed consent” from its clients to any material conflict of interest that could affect the advisory relationship.

Commissioner Peirce, however, questions whether the Commission got that interpretation right, noting that “the Commission cites, not a court decision or other weighty legal precedent, but an Instruction to Form ADV.” She also observes, “The term “fiduciary” has become such an oft-repeated mantra that I worry it will have the perverse effect of harming investors. Investors are told repeatedly that all they need to ask is one simple question about their financial professional: Are you a fiduciary?” Commissioner Peirce concludes, “In short, the term fiduciary duty is not easy to define even within the advisory context.”

Regulation Best Interest. Proposed Regulation Best Interest was also released in April of this year, and it addressed the standards applicable to broker-dealers. In short, the regulation requires a broker-dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, to act in the best interest of the retail customer at the time the recommendation is made without placing the financial or other interest of the broker-dealer ahead of the interest of the retail customer.

Commissioner Peirce, in her remarks, critically observes: “As with the fiduciary standard … one has to ask: regardless of how nice it sounds, what does “best interest” actually mean? The Commission spent hundreds of pages describing the new “best interest” standard, but it is not clear that people understand it.” Peirce also notes, “A bigger concern for me is that the best interest standard suffers from the same problem the fiduciary standard does—a term that is wonderful for marketing purposes, but potentially misleading for investors.” She continues, “Just as “fiduciary” has been used to lull investors into not asking questions about their financial professional, so “best interest” runs the risk of becoming a term that encourages investors simply to rely on the fact that their best interest is being taken care of.”

Practical differences. According to Peirce, when comparing the proposed Regulation Best Interest standard (as well as a broker-dealer’s other requirements under the securities laws) to an adviser’s fiduciary duty as described in the proposed interpretive release, only two differences stand out. She observes, “First, an adviser generally has an ongoing duty to monitor over the course of its relationship with its client, while a broker-dealer generally does not. Second, a broker-dealer must either mitigate or eliminate any material financial conflict of interest it may have with its client. An adviser is required only to disclose such a conflict.”

With some irony, Commissioner Peirce concludes that proposed Regulation Best Interest arguably would subject broker-dealers to an even more stringent standard than the fiduciary standard for advisers outlined in the Commission’s proposed interpretation.

Potential impact on retail investors. Pierce also points to the Commission’s acknowledgement that the imposition of a new higher standard of conduct on broker-dealers could result in retail customers losing access to advice they receive through recommendations from broker-dealers, and customers that do not have the option of moving to fee-based accounts would in effect be unable to obtain investment assistance. Peirce asserts that, “At a minimum, their costs of obtaining such assistance might rise markedly. Although we tried to be cognizant of these access concerns, given the relative balance of the two standards, I fear that more and more broker-dealers will decide to become advisers that offer only fee-based accounts resulting in many Americans being shut out from receiving any investment advice.”

Commissioner Pierce also asserts that we are already seeing this dynamic at work, noting: “Brokers are taking a hard look at the existing regulatory framework coupled with FINRA arbitrations in which sometimes a fiduciary standard is applied. Then they look over the fence to the adviser world with its principles-based fiduciary standard, less frequent exams, absence of arbitration, and predictable revenue streams.” On this point she concludes, “Having engaged in this comparative exercise, many firms and individual financial professionals say farewell to FINRA, hop on the fiduciary bandwagon, and never look back. Regulation Best Interest could exacerbate this trend.”

Monday, July 30, 2018

Cybersecurity remains advisers’ top concern, compliance survey finds

By Amy Leisinger, J.D.

According to a report issued by the Investment Adviser Association and ACA Compliance Group, cybersecurity remains the most pressing concern among advisory firms with nearly two-thirds of companies noting an increase in compliance testing with regard to cyber threats. In their survey, the organizations also found an increased focus on compliance with the SEC’s advertising rule, measures to properly maintain custody of assets, and issues relating to privacy.

Of the 454 investment advisers surveyed, the majority are small businesses in which the chief compliance officers serve in multiple roles. “[T]he job of a CCO is becoming more complex and varied, as demonstrated by the wide range of legal and compliance areas CCOs are responsible for, with new ones being added every year,” said IAA President and CEO Karen Barr.

The survey found that advisory firms are using technology to fill gaps as necessary with nearly 70 percent using some form of it in their compliance programs, particularly in connection with personal trading, codes of ethics, gifts and entertainment, and political contributions. A majority of firms noted, however, that they do not use trading data analytics in monitoring trading activity and do not currently use alternative data research. Forty-six percent of the adviser respondents report that they consider environmental, social, and governance factors in managing client portfolios, and most have policies and procedures designed to ensure that client objectives are being met with almost half using automated compliance systems to do so.

Eighty-eight percent of the adviser respondents stated that they test fee calculations, most on a periodic sample basis; the top tests including ensuring that expenses remain consistent with advisory contracts or offering documents and are explicitly disclosed in the firm brochure. The vast majority of firms also evaluate best execution with respect to equity, fixed income, derivatives, and foreign currency transactions. Approximately one-third of the advisers reported that they do not engage full-service broker-dealers and do not receive proprietary research, and most serve individual clients and have documentation in place respecting, and provide training regarding, aging clients. Most advisers also reported that they do not trade in cryptocurrency, and many also noted an increase in the scope and/or frequency of their compliance testing with regard to cybersecurity issues.

The respondents also noted that the top controls in place relating to the safeguarding client assets include conducting background checks on employees with access and limiting those authorized to transmit trade orders. The most common controls with regard to advertising involve formal CCO pre-approval and reviewing information posted online and provided in new documentation.

With regard to preparation of Form ADV, the respondents cited disclosures relating to separately managed accounts as the most challenging part. Many cited issues with increased reporting of derivatives and borrowing, classification of investments, and determinations as to what qualifies as a separately managed account.

Friday, July 27, 2018

Giancarlo updates House oversight committee on clearinghouse, cryptocurrency issues

By Lene Powell, J.D.

In an oversight hearing of the House Agriculture Committee, CFTC Chairman J. Christopher Giancarlo gave updates on derivatives issues, including the increasingly precarious status of the existing U.S.-E.U. agreement on regulation of derivatives clearinghouses and the proper role of the CFTC and other agencies in regulating cryptocurrencies and blockchain. Giancarlo also discussed other issues including LIBOR and proposed position limits rules.

Clearinghouse issues. Currently, the European Commission and CFTC have an agreement providing for mutual recognition of derivatives clearinghouse regulatory regimes. However, there is a proposal before the European Parliament that would impose European substantive law on U.S. clearinghouses. This prompted questions from several members, including Committee Chairman Mike Conaway. Giancarlo said that the threatened breakdown of the existing agreement is happening because of Brexit, and it is of great concern because the laws are quite different.

“If their law applies and our law applies, I don’t know how we’re going to reconcile these two very different approaches,” said Giancarlo.

In response to a question from Rep. David Scott (D-Ga) as to what would happen if the existing agreement broke down, Giancarlo explained the probable sequence would be that after the European legislation passed, probably after Brexit, the E.U. would say that the law will apply to U.S. clearinghouses. Then, the probable next step would be that European firms could no longer use the services of U.S. clearinghouses.

Giancarlo said the proposed change is not due to any shortcoming in the U.S. regulatory regime, as U.S. clearinghouses have never had a major failure going back to the start of the clearing regime in the 1930s, including during the financial crisis, when U.S. clearinghouses stood “tall and strong.” He added that for the world’s fifth largest market to dictate rules for the world’s largest market seems a little “outside their lane.” Further, cutting off European firms from U.S. clearinghouses would create problems for Europe because some of the most important products, including dollar interest rate futures, only trade on the CME, and European hedge and pension funds need to use those products. Some of these products have no substitutes, he said, noting that trade disputes can add to heated discussions.

On the domestic front, clearinghouses are facing the challenge of explaining why they should not be treated like banks for purposes of “too big to fail” bank capital and wind-down regimes. Giancarlo said that the biggest difference is that the goal for clearinghouses should not be to wind them but to keep them going, and he has spent a lot of time with the FDIC helping them understand their unique nature. Rep. Frank Lucas (R-Okla) said that bank capital requirements should not interfere with clearing, and noted that the CFTC’s economist recently published a paper showing that capital requirements, specifically the leverage ratio, is impacting liquidity. Giancarlo said there has been progress on this in conversations with prudential regulators, particularly Federal Reserve Vice Chairman for Supervision Randal Quarles, and that he thinks this is “on their to-do list.”

Cryptocurrency and LabCFTC. Several members asked about CFTC jurisdiction over cryptocurrency and expressed concern about duplicative regulation by multiple regulators. Giancarlo explained that the CFTC does not have jurisdiction over the underlying cryptocurrency cash markets, but does have authority over fraud and manipulation.

Asked by Rep. Stacey Plaskett (D-Va) and Rep. Darren Soto (D-Fla) if the CFTC should be given additional jurisdiction, Giancarlo demurred, saying that the CFTC has not traditionally had jurisdiction over cash markets and has not been a retail regulator, and gaining that jurisdiction would change the agency’s orientation. He said there may come a time for federal regulation, but noted that the futures markets were around for many years before being federally regulated, and they policed themselves reasonably well. Also, cryptocurrency is still a relatively small market.

“I think we can allow it to evolve a little bit before we run in with regulation. But we need to stay close to it, and we are,” he said. He added that the CFTC has been working with the National Futures Association (NFA) and has taken a number of steps in the area including issuing consumer advisories. Asked by Conaway if the CFTC could demand a “regulator node” on blockchains, Giancarlo said he was not sure if authorizing legislation would be needed. The CFTC does have subpoena authority, but that would probably not be the right way to go.

But to keep up with cryptocurrency developments as well as other areas, the CFTC does need to step up its data analytics abilities and access to new technology, said Giancarlo. In response to a question from Rep. Austin Scott (R-Ga), he said that the agency’s innovative technology working group, LabCFTC, has had “well over” 200 meetings with innovators, who run the gamut from startups to large financial service providers. He said that the CFTC faces challenges in obtaining new technology, explaining that currently, if the CFTC goes through the procurement process, by the time the agency obtains new technology in development, it has already launched. He welcomed proposed legislation called the Research & Development Modernization Act, which would allow the CFTC to get around restrictions imposed by the Administrative Procedure Act to obtain new technology.

LIBOR transition. Ranking Member Collin Peterson (D-Minn) said he is very concerned about a delay in an official transition away from the use of the London Interbank Offered Rate (LIBOR) as a reference rate. He noted that LIBOR underpins almost $200 trillion in derivatives, and millions of student loans, credit cards, bank deposits, auto financing agreements, and home mortgages. He asked if a delay in transition could disrupt orderly markets, what would that mean for end users, and what measures should regulators or Congress consider.

Giancarlo responded that the LIBOR transition is a very important matter. Because the overnight funding markets are not widely used the way they were 30 or 40 years ago, LIBOR rates are no longer based on trading activities but on the educated professional judgment of a handful of banks. He said there is widespread governmental support for the shift away from LIBOR, including former CFTC Chairman Tim Massad, Governor Powell of the Fed, the Governor of the Bank of England, and the Chief Executive of the Financial Conduct Authority. Giancarlo commended Commissioner Rostin Behnam for using the CFTC’s Market Risk Advisory Committee to flesh out these issues, and said the discussion needs to broaden beyond the Washington–New York corridor into the rest of the country, to make people aware that this change is coming and what it entails.

Position limits. Representative Al Lawson, Jr. (D-Fla) asked, with gas prices rising again, in the interest of preventing price manipulation, where is the CFTC on issuing a position limits rule? Giancarlo said that the agency is making good progress. Although the proposal was put out during the final months of Chairman Massad’s term, in meetings with producers and other industry participants, it emerged that hedge exemptions were too narrowly crafted. Giancarlo hopes to put forward a solid proposal by the end of the year.

Representative Rick Crawford (R-Ar) asked if the hedge exemption issue was keeping bona fide hedgers out of the markets, and if so, if that was creating greater volatility. Giancarlo agreed that the hedge exemption issue is overly narrow, noting that farmers can’t use hedges they have used for generations. Crawford asked if Giancarlo would support an initiative, possibly jointly with the NFA, to authorize a Series 3a brokerage hedge exemption tailored for end users in the agriculture space. Giancarlo responded that he had not thought about such an initiative but it sounded promising.

Thursday, July 26, 2018

Public Citizen Report: Trump is soft on corporate crime and wrongdoing

By R. Jason Howard, J.D.

Public Citizen, a national non-profit organization, has issued a report in partnership with the Corporate Research Project of Good Jobs First, on Corporate Impunity, which highlights the Trump administration’s softening stance on enforcement policies that protect Americans from corporations that break the law.

Softening stance. The report, titled: Corporate Impunity “Tough on Crime” Trump Is Weak on Corporate Crime and Wrongdoing, presents evidence of the administration’s drastic reductions in corporate penalties imposed. The report found that in 11 of 12 agencies led by a Trump administration official for most of 2017, total monetary penalties imposed on corporate violators were reduced across the board with the notable exception of the Treasury Department’s Office of Foreign Asset Control. That office is responsible for blocking corporations from doing business with sanctioned countries, businesses, and individuals, and the change in penalty sums rose by 465 percent.

Penalties issued by the Department of Justice against corporate offenders fell by 90 percent. Civil penalties by the EPA fell by more than 94 percent. Similarly, the Aviation Consumer Protection Division, Consumer Product Safety Commission, Federal Trade Commission, and Securities and Exchange Commission all saw declines in the total number of enforcement actions brought against corporate wrongdoers.

An article titled: ‘Law and Order’ Trump Is Soft on Corporate Crime and Wrongdoing, notes that the DOJ has: 
  • Allowed corporations that engage in illegal bribery abroad to completely avoid prosecution. As long as they meet certain DOJ conditions, corporations that violate the Foreign Corrupt Practices Act never have to enter a plea, and their penalties are reduced by 50 percent. 
  • Reduced corporate penalties by eliminating payments to third parties that help right corporate wrongs. In the past, corporate settlements often included payments to nonprofit organizations that repair corporate harms. For example, a penalty against Harley Davidson for alleged emissions cheating violations was reduced by $3 million because the funds would have gone to the American Lung Association. 
  • Reduced corporate penalties by limiting how much a single corporate violation can trigger penalties from multiple enforcement agencies. The policy led to a bank accused of anti-money laundering deficiencies seeing its penalty reduced by $50 million. 
  • Limited the DOJ’s power to bring charges against corporations that defraud the government. Former Associate Attorney General Rachel Brand instructed DOJ lawyers to stop citing noncompliance with “guidance documents” as evidence that a violation has been committed. Guidance documents are interpretations of regulations that federal agencies provide to the industries they oversee to facilitate compliance. This change severely restricts the DOJ’s power to bring cases against corporations, especially for False Claims Act violations of defrauding the government. Brand’s former employer, the U.S. Chamber of Commerce, celebrated the policy memo. Brand resigned shortly after releasing the memo to take the top legal post at Walmart. 
The article concludes by noting that the impact of these policies is “predictable,” in that, “the longer they are in place, the fewer corporate criminals and wrongdoers will be held accountable.” Public Citizen recognizes that “corporate crimes and wrongdoing cause real harm to Americans who are ripped off by banks, poisoned by polluters, deceived by drug makers and have their data stolen and exploited by tech monopolies,” and it seeks to “amplify these concerns and ensure that corporations that put profits over people are held accountable.”

Wednesday, July 25, 2018

CFTC proposes update to rule governing security futures position limits

By Amy Leisinger, J.D.

The CFTC unanimously approved a proposal to update a rule governing exchanges that list security futures products to increase liquidity in SFP trading. The proposal would provide these exchanges with greater discretion in setting position limit levels to foster more effective risk management. Specifically, the proposed amendments would increase the default level of equity SFP position limits to 25,000 contracts and adjust the criteria for setting higher position limits and position accountability levels.

Current regulations. Under existing regulations, the CFTC generally requires a designated contract market to establish for each SFP a position limit applicable to positions held during the last five trading days of an expiring contract month of no greater than 13,500 (100-share) contracts. A DCM may adopt position accountability for an SFP on a security with an average daily trading volume of at least 20 million shares and at least 40 million outstanding shares.

Proposed changes. Under the proposal, the Commission would amend its position limits rules for SFPs by increasing the default level of equity SFP position limits to 25,000 contracts from 13,500 contracts and modifying the criteria for setting a higher level of position limits and position accountability levels. Rather than setting position limits based on average trading volume and outstanding shares, a DCM listing an SFP would set a specific position limit level, generally equivalent to no more than 12.5 percent of estimated deliverable supply of the underlying security.

Instead of position limits, a DCM would be able to set position accountability levels when six-month total trading volume in the underlying security exceeds 2.5 billion shares and more than 40 million shares of estimated deliverable supply exist, rather than when the six-month average daily trading volume in the underlying security exceeds 20 million shares and there are more than 40 million outstanding shares, as is the case under the current rule. In addition, the maximum accountability level under the position accountability regime would be increased to 25,000 contracts, from the current level of 22,500 contracts.

In addition, the proposal would provide a DCM with discretion to apply limits either on a net basis or on the same side of the market. If a DCM imposes limits on the same side of the market, the DCM could not net positions in SFPs in the same security on opposite sides of the market.

The default level for position limits for SFPs have not changed over time, but those on security options have, which has allowed position limits for security options to be set at a higher default level, potentially placing SFPs at a competitive disadvantage. The proposal is designed to level the playing field, the CFTC notes.

The Commission seeks comment on potential alternatives to the proposal and potential costs to, and benefits for, market participants, as well as whether to eliminate default position limits for equity SFPs and instead simply require that position limits and accountability be based on deliverable supply. Comments on the proposal are due 60 days after publication in the Federal Register.

Tuesday, July 24, 2018

SEC okays FINRA’s proposed new option for simplified arbitration

By John Filar Atwood

The SEC has approved FINRA’s proposed amendment to its rules to provide a new option for simplified arbitration. Effective September 17, parties in arbitration with claims of $50,000 or less will be given an additional hearing option.

Current procedure. Prior to the amendment, FINRA’s codes of arbitration procedure for customer and industry disputes provided two options for administering cases with claims involving $50,000 or less. The default option is a decision by a single arbitrator based on the parties’ pleadings and other materials submitted by the parties, and the alternative option is a full hearing with a single arbitrator.

Under the customer code, a customer may request a hearing regardless of whether the customer is a claimant or respondent, and under the industry code, only the claimant may request a hearing. If a hearing is requested, it is generally held in person, and there are no limits on the number of hearing sessions that can take place.

New system. FINRA amended the codes to provide an additional hearing option for parties in arbitration with claims of $50,000 or less (a special proceeding). When filing a statement of claim through the dispute resolution portal, a claimant now will be prompted to choose one of the three options, including a special proceeding.

The special proceeding option is subject to the regular provisions of the codes relating to prehearings and hearings, including all fee provisions, with several limiting conditions. FINRA said that the conditions are intended to ensure that parties have an opportunity to present their case to an arbitrator in a convenient and cost-effective manner that is less demanding than a regular hearing.

Conditions. The conditions include that a special proceeding must be held by telephone unless the parties agree to another method of appearance. The claimants and respondents are limited to two hours to present their cases and one-half hour for any rebuttal and closing statement, exclusive of questions from the arbitrator and responses to such questions.

Under the new procedure, the arbitrator will have the discretion to cede his or her allotted time to the parties. However, a special proceeding may not exceed two hearing sessions, exclusive of prehearing conferences, to be completed in one day.

In a special proceeding, the parties will not be permitted to question the opposing parties’ witnesses. Parties must still abide by the customer code provision that the customer could not call the opposing party, a current or former associated person of a member party, or a current or former employee of a member party as a witness, and members and associated persons could not call the customer of a member party as a witness. They also must adhere to the industry code stipulation that members and associated persons cannot call an opposing party as a witness.

FINRA indicated that it will create a dedicated hearing script for special proceedings that the arbitrator will read at the start of the proceeding. FINRA also intends to modify its initial pre-hearing conference script so that parties in special proceedings will have advance knowledge of the rule’s requirements, including the pre-hearing exchanges of documents and exhibits. Unlike regular hearings, parties will need to file their exhibits with FINRA before the special proceeding so that FINRA may send the exhibits to the arbitrators.

FINRA plans to create a video training module for arbitrators that covers proceedings. FINRA also will post training materials on its webpage. FINRA said that it will monitor the new process to determine whether it should modify the program in any way.

Monday, July 23, 2018

Commission extends post-Lucia stay 30 more days

By Rodney F. Tonkovic, J.D.

The SEC has extended a stay of pending administrative proceedings for an additional 30 days. The initial order was issued on June 21, 2018 and stayed pending administrative proceedings until July 23, 2018, or further order. The Commission stated that it finds it prudent to extend the stay until August 22, 2018, or further order of the Commission (In re Pending Administrative Proceedings, Release No. 33-10522, July 20, 2018).

Scope. As before, the order applies to “any pending administrative proceeding initiated by an order instituting proceedings that commenced the proceeding and set it for hearing before an administrative law judge, including any such proceeding currently pending before the Commission.” In these pending proceedings, the ALJ must issue a notice indicating that the stay has been extended. The Commission has retained the option, however, of assigning proceedings pending before an ALJ to the Commission itself or to any member of the Commission.

Lucia's effects. The Commission still appears to be mulling the practical consequences of the Supreme Court’s opinion in Lucia v. SEC, which left open several questions. For one, the Court declined to address the question of what effect should be given to the Commission’s earlier order ratifying the appointment of its ALJs in pending cases. But the Court did observe in a footnote that, with respect to Lucia, the Commission can hear the matter itself, or it can assign a new ALJ who was constitutionally appointed independent of the SEC’s ratification order.

In another reaction to Lucia, President Trump issued on July 11, 2018 an executive order excepting federal ALJs from the competitive service. The order states that removing ALJs from competitive hiring and selection rules will mitigate concerns about undue limitations on their selection, reduce the likelihood of successful Appointments Clause challenges, and forestall litigation on these issues. The order noted that in addition to holding that ALJs are “inferior officers” of the United States, Lucia may also raise additional questions about the method of appointing ALJs, including whether competitive examination and competitive service selection procedures are compatible with the discretion an agency head must possess under the Appointments Clause.

The release is No. 33-10522.

Friday, July 20, 2018

FIMSAC subcommittee recommends formation of working group to address e-trading in fixed income markets

By Amanda Maine, J.D.

The Technology and Electronic Trading Subcommittee of the SEC’s Fixed Market Structure Advisory Committee (FIMSAC) issued its preliminary recommendation that a joint working group be formed to conduct a review of the regulatory oversight of electronic trading platforms in the corporate and municipal bond markets. The working group would consist of representatives from the SEC, FINRA, and the MSRB.

Regulatory differences. The subcommittee’s recommendation noted that e-trading platforms for credit and municipal trading bonds in the U.S. are subject to different regulations based on differences in trading protocols or business models. Some platforms are regulated as alternative trading systems (ATSs) while others are regulated as broker-dealers. The subcommittee also pointed out that other significant platforms operating similar models are not regulated at all. According to the subcommittee, these regulatory differences were driven in part by Regulation ATS and the establishment of a class of ATSs that were deemed to furnish services commonly performed by registered stock exchanges. However, the subcommittee advised that a number of aspects of the Reg ATS ruleset reflect the trading practices of the equity markets and not the fixed income markets.

Recommendation. In its recommendation, the subcommittee noted that, because electronic RFQ platforms for corporate and municipal bonds are excluded from Reg ATS based on the characteristics of the RFQ trading protocol, a significant number of corporate and municipal bond volumes occur on e-trading platforms regulated only as broker-dealers. These distinctions in regulatory oversight of e-trading in the fixed income markets complicate efforts to improve the efficiency and resiliency of these markets. Without a unifying regulatory framework for all fixed income e-trading platforms, the subcommittee advised, there is a danger of market structures further fragmenting as regulators adopt new regulations that apply only to one type of platform, such as proposed Form ATS-N and Regulation SCI.

The subcommittee’s recommendation lays out five considerations for the joint working group:
  • Ensure that the regulatory framework best promotes the growth of fair and effective fixed income e-trading markets; 
  • Ensure that no regulatory caps or inconsistencies in the application of such regulation exist that increase the potential for investor harm, systemic risk, or unfair competition; 
  • Consider whether Reg ATS and other rules should be amended to account for differences in protocols regarding fixed income compared to equities; 
  • Ensure that regulation is not unfairly promoting or impeding specific trading protocols and business models over others; and 
  • Consider whether any existing regulation impacting fixed income e-trading markets is unnecessary from a cost-benefit perspective.

Thursday, July 19, 2018

CFTC’s authority over cryptocurrency fraud reaffirmed

By Lene Powell, J.D.

In reconsidering a March ruling, a federal district court again found that the CFTC had standing to exercise enforcement power in a virtual currency fraud scheme. The “actual delivery exception” did not apply because the transactions were not entered into on a leveraged, margined, or financed basis and the exception did not bar enforcement of commodity fraud under Section 6(c)(1) of the Commodity Exchange Act (CFTC v. McDonnell, July 12, 2018, Weinstein, J.).

In March, a district court in the Eastern District of New York entered a preliminary injunction against Patrick McDonnell and his company, CabbageTech, Corp. d/b/a Coin Drop Markets (CDM), prohibiting the defendants from engaging in fraud and requiring them to preserve books and records and provide expedited discovery. The CFTC had charged defendants with fraud and misappropriation in connection with purchases and trading of the virtual currencies Bitcoin and Litecoin.

CFTC antifraud authority. In asking the court to reconsider denying his motion to dismiss, McDonnell argued that the “actual delivery exception” in Section 2(c)(2)(D) of the Commodity Exchange Act (CEA) barred enforcement in the alleged virtual currency fraud scheme. For support, McDonnell cited a May decision from the Central District of California, CFTC v. Monex Co., involving alleged precious metals fraud. The court rejected this argument, noting that Monex was not controlling authority. Also, the exception applies only to transactions entered into on a leveraged, margined, or financed basis. These transactions did not fit that exemption.

The court then went further. The Monex court found that Section 6(c)(1) only protects against fraud where a commodity transaction manipulates or potentially manipulates the derivatives market. Upon full consideration of Monex, the New York court reached a different conclusion. Without elaborating, the court reaffirmed its view that Section 6(c)(1) gave the CFTC standing to exercise its enforcement power over the fraudulent schemes alleged in the complaint. The court also reaffirmed its prior rulings regarding subject-matter and personal jurisdiction.

Because there was no valid basis for a change in the order, the court denied McDonnell’s motion to dismiss.

The case is No. 18-CV-361.