Friday, July 03, 2015

Fifth Circuit Seeks Mulligan on Texas Law Question in Golf Channel case

By R. Jason Howard, J.D.

On appeal from the District Court for the Northern District of Texas, the Fifth Circuit Court of Appeals has granted a petition for panel rehearing, vacated its original opinion, and substituted an opinion certifying a question raised on the interpretation of the Texas Uniform Fraudulent Transfer Act’s (TUFTA) definition of “value” in the context of a good faith transferee of a Ponzi scheme. The certified question concerns an issue of state law that no on-point precedent from the Supreme Court of Texas has resolved (Janvey v. The Golf Channel, Inc., June 30, 2015, per curiam).

Background. Allen Stanford operated a multi-billion dollar Ponzi-scheme for nearly two decades before it was discovered. By 2005, Stanford had devised a plan to increase awareness of the brand, Stanford International Bank Limited (Stanford) and its affiliate entities, by marketing to sports audiences. Thereafter, Stanford became a title sponsor of the Stanford St. Jude’s Championship, an annual PGA Tour event held in Memphis, Tennessee.

Upon discovering this, the Golf Channel offered Stanford an advertising package to augment its advertising efforts and in the ensuing years, Stanford paid at least $5.9 million to the Golf Channel pursuant to the advertising agreement.

In 2009, the SEC uncovered the Ponzi scheme and filed suit in the Northern District of Texas against Stanford and related entities. Ralph S. Janvey was appointed as receiver and, pursuant to his powers, he filed suit under TUFTA to recover the full $5.9 million.

District Court finding. The District Court sided with the Golf Channel, and although the court determined that the payments to the Golf Channel were fraudulent transfers under TUFTA, Golf Channel was entitled to judgment as a matter of law as it met the two elements of TUFTA’s affirmative defense that: (1) it took the transfer in good faith; and (2) in return for the transfer, it gave the debtor something of “reasonably equivalent value” (the market value of advertising on The Golf Channel).

There the court explained that “Golf Channel looks more like an innocent trade creditor than a salesman perpetrating and extending the Stanford Ponzi scheme.” In granting Golf Channel’s motion for summary judgment, the court compared Golf Channel’s services to consumables and speculative investments, which have been held to have value under the Uniform Fraudulent Transfer Act (UFTA) and section 548 of the Bankruptcy Code.

Fifth Circuit. In order to determine if Janvey, as receiver, is entitled to disgorge the $5.9 million that Golf Channel received, the Fifth Circuit turned to Texas law, specifically looking to interpret the meanings of “value” and “reasonably equivalent value” in TUFTA.

Noting that there was no on-point precedent from the Supreme Court of Texas interpreting the meanings of “value” and/or “reasonably equivalent value,” the Fifth Circuit certified a question to the Texas Supreme Court because it was unable to reconcile whether, under TUFTA, proof of the market value is sufficient to establish “reasonably equivalent value” for purposes of the affirmative defense or whether the transferee must produce specific evidence to show value of the transfer to the debtor’s creditors.

Question certified. The Fifth Circuit certified the following question while also disclaiming “any intention or desire that the Supreme Court of Texas confine its reply to the precise form or scope of the question certified”:

  • “Considering the definition of “value” in section 24.004(a) of the Texas Business and Commerce Code, the definition of “reasonably equivalent value” in section 24.004(d) of the Texas Business and Commerce Code, and the comment in the Uniform Fraudulent Transfer Act stating that “value” is measured “from a creditor’s viewpoint,” what showing of “value” under TUFTA is sufficient for a transferee to prove the elements of the affirmative defense under section 24.009(a) of the Texas Business and Commerce Code?”

The case is No. 13-11305.

Thursday, July 02, 2015

District Court Lacks Jurisdiction Over Constitutional Claims Against SEC ALJs

By Amanda Maine, J.D.

A district court dismissed a complaint because it did not have subject matter jurisdiction to address the plaintiffs’ constitutional claims that SEC administrative law judges do not have lawful authority to preside over their case. The plaintiffs were unable to establish that pursuing their claims through the statutory review scheme would result in a denial of meaningful judicial review (SEC v. Tilton, June 30, 2015, Abrams, R.).

Background. In March 2015, the SEC commenced an administrative cease-and-desist proceeding against investment adviser Patriarch Partners LLC, its founder and CEO Lynn Tilton, and several affiliated companies (plaintiffs). The SEC alleged that the plaintiffs provided false and misleading information about certain CLO funds they managed and engaged in a deceptive scheme relating to the values they reported for these funds’ assets.

The plaintiffs sought to enjoin the administrative proceeding, claiming that the method for appointing and removing the SEC’s administrative law judges (ALJs) violates the Appointments Clause of the U.S. Constitution. According to the plaintiffs, the ALJs are “inferior officers” that enjoy two layers of tenure protection in violation of the Constitution. The SEC moved to dismiss, arguing that the district court lacked subject matter jurisdiction over the plaintiffs’ claims because they must seek review only before a court of appeals after going through the administrative process.

Judicial review. The plaintiffs contended that going through the designated scheme would deny them meaningful judicial review. The district court disagreed, noting that precedent involving the constitutionality of ALJs, such as Landry v. FDIC, has allowed such proceedings to go forward even though the plaintiffs argued that they would be forced to endure the very proceedings they claim are unconstitutional. The court also rejected the plaintiffs’ contention that should the ALJ find for the SEC, they would be subject to “irreparable reputational and financial harm.” The court pointed out that such harm would be no different than the harm that would follow a similar finding in a district court.

The plaintiffs also argued that their constitutional claims could not be raised effectively in an administrative proceeding because SEC rules bar them from raising their claims as counterclaims. The court observed that these claims may effectively be raised as affirmative defenses in SEC administrative proceedings. It also rejected the plaintiffs’ argument that SEC rules do not allow the same kind of discovery available in district court, noting that as a purely legal matter, no discovery is necessary to adjudicate their constitutional claims. Meaningful review will still be had, the court stated, so long as the remedial scheme provides for federal appellate court review. Finally, concerns about the SEC’s potential bias may also be addressed by a court of appeals, according to the court.

Wholly collateral. The plaintiffs also argued that because their constitutional challenge is “facial” (unconstitutional in all instances) rather than “as-applied” (relating to the facts of a specific case), it should be considered collateral and should thus be heard in district court. The court admitted that whether the claims should be considered collateral is a close question, but ultimately concluded that because the plaintiffs are able to raise their claims within an administrative scheme as an affirmative defense, the claims are not wholly collateral to that scheme.

Agency expertise. Finally, while the court recognized that the constitutional claims raised by the plaintiffs may not be within an SEC ALJ’s expertise, the court again pointed out that meaningful review of those claims by an appellate court is available, precluding district court jurisdiction.

The case is No. 15-CV-2472.

Wednesday, July 01, 2015

Commissioners Piwowar, Stein United on Move to T+2 Settlement

By Mark S. Nelson, J.D.

Commissioners Michael S. Piwowar and Kara M. Stein demonstrated solidarity in backing a proposal by the securities industry to shorten the settlement cycle from T+3 to T+2 days. The commissioners said the proposal, and feedback the Commission got from its Investor Advisory Committee, show that a faster cycle could lessen systemic risks and boost capital efficiency, according to a joint statement.

“We look forward to working with our fellow Commissioners and the staff, as well as partnering with market participants to shorten the settlement cycle as soon as possible,” said Piwowar and Stein.

A few weeks ago, the Securities Industry and Financial Markets Association (SIFMA) and the Investment Company Institute (ICI) wrote to SEC Chair Mary Jo White to press for regulatory changes that would let their members adopt a T+2 settlement cycle for secondary market transactions. The industry groups explained that the SEC and other regulators may need to update some of their rules to accommodate the new cycle. They also said the proposal does not seek changes to settlement cycles in primary markets.

Moreover, the Industry Steering Committee (ISC), in conjunction with PricewaterhouseCoopers LLP, The Depository Trust & Clearing Corporation, SIFMA, ICI and others, has issued a white paper that explains the proposal in greater detail. The ISC paper sets a timetable for achieving T+2 by Q3 2017.

Tuesday, June 30, 2015

KKR to Pay $30 Million to Settle ‘Broken Deal’ Misallocation Charges

By Amanda Maine, J.D.

Private equity firm Kohlberg Kravis Roberts & Co. (KKR) has agreed to settle SEC charges that it breached its fiduciary duty by misallocating diligence expenses related to unsuccessful deals and by not disclosing how these expenses were allocated. KKR agreed to pay nearly $30 million in disgorgement, prejudgment interest, and penalties to settle the matter with the SEC, which had alleged that KKR’s conduct violated Investment Advisers Act Sections 206(2) and 206(4) and Rule 206(4)-7 (In the Matter of Kohlberg Kravis Roberts & Co. L.P., Release No. IA-4131, June 29, 2015).

According to Enforcement Director Andrew J. Ceresney, the KKR proceeding “is the first SEC case to charge a private equity adviser with misallocating broken deal expenses.”

2006 Fund. KKR, which is registered with the SEC as an investment adviser, advises and manages its main private equity funds (Flagship PE Funds) and other co-investment vehicles. Between 2006 and 2011, the KKR 2006 Fund LP (2006 Fund) was KKR’s largest private equity fund, investing over $16.5 billion.

Limited partners in KKR’s private equity funds include large institutional investors such as pension funds and university endowments. KKR also establishes co-investment vehicles for its executives, certain consultants, and others to make co-investments. Under the 2006 Fund’s limited partnership agreement (LPA), up to 5 percent of every portfolio investment is reserved for these co-investors.

Broken deal expenses. KKR’s “broken deal” expenses include research costs, travel costs, professional fees, and other expenses incurred in deal sourcing activities for deals that never materialize. The 2006 Fund LPA required the fund to pay all broken deal expenses incurred by, or on behalf of, the fund.

According to the SEC, KKR bore 20 percent of the broken deal expenses of the 2006 Fund but did not allocate broken deal expenses to KKR co-investors, even though the co-investment vehicles participated in and benefited from KKR’s general sourcing of transactions. KKR also failed to disclose in the LPA and offering materials that it did not allocate broken deal expenses to the KKR co-investors. This resulted in the misallocation of $17.4 million in broken deal expenses between its Flagship PE Funds and the co-investors and was a breach of its fiduciary duty as an investment adviser, the SEC alleged.

Revision of allocation methodology. Following an internal review and a later review by a third-party consultant, KKR revised its broken deal expense allocation methodology in 2012. The SEC’s Office of Compliance Inspections and Examinations (OCIE) conducted an examination of KKR’s fund expense allocation practices in 2013. During this time, KKR refunded some of the misallocated expenses to the Flagship PE Funds.

Charges and settlement. The SEC’s order instituting administrative proceedings alleged that KKR’s broken deal expenses conduct violated Advisers Act Section 206(2). In addition, the order charged KKR with violating Section 206(4) and Rule 206(4)-7 for not adopting and implementing written policies and procedures designed to prevent violations of the Advisers Act. To settle the charges, KKR agreed to pay disgorgement and prejudgment interest of $18.7 million and a civil penalty of $10 million. KKR also agreed to cease and desist from committing further violations.

The release is No. IA-4131.

Monday, June 29, 2015

Aguilar Calls for Public/Private Partnership to Address Cyber Crime

By Jacquelyn Lumb

Commission Luis Aguilar spoke last week at the SINET Innovation Summit on the need for a public and private sector partnership to help combat cyber crime. Cybersecurity is one of the defining issues of our time, he said, and no single organization has the resources or the expertise to combat it alone.

SEC’s approach. Aguilar reviewed some of the developments over the past few years, all of which emphasize the serious and persistent threat posed by cyber crime. The financial industry, in particular, is a prime target for cyber criminals. Aguilar described the SEC’s multi-faceted approach to cyber security, which includes the adoption of new rules, the inspection and examination of regulated entities, enforcement actions, and the issuance of guidance for the industry and the public.

Regulation SCI. Key market participants must comply with the SEC’s Regulation Systems Compliance and Analysis (Reg. SCI) in November, which requires that they implement robust cybersecurity protocols to ensure that their systems are secure, and also that enables them to recover if an attack succeeds. These entities must monitor their systems for cyberattacks, promptly respond to any intrusions, and report these events to the SEC within 24 hours.

Aguilar pointed out that Reg. SCI holds the most critical systems to a higher standard. It also mandates that senior management and the board of directors be actively engaged in cybersecurity issues. Board involvement ensures greater accountability, he explained. It also may make breaches less likely and less costly when they occur.

Examinations. Aguilar reviewed the results of the sweep conducted last year by the Office of Compliance Inspections and Examinations of the cybersecurity protocols of 57 broker-dealers and 49 investment advisers. The sweep revealed that most of the firms had been subject to an attack. Most firms had written policies relating to information security and cyberattacks, but they generally failed to specify how firms would determine responsibility for client losses from an attack.

OCIE found that two-thirds of the broker-dealers and one-third of the advisers had a designated chief information officer. Just over half of the broker-dealers and less than a quarter of advisers carried cybersecurity insurance. Aguilar said that the designation of an information security officer and carrying cybersecurity insurance are commonsense precautions that will decrease the costs of a data breach. He found it disappointing that so many firms fell short in these areas.

Enforcement. Aguilar described a number of enforcement actions relating to data breaches and the failure to protect customers’ confidential information. He assured that the SEC takes cybersecurity issues very seriously and said the industry must do so as well.

Staff guidance. Aguilar also reviewed staff guidance related to cybersecurity issues, including guidance for investment advisers and investment companies, guidance for public companies about their obligation to disclosure cybersecurity risks, and guidance for investors on ways to avoid being the victims of cyber criminals.

Information sharing. Cyber crime is a common threat that requires a coordinated response, according to Aguilar. One of the best defenses against cyberattacks is the prompt sharing of actionable information about threats and potential defenses, he explained. Harnessing the industry’s collective knowledge and coordinating responses will improve cyber defense, he said.

Many experts have advised that cybersecurity defenses will not be truly effective until the process for sharing threat intelligence is automated. While there are industry specific information sharing and analysis centers, they may prevent the broader sharing of cyber threat intelligence that may help other industries and companies. Aguilar said that an executive order signed by President Obama earlier this year may help. It directs the Department of Homeland Security to develop new information sharing and analysis organizations and to develop common standards for sharing cyber threat intelligence.

Legislative fix. Aguilar said that legal risks to information sharing present another barrier that only legislation can address. He called on Congress to put aside its differences and adopt legislation that will allow firms to share information without the fear of liability.

Additional measures. The SEC also should take additional measures, in Aguilar’s view. It should expand the scope of Reg. SCI to include other market participants, ensure that public companies provide better and more timely information about their cybersecurity risks, and provide more guidance to market intermediaries about how to respond to more limited cybersecurity incidents. He reiterated, however, that the linchpin to an effective cybersecurity framework is a vibrant public and private sector partnership.

Saturday, June 27, 2015

No Surprise Here, CPA’s Failure to Conduct Required Exams Draws SEC Ire

By Joanne Cursinella, J.D.

The Commission has accepted offers of settlement in a cease-and-desist proceeding against an Ohio CPA firm and a partner in the firm for failing, pursuant to the Advisers Act custody rule, to conduct required surprise examinations of its investment adviser client (In the Matter of Michael S. Wilson, CPA and Cotterman-Wilson, CPAs, Inc., Release No. 34-75298, June 25, 2015).

Custody rule requirements. Investment Advisers Act Section 206(4) and Rule 206(4)-2 thereunder (the so-called custody rule), require registered investment advisers with custody of client funds or securities to implement certain controls designed to protect those client assets from loss, misappropriation, misuse, or the adviser’s insolvency. Professional Investment Management, Inc. (PIM) is a registered investment adviser subject to the rule. The firm hired Cotterman-Wilson, CPAs (respondents) to complete its required surprise examinations for the periods ending April 30, 2009, April 30, 2010, and May 31, 2011. According to the Commission’s order, Wilson, also a CPA and a Cotterman-Wilson shareholder, served as the engagement partner for all of the services provided to PIM, including the surprise examinations.

SEC files suit. The SEC filed suit against PIM and its owner Douglas E. Cowgill in the Southern District of Ohio in 2014 claiming that they violated the antifraud provisions of the U.S. securities laws, and that PIM violated, and Cowgill aided and abetted and caused PIM’s violations of, the registration provisions of the Advisers Act and the custody rule. In an amended complaint, the Commission also alleged that PIM and Cowgill hid a shortfall of more than $700,000 in client assets by sending false account statements to clients.

According to the Commission, PIM was obligated in 2009, pursuant to the relevant custody rule requirements, to have the client assets held in omnibus accounts by custodians verified through surprise examination by an independent public accountant because none of these custodians sent quarterly account statements directly to PIM’s clients (and PIM did not have a reasonable basis for believing that they did so), and also was obligated in 2010 and 2011 to have the client assets held in omnibus accounts at by certain custodians verified through surprise examination by an independent public accountant because PIM had custody of those assets.

Commission deems respondents’ work deficient. According to the Commission, the respondents’ 2009 report lacked reasonable basis in that they did not obtain a management assertion upon which their opinion is purportedly based, and they had identified material variances in the records of certain of PIM’s client securities-holding accounts that were never explained. Also, the respondents never filed a Form ADV with the Commission in connection with this examination.

For 2010 and 2011, the Commission said that the respondents neither completed the exams nor did they timely withdraw from them. Again they never filed the required Form ADV in connection with either of the examinations.

Findings and sanctions. The Commission found that the respondents caused PIM’s custody rule violations by their actions during the 2009-2011 exams. It also found that they engaged in improper professional conduct resulting in violations of applicable professional standards that indicated a lack of competence to practice before the Commission.

As a result of the findings, which the respondents neither admitted nor denied, the SEC barred Wilson from appearing or practicing before the Commission as an accountant and ordered him to pay a $50,000 penalty. The SEC also denied Cotterman-Wilson the privilege of appearing or practicing before the Commission as an accountant, but the firm can request reinstatement in three years. Cotterman-Wilson was also ordered to pay civil money penalty of $25,000; disgorgement in the amount of $10,868, which represents profits gained; and prejudgment interest of $1,029.

This is Release No. 34-75298.

Thursday, June 25, 2015

Institutions Ask for New Rules, Guidance on Vote Transparency

By Mark S. Nelson, J.D.

The Council of Institutional Investors (CII) is asking the SEC to undertake rulemaking and to issue guidance to make the proxy process more transparent. Glenn Davis, CII’s director of research, made the request to Keith F. Higgin, director of the SEC’s Division of Corporation finance in a recent letter.

On the rulemaking front, the CII wants more fulsome disclosures of proxy results in companies’ Forms 8-K. Specifically, the CII recommended adding five new disclosures to Item 5.07 of Form 8-K to make clear to investors what the voting requirements were, the percentage of support each nominee or item received, whether a nominee was elected or unelected, and whether an item passed or failed. The CII also said the vote option terms should be keyed to the proxy card.

The CII noted that companies already possess much of this information and adding it to their Forms 8-K would not be burdensome. The CII also said a few companies already provide this data voluntarily.

Moreover, the CII asked the SEC to provide guidance on two related topics. First, the organization wants more clarity regarding proxy statement disclosures on ballot items and voting options. The CII also wants guidance regarding how proposals are described on proxy cards.

Wednesday, June 24, 2015

PCAOB Chairman Doty Emphasizes International Cooperation, Expects Proposal Soon on Engagement Partner Disclosure

By Lene Powell, J.D.

At a conference of the Federation of European Accountants (FEE) in Belgium, PCAOB Chairman James Doty stressed the importance of international cooperation in joint inspections and policy work. The PCAOB is “closely following” implementation of a 2014 EU law expanding audit reports and a new IAASB standard requiring disclosure of key audit matters. In addition, the PCAOB is seeking to align with international standards on disclosure of the audit engagement partner, and Doty expects to seek comment at the end of June on a proposed form that would provide such disclosure.

Engagement partner disclosure. In many jurisdictions including Europe, it is the custom for engagement partners to sign audit reports in their own name in addition to the name of their firms, Doty explained. Recent studies indicate that such disclosure makes a difference to the investing public and the markets. In 2009, the PCAOB issued a concept release exploring this possibility in the U.S., and in 2011 and 2013 developed a proposal on mere disclosure, rather than signature, in response to concerns about litigation risk.

Doty believes there is a “middle ground” that will disclose the information in a way that reduces auditors’ perception of risk. The PCAOB has developed a form that auditors could file with the PCAOB, and Doty expects to seek comment on it at the end of June.

Auditor’s reporting model. The PCAOB continues to explore possibilities to enhance the form and content of the audit report, and has issued a concept release and held two hearings on this subject, Doty said.

According to the chairman, the UK Financial Reporting Council has required expanded audit reports for financial statements for periods that began on or after October 1, 2012, and about 900 UK-reporting companies are subject to the requirement. In its March 2015 report, the FRC said auditors have not only met but in many cases exceeded requirements, providing detailed audit findings relating to identified risks, informative explanatory diagrams and graphs, and well-organized presentations with the opinion located at the beginning of the report instead of the end.

Doty said he is eager to see how implementation of the EU’s April 2014 law expanding auditor reporting will play out, as well as the IAASB’s new reporting standard to disclose key audit matters, effective for audits of financial statements for periods ending on or after December 15, 2016. The Netherlands has early adopted this standard, and soon more than 100 markets across the globe will have expanded audit reports.

Regulatory cooperation on inspections. In the past, national regulators merely hoped to be able to call on other national regulators in a breach, said Doty. Because global audit firms don’t stop at the border, however, audit regulators can’t either. The PCAOB has bilateral cooperation agreements with 19 foreign audit regulators, of whom 11 are in Europe. Doty looks forward to working with EU Commissioner Lord Jonathan Hill, Director Ugo Bassi, and the Head of Unit for Audit and Credit Rating Agencies, Alain Deckers, to continue and deepen cooperative inspection and other oversight arrangements. He noted that to continue the PCAOB’s inspection work in and with European Union member states, another renewal will be needed in 2016 of the European Commission’s Adequacy Decision.

Audit Committee Dialogue. Doty highlighted a new communication series the PCAOB launched in May, the Audit Committee Dialogue, available on the PCAOB website. Based on feedback from audit committee members, the Dialogue is an interactive, digital publication with charts, data and tips for audit committees based on insights the PCAOB has gleaned from its inspections, including key recurring areas of concerns and new risks the PCAOB is monitoring. The PCAOB plans to issue additional Dialogues at least twice a year, said Doty.

Tuesday, June 23, 2015

IOSCO Wants to Know Asset Managers Better in Shift from SIFI Label Focus

By Mark S. Nelson, J.D.

Several major players in the asset management world reacted favorably to a decision by the International Organization of Securities Commissions (IOSCO) to back off its earlier push to develop a framework for designating some asset managers as systemically important financial institutions. Both the Managed Funds Association (MFA) and the Investment Company Institute (ICI) voiced support for the IOSCO’s move.

According to a press release, the IOSCO decided to shift its “immediate focus” to understanding the larger milieu of asset managers’ activities and products rather than emphasizing a need to designate these entities as SIFIs. In March, the IOSCO published its second consultative document on non-bank non-insurer global systemically important financial institutions or NBNI G-SIFIs.

The March draft provoked a strong response from industry players who feared the IOSCO framework could help push regulators to pin the SIFI label on many asset managers. The Securities Industry and Financial Markets Association, representing a wide swath of the securities industry, had urged the IOSCO to take a more activities-and-products-centric approach to asset managers. The Private Equity Growth Capital Council, along with its European counterpart, commented jointly that private equity funds do not raise the type of systemic risks that would justify the SIFI tag.

Last week’s announcement by the IOSCO drew praise from the MFA, which emphasized the comparatively small size of the hedge fund industry. “IOSCO’s decision to focus on understanding potential risks to the financial system on a structural, market-wide basis, instead of focusing on individual funds is consistent with the approach of other global regulators,” said MFA President and CEO Richard H. Baker.

The ICI likewise backed the IOSCO’s new focus. Said ICI President and CEO Paul Schott Stevens: “As we have said repeatedly, asset management is a diverse enterprise, and effective risk mitigation in this area requires consideration of activities that are sector-wide.”

The Financial Stability Board posted the public comments on the ISOCO’s second consultative document on its website little more than a week ago. FSB Chairman Mark Carney issued a statement the day after the IOSCO publicized its new focus on asset managers by saying only that asset management industry poses many challenges, especially regarding investors’ perceptions of liquidity in fixed income markets, but without specifically mentioning the IOSCO developments.

Monday, June 22, 2015

‘All Factors’ Test Applied to Whether Notes Were Securities Under Arkansas Law

By John M. Jascob, J.D.

The Arkansas Supreme Court has held that a court must consider all factors surrounding the transaction in determining whether a note constitutes a security under the Arkansas Securities Act. Although declining to adopt the “family resemblance test” put forward by the Arkansas Securities Commissioner, the state high court ruled that the lower court incorrectly applied a narrower five-factor test in granting summary judgment for the defense in a civil enforcement action over the sale of unregistered securities. Accordingly, the court reversed the decision below and remanded the matter for a determination of whether the loan agreements at issue qualified as securities under Arkansas law (Waters v. Millsap, June 18, 2015, Baker, K.).

Background. In January 2012, the Arkansas Securities Commissioner filed a complaint against the appellees, alleging that they had unlawfully sold unregistered securities without being registered under the Arkansas Securities Act. According to the Commissioner, the appellees had solicited investors to purchase notes issued by the British American Group, which purportedly matched borrowers from the United Kingdom with lenders. Under the terms of the notes, the borrowers would borrow money for real-estate projects for one year at annual interest rates of 15 to 17 percent. The complaint further alleged that, although some of the British American Group investors received interest payments, the vast bulk of the money was never repaid.

Moving for summary judgment, the Commissioner argued that the notes were securities because, among other things, the investors had no control over the real estate projects and “expected their profits to come solely from the efforts of the borrower.” The Commissioner also contended that the proper test for determining whether the loan agreements constituted a security was the “family resemblance test” announced by the United States Supreme Court in Reves v. Ernst & Young (U.S. 1990).

The circuit court disagreed, however, reasoning that the Arkansas Supreme Court had not adopted the Reves test, and that the law in Arkansas remained the test set forth by the Arkansas Court of Appeals in Smith v. State. Decided in 1979, Smith set forth a five-element test for identifying securities: (1) the investment of money or money’s worth; (2) investment in a venture; (3) the expectation of some benefit to the investor as a result of the investment; (4) contribution towards the risk capital of the venture; and (5) the absence of direct control over the investment or policy decisions concerning the venture. After concluding that the notes did not meet the test for securities announced in Smith, the circuit court granted summary judgment in favor of the appellees.

All factors test. On appeal, the Commissioner contended that the Arkansas Supreme Court had never explicitly adopted the Smith test as the exclusive test of whether a transaction involves a security, and that the element of a fixed rate of interest does not automatically preclude the notes at issue from being securities. Reviewing the case law, Justice Baker noted that since its 1977 decision in Schultz v. Rector-Phillips-Morse, Inc., the court has held that the Arkansas Securities Act should not be given a narrow construction. Rather, the definition of what constitutes a security must necessarily depend on an analysis of all of the factors in any given transaction.

Although finding the Smith factors to be instructive, the Arkansas Supreme Court has never relied on those factors exclusively, Justice Baker wrote. Instead, the unifying thread in the court’s line of cases addressing whether an instrument constitutes a security is the Schultz test, which requires a review of all of the facts and is better suited to the Act’s purpose of preventing fraudulent practices and activities aimed at unsophisticated investors and the general public. The circuit court erred, therefore, because it failed to consider all the factors surrounding the transaction, including the sophistication of the parties, a factor that has been prominent in the court’s prior cases. Accordingly, the state high court reversed the decision below and remanded the case to the circuit court to consider all the surrounding factors, as required by Schultz. The court declined to formally adopt the Reves test, however, reasoning that all of the Reves factors are embraced within the flexible, all-inclusive Schultz test.

Dissent. Writing for the three judges in dissent, Justice Danielson stated that he would have affirmed the lower court’s order as reaching the right result, even without any mention of reliance on Schultz. Drawing a distinction between an investment and a loan, Justice Danielson reasoned that the clients of the appellees had extended sums of money with the sole expectation of receiving interest and ultimately having their money repaid. The realization of that interest was not tied to the efforts or successes of the borrower or the venture, but only to the borrower’s ability to pay. “In light of these circumstances,” he wrote, “I cannot say that the transactions at issue were securities; they were simply nothing more than loans, albeit in hindsight, risky ones.”

The case is No. CV-15-18.

Friday, June 19, 2015

Commissioner Gallagher Issues Statement on CCO Settlements, Calls for Examination of Rule 206(4)-7

By Rodney F. Tonkovic, J.D.

SEC Commissioner Daniel Gallagher has issued a statement concerning his voting against two settled enforcement actions against chief compliance officers. Gallagher said that he has long called on the Commission to "tread carefully" when acting against compliance personnel and that he felt compelled to explain his dissents. According to Gallagher, the Commission must examine Investment Advisers Act Rule 206(4)-7 and consider whether amendments or guidance are needed to clarify the roles and responsibilities of compliance personnel.

BlackRock and SFX. In an action against BlackRock Advisors, LLC, CCO Bartholomew A. Battista was charged with causing the firm's violations of Rule 206(4)-7. Battista allegedly failed to ensure that BlackRock had compliance policies and procedures to assess and monitor the outside activities of employees and disclose conflicts of interest to fund boards and advisory clients. In its action against SFX Financial Advisory Management Enterprises, Inc., the Commission alleged that CCO Eugene Mason failed to ensure that the firm had compliance policies and procedures to assess and monitor the outside activities of employees and disclose conflicts of interest to fund boards and advisory clients.

Gallagher observed that in both instances the order states that the CCO was responsible for the implementation of the firms' policies and procedures, illustrating a Commission trend toward strict liability for CCOs under Rule 206(4)-7. This, Gallagher warns, sends a troubling message to CCOs that they could be held accountable for conduct that, under Rule 206(4)-7, is the responsibility of the adviser itself. A CCO, he said, will opt not to take ownership of their firm's compliance policies and procedures, or worse, will opt for less comprehensive policies and procedures in order to avoid liability "when the government plays Monday morning quarterback." Small advisers are especially at risk, Gallagher added.

It's Rule 206(4)-7's fault. Gallagher lays the blame for this state of affairs on Rule 206(4)-7, which he describes as "not a model of clarity." The rule, Gallagher explains, offers no guidance on the distinction between the role of CCOs and management in carrying out the compliance function, and the Commission has offered no guidance in the 11 years since the rule was adopted.

The only guidance available to market participants, therefore, is enforcement actions, which, according to Gallagher, have "contorted the rule to treat the compliance function as a new business line, with compliance officers assuming the role of business heads." The Commission interprets the rule as being directed at CCOs, Gallagher said, but the rule expressly states only that the CCO administers the firm's compliance policies and procedures – responsibility for the implementation of those policies and procedures rests with the adviser itself.

Gallagher finds this uncertainty as to the contours of the rule troubling due to the vital role played by compliance personnel. He notes that CCOs are the only line of defense for the vast majority of advisers, and, unlike broker-dealers, there are no SROs standing between the SEC and advisers. Gallagher said that he is concerned that a vigorous compliance function will be disincentivized and that targeting compliance personnel could result in perverse incentives. He calls for restraint even in the investigation stage, noting that the months or years that the process takes can cause psychological and reputational damage that are just as chilling as the "scarlet letter" of a violation.

Take a look at the rule. In closing, Gallagher urges the Commission to take a hard look at Rule 206(4)-7 to consider whether amendments or guidance are needed to clarify the roles and responsibilities of compliance personnel. The status quo, where compliance personnel are improperly held accountable for the misconduct of others, simply will not do, Gallagher says.

Thursday, June 18, 2015

Three Days Before Effective Date, SEC Denies Stay of Regulation A+

By Matthew Garza, J.D.

The SEC has issued an order denying a stay of Regulation A+ sought by the state of Montana. The Commission rejected the state’s argument that the rulemaking, set to become effective on June 19, would subject Montana issuers and “unsophisticated and unwary consumers” to irreparable harm, countering that a delay in implementation of the rule would hurt capital formation (In the Matter of Monica J. Lindeen, Release No. 33-9808, June 16, 2015).

Background. Montana sought a stay of the final rule in its entirety for the length of the pendency of litigation in the U.S. Court of Appeals for the D.C. Circuit, where Montana state auditor and commissioner of Securities and Insurance, Monica Lindeen, along with Massachusetts Secretary of the Commonwealth William Galvin, have filed for preemptive relief in Lindeen v. SEC and Galvin v. SEC. Lindeen pursued the stay with the SEC on the argument that the SEC’s definition of “qualified purchaser” was impermissible and the Commission did not conduct sufficient economic analysis of the effect of preempting state laws in Tier 2 offerings.

Rulemaking. Regulation A+, adopted in Release No. 33-9741 on March 25, created two tiers of offerings — Tier 1 offerings of up to $20 million and Tier 2 offerings of up to $50 million. While Tier 1 offerings remain subject to state regulation, Tier 2 offerings are exempt from state pre-sale review, although they remain subject to some state requirements, including anti-fraud rules. Tier 2 offerings are subject to more strict SEC disclosure and reporting requirements than Tier 1 offerings.

SEC ruling. The SEC recounted that in order to obtain a stay, it must consider whether: (1) the movant has a strong likelihood of success on the merits; (2) a party will suffer imminent and irreparable injury absent a stay; (3) granting a stay will cause substantial harm to any person; and (4) whether a stay would serve the public interest. Lindeen lost on all four factors.

The SEC said that the D.C. Circuit is not likely to agree that the rule’s definition of qualified purchaser is contrary to congressional intent in the JOBS Act and the National Securities Markets Improvement Act of 1996 (NSMIA). Qualified purchasers are defined as “any person to whom securities are offered or sold pursuant to a Tier 2 offering of this Regulation A,” which incorporates the investor protections applicable to all Reg A offerings and the additional requirements of Tier 2 offerings, wrote the Commission.

Chevron deference. The Commission said NSMIA gives it “express and broad” authority to define qualified purchaser by rule and “when Congress expressly delegates definition authority in this fashion, the deference afforded to an agency is at its zenith.” Its judgement is given “controlling weight” unless it is arbitrary, capricious, or manifestly contrary to the statute, as established in Chevron U.S.A. Inc. v. Natural Res. Def. Council, Inc., reasoned the Commission. Lindeen’s attempt to distinguish the ordinary, dictionary definition of “qualified” from the SEC’s definition was not persuasive to the agency because it said it has express power to define the term separate from its ordinary meaning.

In addition, purchasers in Tier 2 offerings are limited to accredited investors and a requirement that the purchase price not be more than 10 percent of the greater of a purchaser’s annual income or net worth. “The definition is consistent with the statute because it appropriately and reasonable balances the capital formation imperative imposed by Congress with numerous provisions designed to protect investors,” wrote the Commission.

The agency rejected Lindeen’s assertion that the rule amounted to a blanket preemption of state laws. Besides, a limited preemption of state laws was intended by Congress when it passed the JOBS Act, argued the Commission. Tier 2 offerings remain subject to state anti-fraud rules as well as rules requiring filing of documents and fee payments.

The SEC’s order went on to reject the argument that the economic analysis in the adopting release was insufficient, saying that the mandated rulemaking thoroughly analyzed the economic effects of the regulation, including the potential for additional costs imposed by a loss of some investor protections provided by state regulators. The “robust” protections provided by the rule discredited Lindeen’s argument that irreparable harm to investors would result absent a stay, but on the other hand ordering a stay would hurt capital formation by delaying a congressionally mandated fix to the relatively unused Regulation A, the Commission concluded.

Wednesday, June 17, 2015

Abuse-of-Discretion Review May Destabilize Law of Derivative Actions, Panel Warns

By Anne Sherry, J.D.

The Second Circuit affirmed a district court’s dismissal of a shareholder’s complaint for wrongful dismissal of his demand that JPMorgan’s board investigate the London Whale debacle. While the panel followed the rule of the circuit that dismissals of derivative actions be reviewed for abuse of discretion, it urged that the standard of review be changed to de novo as it is for other dismissals (Espinoza v. Dimon, June 16, 2015, Katzmann, R.).

Background. In 2012 Ernesto Espinoza, a JPMorgan shareholder, sent a letter to the board of directors demanding that they investigate aspects of the London Whale scandal, specifically the underlying trading losses and the alleged dissemination of misleading statements. A review committee considered the demand (among others) and concluded that litigation was not in the company’s best interests. Espinoza then sued on the basis that his demand had been wrongfully refused, asking the district court for leave to amend if his complaint were to be dismissed. The district court dismissed the complaint for failure to state a claim and entered judgment for the defendants immediately, without allowing leave to amend.

Standard of review. The panel made a forceful detour by arguing that dismissals under Federal Rule of Civil Procedure 23.1, dealing with derivative actions, should be reviewed de novo, like other dismissals, rather than for abuse of discretion. Thirty years of case law in the circuit holds that determining the sufficiency of allegations depends on the circumstances of the individual case and is within the discretion of the district court. But the First and Seventh Circuits recently adopted a de novo standard, and judges in the Ninth Circuit and D.C. Circuit have questioned the wisdom of deferential review in this context. The Delaware Supreme Court also discarded abuse-of-discretion review of dismissals under the Chancery Court’s version of Rule 23.1.

The Second Circuit panel cited three reasons for its endorsement of de novo review. First, none of the usual justifications for deferring to district courts are present; in determining pleading sufficiency under Rule 23.1, the lower court and appellate court both are simply reading the language of a pleading and applying it to the pleading statutes, case law, and Rule 23.1 requirements. Second, abuse-of-discretion review is illogical: questions of fact drop out on a motion to dismiss because the court accepts a complaint’s factual allegations as true. Therefore, a dismissal is based on a purely legal determination that would ordinarily be reviewed de novo under the usual abuse-of-discretion standard. In other words, the panel maintains, abuse-of-discretion review encompasses de novo review of issues of law, and because a dismissal is based only on issues of law, it should collapse into pure de novo review.

Finally, the panel wrote, abuse-of-discretion review could destabilize the law of derivative action because deferring to a district court’s discretion implies that the court could have come to a number of permissible decisions. Under abuse-of-discretion review, the different conclusions of two district courts reviewing the same complaint could both be acceptable and affirmed on appeal. “Permitting such divergent results does a disservice to shareholders and corporate boards alike by depriving them of clear rules to guide the management of corporate affairs,” the panel concluded.

District court’s discretion. Absent intervention by the U.S. Supreme Court or the Second Circuit acting en banc, however, the panel was bound to review the dismissal for abuse of discretion. Espinoza conceded that the JPMorgan board adequately investigated the underlying trading losses, but his demand and complaint also took issue with the dissemination of public statements minimizing the scale of the London Whale losses, in particular Jamie Dimon’s statement that the media attention was “a complete tempest in a teapot.” The board’s response to his demand letter, however, made no mention of the misstatements and characterized the demand as solely relating to the trading losses. The panel determined that the district court did not abuse its discretion. A corporate board must investigate before refusing a demand, but directors have substantial leeway over how to conduct that investigation. In light of the presumption that directors act on an informed and good-faith basis when making a business decision, the district court could reasonably conclude that the board’s decision to focus on the crux of the demand, even if it did not address every topic in the demand letter, did not rise to the level of gross negligence.

Furthermore, the district court did not err by entering judgment for the defendants immediately without addressing Espinoza’s request for leave to amend. Amendment would have been futile because Espinoza failed to identify additional allegations that would fix the issues with his first complaint.

The case is No. 14-1754.

Tuesday, June 16, 2015

Adviser Wages Another Attack on Constitutionality of ALJ Proceedings

By Amy Leisinger, J.D.

An investment adviser and certain of its executives have filed a complaint for declaratory and injunctive relief in the line of the cases challenging the propriety of the SEC’s use of administrative proceedings and the constitutionality of the appointments and decisions of administrative law judges (ALJs). According to the complaint, unless the Commission is restrained in its activities, the plaintiffs will be required to submit to irreparable injury of an unconstitutional proceeding lacking the safeguards provided within the court system. The parties also moved for an order temporarily restraining or preliminarily enjoining the SEC from publicly disseminating the decision against them in the administrative proceeding and staying the effect of any relief entered pending resolution of the matter (Timbervest, LLC v. SEC, June 12, 2015).

Background. Timbervest, LLC is an SEC-registered investment adviser that manages approximately $1.2 billion in investments related to timber and environmental remediation through various client funds. In September 2013, the SEC instituted administrative proceedings against Timbervest and four of its executives, alleging that Timbervest sold a tract of timberland on behalf of a client and caused the client to pay a brokerage fee without disclosing the fee. The SEC also alleged that Timbervest repurchased the same property a few months later on behalf of a different client pursuant to a side agreement and that this was not disclosed to either client.

In August 2014, an ALJ issued an initial decision finding that Timbervest violated Advisers Act Sections 206(1) and 206(2) and that the individual respondents caused, aided, and abetted the violations. The ALJ ordered the plaintiffs to cease and desist from committing or causing further violations of the provisions and ordered disgorgement of approximately $1.9 million, plus prejudgment interest.

Both Timbervest and the Division of Enforcement appealed the initial decision to the full Commission, and, at oral argument (covered in the Securities Regulation Daily Wrap Up for June 8, 2015), counsel for Timbervest and the individual respondents contested the ALJ’s initial decision on both substantive and constitutional grounds. According to the parties, the evidence making up the record was insufficient to support a finding against them, and the SEC’s ALJ proceedings are unconstitutional under Article II of the U.S. Constitution because ALJs are “inferior officers” that may not be separated from presidential supervision and removal by more than one layer of protection.

Injunctive relief and declaratory judgment. In their complaint, the plaintiffs stated that they have appealed the ALJ’s decision to the Commission but noted that the appeal would be “futile,” as the Commission itself did not properly appoint the ALJ and has argued in other cases that its administrative forum is constitutional. “Moreover, any appeal of an SEC ALJ’s decision is heard by the SEC itself, the very body that authorizes the bringing of the administrative proceeding in the first place,” the plaintiffs explain. As such, the plaintiffs explained, an action in federal court is necessary to “meaningfully litigate” their constitutional challenges.

According to the complaint, SEC ALJs are inferior “officers” of under the U.S. Constitution as a result of their broad discretion to exercise significant power. Article II of the U.S Constitution vests the sole power to appoint inferior officers in the President, the courts, and the “heads of departments,” and SEC ALJs are not appointed by any of these, the plaintiffs note. Further, ALJs receive career appointments and are only removable by the SEC for “good cause,” the plaintiffs contend, and, as such, ALJs are shielded by at least two levels of tenure protection—the “good cause” standard and the Commissioners’ own tenure. According to the U.S. Supreme Court, inferior officers may not be separated from Presidential supervision and removal by more than one layer of tenure protection, and, as such, the SEC’s administrative proceedings are unconstitutional, the plaintiffs reason.

The plaintiffs argue that declaratory and injunctive relief is necessary to prevent the irreparable injury that will result from the unconstitutional enforcement action and the threat to their business and reputation. Further, the plaintiffs contend, without injunctive relief, their due process right to a meaningful review will be violated, which, on its own, qualifies as an irreparable injury. These types of harm “cannot be effectively remedied after the fact by money damages,” the plaintiffs conclude.

The case is No. 1:15-CV-2106.

Monday, June 15, 2015

SEC Requests Comment on Issues Surrounding Exchange-Traded Products

By Amy Leisinger, J.D.

The SEC is seeking public comment to learn more about the listing and trading of novel and complex exchange-traded products (ETPs). Specifically, the request for comment addresses issues that arise in exemption requests for new ETPs or when an exchange establishes standards for their listing. The request for comment discusses arbitrage mechanisms and market pricing for ETPs, regulatory positions related to their trading, and potential listing standards and invites comments on the marketing of ETP products by broker-dealers and investor understanding of these products, particularly with regard to retail investors (Request for Comment on Exchange-Traded Products, Release No. 34-75165, June 12, 2015).

In a press release, SEC Chair Mary Jo White noted that “[a]s new products are developed and their complexity grows, it is critical that [the SEC] have broad public input to inform our evaluation of how they should be listed, traded, and marketed to investors, especially retail investors.”

Background. ETPs traded on national securities exchanges and through secondary markets provide investors with exposure to financial instruments, benchmarks, and strategies across a broad range of asset types. Since the Commission approved the listing and trading of shares of the first ETP in 1992, there has been significant growth in the number and variety of ETPs with a wide range of investment strategies. As of the end of 2014, there were 1,664 U.S.-listed ETPs with an aggregate market capitalization of just over $2 trillion.

Before ETP securities can be listed and traded on a national securities exchange, those securities and their issuer must comply with, or obtain exemptions from, several provisions of the securities laws. In addition, the exchange must agree to list the ETP securities for trading and have in place Commission-approved listing standards. Broker-dealers recommending buying or selling ETPs may be subject to additional scrutiny in connection with complex products and non-traditional ETPs.

Request for comment. Given the increasing scope and complexity of ETP investment strategies and related exemption requests, the SEC decided to seek public comment on topics associated with its oversight of the listing and trading of ETPs on national securities exchanges. The Commission requests views on the manner in which ETP securities are initially listed on an exchange and traded in the secondary market, as well as existing relief that has been granted to ETPs under the federal securities laws. In addition, commenters are also asked to provide information regarding how broker-dealers fulfill their obligations to investors when recommending and selling ETP products and whether they should be subject to additional requirements to provide information about the risks of investing in ETPs with complex strategies. The SEC also seeks comment with respect to arbitrage mechanisms for ETPs designed to help ensure efficient market pricing of ETP securities and keep intraday trading prices roughly equal to the value of the underlying portfolio or reference assets.

The comment period will remain open for 60 days following publication of the comment request in the Federal Register.

The release is No. 34-75165

Friday, June 12, 2015

Transfer Agent Rules May Yet Get a Long Needed Update

By R. Jason Howard, J.D.

SEC Commissioners Luis A. Aguilar and Daniel M. Gallagher, acknowledging that the Commission’s rules governing transfer agents are anachronistic and out of sync with the industry, have released a statement regarding the need to modernize the rules that govern transfer agents; rules that have not been significantly revised in almost 30 years.

The Commissioners shared the view that a “lengthy delay in updating the Commission’s transfer agent rules would be bad for the markets, investors, and issuers.” A recent article in the Securities Regulation Daily Wrap Up, May 12, 2015 and the corresponding paper reflect the fact that industry insiders and the Commission have in the past recognized the need for change. In a separate post, covered in the Securities Regulation Daily Wrap Up, December 18, 2014, Commissioner Aguilar acknowledged that “technological advances and changes to business practices and market structure have created a significant gap between the transfer agent rules and their current activities.”

Concept release. The need to update the rules governing transfer agents has been a topic long discussed by the Commission and industry experts because the securities industry and the functions that transfer agents now provide have changed dramatically since the inception of the rules. In the most recent statement, Aguilar and Gallagher said that The Division of Trading and Markets has been working on a concept release seeking public comment on possible updates and improvements to the Commission’s regulatory framework for transfer agents.

Prior to the issue of this concept release, however, the Division had developed recommendations for proposed transfer agent rules and briefed Commissioners on those rules. The Commissioners explained that while the Division’s desire to issue a concept release is “laudable,” they believe the Division’s first inclination to propose transfer agent rules was the right one. Moreover, Aguilar and Gallagher expressed the belief that while a concept release may be valuable in gathering additional information, “there are critical reforms requiring immediate action that we can propose now.”

Reforms. The Commissioners noted that Chair White recognized the need to update the rules governing transfer agents last year when she instructed the staff to prepare a concept release addressing the need to modernize these rules. At her invitation, the Commissioners said “we have presented Chair White with our joint recommendations for proposed updates and improvements to the Commission’s transfer agent rules that we believe need not wait for a concept release.”

They explained that they hope to “catalyze” Commission action to improve the transfer agent rules and to enhance Commission monitoring of the transfer agent industry. They continued, saying that among other things, their recommendations will help to ensure that transfer agents do the following:
  • Safeguard investor assets, in part by requiring transfer agents to be appropriately insured or bonded;
  • Establish written agreements with their issuer clients, so that both parties fully understand their rights and obligations;
  • Process dividends and other payments in a timely manner, and promptly notify shareholders about the status of their payments;
  • Develop business continuity and disaster recovery procedures;
  • Prevent fraud, particularly with regard to microcap securities;
  • Avoid or properly disclose and manage conflicts of interest;
  • Develop procedures to govern their use of information technology; and
  • Disclose key information in their annual filings with the Commission, including the identities of all issuers and securities for which they perform services.
The Commissioners said they hope and expect that proposals for rule updates will be published for comment as soon as possible and the Securities Transfer Association (STA) has stated that it will comment on any rule proposals.

Thursday, June 11, 2015

Enjoined by District Court, SEC Cancels Start of Administrative Proceeding

By John Filar Atwood

The day after the U.S. District Court for the Northern District of Georgia enjoined the SEC from conducting an administrative proceeding against Charles L. Hill, Jr., the Commission cancelled the hearing scheduled for June 15. The hearing, which was to be held before an administrative law judge (ALJ), would have begun the administrative proceeding against Hill.

The notice follows the court’s decision that Hill was likely to succeed on the merits of his claim that the designation of the administrative law judge presiding over his insider trading case violated the Appointments Clause. As previously reported, the administrative proceeding was enjoined to give the court sufficient time to consider the constitutional arguments.

Allegations. Hill was a friend of a friend of the chief operating officer of Radiant Systems, Inc. The SEC claims that he purchased over 100,000 Radiant shares between June 1 and July 8, 2011, shortly before Radiant announced a tender offer. The day after the announcement, Hill sold his shares for a profit of $744,000. The Commission alleged that Hill traded on inside information. Hill is suing in federal court, seeking a declarative judgment that the SEC administrative proceeding is unconstitutional.

Likely to succeed. The court determined that Hill was likely to succeed on the merits of his claim that the ALJ’s appointment violates Article II’s Appointments Clause because the law judge was not appointed by the president, a court, or a department head. The court found that the ALJ was an inferior officer, triggering the Appointments Clause, rather than a “mere employee” as the SEC had claimed.

The court acknowledged that its decision may appear to be unduly technical, but it stressed the importance of the Appointments Clause to the Constitution’s separation of powers framework. The Appointments Clause protects the executive from congressional encroachment and may not be waived, even by the executive.

Wednesday, June 10, 2015

Texas Adopts General Records Rules, Proposes Application Reviews

By Jay Fishman, J.D.

The Texas State Securities Board adopted amendments to general records, notice and compliance rules, and repealed Form 133.1, Texas Public Information Request Form. Separately, the Securities Board proposed amendments to application reviews and financial statement requirements for securities, dealer and investment adviser registration applicants.

Adopted Rule Changes

Open records requests. Agency records requests will be handled in accordance with the open records provisions of the Public Information Act, Texas Government Code, Title 5, Chapter 552. The requesting party must indicate in writing the specific nature of the documents requested for examination or duplication.

Notice. General notice of the adoption, amendment or repeal of any rule must be given as required by law and sent by U.S. mail, or by email if the requestor has provided an email address, to all persons who have made timely written requests for advance notice or rulemaking proceedings. However, failure to send the notice will not invalidate any actions taken or rules adopted.

Compliance. No adopted rule will be valid unless its adopted in substantial compliance with the rulemaking provisions of the Texas Government Code, Title 10, Chapter 2001.

Proposed Rule Changes

Securities registration application reviews. Written communications between the Texas Registration Division and a securities registration applicant could be transmitted by fax, email, U.S. mail or by another more timely communication method. The Registration Division would send a written deficiency letter to the applicant setting forth a list of the yet-unfiled items and exhibits, within seven days of the Agency’s receipt of the application. The Registration Division would, within 45 days of receiving the requested items and exhibits, review the application and send the applicant a written initial comment letter setting forth any deviations from the Texas Securities Act’s or Board rules’ substantive requirements that relate to the securities registration.

Dealer/investment adviser application reviews. Written communications between the Texas Registration Division and a dealer or investment adviser applicant could be transmitted by fax, email, U.S. mail or by another more timely communication method. The Registration Division would send a written deficiency letter to the applicant setting forth a list of the yet-unfiled and/or error-containing items and exhibits, within 14 days of the Agency’s receipt of the application. Procedural or non-disciplinary deficiency corrections on applications filed through the CRD or IARD would be handled by those organizations. Insufficient fees submitted with an application would be returned to the applicant with notification of the correct fee amount, and the application will be held in abeyance until the Agency receives the correct fee. The Registration Division would, within 14 days of receiving the requested items and exhibits, review the application and, if necessary, send the applicant a written comment letter setting forth any deviations from the Act’s or Board rules’ substantive requirements that relate to the dealer or investment adviser registration.

Dealer/investment adviser application requirements. Dealer and investment adviser applications would consist of a U.S. GAAP-prepared balance sheet reflecting the financial condition of the dealer or investment adviser as of a date not more than 90 days before the application filing date. The balance sheet should be compiled, reviewed and audited by independent certified public accountants or independent public accountants or, instead, be attested by the sworn notarized statement of the applicant’s principal financial officer on Form 133.18, Certification of Balance Sheet by Principal Financial Officer.

Tuesday, June 09, 2015

Lawmakers Urge DOL Not to Rubber-Stamp Megabank Waiver Requests

By John Filar Atwood

Citing their disappointment that the SEC granted waivers without public input to UBS, JPMorgan Chase, Citigroup, Barclays, and Royal Bank of Scotland despite their roles in manipulating the foreign currency exchange (FX) spot market, key Democratic members of Congress are urging the Department of Labor not to make the same mistake. Led by Rep. Maxine Waters (D-Calif) and Sen. Elizabeth Warren (D-Mass), the 12 lawmakers have asked the DOL to hold a public hearing on any bad actor waiver requests it receives from these banks.

Background. In May, the banks pleaded guilty to conspiring to manipulate benchmark rates and were fined nearly $3 billion. Four banks pleaded guilty to criminal antitrust violations relating to the rigging of various FX benchmarks, and UBS pleaded guilty to manipulating LIBOR in breach of a non-prosecution agreement it entered into in December 2012.

The day after entering the guilty pleas, the SEC granted waivers to the banks to prevent them from being ineligible issuers under Securities Act Rules 405 and 506. The SEC waivers preserved the banks’ status as well-known seasoned issuers, allowing them to sidestep certain bad actor disqualifications under the securities offering rules.

Lawmakers’ request. In a letter to Labor Secretary Thomas Perez, the lawmakers encouraged the DOL to consider the facts thoroughly before ruling on any waiver requests, four of which the DOL has already received. They urged the DOL to give due weight to the seriousness of the criminal behavior and the extensive recidivist history rather than simply rubber-stamping the waiver requests.

The letter discusses the severity of the crimes for which the banks pleaded guilty, and cites current law, which provides that criminal misconduct of this nature automatically disqualifies the banks from claiming the status of a “qualified professional asset manager.” As a result, the lawmakers noted, the banks should be prohibited from providing certain asset management services to pension funds.

Too big to bar. The lawmakers expressed their concern that the two-tiered system of justice seems to put low-level offenders in jail while the rich and powerful buy their way out of trouble. Rather than continuing the double standard, the lawmakers said that the megabanks should be subject to the collateral consequences provided for by law. They asked the DOL to reject a too-big-to-bar policy of reflexively granting waivers and to use the disqualification provisions to deter future misconduct.

In a press release, the lawmakers noted that last year Rep. Waters and others asked the DOL to think twice before approving a waiver of sanctions for Credit Suisse, requesting that the Department conduct a hearing to allow for public input. In that case, the DOL granted their request, holding a public hearing in January.

Monday, June 08, 2015

Advisers’ “Belt-and-Suspenders” Compliance Approach Shows Lack of Intent to Conceal Conflicts

By Anne Sherry, J.D.

An investment adviser and its co-owners were let off the hook for receiving undisclosed servicing fee payments tied to particular mutual funds. An administrative law judge held that although the payments were material, the SEC failed to show that the respondents acted with the requisite state of mind, and even assuming it had met that threshold burden, the respondents relied in good faith on the advice of compliance professionals (In the Matter of The Robare Group, Ltd., June 4, 2015, Grimes, J.).

Background. Last September, the SEC charged Houston-based investment advisory firm Robare Group Ltd. and its co-owners with fraud for failing to disclose to clients a servicing fee agreement with Fidelity under which Robare Group received a percentage of investments in certain mutual funds. The Commission alleged that the respondents violated (or aided and abetted violations of) Investment Advisers Act Sections 206(1), 206(2), and 207 by failing to disclose the arrangement and the resulting conflicts of interest.

Disclosures. The ALJ found that from 2005 onwards, the disclosure in Fidelity’s own brokerage agreement adequately disclosed the fee program to Robare Group’s clients. Given that the instructions for Form ADV itself permit advisers to disclose conflicts “by some other means,” the ALJ determined that the SEC tacitly conceded adequate disclosure by its failure to dispute that point. However, approximately 150 of the firm’s clients had signed on before 2005 and thus received a version of the Fidelity brokerage agreement that did not reference the program. By 2011, Robare Group included a disclosure in its Form ADV that the law judge found “plainly adequate.” As a result of these findings, the focus of the case narrowed to Robare Group’s disclosures prior to December 2011 to its first 150 clients.

Scienter. The law judge held that even if the disclosure to that group of clients was inadequate, the SEC could not prevail on its Section 206(1) claim because it cannot show scienter. The evidence of scienter consisted of nothing more than asserting that Robare Group’s co-owner was knowledgeable about the program and possessed ultimate authority over the Form ADV filings. On the contrary, the law judge found the individual respondents to be honest and credible, remarking that “it is difficult to imagine them trying to defraud anyone, let alone their investment clients.” Their testimony that they did not know which mutual funds paid fees under the program was supported by evidence that the percentage of client assets in non-paying funds always exceeded the percentage of available non-paying funds. Even assuming that the SEC had carried its threshold burden on the scienter element, the respondents relied in good faith on the advice of its compliance firms.

Negligence. As to the alleged Section 206(2) violations, the ALJ held that the SEC failed to present evidence of the applicable standard of reasonable care. Although in some cases it may be readily apparent that a person failed to act with reasonable care, here Robare Group relied on multiple firms to guide its compliance efforts, so some evidence as to the applicable standard was necessary.

Willful violation of Section 207. Finally, the law judge determined that no respondent willfully violated Section 207 by making untrue statements or omissions in a Form ADV. Given the respondents’ diligence and the SEC’s failure to show a failure to act with reasonable care, it could not be said that the respondents acted willfully.

This is Release No. ID-806.