Thursday, May 26, 2016

Valeant staff comment dialogue spotlights non-GAAP measures

By Mark S. Nelson, J.D.

Valeant Pharmaceuticals International, Inc.’s answers to queries by SEC staff about the company’s financials may offer a glimpse into the SEC’s recent focus on non-GAAP financial measures. As the Valeant dialogue progressed, the staff and Valeant even tussled over whether a non-GAAP presentation that implied the company could produce billions in pre-tax profits while paying only a tiny tax bill could be misleading. The SEC’s latest non-GAAP guidance arrived after the Valeant dialogue ended yet before Valeant’s comment letters appeared publicly on EDGAR. Still, some of the agency’s concerns with Valeant’s presentation are at least broadly suggestive of topics covered in the agency’s revised C&DIs (SEC Staff Letters: December 4, 2015, February 1, 2106, March 18, 2016, April 26, 2016; Valeant’s Replies: December 18, 2015, February 16, 2016, April 1, 2016, April 8, 2016).

In a broadside query to Valeant’s Form 8-K, the SEC staff stated its worries about the “overall format and presentation” of Valeant’s non-GAAP measures. Valeant replied that it includes these items because it considers them to be useful to analysts and other investors who wish to see the company’s operating results through the lens used by its managers. Valeant also said the non-GAAP measures are responsive to frequent questions it gets from the analyst community and investors, and that inclusion of the measures may help the company to avoid troubles that might otherwise arise under Regulation FD.

In a follow-up comment, the staff asked Valeant to remove references to “core operating results,” which the company’s reply indicated it would do. Previously, Valeant had explained to the staff that it had grown via both acquisitions and organic growth.

The SEC staff also peppered Valeant with numerous, more specific questions about various features of the company’s non-GAAP measures. Valeant repeatedly said it would update its future filings. Specifically, the staff asked Valeant to give equal prominence to GAAP financial measures, to avoid the use of confusingly similar titles and descriptions per Item 10(e) of Regulation S-K, and to do more to identify and explain each non-GAAP measure and the most directly comparable GAAP measure.

Moreover, Valeant was asked to revise several tables to better quantify tax matters. A later reply by Valeant indicated the company would do more to explain adjustments in its future earnings releases. The company also clarified that its earlier presentation followed ASC 740-270.

The SEC staff also went beyond the Form 8-K and commented on Valeant’s Q3 2015 financial results presentation based on information gleaned from the company’s investor relations webpage. Here, the staff wanted Valeant to remove certain words related to “cash EPS” and to add cross references to its reconciliation to non-GAAP measures under Item 100 (Note 1) of Regulation G.

Valeant’s drug pricing practices have been separately targeted by a congressional committee that heard testimony from Valeant’s interim CEO. In March, the company announced that it would seek to replace CEO J. Michael Pearson and that the company was adding William Ackman, CEO of Pershing Square Capital Management, L.P., to its board. The company’s press release also offered a further explanation of its accounting and financial reports. The SEC staff indicated that it had completed its review of Valeant’s Form 8-K.

Wednesday, May 25, 2016

SEC to up ‘qualified client’ threshold for performance-based fees

By Amy Leisinger, J.D.

The SEC intends to issue an order to adjust for inflation the dollar-amount thresholds in the Advisers Act rule permitting investment advisers to charge performance-based fees to “qualified clients.” The order would increase the minimum net worth of a “qualified client” under Rule 205-3 from $2 million to $2.1 million and leave intact the minimum $1 million amount for assets under management. The adjustment will be the second for the Commission since the Dodd-Frank Act mandated inflation adjustments in 2010 (Performance-Based Investment Advisory Fees, Release No. IA-4388, May 18, 2016).

Performance-based fees. Advisers Act Section 205(a)(1) generally prohibits an adviser from entering into or performing any advisory contract that provides for compensation based on a share of capital gains on or appreciation of client funds. Congress authorized the SEC to exempt any contract from the prohibition if it was made with a party who does not need its protections. Under Rule 205-3, an adviser may charge performance-based fees if a “qualified client” has a certain minimum net worth or minimum dollar amount of assets under the management of the adviser. The Dodd-Frank Act amended Section 205 to require the Commission to adjust for inflation the dollar amount thresholds following its enactment and every five years thereafter. In February 2012, the Commission revised the thresholds for the assets-under-management test and the net worth test to $1 million and $2 million, respectively.

Proposed adjustment. The SEC plans to issue an order that would maintain the dollar amount of the assets-under-management test and would increase the net-worth test to $2.1 million. Both amounts would take into account the effects of inflation by reference to PCE Index levels. The Commission anticipates that the order will be effective 60 days after its issuance and that future changes to the tests will be reflected in technical amendments to Rule 205–3(d).

Interested persons may request a hearing before June 13, 2016.

The release is No. IA-4388.

Tuesday, May 24, 2016

Omitting speculative projections was not bad faith

By Anne Sherry, J.D.

Directors of Chelsea Therapeutics did not breach their duty of loyalty in approving the biopharm company's sale to Lundbeck. The Chelsea shareholders seeking damages post-closing did not state a claim that the board acted in bad faith by instructing its advisors not to consider speculative projections that its assets would increase in value years in the future. That decision, the Delaware Court of Chancery held, did not amount to an intentional disregard for the directors' duties, nor was it inexplicable on any ground other than bad faith (In re Chelsea Therapeutics International Ltd. Stockholders Litigation, May 20, 2016, Glasscock, S.).

Chelsea had researched and developed a drug, Northera, to treat a blood-pressure condition associated with Parkinson's disease. During the negotiations with Lundbeck, the director defendants instructed Chelsea's financial advisors to ignore a set of projections that assumed a higher market share should the FDA remove the company's primary competitor from the market. The directors also disregarded a second set of projections predicting increased revenue streams should the FDA approve Northera for the treatment of other medical conditions. The plaintiffs contended that the defendants breached their fiduciary duties by intentionally concealing the true, higher value of the company from its stockholders.

Duties of care and loyalty. Because the directors were exculpated from liability for duty-of-care claims, the plaintiffs' damages action could only rest on a duty-of-loyalty theory. The only such claim articulated in the complaint was a narrow one based on bad faith. To state a breach-of-duty claim predicated on bad faith, a plaintiff must show either an extreme set of facts establishing that disinterested directors were intentionally disregarding their duties or that the decision was so far beyond the bounds of reasonable judgment that it is essentially inexplicable on any ground other than bad faith.

The plaintiffs conceded that the directors' and shareholders' interests were aligned because the directors held equity positions, but pointed out that they would receive change-in-control payments in the event of the company's sale. However, the plaintiffs failed to allege that those payments would overcome the alleged loss from undervaluing the company, much less exceed that loss in a way material to the defendants.

This left the plaintiffs to rely on the most difficult path to overcoming dismissal of a bad-faith claim: alleging that the action complained of is otherwise inexplicable so that bad faith must be at work. In fact, however, the court found that it was readily explicable that the board would decline to use the higher projections to value the company. The projections were both highly speculative, and the second set estimated potential revenue streams that could occur more than 15 years into the future, without adjustments for risk.

Can disclosure cleanse bad faith? The court did not reach the issue, raised by the defendants, of whether under Corwin v. KKR the company's disclosures were adequate to cleanse any bad faith on the part of the directors and thus the case should be dismissed under the business judgment rule. The complaint failed to state a claim regardless of the outcome of this issue. In dicta, the court did say it was "unclear" that Corwin would cleanse a bad-faith act, even if disclosed.

The case is No. 9640-VCG.

Monday, May 23, 2016

Nasdaq hints at legal challenge to IEX quotations delay

By John Filar Atwood

In a letter to the SEC, Nasdaq suggested that the Commission’s proposed interpretation that would allow Investors’ Exchange LLC (IEX) to operate with a delay on quotation response times would likely be subject to judicial scrutiny. Nasdaq urged the SEC to abandon its plan to interpret the term “immediate” to allow for IEX’s 350 microsecond delay on response times, saying that the Commission lacks the authority to treat the delayed quotations as protected.

As previously reported in Securities Regulation Daily, the SEC is seeking comment on a proposed interpretation of the definition of “automated quotation” under Rule 600 of Regulation NMS in connection with IEX’s application for registration as a national securities exchange. The SEC’s proposal would interpret “immediate” when determining whether a trading center maintains an “automated quotation” for purposes of Rule 611 of Regulation NMS to include response time delays at trading centers that are de minimis, whether intentional or not.

IEX delay. IEX, which currently operates as an alternative trading system, provides access to users through a “point of presence” (POP) located in Secaucus, New Jersey. After entering through the POP, a user’s electronic message sent to the IEX trading system traverses the IEX coiled optical fiber cable and an additional physical distance to the IEX system in Weehawken, New Jersey. According to IEX, the Pop and coil structure provides IEX users sending non-routable orders to IEX with a one-way delay of 350 microseconds.

Nasdaq does not believe that IEX’s system and its intentional delay on quotation times is consistent with Regulation NMS and the SEC’s prior interpretations of the regulation. In Nasdaq’s opinion, the proposed interpretation of “immediate” would conflict with the plain language of Regulation NMS, with the requirements of decisions under the Administrative Procedure Act, and with the Commission’s duty to consider the effect of its actions on competition, and capital formation.

Rewriting Reg NMS. According to Nasdaq, the proposed interpretation of “immediate” would rewrite Regulation NMS, not interpret it. The interpretation would depart from the unambiguous meaning of that term by condoning intentional response time delays of up to one millisecond in duration, Nasdaq said.

Nasdaq pointed out that the SEC recognized when it first adopted Regulation NMS that the requirement of immediacy imposed by Rule 600(b)(3) is incompatible with intentional delays in response time. In promulgating Regulation NMS, Nasdaq noted, the Commission rejected commenters’ requests to specify a specific time standard that may become obsolete as systems improve over time.

Instead, the SEC confirmed that the definition of “automated quotation” does not include a specific time standard for responding to an incoming order, emphasizing that a trading center’s systems should provide the fastest response possible without any programmed delay. As a result, an intentional response time delay like the 350-microsecond delay imposed by IEX’s POP/coil system is inconsistent with the plain meaning of “immediate” and with the Commission’s own understanding that the term requires response times that are as fast as technologically feasible, Nasdaq argued.

Judicial scrutiny. In its letter, Nasdaq warned that although courts often afford deference to an agency’s interpretation of its own regulations, that deference is not boundless and would not shield the proposed interpretation from judicial scrutiny. Nasdaq cited judicial decisions holding that deference to an agency’s interpretation of a regulation is not warranted unless the language of the regulation is ambiguous. When the text of a regulation is unambiguous, Nasdaq continued, a conflicting agency interpretation will be plainly erroneous or inconsistent with the regulation.

Nasdaq argued that the term “immediate” in Rule 600(b)(3) unambiguously forecloses an intentional, planned delay, and a court would afford no deference to the Commission’s construction of Rule 600(b)(3) as permitting intentional delays of less than one millisecond. Deference to the proposed interpretation would be particularly inappropriate, Nasdaq concluded, because it conflicts not only with the meaning of “immediate” but also with the SEC’s prior interpretation of Rule 600(b)(3) issued contemporaneously with Regulation NMS.

Friday, May 20, 2016

SEC nominees move forward in confirmation process

By Amy Leisinger, J.D.

The Senate Banking Committee has voted to approve several executive nominations for a full Senate vote, including Lisa Fairfax and Hester Peirce for the SEC, according to a statement by the committee’s ranking Democrat. Also moving forward are Jay Lerner for FDIC inspector general, Amias Gerety for assistant secretary of the Treasury, and Rhett Jeppson for director of the U.S. Mint. Frustrated with slow pace of approvals, senior committee Democrat Senator Sherrod Brown (D-Ohio) says he will continue to push to clear the remaining backlog of nominations.

“It is disgraceful that the Senate still hasn’t confirmed any of the 20 nominations that the Banking Committee has received since the start of last year,” Brown said. “These nominees are essential to promoting financial stability, protecting national security, and ensuring that American businesses of all sizes can compete on a level playing field with foreign competitors.”

SEC nominees. Last October, President Obama nominated academics Fairfax and Peirce for the office of SEC commissioner. Fairfax is a professor at George Washington University Law School, and Peirce serves as a senior research fellow and director of the Financial Markets Working Group at George Mason University’s Mercatus Center.

Lengthy process. In April, the Senate Banking Committee postponed a confirmation vote on the block of nominees after a number of Democratic senators opposed the SEC nominees. Senator Chuck Schumer (D-NY) said he would vote against the nominees because Fairfax and Peirce failed to provide satisfactory responses to his inquiries regarding rulemaking to require the disclosure of corporate political spending during their confirmation hearing. Senator Robert Menendez (D-NJ) also objected, noting his fears that they would continue to obfuscate on proceeding with rulemaking despite the historic amount of comment letters in support of the initiative. Other “no” votes came from Sens. Jeff Merkley (D-Ore) and Elizabeth Warren (D-Mass), who also expressed concern regarding Peirce’s adamant opposition to the Dodd-Frank Act.

While pleased with the step forward in approval approach, Sen. Brown urged the committee to forge on with all of remaining nominees without further delay. The committee has not yet held hearings on the President’s nominees for seats on the governing boards of the Federal Reserve and Export-Import Bank.

Thursday, May 19, 2016

SEC updates C&DIs on non-GAAP financial measures

By Rodney F. Tonkovic, J.D.

The SEC has updated a dozen of its Compliance & Disclosure Interpretations (C&DIs) on the use of non-GAAP financial measures. Among other items, the updates concern the definition of "funds from operations," the use of per share non-GAAP financial measures, and free cash flows.

Misleading measures. The first set of updates, to Questions 100.01 through 100.04, applies generally and concerns misleading non-GAAP measures that could violate Rule 100(b) of Regulation G. For example, Question 100.01 states that certain adjustments, even if not expressly prohibited, can violate Rule 100(b) because they cause the presentation of the non-GAAP measure to be misleading. A non-GAAP measure be misleading if it is presented inconsistently between periods.

Funds from operations. Question 102.01 discusses the definition of "funds from operations" (FFO) as used in in footnote 50 to Exchange Act Release No. 47226: Conditions for Use of Non-GAAP Financial Measures. The SEC uses the definition of FFO used by the National Association of Real Estate Investment Trusts (NAREIT) in effect as of May 17, 2016. The response to Question 102.02 states that a registrant can present FFO on a basis other than this definition provided that any adjustments made to FFO comply with Item 10(e) of Regulation S-K and the measure does not violate Rule 100(b). The response to Question 102.03 notes that registrants can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K

Per share measures. Next, Question 102.05 notes the adopting release for Item 10(e)(1)(ii) of Regulation S-K states that "per share measures that are prohibited specifically under GAAP or Commission rules continue to be prohibited in materials filed with or furnished to the Commission." The response says, however, that certain non-GAAP per share performance measures are not prohibited. Non-GAAP per share performance measures, the staff says, should be reconciled to GAAP earnings per share, but non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis.

Free cash flow. Measures of "free cash flow" are also not prohibited under Item 10(e)(1)(ii). The response to Question 102.07 cautions, however, that a clear description of how this measure is calculated, as well as the necessary reconciliation, should accompany the measure where it is used. Additionally, free cash flow is a liquidity measure that must not be presented on a per share basis.

Prominence of non-GAAP measures. In the response to Question 102.10, the staff provides several examples of how, when presenting a non-GAAP measure, to present the most directly comparable GAAP measure with equal or greater prominence, as required under Item 10(e)(1)(ii). The list shows what the staff would consider as presenting the non-GAAP measure as more prominent, including omitting comparable GAAP measures from an earnings release headline that includes non-GAAP measures and presenting a non-GAAP measure in a larger font than the comparable GAAP measure.

Income tax effects. The updates also indicate that a registrant should provide income tax effects on its non-GAAP measures depending on the nature of the measures. The response to Question 102.11 states, to illustrate, that liquidity measures including income taxes might show taxes paid in cash.

EBITDA. Finally, under Question 103.02, if EBIT or EBITDA is presented as a performance measure, that measures should be reconciled to net income as presented in the statement of operations under GAAP. Operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income, the response says. These measures also must not be presented on a per share basis.

Wednesday, May 18, 2016

SEC okays FINRA rule for brokers bringing customers to new firm

By Anne Sherry, J.D.

The SEC approved FINRA's adoption of a rule requiring brokers who move to a new firm to provide a communication to customers they want to take with them. The two-page document is a standardized list of issues and questions for the customer to consider, rather than the dollar-figure disclosure NASAA had requested. The recruiting firm must provide the communication whenever a broker's former customer (not including institutional accounts) transfers assets to an account that will be assigned to the broker, or whenever the firm contacts the broker's former customer to transfer assets.

Timing of communication. The disclosure, appended to FINRA's regulatory notice, will be required at the time of first individualized contact with a former customer regarding an asset transfer. If this first contact is oral, the firm or broker must notify the former customer at that time that the written communication will follow within three business days. However, if the customer expressly rebukes the firm's solicitation, the firm does not need to provide the communication unless the customer has a change of heart within three months after the broker associates with the firm.

The rule also applies when the former customer transfers assets to an account that is, or will be, assigned to the broker—even if the broker or firm has not made individualized contact. When it is the customer that makes first contact in this way, the communication must accompany the account transfer approval documentation.

Content of communication. The communication suggests customers ask about potential conflicts of interest, the implications and costs associated with liquidating and transferring assets (or leaving some assets where they are), how the product offerings at the two firms compare, and what level of service the new firm will provide.

Standardized vs. dollar-figure disclosure. The rule was adopted over NASAA's criticism. The regulators' group had advocated for a disclosure of the actual compensation that the representative received or would receive in connection with the transfer and whether the compensation was asset- or production-based. The first proposal, which did call for dollar-figure disclosure, was scrapped after commenters complained about its effects on operations and competition.

FINRA Rule 2273 becomes effective November 11, 2016.

Tuesday, May 17, 2016

Regulators propose crowdfunding model rule for state offerings

By Jay Fishman, J.D.

The North American Securities Administrators Association, Inc. has proposed a model rule for issuers intending to make a federal crowdfunding offering in the states. The model rule, arising from the SEC’s May 16, 2016—effective crowdfunding rules, would require issuers making a federal crowdfunding offering to file a notice in those states where either: (1) the issuer has its principal place of business; or (2) where 50 percent of the aggregate amount of the offering has been purchased by residents. Public comments on the proposed model rule are due by June 17, 2016.

Proposal. For offerings made in reliance on federal regulation crowdfunding, the above issuers would be permitted, under the proposed model rule, to file a short form, Form U-CF, Uniform Notice of Federal Crowdfunding Offering, containing basic information about themselves, accompanied by a state-specific filing fee. A consent to service of process would be incorporated within the model form. The model rule would additionally include renewal and amendment requirements for federal crowdfunding offerings. The model rule and form can be adopted by any state desiring to have a notice filing requirement.

Issuers, instead of filing the above form, could send the states all SEC-filed materials in connection with the offering, along with federal Form C and a completed Form U-2, Uniform Consent to Service of Process.

NASAA President and Maine Securities Administrator, Judith Shaw said “today, as the SEC’s Regulation CF takes effect, the United States enters a new era in crowdfunding. I believe this milestone gives state regulators another opportunity to increase our collaboration with our federal partners. Ultimately, NASAA believes that the adoption of a model rule and uniform notice filing form by those states that wish to require notice filings will be a benefit to both issuers and regulators.” Shaw noted that 32 states and the District of Columbia have adopted intrastate crowdfunding models.

Monday, May 16, 2016

Hensarling touts FSC plans to send the Dodd-Frank to the ‘trash heap’

By Amy Leisinger, J.D.

Financial Services Committee Chairman Jeb Hensarling (R-Tex) recently spoke about the committee’s plan to offer reforms to the Dodd-Frank Act. With the Act’s breadth of regulatory changes and creation of new federal authorities, he stated, American society has become less prosperous and further removed from overall market freedom. In the coming weeks, the chairman noted, the FSC will put forward legislation to restore economic growth while protecting consumers and retaining economic liberty. Regulatory micromanagement is not a substitute for market discipline, and simplicity of regulation is key, he explained.

“I will not rest—and my Republican colleagues on the House Financial Services Committee will not rest—until we toss Dodd-Frank onto the trash heap of history,” Hensarling stressed.

Dodd-Frank rollback. In his remarks, Hensarling lamented the volume and complexity of the regulations resulting from the Dodd-Frank Act and noted that deregulation was not the root cause of the financial crisis. Dodd-Frank supporters said the legislation would promote financial stability and end too big to fail, he said, but this has not happened. Arguably, he noted, Dodd-Frank codified “too big to fail” and taxpayer funded bailouts with SIFI designation and the creation of the Orderly Liquidation Authority.

Further, Hensarling stated, Dodd-Frank led to a rise in unbanked or underbanked households and curtailed credit availability. Citizens have not only lost economic freedom, but also constitutionally protected freedoms with respect to Dodd-Frank’s creation of the Consumer Financial Protection Bureau (CFPB) and Financial Stability Oversight Council, whose members are not elected but yet yield substantial power, according to Hensarling. On top of this, Hensarling noted, Dodd-Frank has resulted in unstarted small businesses, unproduced innovative products, and unrealized economic security.

Proposed changes. The chairman noted that FSC Republicans will offer a “vision” of banking and capital markets to effectively repeal and replace Dodd-Frank. Growth must be restored through competitive and transparent capital markets, and everyone must have the chance to become financially independent, he explained. Systemic risk should be reduced through market discipline while ensuring that Americans are protected from fraud and deceptive practices, Hensarling stated, and taxpayer bailouts of financial institutions must end.

Under the new plan, he explained, if financial institutions choose to meet high but simple capital requirements, they will find substantial relief from both Dodd-Frank and Basel’s burdensome obligations. The reform legislation will also include limitations on Federal Reserve overreach and put the CFPB on budget and create a bipartisan commission with appropriate rulemaking authority, according to the chairman.

“Help is on the way,” Hensarling assured.

Friday, May 13, 2016

White describes initiatives for smaller company capital formation at IOSCO meeting

By Jacquelyn Lumb

Chair Mary Jo White addressed a panel at IOSCO’s meeting in Lima, Peru, on the SEC’s initiatives to facilitate capital formation for small and emerging companies, including the crowdfunding rules that go into effect on May 16, 2016. The option to use crowdfunding as a capital raising tool has been anxiously awaited, she advised. While the SEC wants to streamline capital raising, it also seeks to maintain strong investor protections, which she described to the panel.

Crowdfunding. In order to protect investors in crowdfunding offers, they must be conducted through SEC-registered funding portals, White explained. There are also both offering and investing limitations and initial and ongoing disclosure requirements. White expects to receive feedback from investors and companies about how the rules can be improved as these offerings get underway.

The SEC has now completed all of the statutory requirements under the JOBS Act that promote capital raising, according to White, including the addition of a new exemption to permit companies to engage in general solicitation for certain unregistered offerings as long as the purchasers are accredited investors.

Reg. A+. Under Regulation A+, companies can raise up to $50 million over a 12-month period without incurring the full cost of registration and reporting. White reported that since Regulation A+ became effective in March 2015, issuers have publicly filed 85 offering statements. Others have taken advantage of the nonpublic staff review of draft offering statements before publicly filing. The SEC has qualified over 30 offering statements from companies seeking to raise approximately $500 million, she advised.

EGCs. White also reported that emerging growth companies, which may confidentially submit draft registration statements for initial public offerings and are subject to scaled disclosures, now constitute about 85 percent of companies doing IPOs since the statute was enacted. She said about 1,000 EGCs have taken advantage of the confidential staff reviews of their registration statements.

Intrastate offerings. The SEC also proposed updates to the rules for companies engaged in local and regional offerings to give states more flexibility (Release No. 33-9973). The proposal would provide a new exemption for those relying on the intrastate crowdfunding provisions under state securities laws. It also would increase the amount of securities that can be offered and sold in a 12-month period under Rule 504 of Regulation D from $1 million to $5 million. The comment period on the proposal closed January 11, 2016.

Disclosure effectiveness. White concluded her remarks with a review of the SEC’s disclosure effectiveness project, which includes a consideration of ways to improve capital formation for smaller companies. She said the goal is to comprehensively review the current disclosure requirements and consider how they can be updated to improve timely material disclosure and shareholders’ access to the information.

This initiative includes the consideration of a scaled disclosure system for smaller reporting companies. She expects that the public’s comments will help inform the SEC about possible changes it could make to the scaled disclosure system. White also noted that Congress last year enacted legislation that requires the SEC to further scale or eliminate disclosure requirements for smaller public companies. The work being done under the disclosure effectiveness project complements the work required under this statutory mandate, she said.

Thursday, May 12, 2016

Electronic trading for fixed income gaining momentum, FINRA economist says

By Kevin Kulling, J.D.

Although automation in the fixed income markets has lagged behind that of the equities markets, FINRA’s chief economist and senior vice president said that electronic trading in the corporate and municipal bond markets is gaining traction, “like a slow train gathering speed.” As the electronic transformation continues, he said that it was imperative that regulators and the industry continue to work to strengthen programs that minimize the impact of market volatility and to limit market disruption.

Current state of electronic trading. In remarks to the North American Electronic Bond Trading Forum, Jonathan Sokobin said that while nearly all stock markets are electronic, on the fixed income side, trading and markets are a dramatically different story and electronic trading platforms have not yet been as transformative. The reasons are varied, he said. One reason may be the inherent value of voice trades in maintaining discretion in thinly traded markets. Another reason often cited is the large number of unique assets and infrequent trading of many corporate bond markets.

Regardless, he noted that today there are 19 electronic bond trading platforms operating, up from 5 in 2008. The platforms have evolved in response to the differing demands of participants and to increase participation.

He also said that electronic trading is dominant in the fixed income futures and the U.S. Treasury markets. There is also a general uptick in electronic trading in the corporate market, he said, and the number of corporate bond trading protocols that have been structured to address the differing demands of market participants has more than doubled since 2013.

Increased electronic trading factors. One factor driving the creation of electronic platforms in fixed income is the significant shift in the balance sheets of traditional liquidity providers such as banks and broker-dealers, in contrast to non-traditional liquidity providers, such as asset managers and proprietary trading firms. Since the financial crisis, regulatory reforms have resulted in greater capital and liquidity requirements for banks. In turn, the traditional liquidity providers have offloaded a significant amount of inventory.

Sokobin said that there is likely a change in the demand for liquidity services, led by market participants who demand liquidity because they may need to adjust their portfolios quickly to meet inflows and outflows. Additionally, as traditional liquidity providers move back toward more agency-like models, it takes more time and more work to identify counterparties and more opportunities for asset managers to selectively provide liquidity.

Regulatory concerns. Electronic trading, in particular automated and high-frequency trading, pose a number of challenges to regulators, including a lack of transparency regarding alternative trading systems, or ATSs. This is a concern to regulators generally, he said.

On the fixed income side, FINRA is seeing increased trading of TRACE-eligible securities in dark pools, greater use of request-for-quote processes, and more executions of customer orders by firms that participate as both broker and as dealer. As a result, FINRA will begin requiring firms to report additional information to TRACE.

He said that regulators are also concerned about some of the protocols within the platforms. For example, some protocols allow participants to filter out participants with whom they do not wish to trade. Because participants may not wish to trade with certain counterparties, this may create an uneven playing field.

Wednesday, May 11, 2016

Giancarlo details Hippocratic oath for blockchain regulations

By Mark S. Nelson, J.D.

The ancient Greek physician Hippocrates is often cited as the founder of medical study, even if attribution to him of the Hippocratic oath—first, do no harm—is sometimes elusive. CFTC Commissioner J. Christopher Giancarlo, whose father was a doctor, has pulled together his several recent speeches on FinTech into a Hippocratic oath for regulators who may stand to gain by adopting globally harmonized rules for the use of blockchain or distributed ledger technology (DLT), but only if they take a “do no harm” approach akin to regulators’ handling of the Internet’s early days.

According to Giancarlo, “five practical steps” can ensure that both regulator and regulated can benefit from the use of new technologies, like DLT. As he has done in earlier presentations (Harvard law School; CFTC Technology Advisory Committee; DTCC 2016 Blockchain Symposium), Giancarlo imagines a financial world in which events like the 2008 financial crisis might be dealt with faster and in a more proportionate manner, if only regulators can access real-time ledgers of all market participants’ trading portfolios. In 2008, those technologies were several years away and regulators had to make old-school phone calls to gain insight into the unwinding of complex financial instruments.

Giancarlo said one step would be for financial regulators and industry participants to work together in a more collaborative manner. He said the emergence of DLT and other FinTech innovations have left a vacuum regarding legal clarity and rules for the marketplace are unlikely to materialize for years.

A second step is to promote the use of a regulatory sandbox where FinTech firms can explain their innovations to regulators without fear of enforcement actions. Giancarlo suggested that a U.S. version of the regulatory sandbox could follow the precepts employed by the U.K. Financial Conduct Authority’s Innovation Hub, which FCA Director of Strategy and Competition Christopher Woolard said was to begin taking applications this week. Giancarlo also noted that Australia, Singapore, and Japan may implement regulatory sandboxes or other flexible approaches to FinTech.

Yet another corollary of do no harm is spurring regulators to participate in proof of concept (POC) events in order to gain insight into how DLT and related FinTech innovations can help them to oversee markets. Giancarlo noted ongoing POCs led by DTCC regarding smart contracts for single name CDS and repo settlement. He also cited a Barclays POC that applied smart contracts to interest rate swaps, an early use of the R3 consortium’s Corda platform. Last month, a blog post by R3’s CTO Richard Brown introduced Corda to the world.

The fourth step is for regulators to listen and learn from FinTech firms. Giancarlo suggested that federal regulators also listen to their global counterparts, such as the FCA, which are far ahead of them in understanding FinTech. He also suggested looking to the state of Delaware, which has announced various initiatives on DLT and related technologies.
Lastly, Giancarlo urged global collaboration on DLT issues to avoid a scenario that results in a lack of international harmonization of regulatory standards. He suggested this aspect of the do no harm approach in a speech last month at the Cato Institute, where he cited a similar view proposed by IOSCO Chairman Greg Medcraft. According to Giancarlo, too much regulation, especially across multiple jurisdictions, could prevent DLT from achieving its full potential.

Tuesday, May 10, 2016

EC sees no current need for EU-level crowdfunding regulation

By John Filar Atwood

The European Commission has concluded that crowdfunding in the EU remains relatively small and local so there is no need at the moment for an EU-level regulatory framework for the crowdfunding sector. However, the EC acknowledged that the industry is growing rapidly and pledged to review developments at least twice a year to determine if it needs to take steps to support regulatory convergence in this area.

As part of its capital markets union action plan, the EC published a report on the EU crowdfunding sector. The EC believes that if it is appropriately regulated, crowdfunding has the potential to be a key source of financing for small and medium-sized entities (SMEs) over the long term.

The Commission notes in the report that member states have begun to put in place national frameworks to support the growth of crowdfunding and to ensure that investors are protected. The national frameworks are broadly consistent in terms of the objectives and outcomes they seek to achieve, the EC said, but are tailored to local markets and domestic regulatory approaches.

In a press release, EU Commissioner Jonathan Hill emphasized that the EC supports the development of crowdfunding models as a source of financing for entrepreneurs, start-ups and other SMEs. The Commission’s focus is on promoting best practice, appropriate investor protection and consistency of national regimes, he said.

Crowdfunding numbers. According to the report, approximately €4.2 billion was successfully raised through crowdfunding platforms in 2015 in the EU, compared with €1.6 billion in 2014. Crowdfunding projects were present in all member states, but activity is currently concentrated in a small number of member states. The U.K. has by far the largest amount raised and number of projects funded through crowdfunding, the report states.

The report indicates that cross-border project funding is still limited and crowdfunding remains a regional or local phenomenon to a large extent. Several member states have already introduced or are planning to introduce domestic custom regimes on crowdfunding with rules aimed at supporting the development of crowdfunding while addressing risks that may arise for investors.

Member state regulation. One purpose of the report is to assess national crowdfunding regulatory regimes and identify best practices. To date, seven EU member states have introduced custom regulatory frameworks for crowdfunding activities, with requirements for issuers/borrowers, platforms, and investors/lenders. In addition, the report notes that a number of member states are either preparing or planning to introduce a regulatory system.

The U.K. has the most developed market for peer-to-peer lending, according to the report, with a trade association representing 90 percent of the lending market. The trade association’s members must apply operating principles setting out the standards of business conduct, such as clarity and transparency, including on bad debt rates, returns performance and full loan book availability, risk management and reporting. These align with, and in some areas supplement, requirements of the U.K. Financial Conduct Authority, the report notes.

Data protection. The report states that in crowdfunding there is likely to be significant processing of personal data. Consequently, the rules of the Data Protection Directive will apply to platforms and issuers/borrowers. For example, data controllers should ensure that all data protection obligations are met, including right of access of individuals to their personal data.

The report notes that the Data Protection Directive has liability and compensation provisions for unlawful processing of or incompatible acts relating to the processing of personal data, which are separate from the other liability regimes. The report suggests that crowdfunding platforms need to ensure the awareness of and compliance with the obligations for data controllers and data processors and the rights of individuals.

According to the report, in addition to regulatory frameworks put in place by governments, several industry associations have introduced systems of self-regulation for crowdfunding. These include codes of conduct which may set minimum requirements and best practices for platforms in terms of transparency and good business conduct.

Guiding principles. The report indicates that the European Crowdfunding Network has published some guiding principles as its code of conduct for observation and application by its members and the European crowdfunding industry at large. The guiding principles are: act with integrity and in fairness; keep your promises; disclose conflicts of interest; foster data transparency; maintain confidentiality; do not harm the industry, society or environment; and use, at all times, adequate and appropriate human and technical resources that are necessary for the proper management of a crowdfunding platform. The Code of Conduct also sets out specific compliance procedure, such standardized information sheets and reporting requirements, the report notes.

Monday, May 09, 2016

Nothing's shocking as Electrical Workers case is sent back to state court

By Rodney F. Tonkovic, J.D.

The district court sitting in California's Northern District has sent yet another case alleging only claims under the Securities Act back to the state court from which it originated. This reinforces what is becoming the dominant view in the circuits, and what is definitely the current view of the Ninth Circuit: that only covered class actions based on state law can be removed to federal court. Finding that the action was filed in a state court of competent jurisdiction and was thus not removable, the court granted the plaintiff's motion to remand (Electrical Workers Local #357 Pension and Health & Welfare Trusts v. Clovis Oncology, Inc., May 5, 2016, Chen, E.).

Clovis Oncology, Inc. is a biopharmaceutical company that, in May 2014, announced that the FDA had granted "Breakthrough Therapy" designation for its product, rociletinib, a treatment for lung cancer. One year later, Clovis filed a prospectus for a secondary offering. In late 2015, however, Clovis announced that the FDA had requested more clinical data on rociletinib and that the Prescription Drug User Fee Act date for Clovis's NDA for rociletinib was extended by three months; Clovis's share price dropped after each of these announcements.

Complaint filed. In early 2016, this action was filed in the San Mateo County Superior Court on behalf of all persons who acquired Clovis common issued in connection with the secondary offering. The complaint, which asserted claims under Sections 11, 12, and 15 of the Securities Act, alleged that Clovis knew, but concealed from investors, that, among other items, the NDA submitted by Clovis contained an immature data set and that the NDA was likely to be either delayed or rejected. In February 2016, Clovis removed the action to the Northern District, and, in response, the plaintiffs filed a motion to remand the action back to state court.

Remanded. The district court found that it lacked jurisdiction over the action and remanded it to the state court. The court noted at the outset that the majority of courts that have addressed the issue concluded that removal of securities class actions with only federal claims is explicitly barred by the Securities Act, as amended by the SLUSA, and that these actions must be remanded to state court.

According to the court, the plain language of the removal provision states that only covered class actions asserting state law claims are removable. This reading, the court said, is consistent with dicta from opinions of the Supreme Court and the Ninth Circuit. Reinforcing its point, the court observed that every court in its district has granted remand of removed suits alleging violations of the Securities Act and that this "appears to be emerging as the dominant view around the country." Moreover, many of these courts have analyzed and rejected the arguments advanced by Clovis in this case. The SLUSA's legislative history supports this conclusion, the court added.

The case is No. 3:16-cv-00933.

Friday, May 06, 2016

Cyber bill would up ante for internal controls reporting

By Mark S. Nelson, J.D.

A bill introduced by Rep. Jim McDermott (D-Wash) would bring the Sarbanes-Oxley Act into the world of modern technology by explicitly making cybersecurity a part of internal controls reporting. But the Cybersecurity Systems and Risks Reporting Act (H.R. 5069) stands in contrast to the less exacting disclosures that would be required by a bill introduced in the Senate last December. If enacted, either bill would add cybersecurity to the growing list of disclosures required by reporting companies.

Executive certifications. Enactment of SOX Section 302 squarely put the onus on executives to stand behind their companies’ financial reports by requiring CEOs and CFOs to certify these disclosures, including the effectiveness of internal controls, subject to hefty fines and imprisonment for knowing or willful violations of the certification requirement. Under the McDermott bill, the certification mandate would be extended to include a company’s principal cybersecurity systems officer or officers.

The McDermott bill also defines several key terms, including “information system” and “cybersecurity system.” According to the bill, “cybersecurity risk” means a significant vulnerability to, or deficiency in, the security and defense activities of a cybersecurity system.

Internal controls assessment. SOX Section 404 requires a company’s managers to state their responsibility for and their assessment of the effectiveness of the company’s internal controls. This requirement, subject to an exception for emerging growth companies and an exemption for smaller issuers, is buttressed by the accompanying registered public accountant’s attestation and report on the assessment made by the company’s managers.

The McDermott bill would revise managers’ duties to include cybersecurity systems structures and procedures for financial and information systems reporting. A public accountant that prepares or issues the audit report for a company likewise would have its duties regarding the attestation and report on managements’ assessment expanded to embrace cybersecurity system structure assessments.

Audit committee expert. The McDermott bill also would amend SOX Section 407, which defines “financial expert,” to require a company to disclose whether (and if not, the reasons why not) its audit committee has at least one member who is a cybersecurity systems expert. The relevant terms of art would be defined by the Commission in consultation with the Department of Homeland Security and the Commerce Department.

The Commission’s definition of “cybersecurity expert” must consider whether a person, through education or experience as an information technology or systems security officer, has: (1) an understanding of generally accepted principles of computer, network, and data security and privacy; (2) experience in preparing information systems audits for cybersecurity risk discovery and related experience in implementing and monitoring information and cybersecurity systems; (3) experience with the information systems aspect of internal accounting controls; and (4) an understanding of how audit committees function.

Enhanced disclosure reviews. The SEC’s staff already reviews Exchange Act reporting companies’ filings at least once every three years under SOX Section 408. This provision would be revised to add cybersecurity risks disclosures to the list of criteria the Commission must consider in scheduling these reviews. As a result, periodic reviews would include a review of a company’s financial statement and its information systems and cybersecurity systems statements.

Senate alternative. In contrast to the extensive disclosures and certifications that would be required by the McDermott bill, related Senate legislation would impose comparatively fewer obligations. Under the Cybersecurity Disclosure Act of 2015 (S. 2410), co-sponsored by Sens. Jack Reed (D-RI) and Susan Collins (R-Maine), the Commission would have to issue final rules within a year of enactment to require reporting companies to make cybersecurity disclosures in their annual report or annual proxy statement.

Specifically, the Reed-Collins bill would require a company to disclosure if any member of its board of directors has cybersecurity expertise or experience, and to fully describe that expertise or experience. In the case of a board with no member who has this expertise or experience, the company must state the cybersecurity steps considered by those persons who identify and vet board nominees. The proposed disclosures are similar to the McDermott bill’s audit committee expertise disclosure.

The Reed-Collins bill also requires the Commission to coordinate with another federal agency that has cybersecurity subject matter expertise. But unlike the McDermott bill, which requires consultation with the Department of Homeland Security and the Commerce Department, the Reed-Collins bill would have the Commission coordinate with the National Institute of Standards and Technology.

Thursday, May 05, 2016

ECB study calls for tighter controls on release of market-moving news

By John Filar Atwood

A European Central Bank (ECB) study on the movement of stock index and Treasury futures markets around the release of U.S. macroeconomic news has found evidence of substantial informed trading before the official release time. As a result, the ECB said that strict release procedures should be implemented for all market-moving announcements, including announcements originating in the private sector.

The working paper examined the prevalence of pre-announcement price drift in U.S. stock and bond markets and looked for possible explanations. The authors found that seven out of 21 market-moving announcements show evidence of substantial informed trading before the official release time.

According to the paper, prices begin to move in the “correct” direction about 30 minutes before the release time, and the pre-announcement price drift accounts on average for about half of the total price adjustment. The authors defined the “correct” direction as movement in the direction of the price change consistent with the announcement surprise.

Private information. The authors concluded that the results imply that some traders have private information about macroeconomic fundamentals. In addition, they believe the preannouncement drift likely comes from a combination of information leakage and superior forecasting based on proprietary data collection and reprocessing of public information.

The paper also concluded that the total impact of macroeconomic news is larger than measured in most event studies, which ignore the pre-release price drift. Consequently, the authors believe that the total impact of macroeconomic news on financial markets is larger, and financial markets are linked more tightly to the real economy, than usually found.

Study mechanics. The authors studied the impact of announcements on second-by-second E-mini S&P 500 stock index and 10-year Treasury note futures from January 2008 to March 2014. The study was based on 21 market-moving announcements among a sample of 30 U.S. macroeconomic announcements. According to the paper, 11 of the 21 announcements exhibited some pre-announcement price drift, and for seven of the announcements the drift was substantial.

The authors found that extending the sample period back to 2003 with minute-by-minute data revealed both a higher announcement impact and a stronger pre-announcement drift since 2008, particularly in the S&P E-mini futures market. They estimated that since 2008 in the S&P E-mini futures market alone the profits associated with trading prior to the official announcement release time have amounted to about $20 million per year.

Pre-release drift. The paper stated that the difficulty in identifying the causes of pre-announcement drift stems from the relatively small number of announcements that actually move financial markets. However, the authors still found that an implementation of strict release procedures makes pre-release drift less likely. They said that this applies in particular to data released under the Principal Federal Economic Indicator guidelines, which impose strict security procedures.

The authors noted that public information, such as internet activity data, predicted the surprise in a few cases where the public information closely corresponded to the forecasting target. Similarly, improvements in data processing render privately collecting large amounts of comparable information feasible, which can be used for generating proprietary forecasts ahead of time, they stated.

Wednesday, May 04, 2016

NASAA proposes policy on electronic offering documents

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

NASAA's Corporation Finance Section has released for public comment a proposed policy statement on the use of electronic offering documents and signatures. The proposal seeks to establish uniform state guidelines for issuers wishing to provide investors with electronic subscription agreements and other documents that may be executed electronically.

Uniform guidelines. NASAA’s proposal reflects the ongoing efforts of state regulators to address appropriately the increasing use of technology in the securities industry. NASAA’s proposing release notes that several issuers have requested no-action letters or other relief on a case-by-case basis in order to gain state approval of the electronic distribution and execution of offering documents. The proposed statement of policy is intended to provide a tool for NASAA jurisdictions to establish uniform standards for these initiatives and to streamline the process for industry participants.

Format, delivery, and custody. The proposal would permit an issuer to deliver offering documents, including subscription agreements, over the Internet or by other electronic means, provided that they are prepared and delivered in a manner consistent with state and federal securities laws. The offering documents must be delivered as a single, integrated document or file that permits storage and printing by the recipient and which does not contain any links to or from external documents or content.

The issuer must obtain informed consent from the prospective investor to receive the documents electronically and must maintain evidence of delivery, among other requirements. An investor may revoke his or her consent at any time. Investors who decline to receive documents electronically must not be subjected to higher costs, other than the direct cost of printing, mailing, and processing the documents in paper form.

Entities participating in an electronic documents initiative—including placement agents, broker-dealers, and other selling agents—must maintain written policies and procedures governing their use. Entities and agents which have custody of these documents must store them in a non-rewriteable and non-erasable format and maintain secure offsite backups.

Request for comments. Comments on the proposal are due by June 1, 2016. After the comment period has closed, NASAA will post the comments it receives to its website.

Tuesday, May 03, 2016

Blockchain protocol for financial firms released as open source software

By Anne Sherry, J.D.

The blockchain protocol developed for financial firms over the last 18 months is now available to the wider financial community. Chain, Inc., which developed the protocol in partnership with Nasdaq, Fidelity, Citi, and other financial firms, released the blockchain standard as open source software. The service promises to reduce costs and enable new product opportunities by enabling institutions to securely issue, transact, and store financial assets digitally.

Blockchain technology was invented by the creator of Bitcoin, who used the pseudonym Satoshi Nakamoto. (Unrelated to the Chain announcement, an Australian computer scientist named Craig Wright today came forward as Nakamoto, although Bitcoin experts and enthusiasts are skeptical.) A blockchain enables transactions to be recorded in a digital ledger that can span multiple organizations and is impossible to forge. Chain Open Standard 1 (Chain OS 1) promises to address key requirements of financial institutions:
  • Support for any asset in any market;
  • Role-based permissions for users;
  • Selective privacy so that only the parties to a transaction can view its details; 
  • Immediate transactions with absolute finality;
  • Smart contracts with automatic enforcement and no counterparty risk;
  • High scalability;
  • Perfect auditability;
  • Integrated compliance data;
  • Integration with existing financial systems and other blockchain protocols.
Chain's website provides some examples of financial transactions that can use Chain OS 1, from a simple transfer of assets to a collateralized loan.

Last year, Nasdaq announced that its partnership with Chain would allow stockholders to seamlessly transfer securities between entities, while also providing companies with a complete historical record of the issuance and transfer of their securities. Capital One, Citigroup, Fidelity, First Data, Fiserv, MUFG, State Street, and Visa also partnered with Chain during the development process.

Monday, May 02, 2016

Agency officials give views on derivatives enforcement trends

By Lene Powell, J.D.

In a discussion panel hosted by the Practising Law Institute, enforcement officials from the CFTC, SEC, Department of Justice, and other agencies talked about new types of cases their agencies are bringing in the commodities and derivatives space under the Dodd-Frank Act, as well as the issue of individual versus corporate liability.

Commodities insider trading. Ben Singer, chief of the DOJ Securities & Financial Fraud Unit, said most people think of equities when it comes to insider trading, but the same incentives at play in the equities markets also affect the swaps and derivatives markets. The Dodd-Frank Act added a provision involving misappropriation of inside information to the Commodity Exchange Act (CEA), and the CFTC brought its first enforcement action under this provision last year (In re Motazedi).

Singer didn’t think any criminal cases have yet been brought in this area, but anticipates that there will be action over the next year or two from the DOJ. In particular, it’s likely that the DOJ’s work will bring out insider trading in the foreign exchange (FX) space. When traders get market-moving info, they can act on it. But if the information is obtained in violation of a trust or duty to a client, then it can sound in fraud, he said.

Commodities spoofing. In 2013, the CFTC settled its first enforcement action for spoofing, a type of disruptive trading practice specifically made illegal by the Dodd-Frank Act. The CFTC’s order found that Michael Coscia and his firm Panther Energy Trading violated Section 4c of the CEA by placing orders for trades with the intent of canceling them before execution in order to move prices in the direction he desired. The DOJ obtained a guilty verdict in its criminal case against Coscia in 2015, following jury deliberations that lasted only one hour.

The benefit of having the first trial out of the way is that you see what the government has to prove and what the jury instructions will be, said Singer. His office is working on its case against Navinder Sarao, alleged to have engaged in spoofing activity during the May 2010 Flash Crash. The CFTC is also pursuing a case against Sarao. The DOJ has prevailed in the U.K. extradition proceedings. Although there is no specific spoofing statute in the U.K., the court found that the conduct resembled conduct prohibited by other statutes. Given the international nature of the commodities markets, this extradition ruling was an important precedent, said Singer. He hopes it will survive appeals.

Singer thinks there will be an uptick in spoofing cases. At least anecdotally, it seems this conduct is pretty widespread in the markets, he said. In fact, Sarao himself complained about other people spoofing in the markets.

Benchmark manipulation. CFTC Enforcement Director Aitan Goelman said in the benchmark manipulation cases brought by the CFTC and other authorities, a cabal of banks conspired against their customers. He said benchmark manipulation is widespread and “there is no reason to be sanguine about the integrity of any benchmark.” The CFTC is moving through various benchmarks in a seriatim manner, including LIBOR, FX, and ISDAfix.

False statements. Goelman said it’s probably not a surprise that a violation of Section 6(c)(2) of the CEA to lie to the CFTC. However, not all might be aware that it’s also a violation to lie to the exchanges and the National Futures Association (NFA). The CFTC recently issued an order in In the Matter of Galileo Trading, a commodity pool fraud case in which the respondent made false statements to the NFA.

When false statements are made to regulators, said Goelman, “That’s on the record. It counts. People lie to us all the time, and most of the time we can’t prove it. But where we can prove it, we bring those cases.”

SEC derivatives rules. Michael Osnato, chief of the SEC enforcement unit focusing on complex instruments including derivatives, called attention to recently issued business conduct rules for swap dealers, which include requirements for fair dealing and disclosure of conflicts of interest. Although the rules are not effective yet, the unit is gearing up for enforcement. He said that although enforcement has traditionally been reactive, the SEC is building out a surveillance infrastructure that allowing the agency to mine the data for aberrational behavior, so it can pursue a proactive approach.

Individual vs. corporate liability. In 2015, the DOJ issued the “Yates Memo”, which described a renewed focus on sanctions for individual wrongdoers. Singer said it’s not really anything new, but perhaps it got attention, which is useful. It’s probably too early to tell if it has made a real difference, but the DOJ has seen some uptick in the level of cooperation and the specificity of information they are getting with respect to individuals. A recent case against two individual executives at State Street was really driven by the cooperation of the company, he said.

Osnato said that it’s always been a longstanding SEC practice to build cases from the bottom up, and that you can’t bring a fraud case without a laser focus on individuals. Part of cooperation is identifying and remediating any individual bad actors. He said this particular Commission has taken a very aggressive approach to enforcement and staff has to account for what they have done or not done. The SEC always tries to anchor the state of mind in a person. If there’s a feel of collective scienter, that certainly influences the choice of penalties and relief, he said.

Regarding the role of remedial sanctions, Osnato said that the SEC looks to see what compliance measures are already in place, and this factors into penalties. In the LIBOR and FX cases he works on, the SEC works closely with the CFTC to come up with measures that make sense. In other areas, they coordinate with other regulators.

Larry Parkinson, director of investigations at FERC, said his agency builds compliance credit into their penalty program. In particular, they look at compliance culture. Companies often pay a lot of money to have a law firm create a compliance manual, but often the books are left on the shelf. Training is either sloppy or ineffective, he said. When the company is investigated, the compliance manual is trotted out, but it is often accomplishing very little in-house. FERC looks at how knowledge of the rules filters down, and what kind of training program is in place. He said that a culture of compliance doesn’t just happen naturally—it’s driven by an institutional focus on compliance.

Friday, April 29, 2016

House passes bill easing solicitation restrictions on angel investors

By Amanda Maine, J.D.

The House of Representatives has passed a bill aimed at encouraging investments from “angel” investors by exempting certain investor events from being considered “general solicitation” under the federal securities laws. The bill passed on a 325-89 vote, although some Democrats and the Obama Administration have expressed concerns that it does not do enough to protect investors.

HALOS Act. The Helping Angels Lead Our Startups Act (HALOS Act) clarifies the definition of “general solicitation” under Rule 506 of Regulation D. Rule 506 allows companies to offer securities for sale to up to 35 non-accredited investors and an unlimited number of accredited investors as long as the securities are not marketed through general solicitations or advertising. Under the JOBS Act of 2012, issuers that take “reasonable steps” to verify that the purchasers are actually accredited investors may market its securities through general solicitations or advertising. The “reasonable steps” requirement was added to protect unsophisticated investors who may not understand the risks of investing.

The HALOS Act would exempt issuers that hold investor events, such as “Demo Days,” from requiring the taking of reasonable steps to verify the accredited investor status of specific groups deemed “angel investors,” essentially exempting these events from being considered a general solicitation. An “angel investor group” under the HALOS Act is a group that: (1) is composed of accredited investors interested in investing personal capital in early-stage companies; (2) holds regular meetings and has defined processes and procedures for making investment decisions, either individually or among the membership of the group as a whole; and (3) is neither associated nor affiliated with brokers, dealers, or investment advisers. The HALOS Act also rolls back the verification requirement for sales groups sponsored by colleges, nonprofits, and trade associations.

According to House Financial Services Chair Jeb Hensarling (R-Texas), the HALOS Act fixes “regulatory overreach” by helping angel investors provide early-stage capital for startups.

Investor protection concerns. While the bill passed with bipartisan support, Financial Services Committee Ranking Member Maxine Waters (D-Calif) raised concerns that the HALOS Act could harm retail investors. Events sponsored by government entities, nonprofits, and universities, she said, are likely to attract non-accredited investors, which are the people the verification requirement is intended to protect. Waters had offered an amendment that would codify existing relief that the SEC has already provided to angel investor groups and would limit the exemptions to operating companies to prevent shell companies and hedge funds from soliciting unknowing investors into potentially risky offerings. However, the Waters amendment was defeated by a vote of 139-272.

The Obama Administration also issued a statement expressing concerns with the bill. In the statement, the Administration acknowledged that exempting angel investors and other groups from the requirement that issuers take reasonable steps to verify an investor’s accredited investor status could make it easier to raise capital. However, it could also result in some investors being subject to increased risk. The Administration stated that it would like to work with Congress on the HALOS Act as it moves forward to increase protections for investors.