Friday, May 22, 2015

House Committee Approves 13 Capital Formation Bills

By John M. Jascob, J.D.

The House Financial Services Committee voted Wednesday night to approve 13 bills designed to create jobs by stimulating capital formation by Main Street businesses. The Committee approved seven of the bills by unanimous vote, with four others passing by wide margins. The lawmakers divided largely on partisan lines, however, with regard to legislation that would reduce registration burdens on smaller companies and create a federal exemption for mergers and acquisition brokers.

“We still have millions and millions of our fellow countrymen, hardworking moderate-income taxpayers, who find themselves with stagnant to lower paychecks; bank accounts that are less than before the great economic crisis—and they need more jobs, better jobs, and you can’t have more and better jobs without more and better capital formation,” said Committee Chairman Jeb Hensarling (R-Tex) in a news release.

Ex-Im dust up and Waters’ concerns. During Wednesday’s mark-up session, much of the discussion focused not on the bills under consideration, but on the renewal of the charter of the Export-Import Bank (see the Securities Regulation Daily wrap-up for May 20, 2015). In addition to chastising the Republican majority for failing to consider legislation to renew the Bank’s charter, Ranking Member Maxine Waters (D-Cal) also took the Committee leadership to task for advancing certain proposals that, in her view, may unintentionally reduce transparency and undermine investor confidence.

“I’m concerned that these changes may make it harder for investors, analysts, regulators and the public to evaluate the investment potential of certain companies,” Waters said. “I’m also wary of how this patchwork of bills will interact with one another and with current regulatory efforts. A piecemeal approach may unnecessarily eliminate valuable investor protections, and thereby undermine investor confidence and hamper the very goal that these proposals are designed to achieve: promoting capital formation.”

Short-form registration. Waters comments may have been directed in part to the Accelerating Access to Capital Act (H.R. 2357), which the Committee passed by a 33-24 vote. Introduced by Rep. Ann Wagner (R-Mo), the bill would direct the SEC within 45 days of enactment to revise Form S–3 so as to provide issuers with common shares listed on a national securities exchange an additional basis for satisfying the eligibility requirements for short-form registration. The vote fell strictly along partisan lines, with all of votes in favor coming from the Republican side of the aisle.

Exemption for M&A brokers. Lawmakers also generally divided along party lines with respect to the Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act (H.R. 686), which would create a federal registration exemption for certain brokers facilitating merger and acquisition deals that involve a transfer of securities. Thirty-four Republicans and two Democrats approved the bill, with all 24 opposing votes coming from Democrats. The two Democrats supporting the measure were Rep. John Delaney (D-Md) and Rep. Kyrsten Sinema (D-Ariz).

State securities regulators had criticized the bill for failing to include a provision disqualifying “bad actors” from the registration exemption. In a letter submitted Wednesday to the Committee leadership, NASAA President William Beatty wrote that NASAA continues to recognize a valid basis for a federal statutory exemption, noting that state securities regulators have proposed their own model exemption at the state level after working closely with the American Bar Association, M&A practitioners, and other stakeholders. NASAA declines to support H.R. 686, however, until Congress restores the bad-actor disqualification and the prohibition on shell transactions that had been included in earlier versions of the bill introduced in the 113th Congress, Beatty wrote.

XBLR tagging. NASAA had also opposed provisions of the Small Company Disclosure Simplification Act (H.R. 1965), which would exempt, for a five-year period, emerging growth companies and other smaller companies from using eXtensible Business Reporting Language (XBRL) in financial statements and other periodic reports filed with the SEC. NASAA observed that effect of the legislation would be to exclude the XBRL filing requirements for more than 60 percent of all public companies. The Financial Services Committee disagreed, however, approving the bill by a vote of 44-11.

Other capital formation bills. The remaining ten bills passed by the Committee generally received wide bi-partisan support. A summary drawn from information provided by the Committee follows, with the tally of the vote for each bill included in parentheses.

Thursday, May 21, 2015

SEC Proposes New Disclosure by Investment Companies and Investment Advisers

By Jacquelyn Lumb

The SEC commissioners yesterday unanimously approved proposals to increase the transparency and modernize the reporting requirements for investment companies and investment advisers. In opening remarks, Chair Mary Jo White noted that the SEC oversees more than 28,000 funds and investment advisers, with assets of registered funds exceeding $18 trillion and assets managed by registered investment advisers exceeding $62 trillion. Given the advancement of new product structures and investment strategies, White last December outlined a number of initiatives to address the risks that may arise from evolving portfolio compositions and fund operations. The proposed reforms will help the SEC identify and monitor evolving risks that could threaten the stability of the U.S. financial system, according to White, and will complement the efforts of the Financial Stability Oversight Council with respect to systemic risks.

New forms, enhanced disclosure. The Investment Company Act reforms would include a new Form N-PORT, which registered funds other than money market funds would file monthly to report portfolio-wide and position-level holdings. The disclosure would include data relating to the pricing of securities and the terms of derivatives contracts. Funds also would be required to disclose information about repurchase agreements, securities lending activities, and counterparty exposures. New disclosure about discrete portfolio-level and position-level risk measures would provide transparency about funds’ exposure to changes in market conditions.

Form N-PORT would be available to the public, so the SEC will consider rescinding Form N-Q on which funds currently report their portfolio holdings for their first and third quarters.

Registered funds would report annually on a new Form N-CEN which would replace current Form N-SAR. The disclosure requirements would be updated and streamlined to include more information about exchange-traded funds and securities lending. The reports would be filed within 60 days of the end of the funds’ fiscal years rather than semi-annually as currently required for most funds.

The portfolio and census information would be disclosed in a structured data format to make it more efficient to aggregate and analyze. The proposal would also standardize the disclosure in the financial statements included in fund registration statements and shareholder reports.

Website posting of reports. Under the proposal, mutual funds and other registered investment companies would have the option of providing shareholder reports and the past year’s quarterly portfolio holdings on their websites. Shareholders would continue to have the option to receive paper copies of the shareholder reports. Aguilar suggested that the SEC should proceed with this option with caution, given its experience with the e-proxy rules and based on investor research, which has shown a decline in retail investor participation in the proxy voting process after the adoption of the electronic filing rules.

Investment adviser amendments. The proposed investment adviser amendments would include changes to Form ADV to require additional information about advisers’ risk profiles. The new disclosure requirements reflect issues the staff has identified since the last changes to Form ADV in 2011. In particular, the SEC would require aggregate information about assets held and the use of borrowings and derivatives in separately managed accounts. White noted that 73 percent of registered investment advisers manage a wide variety of client assets in separately managed accounts, through which they provide individualized investment advice and direct ownership of the securities and other assets in the accounts. She said the SEC must have the ability to assess the potential risks in these arrangements.

Umbrella arrangements. The SEC also proposes to codify staff guidance that permits certain umbrella registration filing arrangements. The guidance has allowed advisers to private funds that are separate legal entities to organize as a group of related advisers under a single umbrella and operate as a single advisory business. They may file a single Form ADV as long as certain conditions are met.

Books and records. The proposal also would amend Rule 204-2 to require advisers to maintain records on their calculations of performance. Advisers currently must maintain this information if it is distributed to 10 or more persons, but under the proposal it would require the information to be kept if it is distributed to anyone. Advisers also would be required to maintain communications with respect to the performance or rate of return of accounts and securities recommendations.

Commissioners’ remarks. Commissioner Daniel Gallagher said he particularly appreciated the inclusion of a scaled compliance period to give smaller funds more time to comply with the rules, if adopted.

Commissioner Michael Piwowar, while supporting both proposals, raised two concerns. First, funds would have to include in Form N-PORT and N-CEN the legal identifier assigned or recognized by the Global LEI Regulatory Oversight Committee, he explained, which could result in the SEC helping to establish a monopoly for the provision of legal identifiers.

Second, he was concerned about the requirement to disclose in Form N-PORT, in connection with derivative instruments, the components of an underlying reference index if it is not already publicly disclosed on a website. Some index providers may not be willing to make this disclosure public, he explained, which could negatively impact funds that make these investments and the index providers.

The comment period on both proposals will be open for 60 days.

Additional initiatives. White noted that the staff is also developing recommendations to enhance the management and disclosure of liquidity risk by mutual funds and ETFs, and to update their liquidity standards. In addition, the staff is considering requirements for the use of derivatives by funds which may include limits to the leverage the derivatives may create. The staff also may recommend new requirements for stress testing by large investment advisers and large funds, and provisions for transition plans in the event of a major disruption of an adviser’s operations.

Wednesday, May 20, 2015

House Panel Hears from Financial Industry on Cybersecurity

By Mark S. Nelson, J.D.

The House Financial Services Committee’s Subcommittee on Financial Institutions and Consumer Credit heard from representatives of the financial services industry today regarding cybersecurity preparedness. Subcommittee Chairman Randy Neugebauer (R-Tex) observed in his opening remarks that a few recent studies rank cybersecurity as a bigger threat to financial firms than overregulation or geopolitics, but he closed the hearing by noting the “good” intra-industry response to cyber threats. Ranking Member William "Lacy" Clay, Jr. (D-Mo) focused his remarks and questions on the escalating severity of recent cyberattacks.

Threat sharing gets faster. The hearing focused on threats, information sharing, and contingency planning. The house earlier this year passed two bills that would broadly re-configure the federal government’s cybersecurity response and extends some liability protections to private entities with corresponding privacy and civil liberties limits. The Senate has yet to act on similar legislation.

Chairman Neugebauer opened the question and answer session by asking about the benefits of new software called Soltra Edge. Gregory T. Garcia, testifying for the Financial Services Sector Coordinating Council, had explained in his prepared remarks that this software is a joint venture between the Financial Services Information Sharing and Analysis Center (FS-ISAC) and the Depository Trust and Clearing Corporation that allows for automated threat sharing within the financial services industry. In his live testimony, Garcia further explained that Soltra Edge employs two open specifications funded by the Department of Homeland Security to provide machine-to-machine sharing.

Worries linger on defensive abilities. Ranking Member Clay put the question directly: Can the financial services industry stop cyberattacks? According to Jason Healey, Senior Research Scholar, School of International and Policy Affairs at Columbia University, the ability to fend-off cyberattacks depends more on the target’s mindset. Healey said many financial firms work from a presumption of breach, which then enables them to focus on locating hackers within their systems. He said this presumption is a helpful starting point because a determined hacker can usually get into a target’s system.

Kenneth E. Bentsen, Jr., President and CEO of the Securities Industry and Financial Markets Association (SIFMA), likewise noted that there is “no impregnable defense” to cyberattacks, but it is important for financial firms to have the ability to recover afterwards. Bentsen also said SIFMA is trying to increase membership in the FS-ISAC, what he termed the industry’s “go-to resource.”

In response to a question by Rep. Robert Pittenger (R-N.C.) regarding the U.S. electric grid, Bentsen said a financial firm can function if Fedwire is down, but a power outage would be more challenging. Bentsen acknowledged that different economic sectors need to work towards the same goal of detecting and preventing cyberattacks.

Representative Stephen F. Lynch (D-Mass) asked in later questioning about the risk management side of cybersecurity. Healey replied that cybersecurity is different from the familiar risk modeling methods used in the financial services industry. In the case of cyber risk, Healey said it is hard to know where the risk is at the end of the day, unlike with value at risk calculations, which yield a single number representing potential loss.

Where the threats come from. Ranking Member Clay also asked panelists about the sources of cyberattacks, especially those from China, Russia, and North Korea. Healey said point-of-sale attacks are common, while insider abuse and espionage are less common. Russ Fitzgibbons, Executive Vice President and Chief Risk Officer at The Clearing House Payments Company, agreed that phishing is the most common form of cyberattack, and that defense is the key.

But Healey sounded a cautionary note about this time in history. He sees the confluence of Russia’s economic woes and the potential for the failure of nuclear arms talks with Iran as making this the “most dangerous moment” yet for cyber conflict. He explained that both countries have significant cyber capabilities and either one, if events were to turn against them, could deploy those capabilities. Healey urged the financial sector to take these potential risks seriously.

Tuesday, May 19, 2015

Yahoo Did Not Misrepresent Its Stake in Alibaba and Alipay

By Rodney F. Tonkovic, J.D.

In an unpublished opinion, a Ninth Circuit panel has affirmed the dismissal of fraud claims against Yahoo!, Inc. for alleged misrepresentations concerning the valuation of the company’s holdings in Alibaba and Alipay. The district court held that Yahoo had no duty to disclose the allegedly omitted information at the time the statements were made. The panel found that the complaint failed to identify any actionable misrepresentation or omission (In re Yahoo! Inc. Securities Litigation, May 15, 2015, per curiam).

Background. According to the complaint, Yahoo and three of its executives made materially false and misleading statements regarding Yahoo's investment in Alibaba, a Chinese e-commerce company, and its payment platform, Alipay. As a result of new Chinese regulations adopted in 2010, Alibaba restructured its holdings resulting in the termination of Yahoo's ownership and control interest in Alipay. The investors alleged that Yahoo continued to speak as if it still had an ownership interest in Alipay that added significant value to the overall investment. When the restructuring was disclosed, Yahoo's stock price declined. The complaint alleged that Yahoo failed to disclose information about the restructuring, and while it disclosed the transfer of Alipay's shares to a Chinese company, it delayed disclosing additional details of the transactions underlying the restructuring.

The district court found that the investors failed to plead facts sufficient to establish a false or materially misleading statement. The court also found that Yahoo had no duty to correct or update its earlier statements once it learned of the restructuring in early 2011 and that none of Yahoo's statements triggered the duty to update. Finally, to the extent that any of the statements may have given rise to a duty to correct, the court found that the corrective disclosure was made within a reasonable time period.

Affirmed. On appeal, the first alleged misrepresentation at issue was a report of the market value of Alibaba that noted that the figures did not "include estimates of the value of Alibaba’s privately held businesses." This statement, the panel said, did not say or imply anything about Alipay's value or that it was restructured. Another alleged misrepresentation disclosed the restructuring, stating that 100 percent of Alipay's shares had been transferred to a Chinese company. While no additional details were disclosed in that statement, the panel found that it was "entirely consistent" with a more detailed explanation of the restructuring. Taken in context, the panel concluded, these statements did not create an impression of Yahoo's affairs that differed in a material way from that which actually existed.

The plaintiffs also argued that several pre-class period statements regarding Alipay gave rise to a duty to correct. The panel pointed out that neither the Supreme Court nor the Ninth Circuit have recognized a duty to correct. Still, even if the prior statements were misleading when made, and if there were a duty to correct, Yahoo corrected the statements within a reasonable time. The statements were corrected within six weeks, which the court found to be reasonable given the ongoing discussions regarding Alipay's restructuring.

The case is No. 12-17080.

Monday, May 18, 2015

Canadian Provinces Adopt Crowdfunding

By Jay Fishman, J.D.

The securities regulatory authorities of six Canadian provinces—British Columbia, Saskatchewan, Manitoba, Quebec, New Brunswick, and Nova Scotia—are adopting, by exemption orders, harmonized crowdfunding provisions to allow start-up and early stage companies to raise capital in these jurisdictions. The start-up crowdfunding exemptions are comprised of a prospectus requirement exemption called the “start-up prospectus exemption,” along with a dealer registration exemption called the “start-up registration exemption.” The start-up exemption orders expire on May 13, 2020.

Start-up prospectus exemption. The start-up prospectus exemption permits non-reporting issuers to issue eligible securities, subject to the following conditions:
  • the head office of the issuer is located in a participating jurisdiction;
  • the issuer distributes eligible securities of its own issue through an online funding portal;
  • the issuer distributes eligible securities using an offering document in the form required that is made available through the online funding portal. The offering document includes basic information about the issuer, its management and the distribution, including how the issuer intends to use the funds raised and the minimum offering amount;
  • the issuer group cannot raise aggregate funds of more than $250,000 per distribution and is restricted to not more than two start-up crowdfunding distributions in a calendar year;
  • no person invests more than $1,500 per distribution;
  • the distribution may remain open for up to a maximum of 90 days; 
  • the distribution must be made through a funding portal that is either relying on the start-up registration exemption or is operated by a registered dealer. Registered dealers that operate funding portals must meet their existing registration obligations under securities legislation and confirm to issuers that they meet or will meet certain conditions provided in the start-up registration exemption; 
  • the issuer provides each purchaser with a contractual right to withdraw their offer to purchase securities within 48 hours of the purchaser’s subscription or notification to the purchaser that the offering document has been amended; 
  • none of the promoters, directors, officers and control persons (collectively, the principals) of the issuer group is a principal of the funding portal; and 
  • the eligible securities are subject to an indefinite hold period and can only be resold under another prospectus exemption, or under a prospectus, or four months after the issuer becomes a reporting issuer. 
Start-up registration exemption. The start-up registration exemption permits funding portals to facilitate distributions under the start-up crowdfunding exemption, subject to the following conditions:
  • the funding portal must deliver to the participating regulators a funding portal information form and individual information forms for each of its principals, at least 30 days before facilitating its first start‑up crowdfunding distribution;
  • the head office of the funding portal is located in Canada;
  • the majority of the funding portal’s directors are Canadian residents;
  • the funding portal does not provide advice to a purchaser or otherwise recommend or represent that an eligible security is suitable, or about the merits of the investment;
  • the funding portal does not receive a commission, fee or any other amount from a purchaser of eligible securities;
  • the funding portal makes the issuer’s offering document and the risk warnings available online to purchasers and does not allow a subscription until the purchasers have confirmed that they have read and understood these documents;
  • the funding portal receives payment for an eligible security electronically through the funding portal’s website;
  • the funding portal holds the purchasers’ assets separate and apart from its own property, in trust for the purchasers and, in the case of cash, at a Canadian financial institution; 
  • the funding portal maintains books and records at its head office to accurately record its financial affairs and client transactions, and to demonstrate the extent of the funding portal’s compliance with the start-up crowdfunding exemption orders for a period of eight years from the date a record is created; 
  • the funding portal either releases funds to the issuer after the minimum offering amount has been reached and provided that the 48-hour right of withdrawal has elapsed, or returns the funds to purchasers if the minimum offering amount is not reached or if the start-up crowdfunding distribution is withdrawn by the issuer; and 
  • a participating regulator has not notified the funding portal that it cannot rely on the start-up registration exemption because its principals or their past conduct demonstrate a lack of integrity, financial responsibility or relevant knowledge or expertise. 
Start-up crowdfunding exemption orders amended. Comments received about the 2014 proposed exemption orders led to amendment of the following provisions: (1) “issuer group” definition and “participating jurisdictions” list; (2) offering limits; (3) funding portal head office and residence conditions for directors, officers, promoters and control persons; (4) 48-hour right to withdraw investment; (5) funding portal’s handling of purchaser funds; (6) funding portal’s books and records; (7) funding portal’s operated by registered dealers; (8) issuer information and individual forms; (9) offering document; (10) risk acknowledgment form; (11) filing or delivery of offering document and issuer access agreement; (12) funding portal disclosure of contact information; and (13) availability of the registration exemption.

Friday, May 15, 2015

Ceresney Reviews SEC’s Successes with National Litigation Program

By Jacquelyn Lumb

In the keynote address at the New York City Bar’s annual white collar institute, Enforcement Director Andrew Ceresney said the SEC’s ability to successfully litigate cases is critical to its mission of protecting investors. Litigation and trials are among the Division’s most important work, he said. He also emphasized that the SEC uses fair, reasonable, and consistent factors when choosing where to bring its cases.

Litigated cases. The SEC typically does not litigate cases where it has obtained the strongest evidence of wrongdoing, according to Ceresney. Those cases typically are brought by the criminal authorities or they settle on terms that are favorable to the Commission, he explained. Litigated cases tend to be those where the evidence is less clear, the law is unsettled, or the defendants are willing to spare no expense to clear their names, he advised.

Last year, the SEC litigated 30 cases — the largest number in the last 10 years. Ceresney reported that the SEC has filed more than 80 litigated actions and tried 16 cases in fiscal 2015. He reviewed the litigators’ results, which he characterized as remarkable, and highlighted some of the significant wins at trial. He also reviewed some of the Division’s successes in administrative proceedings. What is important to him is that the SEC continues to bring important cases and is willing to litigate those cases, Ceresney advised.

Other remedies. He noted that the Division has had other litigation achievements besides trial wins, including prejudgment relief, summary judgment wins, subpoena enforcement actions, post-filing settlements, and robust remedies after prevailing on summary judgment or at trial. He said that the litigators have an impressive record in obtaining prejudgment relief, including significant asset freezes. They also have had strong success in obtaining summary judgments. Summary judgments are as valuable as wins at trial, he said, and are obtained without expending the resources needed to win at trial.

The SEC also has had strong success in subpoena enforcement actions in which parties are required to produce documents or to appear for investigative testimony. These actions are critical to the SEC’s ability to effectively investigate misconduct and protect investors, he said.

Ceresney reported that the SEC’s admissions settlements have been a success given that the Commission obtains the same findings and relief without the risk and expense of a trial. The trial teams also have had great success in winning robust remedies decisions from district court judges and administrative law judges, according to Ceresney. These remedies send a powerful message of deterrence, he said.

Forum selection. Ceresney concluded with remarks about the SEC’s forum selection, which has generated a lot of interest. He said one point that is often overlooked by commentators is that the vast majority of the increased actions brought as administrative proceedings are settled actions. The SEC continues to bring more litigated cases in federal district court than in administrative proceedings, he said, including tough cases, such as insider trading.

Ceresney reviewed the Division’s recently issued guidance on forum selection in contested actions. The guidance was issued to increase the transparency in the Division’s forum selection process. There is no rigid formula for deciding the appropriate forum, he noted. The Division’s goal is to achieve strong and effective enforcement of the federal securities laws in a fair and efficient manner. The Division recommends the forum that will best use the SEC’s limited resources to carry out its mission, he noted. He added that all of the Division’s recommendations are subject to review and approval by the Commission.

Thursday, May 14, 2015

Campaign for Accountability Sues SEC for Rulemaking on Political Contribution Disclosure

By John M. Jascob, J.D.

The Campaign for Accountability has filed a lawsuit on behalf of investor Stephen Silberstein in an attempt to force the SEC to adopt rules requiring the disclosure of political contributions by public companies. In a complaint filed yesterday in federal district court in Washington, D.C., Silberstein contends that the Commission has acted arbitrarily and capriciously in refusing to grant his petition asking the agency to initiate rulemaking that would require public companies to disclose their use of corporate resources for political activities (Silberstein v. SEC, May 13, 2015).

Petition to the SEC. Silberstein had filed his petition to the SEC in May 2014 along with the non-profit watchdog group, Citizens for Responsibility and Ethics in Washington (CREW). The petition noted that as a shareholder of Aetna, Inc., Silberstein had unsuccessfully sued the company under Section 14(a) of the Exchange Act, alleging that Aetna made false or misleading statements in its proxy materials regarding certain contributions to tax-exempt organizations. The Southern District of New York had denied Silberstein’s request to enjoin Aetna from holding its 2014 shareholder meeting until it amended its reports to reflect all of its political contributions, finding that Silberstein was unable to demonstrate irreparable harm.

Without greater transparency in Aetna’s political contributions, the petitioners argued, Silberstein could not determine whether those contributions were in the best interest of the company. The petitioners thus asked the SEC to take up the issue of political contribution disclosure in a formal rulemaking procedure to address the ineffectiveness of voluntary measures, including numerous deficiencies in corporate disclosure reports. The petitioners noted that a similar petition submitted in 2011 by the Committee on Disclosure of Corporate Political Spending had gained widespread public support, garnering over 700,000 signatures.

SEC’s refusal to take action. In his complaint in the present action, Silberstein notes that despite this demonstration of unprecedented public support and compelling evidence that public companies are “pouring massive amounts of dark money into our electoral system,” the SEC has yet to take action or even respond to his petition. According to the complaint, the SEC’s effective denial of Silberstein’s petition and its failure to provide a reasonable explanation, or any explanation at all, is arbitrary, capricious, and a violation of the Administrative Procedure Act. Accordingly, Silberstein asks the court to issue a declaratory judgment in his favor and to grant him an injunction compelling the Commission to initiate a rulemaking procedure to require public companies to disclose their use of corporate resources for political activities.

The case is No. 1:15-cv-00722.

Wednesday, May 13, 2015

Life Settlement Agreements Meet Howey Securities Test in Texas

By Jay Fishman, J.D.

The Texas Supreme Court affirmed the Texas Court of Appeals’ decision in two consolidated cases filed against a seller of life settlement agreements, finding that the agreements met the 1946 U.S. v. Howey “investment contract” definition to deem them “securities” under the Texas Securities Act (TSA). The court applied the decision retroactively to the company’s previous cases, and remanded the consolidated case to the trial court for the relief defendants to present their arguments (Life Partners, Inc. v. Arnold, May 8, 2015, Boyd, J.).

Facts. Life Partners, Inc. bought an insured person’s life insurance policy (life settlement) and then sold the life settlement interests to purchasers. Life Partners’ pamphlet asserted that “the returns on life settlements, unlike stocks, mutual funds and other investments are unaffected by market fluctuations, business cycles, the economy or global unrest.”

The plaintiffs, in the first case, filed a class action seeking rescission and damages for claims that Life Partners and certain others violated the TSA by selling unregistered securities and materially misrepresenting to purchasers that the life settlements were not, in fact, securities. In the second case, the State of Texas sought an injunction and other relief for allegations Life Partners committed fraud when selling securities. The district courts in both cases ruled in favor of Life Partners, holding that it did not promote or market “securities” and could, therefore, not be liable under the TSA. The appellate court in each district, however, reversed on finding that the life settlements were indeed “securities” under the TSA.

Life Partners’ contention. Life Partners acknowledged that the life settlement agreements fell in line with Howey by being transactions through which purchasers paid money to participate in a common enterprise with the expectation of receiving profits. Life Partners contended, however, that the failure or success of the enterprise, and thus the purchaser’s realization of the expected profits, did not depend on the entrepreneurial or managerial efforts of Life Partners or others. Life Partners also contended that its post-transaction efforts were merely ministerial rather than entrepreneurial or managerial.

Broad definition of securities under TSA. The Texas Supreme Court reviewed the entire history of Howey’s interpretation by U.S. and Texas courts to declare that: (1) The TSA’s definition of “securities” must be construed broadly to protect investors as well as focus on a transaction’s economic realities (regardless of any labels or termination the parties might have used); (2) an “investment contract” under the TSA means a contract through which a person pays money to participate in a common venture with the expectation of receiving a profit, under circumstances where the failure or success of the enterprise, and thus the person’s realization of the expected profits, is at least predominantly due to the entrepreneurial or managerial, rather than merely ministerial or clerical, efforts of others; and (3) the entrepreneurial or managerial efforts, whether those of the purchasers or of others, include those made before as well as after the transaction.

Life Partners’ pre- and post-transaction efforts. The court disagreed with the argument that the enterprise’s success or failure, together with the purchaser’s expected profits does not depend on Life Partners’ efforts. The court determined that Life Partners’ pre-transaction efforts as the facilitator and administrator of the life settlements through its power of attorney drove the enterprise’s success and the purchaser’s profit. The court proclaimed that Life Partners’ identifying insureds, negotiating policy discounts, evaluating policy terms and conditions, evaluating an insured’s health, buying the insured’s policy and then finding purchasers to buy an interest in it until all interests are sold, are entrepreneurial or managerial activities. And these activities, said the court, are significant because they require Life Partners to accurately evaluate the insured’s life expectancy and to set the correct purchase price (discount) to yield a profit based on the insured’s life expectancy.

The court similarly found that Life Partners’ post-transaction activities were significantly entrepreneurial or managerial rather than non-ministerial activities because Life Partners, not the purchasers, had all the control over monitoring the insureds and their health status. The purchasers, moreover, had to rely on Life Partners to obtain the death certificate, complete the required insurance forms, and give them their pro-rata benefit share after an insured dies.

The cases are Nos. 14-0122 and 14-0226.

Tuesday, May 12, 2015

New White Paper and Webinar: "The Volcker Rule: Past, Present, and Future"

Senior Banking Analyst John M. Pachkowski has authored a new Wolters Kluwer Law & Business White Paper, “The Volcker Rule: Past, Present, and Future.” The paper discusses a number of issues that have arisen since the regulations implementing the Volcker Rule became effective in April 2014, including some of the expectations of the agencies charged with overseeing compliance with its provisions.

On May 27, Pachkowski and Securities Writer/Analyst Amy Leisinger will hold a free webinar to provide an update and analysis of the Volcker Rule regulations. Register now!

Canadian SRO Declares Success of Dark-Pool Amendments

By Anne Sherry, J.D.

The Investment Industry Regulatory Organization of Canada (IIROC) has concluded that the dark pool liquidity framework it put into place in 2012 has met its objectives with minimal impact to market quality. An IIROC report concludes that the amendments improved lit market depth, furthering the goal of favoring lit markets over dark markets in the absence of a meaningful, consistently defined price improvement while acknowledging the role of dark orders.

Background. IIROC is a self-regulatory organization charged with establishing and enforcing market integrity rules regarding trading on Canadian markets. In October 2012, IIROC implemented the amendments to the Universal Market Integrity Rules to require that small orders interacting with dark receive meaningful price improvement and that visible orders trade before dark orders at the same price on the same marketplace. The goal of the rule change was to establish a framework that recognized the contribution of dark orders to the post-trade price discovery process and their value to certain investors while satisfying the need to protect lit market price discovery, ensure meaningful price improvement, and establish a level playing field between transparent marketplaces and dark pools.

Trading venues. The report points out that only two Canadian marketplaces had models that needed to be changed as a result of the dark amendments. Alpha Exchange Inc. (ALF), a lit marketplace with a dark trading facility, and TriAct Canada Marketplace LP (TCM), a dark marketplace, offered price improvement that did not meet the new definition of “better price” under the rules—at least one trading increment, or half that if the spread is only one trading increment. The other marketplaces, whether lit, lit with dark order types, or dark, were already in compliance with the rule amendments.

Study. IIROC reviewed trading data covering the two months before and the two months after the dark rule amendments. The study analyzed the relative changes in dark to lit trading and market share shifts among trading venues; the impact to market quality; and the use of dark trading venues by brokers to internalize their order flow. Of the two affected marketplaces, ALF saw the greater impacts to dark trading values as a result of the dark rule amendments. Other than return autocorrelation measuring price efficiency, most market quality measures showed no significant impact. The study also revealed that there was no statistically significant deterioration in overall market liquidity as measured by time-weighted average spreads, effective spreads, and realized spreads. As to brokers’ use of dark markets and order types to internalize their retail order flow, IIROC found that market-met internalization, while low to begin with, decreased significantly following implementation of the dark rule amendments. This decrease was driven by a few brokers reducing their liquidity provisioning on ALF’s dark trading facility.

Remarks. Andrew J. Kriegler, IIROC’s president and CEO since last November, praised the SRO for its initiative in taking action on dark pools “before the genie was completely out of the bottle.” As expected, the rule resulted in an immediate and dramatic decline in dark trading, he said. As IIROC had hoped, the analysis showed some positive results in the visible markets and indicated overall that the regulatory objectives were accomplished with acceptable impacts to market quality. In his remarks before the International Finance Club of Montreal, Kriegler also discussed approaches to curb order routing to the U.S. and improving regulatory transparency in the debt market.

Monday, May 11, 2015

Division of Enforcement Issues Guidance on Its Approach to Forum Selection

By Matthew Garza, J.D.

“There is no rigid formula dictating the choice of forum,” the SEC wrote in guidance released late Friday afternoon on the issue of forum selection in contested actions. The four page document set out a list of four “potentially relevant considerations” the Division of Enforcement uses in deciding whether to bring an action before an Administrative Law Judge or in federal court:
  1. The availability of the desired claims, legal theories, and forms of relief in each;
  2. whether any charged party is a registered entity or an individual associated with a registered entity;
  3. the cost‐, resource‐, and time‐effectiveness of litigation in each forum;
  4. fair, consistent, and effective resolution of securities law issues and matters.
The guidance specifies that the list is not, “and could not be,” exhaustive.

Saturday, May 09, 2015

Bitcoin Exchange Granted New York Banking Charter

By Amanda Maine, J.D.

The New York State Department of Financial Services (NYDFS) has granted a charter to a commercial Bitcoin exchange. NYDFS announced that, in granting charter under New York banking law to New York City-based itBit Trust Company, LLC, the company is the first virtual currency company to receive such a charter.

NYDFS had announced last year that it would be accepting licensing applications for virtual currency exchanges under New York banking law. NYDFS’s order initiating the application process advised that virtual currency exchanges would ultimately be expected to meet the full requirements of the BitLicense regulatory framework as a condition of licensure.

BitLicense. Following an inquiry and fact-finding efforts about regulatory guidelines for virtual currencies, including public hearings, NYDFS issued a proposed BitLicense regulatory framework in July 2014. NYDFS updated its proposed BitLicense framework in December 2014. The new proposal incorporated feedback from the first round of public comments and contained a series of changes and clarifications. The final BitLicense framework should be put forward later this month, according to NYDFS.

itBit. itBit submitted its application in February 2015. As part of a rigorous review of its application, NYDFS evaluated itBit’s anti-money laundering, capitalization, consumer protection, and cybersecurity standards. itBit will be able to start operating immediately as a chartered limited purpose trust company. It will be subject to ongoing supervision by NYDFS and must meet obligations for New York trust companies. It is also subject to the final BitLicense regulations.

Friday, May 08, 2015

Mississippi Adopts Crowdfunding Exemption

By Jay Fishman, J.D.

The Mississippi Securities Division within the Secretary of State’s Office adopted an exemption for intrastate crowdfunding offerings that comply with Securities Act Sec. 3(a)(11) and SEC Rule 147. The exemption highlights include the following:
  • The aggregate amount the issuer, under the exemption, may sell to all investors within the 12 months preceding the transaction date must not exceed either: (1) $1 million, if the issuer did not make the most recent fiscal year’s financial audit documents available to prospective purchasers; or (2) $2 million, if the issuer did make the most recent fiscal year’s financial audit documents available to prospective purchasers; 
  • The aggregate amount multiple issuers, under the exemption, may sell to any single accredited investor within the 12 months preceding the transaction date may not exceed the greater of: (1) If the investor had an annual income of at least $200,000 each year for the last two years (or $300,000 together with the investor’s spouse if married) and expects to make the same amount in the current year, then 5 percent of the investor’s annual income, not to exceed an aggregate amount of $50,000; or (2) If the investor’s net worth is at least $1 million, then 5 percent of the investor’s net worth, not to exceed an aggregate amount of $50,000; 
  • The aggregate amount multiple issuers, under the exemption, may sell to any single nonaccredited investor within the 12 months preceding the transaction date may not exceed the greater of: (1) $5,000; (2) 5 percent of the investor’s annual income if the investor had an annual income of less than $200,000 each year for the last two years (or less than $300,000 together with the investor’s spouse if married); or (3) 5 percent of the investor’s net worth if the investor’s net worth is less than $1 million. 
  • Single or multiple issuers, under the exemption, may sell an unlimited aggregate amount to “qualified Purchaser” investors. 
  • Investor funds must be deposited in escrow, with the issuer required to raise the minimum targeted amount by the offering deadline to receive the proceeds; 
  • The issuer, before consummating the purchase, must require each prospective investor to certify certain prescribed information about himself, e.g., his name, address, social security number, and the aggregate amount sold to him; the issuer must maintain records of the investors’ residence, and must make the records available for Division inspection; 
  • Offers and sales must be made exclusively through an Internet website operated by an intermediary meeting specified requirements; the issuer must, before making any offers or sales, provide the intermediary with evidence that the issuer is organized and authorized to do business in Mississippi; and 
  • The issuer must file a notice with the Division on Mississippi Form IMC, Invest Mississippi Crowdfunding Form, accompanied by a copy of the escrow agreement and all other Form IMC exhibits; the completed Form IMC, including exhibits, must be provided to the relevant intermediary; and this must be made available to potential investors after the Division issues an Acknowledgment of Completed Invest Mississippi Crowdfunding Exemption Form

Thursday, May 07, 2015

Appellate Panel Hears Arguments on SEC’s Refusal to Accept Mutual Fund’s Accounting Method

By Amanda Maine, J.D.

A panel of the D.C. Circuit Court of Appeals heard arguments from the SEC and a mutual fund regarding the SEC’s decision to deny the fund’s application for an exemption for its method of accounting for potential deferred tax liability (Copley Fund, Inc. v. SEC, May 4, 2015).

Background. On September 4, 2013, Copley Fund, Inc. submitted an application with the SEC requesting an exemption from Rule 22c-1 under the Investment Company Act and Rule 4-01(a)(1) of Regulation S-X. Copley, a mutual fund, requested an exemption that would permit it to alter the manner in which it currently accounts for deferred tax liability on unrealized gains. Copley proposed to account for its deferred tax liability for unrealized gains by establishing a tax reserve based on a pre-set formula designed to present a more accurate and fairer disclosure to the investing public of its invested assets and net asset value (NAV). Copley had used this method until 2007, when the SEC informed it that this method violated GAAP and that it would recommend enforcement action if Copley did not change its accounting for deferred tax liability.

To comply with the SEC’s determination, Copley currently makes a provision for federal income taxes in the full amount of federal income tax that would be due if the full amount of Copley’s existing unrealized gains were realized. Copley argued that under its proposed exemption, its entire federal income tax liability would be due only in the “unlikely event” that its entire portfolio were liquidated. Copley's current use of the full liquidation value method “has produced a skewed and unreasonable result,” according to Copley. Copley's per share NAV does not reflect the realistic value of the Fund, but using the method proposed in its application would “fairly and accurately [reflect] a realistic tax liability,” Copley contended.

The SEC denied Copley's application for exemptive relief. According to the SEC, with respect to Copley’s calculation of NAV, if a high level of shareholder redemptions forced Copley to liquidate portfolio assets with significant unrealized gains in order to pay the redeeming shareholders, then the actual tax liability from those gains could exceed the partial deferred tax liability that Copley proposed recording. The lower recorded tax liability could yield a higher NAV per share at the time of redemptions, causing redeeming shareholders to receive more than their pro rata share of the Fund’s net assets, while the higher actual tax liability could yield a lower NAV per share following the redemptions. This would cause non-redeeming shareholders to receive a lower price for their pro rata share of the Fund’s net assets. The disparity between redeeming and non-redeeming shareholders would produce an “unfair and inequitable result” among Copley’s shareholders, the SEC said, which is contrary one of the Investment Company Act's primary purposes.

Copley appealed to the Circuit Court for the District of Columbia under the Administrative Procedure Act, arguing that the SEC's denial of its request was arbitrary, capricious, and an abuse of discretion. The SEC contended that it reasonably determined that Copley’s method could result in the disparate treatment of investors.

Oral argument. Before a panel of the D.C. Circuit, Copley counsel Paul M. Honigberg criticized the SEC’s denial of Copley’s application because it failed to address the company’s unique operating history, with low levels of redemptions and a philosophy of reinvesting dividends and accumulating capital gains. The denial was based on a “hypothetical and unprecedented” scenario involving massive redemption of shares that actually inflicts harm on present investors because the full liquidation method is misleading and also puts Copley at a disadvantage relative to other mutual funds because it artificially deflates the Fund’s NAV, making it appear to be a less attractive investment opportunity, Honigberg argued. He also found fault with the SEC’s failure to consider alternatives to Copley’s proposal; instead of evaluating alternative methods, the SEC simply said “you can’t do it,” Honigberg added.

Questioned by Judge Janice Rogers Brown on why it took Copley so long to file for an exemption, Honigberg stated that the company tried numerous times in the six years following the SEC’s original notice to get the agency’s attention, but was “stonewalled at every turn.” Judge Sri Srinivasan observed that because investors do redeem their shares sometimes, it was not unreasonable to envision scenario where there will be some level of redemption, even if is not to the extent as hypothesized by the SEC. Honigberg disagreed, maintaining that the SEC’s refusal to grant the exemption based on hypothetical future redemption requests of any degree was “a solution without a problem.”

SEC senior counsel Stephen G. Yoder explained that as a mutual fund registered under the Investment Company Act, Copley holds itself out to stand ready to honor redemption requests at any time and for any reason. The Commission used its expert judgment, Yoder said, to determine that Copley simply cannot anticipate all of its shareholder needs in the future. Judge Brown inquired why Copley’s earlier interactions with the SEC were focused on the company’s alleged GAAP violations, while its denial of the requested exemption was based on the Investment Company Act. Yoder replied that the earlier interactions were at the staff level, including discussions about a potential enforcement action and no-action letter relief, and were not binding on the agency. However, when Copley applied for the exemption, the SEC’s decision was governed by Section 16 of the Investment Company Act.

Judge Nina Pillard asked how the court can know when the SEC makes a decision based on predictive judgments or unfounded conjecture. Yoder said the distinction here is that Copley, in asking for exemptive relief, is asking to be exempted from rules that bind every other mutual fund. Judge Brown pointed out that Copley is unique among mutual funds because, unlike other most mutual funds, it is organized as a C Corporation, subjecting it to different tax treatment than a Regulated Investment Company (RIC). Yoder explained that the SEC is aware of other mutual funds that elected to operate as C Corporations, however, none of them have requested the exemptive treatment that Copley desires.

Pillard also observed that the SEC’s rationale appears to be standardization—it should require the same thing of everyone so the investing public can “compare apples to apples.” Honigberg replied that, due to Copley’s unique structure and operating history, the “apples to apples” comparison does not work in this case. No mutual fund can guarantee what the government is asking of Copley, he said. The SEC is “hiding behind extra deference” because Copley is seeking the exemption, Honigberg said. But deference must be reasoned and based on the facts in the record, and the SEC has failed to do this, Honigberg concluded.

The case is No. 14-1142.

Wednesday, May 06, 2015

Commissioner Stein Opposes WKSI Waiver Granted to Deutsche Bank

By Jacquelyn Lumb

Commissioner Kara Stein issued a dissenting statement in response to the staff’s waiver which was granted yesterday to Deutsche Bank AG. Pursuant to the waiver, Deutsche Bank will not be considered an “ineligible issuer” under Securities Act Rule 405 for its U.K. subsidiary’s role in manipulating LIBOR. Deutsche Bank requested a waiver after its subsidiary pleaded guilty. The Division of Corporation Finance initially granted temporary relief while it considered the matter further, and yesterday granted the waiver on the condition that Deutsche Bank complies with the terms of the plea agreement. Stein said the waiver continues to erode the very low hurdle required to maintain well-known seasoned issuer (WKSI) status. “Deutsche Bank’s illegal conduct involved nearly a decade of lying, cheating, and stealing,” she said. Its criminal conduct was pervasive and widespread.

Absent the waiver, the subsidiary’s guilty plea would have prevented Deutsche Bank from qualifying as a WKSI and enjoying the benefits of that status, including the ability to register offerings on shelf registration statements that become effective automatically upon filing. Stein noted that prior Commissions did not grant WKSI waivers for criminal misconduct, but the Deutsche Bank waiver is the third waiver for criminal conduct at a large institution in a little less than two years.

Stein questioned how the majority could grant the waiver to Deutsche Bank, not only given the egregious criminal nature of its conduct, but also because the bank is a recidivist. Deutsche Bank requested and was granted WKSI waivers in 2007 and 2009 for past misconduct.

CFTC’s intervention. Stein said she also had expected to receive a request from Deutsche Bank for a waiver from the automatic disqualification for so-called bad actors under Rule 506. The bank’s conduct should have triggered an automatic disqualification absent a waiver, she noted. However, a loophole in Rule 506(d)(2)(iii) allowed the CFTC to intervene and prevent the bad actor disqualification issue from coming before the Commission. The CFTC inserted language into its final order regarding Deutsche Bank’s misconduct, advising that a bad actor disqualification should not arise as a consequence of its order, she explained. Stein said the implications of the CFTC’s actions are deeply troubling and called on the SEC to review the provision and how it is being used.

Tuesday, May 05, 2015

Subsidiary of Deadlocked Company Could Seek Dissolution in Equity

By Lene Powell, J.D.

In a petition to dissolve a deadlocked company, the Delaware Court of Chancery held that although a subsidiary lacked standing to bring a petition for statutory dissolution under the Delaware Limited Liability Company Act, it could bring a petition for dissolution in equity. Without intervention, an inequitable situation would persist that unfairly advantaged one of the parties and did not reflect the parties’ relationship as equal business partners (In re Carlisle Etcetera, April 30, 2015, Laster, J.)

Background. Carlisle Etcetera LLC is a Delaware limited liability company formed in 2012 by petitioner Well Union Capital Limited (WU Parent) and respondent Tom James Company (James). After forming the company, the parties executed an initial operating agreement. Soon after, WU Parent assigned its member interest to a wholly owned subsidiary called Well Union U.S. Holdings, Inc. (WU Sub). James knew about the transfer, did not object, and treated WU Sub as a member. Following the assignment, the parties drafted a revised operating agreement that recognized WU Sub as a member.

Before the revised operating agreement could be finalized, the relationship between the parties soured, resulting in deadlock. Both sides recognized that one side needed to buy out the other, but could not agree on a price or procedure. James saw no urgency to act, as it was in an advantaged position because Carlisle’s CEO was appointed by James, and with the board deadlocked, operated free from oversight. WU Sub petitioned to dissolve the company. James moved to dismiss, arguing that the subsidiary lacked standing to petition for statutory dissolution under Section 18-802 of the LLC Act because WU Sub was an assignee, not a member.

Statutory dissolution not available. The court agreed that WU Sub lacked standing to dissolve the company under Section 18-802 of the LLC Act. The statutory language limited the right to “members and managers” of an LLC. The operating agreement made clear that the Board, acting collectively, was the manager of the company. WU Parent was not a member because it had assigned all its interest to WU Sub.

The question of whether WU Sub was an assignee or member was a little more complex. The court determined that WU Sub was only an assignee. First, Section 18-702(b)(1) provides that an assignee is not a member unless specified in the LLC agreement, and the initial operating agreement did not specify that WU Sub was a member. Second, WU Sub was not admitted as a member because admission requires formal action such as a vote or written consent, and James did not take any such action.

Because neither WU Parent nor WK Sub was a member of the LLC, the petitioners lacked standing to bring a petition for statutory dissolution under Section 18-802.

Dissolution in equity. After analyzing its jurisdiction, the court decided that Section 18-802 did not provide the exclusive method for dissolving an LLC, because the court had equitable jurisdiction to hear the petition for dissolution.

Although previous cases established that parties to an LLC agreement can waive by contract the right to seek statutory dissolution under Section 18-802, this ability to waive dissolution did not extend to a party’s standing to seek dissolution in equity, in the court’s view. An LLC agreement is not an exclusively private contract among its members, because the LLC has powers that only the State of Delaware can confer. Therefore, dissolution is also not a purely private affair, and the State of Delaware retains an interest in having the Court of Chancery available to hear a petition to dissolve an LLC when equity demands.

This was a case in which equity should intervene, said the court. Without dissolution, the petitioners would be locked-in as a silent and powerless passive investor, which was contrary to the bargain the parties struck. The parties contributed equal amounts of capital and formed the company as equal business partners. If the collapse of the relationship had not derailed the finalization of the revised operating agreement, WU Sub would have been formally recognized as a member rather than assignee. As the court explained, equity attempts to enforce rights that spring from the “real relationship” of the parties, and the real relationship of the petitioners and respondents was a joint venture in which they were equal participants. Accordingly, in good conscience, WU Sub should be regarded as a member with the power to seek dissolution, the court concluded.

Because WU Sub had standing to seek dissolution in equity, the court denied the motion to dismiss.

The case is No. 10280-VCL.

Monday, May 04, 2015

A Regional View on Prosecutorial, Regulatory Priorities

By Mark S. Nelson, J.D.

Zachary T. Fardon, U.S. Attorney for the Northern District of Illinois, and David A. Glockner, Director of the SEC’s Chicago Regional Office, offered their views on the priorities and challenges faced by their offices regarding securities and commodities enforcement. Their regional views highlighted a few locally significant items, but also mirrored larger national trends.

Fardon and Glockner made their remarks at the 35th Annual Ray Garrett Jr. Corporate and Securities Law Institute held at Northwestern University Law School in Chicago. Wolters Kluwer Law & Business is a program sponsor of this year’s Garrett Institute.

The prosecutor’s view. Fardon noted that his office has many priorities, including ones that span a range of areas with national overtones, such as the interaction between police and citizens as exemplified by recent events in Baltimore, and the myriad national security issues posed by groups such as the Islamic State of Iraq and the Levant.

But Fardon’s office also has a group of lawyers that focuses on financial markets. The Northern District’s Securities and Commodities Fraud Section tracks issues and cases that involve publicly-traded companies and other regulated financial entities, such as trading exchanges. Fardon noted that his office brought the first criminal prosecution for commodity futures “spoofing,” a case that will proceed now that the defendant has failed to persuade a federal judge to dismiss the indictment.

Fardon noted that Chicago overall has changed for the better during the last 20 years, including by burnishing its image as a home for many corporations and as the host city for key trading venues. Despite his office’s many other activities, Fardon said the securities and commodities fraud section is important “because it matters” that federal prosecutors do their part to ensure the fairness and integrity on which U.S. markets rely. He cited a list of cases as examples of his office’s financial markets enforcement activities, including an ongoing investigation under the Foreign Corrupt Practices Act.

In addition to their separate remarks, Fardon’s and Glockner’s discussion included dialogues about enforcement against individual executives and how companies deal with whistleblowers. While the SEC has demanded admissions in some cases against individuals, Fardon said the criminal milieu of federal prosecutors poses the unique challenge of needing to prove each element of an offense beyond a reasonable doubt.

Fardon said many critics of prosecutors’ handling of financial crisis cases do not fully appreciate this last point, which also is influenced by the resources available to prosecutors. “I believe individual accountability is important,” said Fardon. But he said these cases will continue to be pursued based on their specific facts.

Glockner echoed Fardon’s observations about admissions in the SEC’s cases. Glockner added that few cases beget admissions because the conduct charged must be particularly egregious.

As for whistleblowers, Fardon responded to a question from the enforcement panel’s moderator about how companies deal with employees who come forward, saying he questioned what it says about the U.S. culturally when companies think only of whether anyone will learn of the whistleblower’s information. Glockner added that the SEC’s Dodd-Frank Act-mandated whistleblower program was intended to “raise the stakes for those kinds of discussions” at companies.

The federal government’s sequestration order remains a sore spot for federal prosecutors. According to Fardon, his office and other U.S. Attorneys’ offices are part of the “collateral damage” inflicted by the order. Fardon said his Chicago office is currently down 12 assistant U.S. attorneys as a result.

From the regulator’s desk. Glockner said his SEC regional office is now freer to pursue a wider range of enforcement priorities now that much of the office’s work on financial crisis-related matters is done. He also noted the special relationship between the SEC’s Chicago office and federal prosecutors, whose work is complementary, even though the two offices have different statutory missions. Specifically, Glockner said Fardon’s securities and commodities section offers opportunities for both offices to engage in joint training and to make referrals to each other. Fardon said Glockner, a former prosecutor himself, knows the type of cases prosecutors want to take on.

Glockner noted a 45 percent rise over last year regarding reporting fraud cases. He said this was the result of renewed SEC focus on these issues and the freeing up of resources previously devoted to Great Recession-era cases. He cited the example of the case his office brought against two former executives at Assisted Living Concepts Inc. (ALC). The hearing in the SEC’s administrative proceeding against ALC’s ex-CEO Laurie A. Bebo was set to take place April 20 in Milwaukee. Bebo recently lost her bid to get a federal judge to halt the proceeding on constitutional grounds, but she has appealed that decision to the Seventh Circuit.

Other priorities for Glockner include municipal securities and pensions. The focus here is twofold: the link between securities fraud and public corruption, and the accuracy of representations in offering documents. Glockner echoed Fardon’s general concerns about market structure and integrity. He also noted regulators’ interest in “protection of process” cases, especially ones like the compliance personnel action SEC Chair Mary Jo White mentioned in her address to the Garrett Institute yesterday. Subpoena enforcement actions are yet another area of concern for Glockner.

The future of regional enforcement, Glockner said, is for regulators to become more risk-based. Glockner’s observation is consistent with the risk-based focus many SEC staffers in Washington, D.C. began touting publicly a few years ago at Practicing Law Institute’s The SEC Speaks in 2013.

Glockner also said the Chicago regional office’s examination team is now working more closely with its enforcement program, especially on issues for seniors, cybersecurity, and private equity fees and expenses. In the case of seniors, Glockner said it is important to remember that many of those nearing retirement age belong to the first generation to have managed their retirement funds on their own.

Friday, May 01, 2015

Stein Hopes to Explore Problems with Short-Termism, Lack of Board Diversity

By Amanda Maine, J.D.

SEC Commissioner Kara M. Stein shared her thoughts on “short-termism” and the composition of boards of directors at the Treasury Department’s Corporate Women in Finance Symposium. Both of these issues should be explored as part of a larger policy framework, she said.

Short-termism. Stein noted that debate exists about whether short-term pressures from investors and from markets in general compel companies to look narrowly at the short term, including being overly focused on quarterly earnings targets. In particular, she observed that companies are using their cash resources to buy back shares at record numbers, resources that could have been used to invest in longer-term projects. Stein finds it “troubling” that using these buybacks, which have the effect of increasing a company’s Earnings Per Share by reducing the number of outstanding shares, could potentially have the effect of mortgaging the future of companies, their employees, and other stakeholders at the expense of making short-term EPS targets.

Stein acknowledged that other researchers have disputed the idea that short-term targets are at odds with longer-term performance. However, she advised that it is an issue that should be discussed and that the SEC and other federal regulators have a role to play in examining behavior that affects long-term outcomes for American businesses.

Boardroom diversity. Stein also observed that some research has found that having more inclusive boards of directors can benefit a company, including helping boards avoid groupthink. Studies have also shown that boards with above-average levels of gender diversity had fewer instances of bribery, corruption, and other negative corporate occurrences, she said. If diversity in board rooms helps companies, why aren’t boards of directors more diverse, Stein wondered.

Stein suggested that one way to increase boardroom diversity is to increase shareholder engagement. She noted that shareholders who vote by proxy are generally limited either to management or shareholder-proponent board nominees, while those who attend annual meetings in person can vote for any individual nominated. Perhaps a universal proxy ballot could repair this incongruity while providing a better choice for all shareholders, with the possible added benefit of gaining a more diverse board. She encouraged the audience to be part of the ongoing conversation with the SEC and companies to meet shared goals of strengthening the economy and promoting innovation.

Thursday, April 30, 2015

SEC Awards Maximum Payout in First Whistleblower Retaliation Case

By John Filar Atwood

A whistleblower who was subjected to a series of retaliatory actions by Paradigm Capital Management will receive the maximum award payment of 30 percent of amounts collected in connection with the case. In its first whistleblower retaliation action, the SEC determined the level of the award after concluding that the person suffered unique hardships as a result of reporting to the Commission.

Retaliatory actions. The SEC charged Paradigm Capital with retaliating against the whistleblower after the firm learned that the person reported potential misconduct to the agency. According to the SEC, Paradigm Capital immediately engaged in a series of retaliatory actions against the whistleblower including removing the person from a then-current position, and tasking the whistleblower with investigating the very conduct the whistleblower had reported to the SEC. The Commission claims that Paradigm Capital also changed the whistleblower’s job function, stripped the whistleblower of supervisory responsibilities, and otherwise marginalized the whistleblower.

In a press release, Sean McKessy, chief of the SEC’s Office of the Whistleblower, emphasized that the Commission is committed to supporting the whistleblower program. He said that he hoped this anti-retaliation action will encourage potential whistleblowers to come forward in light of the SEC’s demonstrated commitment to protect them against retaliatory conduct and to provide significant financial awards in these cases. According to the order determining the award claim, the whistleblower in the Paradigm Capital case will receive more than $600,000 for aiding the SEC’s successful enforcement action.

Denial of awards. In a separate action, the Commission denied a different whistleblower’s award claims in connection with five actions brought by the SEC. In the order, the SEC noted that the whistleblower applied for an award in cases against Citigroup, Merrill Lynch, Navistar International, Wells Fargo Securities, and Morgan Stanley Investment Management.

To qualify for an award, a whistleblower must voluntarily provide the Commission with original information that leads to the successful enforcement of a covered judicial or administrative action. With respect to four of the five actions in question, the Commission found that the record conclusively demonstrated that the claimant submitted the tip after the matters were settled. As a result, the tip could not have led to the successful enforcement of those four actions, the SEC said.

With regard to the action against Morgan Stanley Investment Management, the staff again concluded that the whistleblower’s tip did not lead to the successful enforcement of the matter. According to the SEC, after the claimant submitted the tip, the staff that conducted a preliminary review of the information designated the tip for no further action and did not forward it to anyone assigned to the case. In addition, there is no indication that the enforcement staff members responsible for the Morgan Stanley case either received or relied upon any information provided by the claimant, the SEC noted.

To date, the SEC has awarded 17 whistleblowers since the program began more than three years ago; payouts total over $50 million.

Wednesday, April 29, 2015

Exclusive Shareholder Remedy Under Alberta Corporations Act Was Not Available in U.S. Courts

By Lene Powell, J.D.

A panel of the Ninth Circuit affirmed the dismissal of a counterclaim alleging breach of fiduciary duty by directors of a California corporation with a Canadian parent company. In what it called an “anomalous case,” the panel said that although the district court did have subject matter jurisdiction regarding the controversy, the counterclaim by the shareholder did not raise a cause of action for which the district court could grant relief, because the right could only be enforced in the Court of Queen’s Bench of Alberta (Seismic Reservoir 2020, Inc. v. Paulsson, April 27, 2015, Sentelle, D.).

Background. Seismic Reservoir 2020, Inc. (Seismic), a California company, provided oil reservoir imaging technology and services. In 2009, Seismic sued Björn Paulsson, alleging violations of the Lanham Act and breach of fiduciary duty. Paulsson countersued, bringing his own breach of fiduciary duty claim, as well as other claims arising from his status as a shareholder and director of Seismic’s parent company, Seismic Reservoir 2020, Ltd., which was incorporated in Alberta, Canada.

In 2012, Paulsson dropped some of the counterclaims, and in a trial brief characterized his remaining counterclaim as “a breach of fiduciary duties owed by directors to shareholders” under Section 242 of the Alberta Business Corporations Act, which gives the Court of Queen’s Bench of Alberta broad equitable powers to regulate corporate matters. The district court recast the claim as an action for shareholder oppression under that section.

To determine whether it could hear the case, the district court appointed an independent expert on Alberta corporate law, who gave the opinion that the statute conferred exclusive jurisdiction on the Alberta court. The expert said that “only an Alberta Court has jurisdiction to grant a remedy for oppression brought in respect of an Alberta corporation.” The district court decided it could not issue a remedy for shareholder oppression under Section 242, and dismissed Paulsson’s counterclaim under Federal Rule of Civil Procedure 12(b)(1) for lack of subject matter jurisdiction.

Exclusive remedy. Reviewing the dismissal de novo, the panel concluded that actually, the district court did have subject matter jurisdiction. Paulsson, a California citizen, sought damages of more than $75,000 against Canadian citizens. This fit “squarely within” the language of 28 U.S.C § 1332(a)(2), relating to diversity jurisdiction. The exclusive jurisdiction provision in the Alberta statute did not divest the district court of its jurisdiction, because only the Constitution and the laws of the United States can dictate what cases or controversies U.S. federal courts may hear.

However, Paulsson was still out of luck. The panel explained that although foreign law cannot limit the jurisdiction of an Article III court to entertain controversies, when foreign law creates a right, it may determine the remedy. The Alberta statute provided a remedy available only through the Court of Queen’s Bench of Alberta, so the district court could not grant the relief requested. Therefore, the panel affirmed the dismissal of the counterclaim under Rule 12(b)(6), rather than 12(b)(1).

Because Paulsson could not possibly win relief, the panel did not remand to the district court to give him an opportunity to amend his pleadings.

The case is No. 13-55413.