Wednesday, April 25, 2018

Justices hear oral argument on constitutionality of SEC ALJs

By Rodney F. Tonkovic, J.D.

The Supreme Court has heard oral argument in Raymond Lucia's case disputing the constitutionality of the SEC’s administrative law judges. Lucia has asked the court to reverse a D.C. Circuit holding that the ALJ’s are employees beyond the reach of the Appointments Clause. Following a change of administration, the Solicitor General makes the same case. Finally, in defense of the current system, a court-appointed amicus defends the judgment below, arguing that the SEC's ALJs are employees, not officers, because they do not exercise significant authority with the power to bind the government or others in their own name (Lucia v. SEC, April 23, 2018).

ALJs are officers. Mark Perry, on behalf of Lucia, opened by stating that SEC ALJs are officers under all the Court's precedents. He was quick to point out that the petitioner's stance is that the ALJs are inferior officers, but not employees, because their work is supervised by principal officers. He noted further that the ALJs have sovereign powers that are given to judges, powers that, as the Court recognized in Freytag, make them officers. In response to a question by Chief Justice Roberts, Perry maintained that ALJs have the power to make final decisions on behalf of the SEC. While the Commission can review an ALJ's decision, those decisions are deemed to be final if not reviewed within 42 days, and 90 percent of ALJ decisions become final with no review.

Justice Kennedy expressed concern about the effect that a ruling in favor of Lucia would have on ALJs in other agencies. Perry responded that his position was limited to a group of 150 ALJs in 25 agencies who decide adversarial proceedings subject to Sections 556 and 557 of the Administrative Procedure Act, some of whom may already have been properly appointed. Here, Perry distinguished other agencies, such as Social Security, that do not, he said, conduct adversarial hearings, in the sense that a private citizen will have his or her "fate" decided.

The government's position. Arguing for the government, Deputy Solicitor General Jeffrey Wall enunciated the test that the government hopes the Court will adopt: "Under Buckley and Freytag, a constitutional officer occupies a continuing position that's been vested by law with significant discretion to do one of two things: Either to bind to the government or third-parties on important matters or to undertake other important sovereign functions." The Commission ALJs, he continued, have both powers, so there is no meaningful difference between this case and Freytag.

The government tests leaves room for discretionary review, but the point, Wall said, is that the ALJs issue decisions which the Commission can review if it wishes. At the end of the day, though, the ALJs decision, if not reviewed, binds the parties, and this is what makes them officers, Wall said.

Effect on independence. Justice Kagan expressed concerns about the ALJ's independence throughout the session. She noted that decisionmakers should be insulated from political pressures and asked Perry if "putting those decisionmakers even closer to the political body" would only exacerbate the problem of bias. Returning to the point during an exchange with Wall, Justice Kagan said that having power over pay, removal, or employment can interfere with decisional independence. The APA, she said, provides for insulation from the political system, but the government's position would "ratchet that down."

Finality. Anton Metlitsky, the Court-appointed amicus arguing in support of the existing system, faced an immediate challenge from Chief Justice Roberts. The amicus's theory is that the SEC’s ALJs are employees, not officers, because they do not exercise significant authority with the power to bind the government or others in their own name. Justice Roberts, however, said that this test does not jibe with Freytag's laundry list of particular authorities. Justice Kagan joined in, noting the commonalities of the ALJs at issue and the judges in Freytag: "If you had a list and you said top 10 attributes of the judges that were involved in Freytag and the judges that are involved here, you'd pretty much say that nine of them are the same." Metlitsky countered that the power to bind is crucial, prompting Justice Alito to counter that this test seems broad and vague because "an enormous number" of executive branch officials have this power.

Near the end of Metlitsky's time, Justice Kagan observed that, in comparison to the other tests on offer, there is a "good deal to be said" for the amicus's argument, but she wondered what the source of the test is. Metlitsky said that the idea of binding authority has been accepted for nearly 100 years. And, the question of authority to act in one's own name reflects a principle "ubiquitous in actual government practice."

In rebuttal, Perry argued that SEC ALJs do meet the finality test. He analogized the Commission's discretionary right to review to having certiorari denied by the Court: the Commission is not reviewing, and the decision stands in the ALJ's name. Turning to the issue of remedies, Perry said that the Constitution requires a new proceeding, with the prior acts stripped of validity. In response to a question by Justice Sotomayor about the effect on already completed cases, Perry said that general principles would "kick in," and distinguished this case, and 13 other similarly-situated cases, as being on direct review and never having gone final.

The petition is No. 17-130.

Tuesday, April 24, 2018

CBS board could face liability for paying salary to incapacitated former chairman

By Lene Powell, J.D.

Despite the extremely high bar for showing corporate waste, the Delaware Court of Chancery held that demand was partly excused in a shareholder action challenging compensation paid to former CBS executive chairman and controlling stockholder Sumner Redstone. Extensive evidence showed that far from the “active engagement” called for in his employment agreement, Redstone was severely incapacitated and uninvolved with corporate duties for over 20 months. The Board would not have been disinterested in considering demand because they faced possible personal liability for allowing his salary to continue to be paid (Feuer v. Redstone, April 19, Bouchard, A.).

Incapacity and alleged corporate waste. Sumner Redstone is the controlling stockholder of CBS Corporation and served as executive chairman until February 2016. (CBS split from Viacom in 2006, and a separate action involving Viacom was resolved.) In February 2014, two months before his 91st birthday, the compensation committee approved goals for Redstone for the year, including “effective communications with the Board.” Shortly after, Redstone’s health took a sharp turn for the worse, and his physical and mental condition declined precipitously over the next 20 months. He nominally attended Board meetings by telephone, but after a few meetings, did not say anything.

Upon examination by a court-appointed psychiatrist in February 2016, Redstone was found to be lacking mental capacity. He resigned as executive chairman, whereupon his title changed to Chairman Emeritus, a role in which he continued to receive compensation. The plaintiff shareholder brought a derivative action on behalf of CBS, arguing that salary and bonuses of almost $13 million paid to Redstone after he became debilitated and unable to contribute were made in bad faith and a waste of corporate assets. The shareholder further argued that Redstone was unjustly enriched by the payments.

Demand partly excused. Taking challenged compensation payments by category, the court held that demand was excused regarding Redstone’s salary, but not bonuses. The court first clarified that Rales, not Aronson, was the correct test for demand futility, because the plaintiff is challenging board inaction, not a board decision. Redstone’s salary and bonuses could only have been reduced or eliminated by terminating his employment agreement, which the Board did not do. Reviewing his performance was not a board decision.

“Extreme factual scenario.” The court found that Redstone’s continued compensation in the face of incapacity constituted an “extreme factual scenario” that supported a valid claim for corporate waste or bad faith by the board. Demand was excused as to the salary portion of the compensation. The board’s failure to inquire into Redstone’s health despite extensive evidence of incapacity, or to at least consider terminating his employment agreement while the company paid him millions of dollars over a twenty-month period, arguably reflects a conscious disregard of the directors’ fiduciary duties. Board members face a substantial threat of liability for non-exculpated claims for waste or bad faith. As a result, the board would not be disinterested in considering demand.

To be clear, the court said, the board did not need to immediately terminate his agreement upon his falling ill. Rather, the court emphasized the Board’s inaction over 20 months of severe incapacity. The court also found that demand was excused as to the bonus portion of the compensation because that was handled exclusively by the compensation committee, which consisted of four board members. The other eight members did not participate in the bonus decision. Because it was not demonstrated that more than half the directors were not independent on the bonus issue, demand was not excused.

The case is C.A. No. 12575-CB.

Monday, April 23, 2018

FINRA testimony insufficient for ‘whistleblower’ status under Dodd-Frank

By R. Jason Howard, J.D.

The United States District Court for the District of New Jersey has determined that a former UBS employee's testimony before FINRA did not equate to providing information to the SEC as required by the Dodd-Frank Act’s definition of “whistleblower” (Price v. UBS Financial Services, Inc., April 19, 2018, Martini, W.).

Claims. The plaintiff brought claims of whistleblower retaliation under Dodd-Frank and the Florida Whistleblower Act (FWA). The court had previously decided to deny dismissal of the FWA and stayed proceedings on the Dodd-Frank claim pending a decision by the Supreme Court in Digital Realty Trust, Inc. v. Somers, which was decided on February 21, 2018.

In Digital Realty, the Supreme Court held that “the anti-retaliation provision of Dodd–Frank does not extend to an individual who has not reported a violation of the securities laws to the SEC and therefore falls outside of the Dodd–Frank definition of ‘whistleblower.’”

With Digital Realty decided, UBS sought to lift the stay and dismiss the Dodd-Frank claim, arguing that “testifying before FINRA does not equate to providing information to the SEC as required by the Dodd-Frank definition of ‘whistleblower.’”

The plaintiff opposed the dismissal of the claim, arguing that he should be considered a whistleblower under Dodd-Frank because the SEC oversees FINRA, which acts under the authority of the SEC. The plaintiff had had testified before FINRA about alleged misconduct by a UBS colleague.

In reply, UBS responded that “FINRA is not the SEC, a division of the SEC, or a component of the government at all.” UBS also argued that the holding in Digital Realty expressly rejects the contention by the plaintiff that he can claim whistleblower protection because he engaged in other activity protected by a subsection of Dodd-Frank.

Discussion. In deciding the matter, the court turned directly to the holding in Digital Realty, explaining that the Supreme Court was unequivocal in its holding that in order to sue under Dodd-Frank’s anti-retaliation provision, a person must first provide information of a violation of the securities laws to the SEC. The Supreme Court further noted that the “core objective” of Dodd-Frank’s whistleblower program is to “motivate people who know of securities law violations to tell the SEC.”

The district court explained that, just as in Digital Realty, the plaintiff did not provide information on violations to the SEC before his termination and, as such, he did not qualify as a whistleblower at the time of the alleged retaliation. The plaintiff’s testimony to FINRA, according to the court, did not meet the statutory requirement and therefore, he is not a whistleblower under Dodd-Frank. The court also noted that the plaintiff “had ample time between when he first learned of the violations and his termination to report the misconduct to the SEC, but he chose not to.”

Conclusion. The court found that the plaintiff did not meet the definition of “whistleblower” under Dodd-Frank and dismissed the plaintiff’s Dodd-Frank claim with prejudice.

The case is No. 2:17-01882.

Friday, April 20, 2018

CII urges IPO companies to reconsider dual-class structure

By John Filar Atwood

The Council of Institutional Investors (CII) has written to the boards of Pivotal Software and Vrio, both of which are preparing their IPOs, urging them to reconsider using a dual-class structure as a public company, or alternatively to incorporate sunset provisions that revert to one share, one vote within seven years. CII believes that the dual-class structure severely limits a company’s accountability to public shareholders over the long-term.

CII noted that without the dual-class structure, Dell already owns in excess of 70 percent of Pivotal’s outstanding shares, and AT&T owns in excess of 83 percent of Vrio, which is enough to exercise control in the near-term. Due to the dual-class structure, Pivotal public shareholders will control just four percent of the voting power despite owning 30 percent the company. CII noted in the Vrio letter that its public shareholders will control less than two percent of the voting power despite owning 17 percent of the company. In CII’s view, this misalignment of ownership and controlling interests undermines the fairness of the capital markets.

CII believes public companies should provide all shareholders with voting rights proportional to their holdings. According to CII, both Dell and AT&T have recognized and upheld the principle of one share, one vote in their years as public companies.

Exclusion from indices. CII stated that the importance of the one share-one vote approach has been underscored repeatedly by market participants, including the recent decision by index providers to discourage multi-class arrangements. As currently structured, Pivotal will not be included in the S&P 1500 Composite or its component indices, including the S&P 500. In addition, the Russell 3000 and other FTSE Russell indices also exclude new listings like Pivotal that leave less than 5% of voting power in the hands of “unrestricted” investors, CII pointed out.

In its letter to Pivotal, CII noted that Dell receives ten votes per share as sole owner of Pivotal’s Class B shares, and elects nine of the 11 directors. CII said that Class A shareholders, voting together with Dell on a one share-one vote basis, should have the right to elect the remaining two directors. However, given Dell’s total equity holding, Dell will control the vote to elect all of Pivotal’s directors. In CII’s opinion, Pivotal’s director elections are structured to erode a defining feature of the corporation—the separation between the company’s management and its owners.

CII believes that independent boards accountable to owners should be empowered to actively oversee management and make course corrections when appropriate. Disenfranchised public shareholders have no ability to influence management or the board when the company encounters performance challenges, as most companies do at some point, CII continued. For these reasons, CII is concerned about the process of electing directors, the unequal voting structure, and the lack of a reasonable time-based sunset provision for Pivotal and Vrio.

CII acknowledged that some technology companies have attracted capital on public markets despite having multi-class structures. However, CII pointed out that the performance record of multi-class companies is decidedly mixed, with some studies finding a substantially lower total shareholder return compared to their single-class counterparts after ten years. CII cited a second study which found that where multi-class structures provide a value premium at the time of the IPO, that premium dissipates within six to nine years before turning negative.

Jackson’s remarks. CII’s argument was echoed by SEC Commissioner Robert Jackson in a February speech in which he argued in favor of putting a limit on the duration of a dual class structure. He noted that early in a company’s life, giving control to the firm’s founders makes sense, but at some point that structure is no longer beneficial. As a result, some observers believe that dual-class firms should include some limit on the amount of time before shareholders can weigh in on whether dual-class still makes sense for the company, he noted.

Jackson and his staff examined 157 dual-class IPOs that have occurred over the past 15 years, and found significant differences between the 71 dual-class companies with sunset provisions and the 86 who gave insiders control forever. According to their research, seven or more years out from their IPOs, firms with perpetual dual-class shares trade at a significant discount to those with sunset provisions. Jackson and his staff also found that, among the small subset of firms that decided to drop their dual-class structures later in their life cycles, those decisions were associated with a significant increase in valuations.

Ultimately, Jackson called for securities exchanges to consider proposed listing standards addressing the use of perpetual dual-class shares. The standards would allow retail investors to share in companies’ growth—but avoid asking them to trust corporate management forever. Companies would still be able to IPO with dual-class voting arrangements, but only if management is willing to someday give shareholders their say, he concluded.

Sunset provisions. In its letters, CII also argued in favor of sunset provisions for the dual-class structures of Pivotal and Vrio. CII noted that recognizable companies like Yelp, Fitbit and Kayak went public with time-based sunsets. Public shareholders at those companies know that they will have a say in company matters equal to their ownership interests within reasonable periods of time, CII said. Similarly, Groupon collapsed its dual-class structure in 2016 and adopted one share-one vote after a five-year sunset expired. CII noted that more companies went public with time-based sunsets in 2017 than in any other year.

CII urged Pivotal and Vrio to reconsider their dual-class structures before going public. In CII’s opinion, investors have demonstrated repeatedly that they will support innovation and investment for the long-term, as has been the case at companies such as Amazon. Establishing accountability to new owners does not always maximize comfort and compensation for management, but accountability is important for longer-term performance, CII concluded.

Thursday, April 19, 2018

PLI panelists discuss audit committee responsibilities

By Amanda Maine, J.D.

Former PCAOB Member Jeanette Franzel stressed the need for audit committees to be prepared for the new auditor’s reporting model, which was adopted by the Board in June 2017. The auditor’s reporting model and other auditing issues were topics of discussion on a panel at the Practising Law Institute’s recent program on corporate governance issues. The panel, which was moderated by former SEC Corporation Finance Director Alan Beller and Walter Ricciardi of Paul Weiss, also featured SEC Chief Accountant Wesley Bricker and Christine Q. Davine, a former associate chief accountant in Corp Fin and now at Deloitte.

Auditor’s reporting model. The big issue under the new auditor’s reporting model is the requirement to include a discussion of critical audit matters (CAMs) in the audit report, Franzel said. CAMs are matters that have been communicated to the audit committee that are related to accounts or disclosures that are material to the financial statements, and involved especially challenging, subjective, or complex auditor judgment. Although the provisions of the new standard relating to CAMs do not take effect until the audits of fiscal years ending on or after June 30, 2019 for large accelerated filers and for fiscal years ending on or after December 15, 2020 for other filers, audit committees should still be on top of the issue, especially for large accelerated filers, Franzel advised.

According to Franzel, it is important that audit committees for large accelerated filers get involved this year to figure out where the risks are. She also observed that there may be differences of opinion between audit firms and the audit committee about CAMs and addressing these differences early opens a chance for dialogue on the matter. There is also the chance that auditors may end up disclosing CAMs that wouldn’t otherwise be disclosed by the company, and it is advisable to sift through this possibility before it becomes an issue in 2019, according to Franzel.

Franzel also noted that a common deficiency identified by the PCAOB is the auditor’s risk assessment. Audit committees can help ensure that judgments made regarding the CAM requirement are properly aligned with the audit risk assessment, she said.

Davine said that in her experience, audit committees have been very engaged in preparing for the new standard through the use of pilot programs and “dry runs” for CAM disclosures. She said there have been significant time and resources spent in putting out publications to educate clients about the new standard. She also reported that there is an expectation from audit committees that the CAMs cannot just be boilerplate.

Auditor tenure disclosure. Bricker noted that the new standard also requires the auditor's report to disclose the tenure of an auditor; specifically, the year in which the auditor began serving consecutively as the company's auditor. Unlike the delayed implementation for CAM disclosures under the new standard, the auditor tenure disclosure requirement is effective for audits for fiscal years ending on or after December 15, 2017. According to Bricker, the purpose of the auditor tenure requirement is to provide a greater degree of consistency by standardizing the disclosure in the auditor’s report.

Bricker said that, while there has not been conclusive research tying auditor tenure to auditor performance, it is an element that the audit committee can incorporate into its oversight of the auditor’s performance.

Non-GAAP disclosures. Non-GAAP reporting is an important element of communicating with investors, Bricker said, explaining that the SEC has long focused on the integrity of reporting in this area, especially with the issuance of Compliance and Disclosure Interpretations (C&DIs) relating to non-GAAP measures. He emphasized the value of good controls and procedures in non-GAAP disclosures, including how a company would assess changes in its policies for its approach to these disclosures.

Franzel noted that the PCAOB auditor’s reporting model project originally featured questions about the auditor's role regarding other information and company performance measures, including non-GAAP measures. However, this aspect of the auditor’s reporting model is no longer on the board’s standard setting agenda, although it is on the PCAOB’s research agenda, Franzel observed. Even though she doesn’t anticipate seeing standard setting on non-GAAP measures coming from the board anytime soon, audit committees should still talk to audit firms to make sure that the company is following SEC guidance on non-GAAP disclosures, she advised.

Risk management oversight. Beller inquired about how audit committees can fulfill their responsibilities for risk management oversight, including issues like cybersecurity and whistleblowers. Franzel said that audit committees need to think about a number of risks, including economic and political risks, that could wind their way into the financial statements. She also cited natural disaster impacts, low interest rates, and policy developments impacting tax, health care, and financial sector regulation as risks audit committees should take into account.

Regarding cybersecurity, Davine highlighted a recent tool issued by the Center for Audit Quality that provides key questions that board members can use as they discuss cybersecurity risks and disclosures with management and accounting firms. Beller echoed the usefulness of the CAQ’s guidance, stating that every board member should have it in his or her file.

Beller asked about the motivation of whistleblowers, especially in the wake of the Supreme Court’s recent decision in Digital Realty Trust, which held that to be covered under the Dodd-Frank Act’s anti-retaliation provision, whistleblowers must report a securities law violation to the SEC and that simply reporting internally is not sufficient. Ricciardi, who previously served as a deputy director of the SEC’s Division of Enforcement, described a worldwide study conducted by NYU that found that the vast majority of whistleblowers were motivated by frustration that something bad was going on within the company and that they were not really in it for the money; they were just frustrated by hitting a brick wall within the company, he explained.

Wednesday, April 18, 2018

NASAA backs FINRA proposal to incentivize payment of arb awards, offers improvements

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

NASAA has offered support for a FINRA proposal that would use FINRA’s Membership Application Program to incentivize the timely payment of arbitration awards. NASAA believes that the proposed rule amendments represent a positive step in addressing the problem of broker-dealers and associated persons who fail to comply with their regulatory and ethical obligations to satisfy arbitral awards against them. NASAA cautioned, however, that the amendments will not, by themselves, resolve this important investor protection concern. Accordingly, NASAA’s comment letter offered suggestions to strengthen the proposal while offering help in finding a solution that will ensure that no investor awards or settlements go unpaid.

Amendments to Membership Application Program. As described in FINRA Regulatory Notice 18-06, the amendments would amend FINRA’s new and continuing member application processes to address situations in which a FINRA member firm hires individuals with pending arbitration claims, where there are concerns about the possible payment of those claims. The proposal also seeks to address situations where a member firm with substantial arbitration claims seeks to avoid the payment of pending claims by shifting assets to another firm and closing down.

In responding to FINRA’s specific requests for comments, NASAA stated that it is appropriate for the proposal to distinguish new membership applications from continuing membership applications with respect to whether a presumption of denial should apply to pending arbitration claims. Applying a presumption of denial to new membership applications with pending awards is appropriate given that these firms will lack operating histories with FINRA, NASAA wrote. In contrast, existing FINRA members have operating histories that FINRA can review and consider in any continuing membership application request. Presumptively denying continuing membership applications with pending claims would be unnecessarily disruptive and would disincentivize FINRA members from taking-on potential liabilities through business acquisitions, possibly resulting in more arbitration awards ultimately going unpaid.

Scope and definitions. NASAA also supports the broad scope of the proposal, which NASAA interprets to cover any person who seeks to become associated with a FINRA member. NASAA believes that making the proposal applicable only to principals, control persons, officers or similar persons would open the process up to gamesmanship by member firms, who could avoid the proposal’s reach by staffing such individuals temporarily in administrative positions.

NASAA urged FINRA, however, to expand the proposal's definition of "Covered Pending Arbitration Claim" to include all investment-related arbitration claims, such as JAMS or AAA proceedings. NASAA also suggested that FINRA expand the definition to include any investment-related claims pending in a state or federal court. Without these clarifications, an investment adviser representative seeking to become associated with a FINRA member might conclude that a private proceeding or pending court case need not be disclosed under the proposal. In addition, NASAA recommends the term “claim amount” be defined more broadly so that pending claims with joint liability are assessed to each respondent maximally, as if no other person could be potentially liable.

Verification of disclosures. Among its other comments, NASAA also recommended that FINRA expressly state in the proposal that FINRA may in its discretion contact claimants to confirm the accuracy of an applicant’s disclosures concerning unpaid arbitration awards or settlements. In addition, the NASAA urged FINRA to revise the proposal to explicitly state that FINRA may require an expert’s opinion to support an applicant’s assertion that it can satisfy any unpaid award or settlement obligation it intends to assume. In NASAA's view, however, this expert opinion does not necessarily need to be from an “independent” source. Instead, the proposal should give FINRA staff the authority to assess the veracity and reasonableness of an offered expert opinion on a case-by-case basis, NASAA wrote.

Tuesday, April 17, 2018

SEC officials outline priorities at annual compliance seminar

By Amanda Maine, J.D.

Staff members from the SEC’s Division of Investment Management and its regional offices in the Office of Compliance Inspections and Examinations’ (OCIE) National Exam Program and the Enforcement Division’s Asset Management Unit (AMU) discussed issues facing compliance personnel at the Commission’s 2018 Compliance Outreach Seminar.

IM priorities. Paul Cellupica, deputy director of Investment Management, directed seminar attendees’ attention to the Commission’s upcoming Open Meeting on Wednesday, April 18. The meeting will consider proposing rules and rule amendments aimed at addressing confusion among investors about services they receive from investment advisers and broker-dealers, Cellupica said.

The three proposal items on the meeting agenda are: (1) requiring registered investment advisers and broker-dealers to provide a brief relationship summary to retail investors; (2) establishing a standard of conduct for broker-dealers and associated persons when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer; and (3) issuing a Commission interpretation of the standard of conduct for investment advisers. Cellupica urged CCOs, particularly those of investment advisers or dually-registered advisers/broker-dealers, to give input on the proposals because their roles make them “uniquely situated” to do so.

Another IM initiative highlighted by Cellupica is reforming how the Division treats ETFs. The Commission’s approach to ETFs began in 1992 with an exemptive order, and since then all ETFs have had to rely on exemptive orders to launch. It is not ideal for such a big segment of the investment management market to operate under so many separate orders, Cellupica said, noting that there are at least 300 such orders. The Division is working on a recommendation to the Commission for a proposed rule to address inconsistencies among exemptive orders and allow new ETFs to launch without an exemptive order, Cellupica advised.

The SEC is subject to a congressionally-mandated rulemaking under the FAIR Act, which requires extending the Rule 139 research report safe harbor to investment fund research reports published by brokers and dealers regarding certain investment funds such as ETFs and business development companies. The current safe harbor, which provides that a research report published or distributed by a broker-dealer is not an offer to sell a security pursuant to an effective registration statement, currently applies only to broker-dealers’ reports on public companies, not reports on ETFs or BDCs, Cellupica explained. There is a grey area between fund research reports and advertising, and Cellupica encouraged input on this issue.

In the medium-to-long term, the SEC would like to revise its marketing and solicitation rules, Cellupica said. The current rules were adopted in 1961 before the age of social media. The anti-testimonial rule in particular makes it difficult for people to research and select investment advisers using social media like they would for other aspects of the market, such as restaurants or travel, he noted.

Enforcement. Dabney O’Riordan, co-chief of the Los Angeles Regional Office’s Asset Management Unit, outlined several of AMU’s priorities. One priority is the disclosure of conflicts of interest. AMU has witnessed the lack of disclosure of conflicts regarding fees, compensation that advisers receive from broker-dealers, products that generate higher fees than others, and transactions that were engaged in to the benefit of an affiliate of the adviser, she said.

Another priority for Enforcement’s AMU is addressing trade allocation issues, or “cherry-picking.” She noted that the SEC identifies this conduct through data analysis of trading records, and reminded firms that they have access to the same records. Cherry-picking conduct usually falls into one of three buckets, O’Riordan explained: when an adviser favors himself over his clients, when he favors certain clients over other clients, or allocation practices that are contrary to the disclosures provided to clients.

O’Riordan highlighted the SEC’s Share Class Selection Disclosure initiative, which was established in February. Under the initiative, advisers are encouraged to self-report conduct where they failed to make disclosures relating to the selection of mutual fund share classes that paid the adviser a 12b-1 fee when a lower-cost share class for the same fund was available to clients. Advisers have until June 12, 2018, to self-report this conduct to the Commission to receive favorable settlement terms, including avoiding the imposition of a civil penalty.

After the June 12 deadline, there is no guarantee that self-reporting firms will get the same favorable settlement terms under the initiative, O’Riordan warned. Firms that do not self-report run the risk that Enforcement will find out about it after June 12. O’Riordan observed that the SEC had recently brought three cases in one week against firms that had failed to disclose that they had charged improper fees, resulting in the return of $12 million to harmed clients. She added that firms should think about how they would explain to their client why they failed to self-report and then went on to get caught anyway.

OCIE. Kristin Snyder, co-national associate director of the SEC’s National Exam Program in the San Francisco Regional Office, drew attention to OCIE’s 2018 exam priorities, which were published in February. In the retail space in particular, OCIE will be focusing on disclosure of the costs of investing; electronic investment advice; wrap-fee programs; cryptocurrency, ICOs and blockchain; and municipal advisers and underwriters.

The National Exam Program will also be focused on the protection of seniors, Snyder said, highlighting the program’s Retirement-Targeted Industry Reviews and Examinations Initiative (ReTIRE). Under the ReTIRE Initiative, which was launched in 2015, the staff gathered information about the distribution and sales practices regarding account rollovers into individual retirement accounts. From the broad look taken at the beginning of the initiative, examination staff will be focusing on specific issues such as target date funds and whether the disclosures match up to how a portfolio is actually performing, fixed-income cross trades, and sales and marketing of variable insurance products to be launched later this year, Snyder said.

She also said that staff will be focused on never-before-examined investment advisers. If you’ve never been examined before, you’re now likely to be examined, she explained. This also includes examinations of new registrants, which will give OCIE an early opportunity to engage with newly-registered advisers.

Another priority area for the National Exam Program is mutual funds and ETFs. This has been driven by the growth of ETFs in particular, Snyder said. One area in this space includes ETFs that are following a custom index, which can create conflicts between the adviser and the index provider. Snyder observed that IM Director Dalia Blass had highlighted this potential conflict in a recent speech to the Investment Company Institute. The staff will also take note of ETFs that are close to liquidation or delisting to ensure that the risk disclosures to investors are robust, Snyder advised.

Monday, April 16, 2018

Commissioners dissent from colleagues on Reg A Tier 2 limitation amount

By Joanne Cursinella, J.D.

In an April 11 letter to Michael Crapo, chairman of the Senate Committee on Banking, Housing, and Urban Affairs, Commissioner Michael S. Piwowar and Commissioner Hester M. Peirce outlined their objection to their colleagues’ determination not to propose an increase, at this time, to the $50 million offering limit set for Tier 2 under Regulation A of the Securities Act. “Calibrating an appropriate Tier 2 limit is a matter for rigorous analysis via the standard notice and comment rulemaking process,” they said, and the time to begin study on this matter is now and “not when the kicked can comes to rest a couple of years down the road.”

Tier 2 limit. The commissioners point out that Section 401 of the Jumpstart Our Business Startups Act added Section 3(b)(5) to the Securities Act of 1933, which requires the Commission to review, biannually, the total offering amount limitation set forth under Regulation A (the “Tier 2” limit). That offering limit is now at $50 million, they added, and it has remained so since the Commission’s adoption of the relevant rules in 2015.

The statute’s default is that the Commission will raise the offering limit but directs the Commission, “if [it] determines not to increase the amount,” to inform the committees, the commissioners said, and their colleagues have apparently done just that.

Time for review? Piwowar and Peirce argue that sufficient time has passed to warrant a consideration of the reason for the lack of Tier 2 activity since the adoption of the relevant rules. They share the views of the Treasury Report’s recommendation that the Tier 2 offering limit be increased to $75 million and point out that this comports with the recently passed the “Regulation A+ Improvement Act of 2017” (H.R. 4263), which likewise called for an increase of the limit to $75 million.

The history of the disuse of Regulation A offers a potential warning about the disuse of Regulation A+ in that “an improperly crafted exemption is worth little to small businesses,” the commissioners warned. They added that “we should welcome the opportunity the statute affords us to take another look at Regulation A+ to ensure that it can become a valuable tool for American companies seeking to innovate and grow.”

Friday, April 13, 2018

Giancarlo: market integrity requires vigorous enforcement, regulatory fairness

By Lene Powell, J.D.

In a democratic capitalist society, market regulators must not only work within economic and legal frameworks, but must also apply moral principles as well, said CFTC Chairman J. Christopher Giancarlo in remarks at Concordia College. In walking a careful line between imposing only necessary rules, yet also vigorously protecting market integrity, regulators must be fair and have “moral capital,” not take sides or favor one set of market actors over another.

“I always feel we have done our job if people welcome adjudication or agency action because they know we will be fair,” said Giancarlo in prepared remarks, “Financial Market Regulation: A Moral Framework.”

Protecting democratic capitalism. Drawing on his experience of 30 years in the private sector as well as his past four years in the federal government, Giancarlo said it was economic fact that free and competitive markets combined free enterprise, personal choice, voluntary exchange, and the legal protection of person and property form the underpinnings of broad and sustained prosperity and human advancement.

In protecting these values, Giancarlo said the Golden Rule is the foundation for civilization and regulation. Market regulators and participants must treat one another with the respect and regard they want for themselves. Market regulators must not limit economic freedom without serious justification and must solve for demonstrable problems, not mere incidents of bad behavior. Yet because freedom can be exploited to create monopoly, defraud others, and manipulate markets, regulators must put reasonable limits on market activity. Distinguishing the two must be based on careful, data driven econometric analysis and not anecdote and political expediency, said Giancarlo.

The perils of self-regulation. In acting within the limits set by Congress, regulators are not free agents or rogue actors, and must be perceived as fair and just agents, Giancarlo said. He pointed to the negative example of the British East India Company, which was a closed private corporation, serving a select few chartered members, yet which also advanced British official interests, to the point where the interests of Britain and company shareholders were often one and the same. As one historian noted, they were both regulatory body and sole operator, overseeing markets for their trade and having a virtual monopoly over them.

Self-regulating and often unaccountable to anyone other than itself, the company was both private and public, a business and quasi-governmental, observed Giancarlo. Notably, the trade involved commodities and the use of futures, long before that name was used. Haunted by secrecy, greed, and unseemly enrichment, the company ultimately failed, closing its doors in 1874.

“We have also learned over time that regulators should not run the very businesses they are regulating nor be captured by them. It is appropriate that there be a proper zone of separation between business and government,” said Giancarlo. “Self-regulation has an important role to play in developing and embracing industry best practices, but that role is different from and not a substitute for government regulation.”

Protecting market integrity. Because criminality takes away our freedom for the personal gain of the few, there must be no tolerance for fraud, deception, or manipulation in financial markets, said Giancarlo. Market regulators must maintain bulwarks against misbehavior because market integrity is essential to fostering robust trading and responsible risk taking.

In turn, free and well-ordered financial markets have the potential to make us more virtuous and better as family members, colleagues, citizens, businesspeople, market participants, and regulators, said Giancarlo. “Financial markets must be a source for human good, not exploitation.”

Thursday, April 12, 2018

IFAC finds that regulatory fragmentation costs financial institutions $780B annually

By John Filar Atwood

Inconsistent regulation among different jurisdictions around the world is costing financial institutions an estimated $780 billion each year, according to a report prepared by the International Federation of Accountants (IFAC) and Business at the OECD (BIAC). Based on their findings, the two organizations called on regulators to make international harmonization a policy-making priority.

The report, which was built on a survey of 250 experts at global financial institutions, suggests that regulatory divergence costs financial institutions on average 5-10 percent of their annual revenue turnover. Dealing with an inconsistent regulation consumes management time and capital that could be better spent on identifying emerging risks in the financial system, the report states. More than half of the respondents said resources have been directed away from risk management due to the costs associated with diverging regulation.

Costs. In the survey, 75 percent of respondents said that costs incurred as a result of regulatory divergence were material to their overall performance. The costs include increased head count to manage local, international, and cross-jurisdictional regulatory issues and hiring external consultants to help deal with the problem.

Companies also incurred training costs for staff to deal with regulation and legislative activity across different regions. System costs, including needing to implement multiple systems specifically designed to address regulatory divergence, were reported by most respondents, as was the expense of restructuring the compliance department to better adjust to divergent regulations.

The report states that the costs arising from regulatory divergence are more material to smaller institutions. Twenty-one percent of respondents with a market capitalization under $10 million said the costs of regulatory divergence were material to their performance, compared to 14 percent of institutions valued at $1 billion or more.

Divergence in competition law was most often cited by respondents as a cause of material costs. Market regulation and financial reporting/auditing also were tagged as material by more than half of the survey respondents.

Nearly three-quarters of institutions in the study reported increased costs from divergent regulations over the past five years. Most respondents attributed the increase to regulations introduced in response to the 2008 financial crisis. Two-thirds of respondents expect costs to rise over the next five years, with Brexit and protectionist politics being the likely drivers.

Among the study’s findings are that regulatory divergence represents a barrier to most financial institutions’ international growth. In addition, half of respondents said that they had fewer resources to invest in innovation, lending activities, corporate social responsibility, product development, and brand development.

Specific inconsistencies. Some of the specific issues that respondents cited within the area of regulatory divergence include duplicative reporting requirements and sometimes contradictory interpretations associated with monitoring and enforcement of regulations. The study also cites divergence in the detail of regulatory definitions, adoption of international reforms at different speeds in different countries, and an overall lack of clarity in rules and regulations.

Solutions. In the survey, IFAC and BIAC asked participants to suggest ways to address regulatory divergence. The recommendations include enhanced international regulatory cooperation in the way regulations are interpreted, monitored, and enforced.

Respondents also suggested an overall increase in the alignment of rules, with a greater adherence to global standards. Improved alignment in regulatory definitions also was recommended as was better communication and awareness among regulatory agencies internationally to avoid duplicating reporting requirements and processes.

Finally, respondents called for greater transparency by international organizations in developing new rules and regulations, and greater overall clarity in rules and regulations.

Wednesday, April 11, 2018

Clayton and Redfearn address equity market structure

By Jay Fishman, J.D.

SEC Chairman Jay Clayton and Trading and Markets Division Director Brett Redfearn addressed equity market structure at an April 10, 2018 symposium sponsored by the University of Chicago and the STA Foundation. Clayton began by emphasizing that equity market structure is integral to the SEC’s three-part mission: (1) to protect investors; (2) maintain fair, orderly and efficient markets; and (3) facilitate capital formation.

Regarding Main Street investors, he said that the focus must be on protecting their long-term interests by fostering transparency with regulations created to allow them public access to material information for empowered investing. But he cautioned that the Commission must listen to those investors and to market participants as well, to ensure that the adopted regulations are functioning as intended. Additionally, he stressed the need for coordination with other regulators to strike the right balance between capital formation and investor protection.

Equity market structure questions and initiatives. Clayton remarked that the Commission does not have to start from scratch to determine the pertinent equity market structure questions, but can jump start its efforts from the following already published materials:
  • The Equity Market Structure Advisory Committee (EMSAC) tackled a broad spectrum of market structure topics from which it made thoughtful recommendations to the Commission; and 
  • The Treasury Department in October 2017 published an insightful report assessing the U.S. Capital markets, and offered recommendations for enhancement. 
Additionally, Clayton mentioned two equity market structure initiatives recommended by the Capital Markets Report (that received broad market participant support):
  1. The Commission’s 2015 proposal to enhance alternative trading system (ATS) operational transparency; and 
  2. The SEC’s 2016 proposal to enhance transparency of broker order routing practices. 
Lastly, Clayton proclaimed that the need for market participant input has prompted the Trading and Markets Division to host a series of staff roundtables devoted to specific equity market structure topics that EMSAC raised with the Commission.

Redfearn, as the Division Director discussed these roundtables in detail. The first one, occurring on April 23 2018, will address the market structure for thinly-traded securities, both equities and ETPs. The purpose of this roundtable, declared Redfearn and Clayton, is to determine whether the current single equity market structure for all NMS stocks, large and small, liquid and illiquid is appropriate for thinly-traded securities.

The second staff roundtable, said Redfearn, will focus on issues related to market participants having access to a wide range of products and services offering differential access to markets and market data. He noted that this differential access raises important questions, some of which are subject to proceedings pending before the Commission. The roundtable would build upon the Commission’s resolution in the proceedings by addressing, for example, the impact of differing views on maintaining fair, orderly and efficient markets, as well as the impact and desirability of many market participants to get data at slower speeds because they are unwilling or unable to pay the rates for the fastest access.

The third staff roundtable, Redfearn said, will address regulatory approaches for combatting retail fraud. He reiterated Clayton’s point that strengthening market structure will enhance and protect the long-term interests of main street investors. Redfearn believed that the roundtable would particularly focus on fundamental market structure objectives in the context of digital assets and penny stocks.

Tick and transaction fee pilots. Redfearn separately referred to two pilots currently underway. The “Tick Pilot” he said is studying the impact of wider pricing increments in stock of smaller companies. The transaction fee pilot, proposed on March 14 2018, was EMSAC-recommended to allow the Commission, market participants, and the public to observe how order routing behavior, execution quality, and market quality may change across different test groups, which should help determine the regulation questions to ask.

Tuesday, April 10, 2018

IOSCO offers recommendations to improve bond market transparency

By John Filar Atwood

In a report on the transparency of corporate bond markets, the board of the International Organization of Securities Commissions (IOSCO) emphasized the importance of ensuring the availability of information to regulators through reporting, and to the public through transparency requirements. In the report, IOSCO offers seven recommendations for improving the information on secondary corporate bond markets that is available to regulators and the public.

IOSCO’s recommendations are intended to ensure that regulators have better access to information and to enhance cross-border information sharing and understanding. The recommendations on transparency are designed to support the price discovery process and facilitate better informed investment choices.

In August 2017, IOSCO issued a consultation report in which it solicited public comments on bond market reporting and transparency. IOSCO received 16 comment letters which were considered in the preparation of the final report.

Changes to band markets. The report updates a 2004 report on the bond markets to reflect the many changes that have occurred in the past 14 years. These include changes in regulation as well as in market structure, the entrance of new participants, a shift from the traditional dealer-based principal model to an agency-based model, and the increasing use of technology.

The report examines data reporting requirements regarding corporate bond markets, and highlights the regimes in place and how the data is used to assist regulators in monitoring and analyzing markets. It also examines the current and proposed regulatory requirements relating to public pre-trade and post-trade transparency that have developed since 2004, the potential impact of transparency on market liquidity, and the steps regulators and legislators have taken to address the potential impact.

IOSCO recommends that regulatory authorities should ensure that they have access to sufficient information to perform their regulatory functions effectively. In addition, it recommends regulatory authorities should have clearer regulatory reporting and transparency frameworks to facilitate better cross-border understanding of corporate bond markets.

Recommendations. Specifically, IOSCO recommends that regulatory authorities be able to obtain the information necessary to develop a comprehensive understanding of the corporate bond market in their jurisdiction. This understanding should include the characteristics of the market and the types of bonds traded.

To facilitate cross-border understanding among regulators of corporate bond markets, IOSCO recommends that regulatory authorities create a clear framework and underlying methodology of regulatory reporting and transparency available. IOSCO also suggests that regulators have access to pre-trade information relating to corporate bonds, which could include information other than firm bids and offers, such as indications of interest.

Post-trade reporting. IOSCO believes that regulatory authorities should implement post-trade (transaction) regulatory reporting requirements for secondary market trading in corporate bonds. Taking into consideration the specifics of the market, the requirements should be calibrated in a way that a high level of reporting is achieved, ISOCO recommended. The requirements should include the reporting of information about the identification of the bond, the price, the volume, the buy/sell indicator and the timing of execution.

Another recommendation included in the report is that regulators consider steps to enhance the public availability of appropriate pre-trade information relating to corporate bonds, taking into account the potential impact that pre-trade transparency may have on market liquidity.

ISOCO recommended that regulatory authorities implement post-trade transparency requirements for secondary market trading in corporate bonds. Taking into consideration the specifics of the market, the requirements should be calibrated in a way that a high level of post-trade transparency is achieved, in IOSCO’s opinion.

The post-trade transparency requirements should take into account the potential impact that post-trade transparency may have on market liquidity, IOSCO stated. Post-trade transparency requirements should include at a minimum, the disclosure of information about the identification of the bond, the price, the volume, the buy/sell indicator and the timing of execution. Where there is transparency of post-trade data relating to corporate bonds, IOSCO recommended that regulatory authorities take steps to facilitate the consolidation of that data.

Monday, April 09, 2018

Passive investors to benefit from Active Share metric disclosures

By R. Jason Howard, J.D.

New York Attorney General Eric T. Schneiderman has released a report on mutual fund fees and announced agreements by 13 major firms to make new and enhanced disclosures to retail investors following an industry-wide investigation. Under the agreements, “the firms will disclose new information that can help retail investors determine whether a higher-cost, actively managed mutual fund fits their investment goals better than another, lower-cost alternative.”

Active Share. Active Share, as the newly disclosed information is known, “measures the percentage of stock holdings in a fund’s portfolio that differs from that fund’s benchmark index—key information investors can use to determine whether a higher-fee, actively managed fund has the potential to beat the benchmark returns of a lower-cost, passively managed fund.”

The Attorney General said, “These new disclosures will give Main Street investors access to critical information before making investment decisions for themselves and their families. By working with us to help level the playing field for all investors, these firms are taking an important step forward. I encourage all mutual fund firms to follow suit.”

The report. The April 2018 Mutual Fund Fees and Active Shares report detailed some of the key findings from the industry-wide investigation, including:
  • Actively managed funds are typically much more expensive investment options than index funds. On average, fees on an investment in an actively managed fund cost an investor almost 4.5 times more per year than fees on an investment in a passive fund. 
  • Higher fees for actively managed mutual funds do not necessarily reflect a higher level of active management. When choosing among actively managed mutual funds, investors should not conclude that a higher fee necessarily reflects a higher level of active management, as measured by the fund’s variation from its benchmark. Based on a review of fees and disclosures for over 2,000 mutual funds, investors cannot necessarily assume that a high fee, or expense ratio, for a particular mutual fund means that the fund will have a high Active Share—in other words, an investor cannot look only to the fees charged to invest in a fund in order to assess the fund’s potential to outperform the market (or the risk of underperformance), as measured by the Active Share metric. 
  • Fund managers use Active Share information to help analyze mutual fund investments, and mutual fund companies provide Active Share to some professional and institutional investors, but generally not to retail investors. The Active Share metric allows investors to understand how much a particular fund overlaps with or diverges from its benchmark index. While not an absolute indicator of active management, Active Share has become a widely-used metric for mutual fund managers. 
The report also stresses the importance of investor vigilance in an era where the “Trump administration and Congress have taken steps to roll back federal regulations that protect investors when they make retirement investment decisions, like choosing to invest in actively management mutual funds.”

Because of the recent changes to fiduciary rules and questions surrounding the standard of care that brokers and financial investors owe to retirement investors under federal law, the report concludes that “Americans saving for retirement must be especially vigilant in evaluating investment choices and the investment recommendations made by their advisors.”

Friday, April 06, 2018

Former SEC Enforcement directors reminisce at SEC Historical Society event

By Amanda Maine, J.D.

Eight former directors of the SEC’s Division of Enforcement spoke about their tenures at the SEC at a recent event hosted by the SEC Historical Society. The former directors discussed their experiences at the SEC and how the Enforcement Division has evolved over time.

Birth of the Division: 1970s. Moderator Dr. Harwell Wells kicked off the discussion with a remembrance of former SEC Commissioner Irving Pollack, who established the SEC’s Enforcement Division in 1972 and was its founding director. Pollack passed away in 2016 at the age of 98. Judge Stanley Sporkin, who served as Division director from 1974 to 1981, praised Pollack as the perfect leader and an extremely principled person who was available to everyone.

Wells inquired how the Division handled high-profile matters in the 1970s. Sporkin said that “no” was never an answer. If there was a problem they had to solve it, and they did it by using imagination and talent. Lawyers were given the opportunity to do their own investigations and this allowed them to develop solutions to their own problems, Sporkin said.

Insider trading in the 1980s. Wells asked Gary G. Lynch, who served as director of the Division of Enforcement from 1985 to 1989, about the challenges that arose during the 1980s, including the M&A boom and the rise of notorious insider trading cases. Lynch said that in 1985, the Division received an anonymous letter from an employee at Merrill Lynch about insider trading. That letter resulted in an investigation that eventually implicated Dennis Levine at Drexel Burnham Lambert, who paid $12 million in disgorgement and gave up his co-conspirators, including Ivan Boesky.

According to Lynch, while there had been criminal prosecutions for insider trading before this matter, after the Boesky case, U.S. attorneys across the country noticed the press it received. The prospect of going to jail for white collar criminals had a major deterrent effect, Lynch said.

Enforcement in the 1990s. Bill McLucas was appointed director of the Division of Enforcement by SEC Chairman Richard Breeden in 1989. According to McLucas, Breeden, who had been focused on the S&L crisis of the late 1980s, believed the only vehicle for effective civil enforcement was penalties. The Securities Enforcement Remedies Act soon followed in 1990. Other events impacting securities enforcement in the 1990s included changes in media coverage like the internet and CNBC, reform of the National Association of Securities Dealers (NASD), and establishing a solid insider trading program. McLucas also pointed out that most people prior to the 1980s had been savers, but by the end of the 1990s, more than 60 percent of Americans owned securities, which created risks and enforcement opportunities.

The 1990s also saw the Supreme Court’s endorsement of the misappropriation theory of insider trading, McLucas said. The misappropriation theory continues to be a key part of the Commission’s insider trading program today, he observed.

Richard H. Walker, who was named Enforcement Director in 1998, talked about the role of technology and how the SEC approached rapidly developing tech issues. Walker noted that while the traditional “boiler room” frauds required space and phone banks, with the internet it was much easier for people to commit these frauds on a computer in their living room. Walker said that this led to the formation of the Office of Internet Enforcement, where the SEC would quickly bring cases to let people know that these types of frauds were being pursued.

Walker also praised former SEC Chairman Arthur Levitt, whose “numbers game” speech criticizing the accounting profession led to a new focus on accounting issues by the Division. Levitt was good at using the bully pulpit to galvanize issues, Walker said. After the numbers game speech, accounting issues became a priority for the enforcement staff, Walker explained.

Scandals and reform: the 2000s. Wells asked about the financial scandals of the early 2000s, including Enron and WorldCom. Stephen Cutler, director of enforcement from 2001 to 2005, said that markets were already volatile in 2001 after September 11 when Enron announced its restatement in October that year. Cutler recalled that when WorldCom’s financial troubles became apparent, then-Chairman Harvey Pitt told him, “We’re going to sue WorldCom tomorrow.” Cutler was initially skeptical that the Division could do so, but with the hard work of the staff, “we filed the papers the next day.” Pitt was also “the brainstorm” behind the Sarbanes-Oxley requirement for management and auditor attestation, Cutler said.

Wells inquired about the influence of state attorneys general in the enforcement realm during this period, mentioning in particular then-Attorney General Elliot Spitzer of New York, who was well-known for going after Wall Street. A somewhat bemused Cutler replied, “It didn’t start out as collaborative,” after which his successor Linda Chatman Thomsen chimed in, “That’s an understatement.” Spitzer’s crusade was front page news in New York, Cutler said, it was like the sports pages.

Wells noted that there was a period of pushback around 2005 against enforcement and aggressive market regulation when Thomsen became Division chair. Thomsen said that the SEC had taken on entire swaths of the financial industry, and a lot of people weren’t happy and were fleeing to the London markets. According to Thomsen, a report on competitiveness was being assembled by people who thought the SEC had gone too far in its enforcement efforts and that others were going to jail for financial fraud for offenses that weren’t “jail-worthy.” However, she remarked, right before the report was issued, “2008 happened,” and they had to scramble to rewrite the report.

Robert Khuzami was named Enforcement Director in March 2009, only a few months after Bernard Madoff’s Ponzi scheme had been revealed. It was a difficult time for the Commission, Khuzami noted, observing that both he and then-Chair Mary Schapiro had been called before Congress multiple times to be harangued about the SEC’s failure to detect Madoff’s fraud. Even the SEC’s successes were criticized, Khuzami said. When the SEC brought charges against Goldman Sachs, there was a congressional investigation into whether the SEC did so just to get the Dodd-Frank Act passed, he remarked.

Andrew Ceresney, Enforcement Director from 2013 to 2017, praised Khuzami and his enforcement staff for their efforts, stating that his own tenure as director benefited from the fruits Khuzami and others put in place. Ceresney noted that the Division had many “first of their kind” cases while he was there. The Division was also able to take advantage of the “data explosion” over the preceding five years, and in some ways had actually surpassed parts of the financial industry in its ability to use data to bring cases.

Ceresney also noted that the whistleblower program put in place under Dodd-Frank has resulted in millions of dollars of awards to whistleblowers. It took a number of years to see the benefits, he observed, but now it’s coming into its own.

Thursday, April 05, 2018

Twitter may not omit shareholder proposal to create board committee on social issues

By Lene Powell, J.D.

In a no-action letter, Division of Corporation Finance staff said Twitter, Inc. may not omit a shareholder proposal to create a Public Policy Committee of the Board of Directors to oversee the company’s activities on broad public policy issues including human rights and corporate social responsibility. Although Twitter told the SEC that management of public policy issues is already intrinsically embedded in its current board activities, the Division concluded that Twitter’s policies, practices, and procedures do not compare favorably with the proposal and, therefore, the company has not substantially implemented the proposal.

Proposed committee on public policy. According to proponent Jing Zhao, who holds 205 shares, Twitter has become the most used public policy platform in the world. He urged the company to establish a Public Policy Committee of the Board of Directors to oversee Twitter's policies and practice that relate to public policy issues including human rights, corporate social responsibility, charitable giving, political activities and expenditures, foreign governmental regulations, and international relations that may affect Twitter's operations, performance, reputations, and stockholders value.

Zhao noted that staff did not concur when Apple tried to exclude his similar proposal in December 2017 and that Facebook included a similar proposal in its 2016 shareholder meeting.

Request for relief. Twitter asked staff to concur in its view that it may omit the proposal from its 2018 proxy materials in reliance on Rule 14a-8(i)(10) because the proposal has already been substantially implemented. Twitter said it is “acutely aware” that public policy issues are “core” to the company’s business due to its unique platform and business model. But the company said its board already provides the oversight requested, and described its oversight regime:
  • The overall board oversees senior management and day-to-day risks; 
  • The Audit Committee is responsible for oversight of the overall adequacy and effectiveness of the company’s legal, regulatory, and ethical compliance programs. In this capacity, it has been at the forefront of key issues of privacy, net neutrality, cybersecurity, freedom of expression, rights of publicity, and protection of minors; 
  • The Nominating and Corporate Governance Committee has sought out board members that can contribute specific policy perspectives and advice; 
  • The Compensation Committee’s work heavily involves human rights and corporate social responsibility with respect to the company’s employment practices across the world. 
In addition to board oversight, the company has a Public Policy function, which is a team of employees throughout the world who have direct responsibility for various policy matters and act as ambassadors of the company to government policymakers, regulators, and civil society groups. Twitter further pointed to a long list of social programs and initiatives, including charitable programs, diversity initiatives, civic engagement, and a political action committee.

SEC response. Division staff was unable to concur that the company may exclude the proposal under rule 14a-8(i)(10) because it did not appear that Twitter’s policies, practices, and procedures compare favorably with the proposal. Accordingly, staff did not believe that the company may omit the proposal from its proxy materials in reliance on rule 14a-8(i)(10).

Wednesday, April 04, 2018

Q1 sees twice as many IPOs as the first quarter of 2017

By John Filar Atwood

The IPO market finished the first quarter, which began with a record-breaking January, with 55 new issues, nearly twice the Q1 2017 total of 28. Seventeen of the deals were completed in March, a slight improvement over February’s 16 offerings. The last week of March saw seven companies go public, including four that are headquartered in China. Nine of the year’s new issuers operate out of China. Business services companies (SIC 7389) Bilibili and iQIYI were two of the week’s Chinese new issuers. Beijing-based iQIYI raised $2.25 billion in the year’s second largest IPO to date, while Bilibili netted $483 million for its online entertainment business. Morgan Stanley, which led Bilibili’s IPO, also served as lead underwriter on deals by OneSmart International Education and GreenTree Hospitality. OneSmart was the second China-based education services provider to go public in the U.S. in the past two weeks. Last week’s other three IPOs were completed by pharmaceutical companies Homology Medicines, Genprex and Unum Therapeutics. The offerings by Homology and Unum raised the number of Massachusetts-headquartered new issuers in 2018 to five. Genprex’s $6.4 million offering was the second smallest of the year so far.

New registrants. The week’s activity included seven new registrations, four of which were filed by prepackaged software companies (SIC 7372). Morgan Stanley was selected as first lead manager by Smartsheet and DocuSign. Smartsheet offers a platform for businesses to plan, manage and report on work progress. DocuSign enables users to move from paper-based to digital agreements, transactions and approval processes. Human capital management software provider Ceridian HCM Holding registered a $200 million offering. In connection with its IPO, Ceridian intends to contribute its LifeWorks employee assistance division to company shareholders. Shanghai-based CLPS, a provider of consulting services to insurance and financial services companies, also registered. The company derives a significant portion of its revenues from major customers Citibank and eBay. HeadHunter Group, which operates out of Cyprus, is hoping to raise $200 million through its IPO. HeadHunter offers an online job recruitment platform in Russia and the Commonwealth of Independent States. The last IPO in U.S. markets by a company headquartered in Cyprus was in May 2013. The week’s other new registrants are nLIGHT and Singapore-based ASLAN Pharmaceuticals. nLIGHT provides high-powered semiconductor and fiber lasers. ASLAN, whose development program is centered in Asia, makes treatments for several kinds of cancer. Overall, the pace of new registrations increased in March with 22 filings compared to 14 in February. There were 53 preliminary registrations in the first quarter, which is eight more than were filed in the first three months of 2017.

Withdrawals. No Forms RW were filed in the last week of March, leaving the month with just two withdrawals. That is one more than was recorded in February, but is four fewer than the March 2017 total. As of March 31, five Forms RW had been filed this year compared to 18 in the same period last year.

The information reported here was gathered using IPO Vital Signs, a Wolters Kluwer Regulatory U.S. database that includes all SEC registered IPOs, including REITs and those non-U.S. IPO filers seeking to list in the U.S. markets. IPO Vital Signs does not track closed-end funds, best efforts or non-underwritten deals, or IPO offerings for amounts less than $5 million.

Tuesday, April 03, 2018

Environmental proposals do not dictate Chevron’s litigation strategy, must be included in proxy

By Amanda Maine, J.D.

Chevron must include two shareholder proposals relating to the environment and climate change in its proxy materials, the staff of the SEC’s Division of Corporation Finance stated. Chevron had argued that the proposals, which request that the company issue reports on aligning its business model with a decarbonizing economy and minimizing methane emissions caused by fracking, are attempts to dictate its litigation strategy because it is a defendant in eight lawsuits seeking relief for climate change injuries. As such, Chevron asserted that it should be allowed to omit the proposals under Rule 14a-8(i)(7)’s “ordinary business” exception.

Proposals. The proposals were submitted by corporate responsibility non-profit As You Sow on behalf of Chevron shareholders. One proposal requests a report describing how Chevron could adapt its business model to align with a decarbonizing economy by reducing its dependence on fossil fuels. The other proposal requests that Chevron report on its actions beyond regulatory requirements to minimize methane emissions from its hydraulic fracturing operations.

Chevron’s request for relief. In seeking to exclude the proposals from its proxy materials, Chevron noted that it is currently one of many defendants in lawsuits filed by several cities and counties alleging that the company is liable under state tort law related to its production, promotion, and sale of fossil fuels. According to Chevron, the proposals involve the same subject matter as the litigation and would directly implicate its legal strategy and conduct in these lawsuits by asking it to reveal information central to its defense, undermining its ability to vigorously defend against the plaintiffs’ claims.

Chevron cited several no-action letters where the staff had allowed the exclusion of such proposals when the subject matter is the same or similar to current litigation in which the company is involved and when the implementation of the proposal would amount to an admission by the company. It also noted the staff has allowed the exclusion of proposals that touch upon a significant policy issue if they implicate ordinary business matters. The proposals seek to substitute the judgment of the stockholders for that of Chevron on decisions involving litigation strategy by requiring it to take action contrary to its legal defense, and is therefore excludable under Rule 14a-8(i)(7), Chevron argued.

Proponents’ response. In their response letters, the proponents disagreed with Chevron’s assertion that the proposal should be excluded because it dictates the company’s legal strategy, drawing a distinction between its submissions and those previously allowed by the staff to be omitted. Unlike the no-action letters cited by Chevron, these proposals do not ask for information on the litigation, make recommendations as to how it should be defended, or ask for information on its resolutions or repercussions, according to the proponents.

The responses also cited several previous staff determinations that matters pertaining to climate change, greenhouse gas emissions, and methane emissions resulting from fracking address significant policy issues that transcend ordinary business and that there is growing interest in these issues from investors, as demonstrated by the number of climate change proposals submitted in 2018 and some large asset managers voting for climate proposals for the first time ever.

In addition, the proponents pointed out that both proposals are prospective in their requests for reporting on carbon impacts and methane emissions, while the crux of the litigation is retrospectively focused on fault for past actions. The proposals do not seek information on whether the company is liable for some share of past emissions, the proponents advised.

According to the proponents, even if the proposals would affect Chevron’s ability to defend itself in the litigation, the effect would be minimal. If Chevron’s argument were accepted, the proponents contended, it would essentially prevent all climate-related proposals at the largest fossil fuel companies from going forward, as most of them are subject to climate lawsuits and the number of lawsuits is likely to grow as litigation gains traction. The proposals do not address pending litigation and do not attempt to “micromanage” Chevron’s litigation strategy, the proponents concluded, and requested that the staff deny Chevron’s requests for no-action relief.

Requests denied. Regarding both shareholder proposals, the staff stated that it was unable to concur in Chevron’s view that it may omit either proposal from its proxy materials in reliance on Rule 14a-8(i)(7).

Monday, April 02, 2018

CBOE responds to SEC on fund innovation and cryptocurrency holdings

By Brad Rosen, J.D.

Cboe Global Markets, Inc. President and COO Jack Concannon provided a comprehensive response to an SEC staff letter issued by the Division of Investment Management earlier in the year which raised numerous concerns relating to cryptocurrencies and related products. In its letter dated March 23, 2018, Cboe focused on the specific areas noted by the SEC where significant outstanding questions exist in connection with how funds holding substantial amounts of cryptocurrencies and related products would satisfy the requirements of the Investment Company Act and SEC rules. These topics included valuation, liquidity, custody, arbitrage for ETFs, manipulation and suitability.

Cboe, including affiliates, was the first national securities exchange to submit a proposal to list and trade an ETP that would hold bitcoin and has since submitted three additional proposals to list and trade ETPs that would hold bitcoin futures. Additionally, the affiliated Cboe Futures Exchange was the first U.S. futures exchange to offer a Bitcoin futures product for trading. In March, 2018, trading volume exceeded 10,000 contracts per day for Bitcoin futures.

A common thread running through Cboe’s letter was that cryptocurrency-related holdings should be treated like other assets for regulatory purposes, although it conceded these holdings do raise a number of unique issues. Cboe’s letter was in response to a letter dated January 18, 2018 from Dahlia Blass, the director of the SEC’s Division of Investment Management, to the Investment Company Institute and the Securities Industry and Financial Markets Association. Some of the key points from Cboe’s submission follow.

Valuation. One area of concern noted in the SEC’s letter was how funds would value cryptocurrencies given their volatility, the fragmented markets, the general lack of regulation, and the current state of the cryptocurrency futures markets. SEC staff noted that mutual funds and ETFs must value their assets each business day to determine a net asset value. A central question raised was: how would funds develop and implement policies and procedures to value, and in many cases “fair value,” cryptocurrency-related products?

Cboe agreed that valuation was of critical importance for cryptocurrency ETPs, but it asserted that most valuation issues are either very similar or identical to those encountered in valuing other assets. Cboe noted that for Bitcoin, there are numerous robust indices that Cboe and other market participants have been tracking for years. Additionally, there is a significant amount of reliable price information available from the bitcoin futures market on Cboe Futures Exchange and CME. Finally, there is real-time trade data available 24 hours a day from a number of different trading platforms around the world, with a collective volume in the billions of dollars daily. Cboe concluded there is more than sufficient information for cryptocurrency ETPs to create reliable and robust valuation methodologies for bitcoin and potentially for other cryptocurrencies.

Liquidity. Another area of concern for the SEC is liquidity. The SEC queried what steps funds would take to assure that they have sufficient liquid assets to meet daily redemptions and how they would classify the liquidity of cryptocurrency and related products for purposes of Rule 22e-4, the new fund liquidity rule. A central question raised was: what steps would funds investing in cryptocurrencies or cryptocurrency-related products take to assure that they would have sufficiently liquid assets to meet redemptions daily?

Cboe noted that while there are certain aspects that differentiate cryptocurrency-related assets from more traditional assets, almost all of the issues related to liquidity are substantively identical to those of other commodities, including the spot, over-the-counter, and commodity futures markets. It pointed to the billions of dollars of bitcoin traded on cryptocurrency exchanges on a daily basis. Cboe asserted that as the volumes continue to grow, especially on regulated U.S. markets, the overall spot bitcoin market looks more and more like a traditional commodity market and believes the spot market is sufficiently liquid to support a bitcoin ETP.

Custody. To the extent that a fund plans to hold cryptocurrency directly, the SEC staff asked how it would satisfy the custody requirements and related rules.

Cboe noted that to the extent that a cryptocurrency ETP plans to hold cryptocurrency directly, whether as fund holdings or for physical settlement of a futures contract, firms like Gemini Trust Company, LLC and a number of others are establishing themselves as regulated custodians offering custodial services.

Arbitrage. SEC staff questioned how ETFs would comply with Commission orders that they have a market price that would not deviate materially from their net asset value given the fragmentation, volatility, and trading volume of the cryptocurrency marketplace.

In its response, Cboe encouraged the Commission to treat cryptocurrency-related assets in the same manner that they have treated existing ETPs that hold commodities or the associated futures contracts. It noted that based upon a number of factors, including conversations with market makers and authorized participants, Cboe believed that the spot and over-the-counter bitcoin market could easily support the arbitrage mechanism for an ETP.

Suitability. SEC staff noted that the cryptocurrency markets that are currently in operation offer less investor protection than traditional markets and provide a greater opportunity for fraud and manipulation. Staff questioned whether investors have sufficient information to consider the risks and whether broker-dealers have analyzed the suitability of offering these funds to retail investors. Investment advisers may face challenges in meeting their fiduciary obligations when investing in these products on behalf of retail investors.

In its submission, CBOE noted that cryptocurrency funds would NOT be appropriate for all investors. It added that comprehensive risk disclosure in the applicable regulatory documentation backstopped by rigorous broker-dealer evaluation of the suitability of a particular product for a client would provide a sufficient framework for investor protection. Cboe indicated that it does not believe that cryptocurrency-related funds are so much different as to warrant disparate treatment from other commodity-related funds.

Friday, March 30, 2018

'Night market' trading of Korean index futures falls under Morrison's shadow

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

Five Korean citizens who conducted overnight transactions in Korea Exchange (KRX) futures contracts plausibly alleged that a New York high-frequency trading firm and its founder injured them by engaging in spoofing in violation of the Commodity Exchange Act (CEA). Reversing the ruling below, a Second Circuit panel held that the complaint plausibly alleged that the trades were “domestic transactions” under the U.S. Supreme Court’s Morrison decision and Second Circuit precedent. Accordingly, application of the CEA to the defendants’ alleged conduct was not an impermissible extraterritorial application of the statute (Choi v. Tower Research Capital LLC, March 29, 2018, Walker, J.).

Night market trading and spoofing. The plaintiffs purchased on the so-called “night market” commodity futures contracts based on the KOSPI 200, a Korean stock index. On the KRX night market, traders enter orders in Korea, when the KRX is closed for business, whereupon their orders are quickly matched with a counterparty by CME Globex, an electronic trading platform located in Aurora, Illinois. The trades are then cleared and settled on the KRX when it opens for business the following morning.

In December 2014, the plaintiffs filed a class complaint alleging that Tower Research Capital LLC and its founder, Mark Gorton, utilized their algorithmic flash trading abilities to illegally manipulate prices of the KOSPI 200 futures during night market trading on the CME. Specifically, the plaintiffs alleged that Tower’s traders engaged in illegal spoofing by creating hundreds of fictitious buys and sells to artificially manipulate the price of the contracts by creating a false impression about supply and demand. Relying on the Supreme Court’s holding in Morrison v. National Australia Bank Ltd., (U.S. 2010), however, the Southern District of New York concluded that application of the CEA to the defendants’ conduct would be an impermissible extraterritorial application of the act and dismissed the complaint.

After the plaintiffs amended their complaint to add allegations about the domesticity of KRX night market transactions, the district court again granted the defendants’ motion to dismiss. Among other things, the district court concluded that the plaintiffs still failed to sufficiently allege that CME Globex is a “domestic exchange” under Morrison because it is not structured like other exchanges and is not registered as an exchange with the CFTC. The court also held that the trades on the KRX night market were not “domestic transactions” because KRX rules suggest that transactions become final only when they settle on the KRX, not when they match on CME Globex.

Irrevocable liability. On appeal, the Second Circuit reversed. The appellate panel began by noting that Morrison said nothing about the CEA’s territorial reach, and only once, in Loginovskaya v. Batratchenko (2d Cir. 2014), did the Second Circuit itself address the question. In Loginovskaya, the Second Circuit concluded that Morrison’s “domestic transactions” test applies to the CEA. In so holding, the panel adopted a rule established in the Section 10(b) case of Absolute Activist Value Master Fund Ltd. v. Ficeto (2d Cir. 2012), where the court concluded that a transaction involving securities is a “domestic transaction” under Morrison if “irrevocable liability is incurred or title passes within the United States.”

Here, the plaintiffs’ amended complaint alleged not only that KRX night market trades bind the parties on matching, it also alleged that the express view of CME Group is that matches on CME Globex are “essentially binding contracts” and that members are required to honor all bids or offers which have not been withdrawn from the market. Accordingly, the complaint plausibly alleged under the Absolute Activist rule that parties incur irrevocable liability on KRX night market trades at the moment of matching.

The appellate panel rejected the defendants’ contention that the KRX rules establish that irrevocable liability attaches only at settlement on the KRX the morning after matching on CME Globex. Although the rules give the exchange power to cancel or modify trades due to errors, the exchange’s power to rectify errors in the parties’ contracts does not render those contracts “revocable” in any meaningful sense, the court opined. And, although liability might ultimately attach between the buyer/seller and the KRX upon clearing, that does not mean liability does not also attach between the buyer and seller at matching prior to clearing. Before a subsequent transfer of liability takes place in Korea the next morning, the buyer and seller are first bound to each other when they enter a binding irrevocable agreement through matching on CME Globex. Accordingly, the plaintiffs sufficiently alleged that the parties incurred irrevocable liability for KRX night market trades in the United States.

The case is No. 17-648.

Thursday, March 29, 2018

Massachusetts conducts cryptocurrency sweep, censures five companies

By Jay Fishman, J.D.

The Massachusetts Securities Division, upon completing a sweep of unregistered cryptocurrency transactions, censured five companies and additionally ordered them to permanently desist from selling unregistered or non-exempt securities in the state. The companies, for failing to either register or claim an exemption for their respective initial coin offerings, entered into settlement offers with the Division. The Division determined that the unregistered, non-exempt coin offerings fell within the “security” and “investment contract” definitions of the Massachusetts Securities Act and rules.

Company cryptocurrency offerings.
  1. 18Moons, Inc., a children’s programming company, planned to offer up to 100 million in planet kid coins to potential purchasers in late 2017 but ceased operations upon receiving a Division subpoena on January 25, 2018 (In the Matter of 18Moons, Inc., March 27, 2018). 
  2. Across Platforms, Inc., d/b/a ClickableTV, planned to initially offer up to $100 million ClickableTV tokens, with a hard cap of $27.5 million, on March 1, 2018 but stopped the offering upon receiving a Division subpoena on February 7, 2018 (In the Matter of Across Platforms, Inc., March 27, 2018). 
  3. Mattervest, Inc., used Twitter to provide potential customers with links to a weekly newsletter listing the latest investment pool deals but ceased operations when it received an inquiry letter from the Division on January 31, 2018 (In the Matter of Mattervest, Inc., March 27, 2018).
  4. Pink Ribbon ICO, a publicly traded company on the blockchain that supports women and families facing financial burdens from Cancer, stated on its Facebook page an intent to trade $5 million coins on the open market, but took down the page after receiving a Division inquiry letter on February 2, 2018 (In the Matter of Pink Ribbon ICO, March 27, 2018). 
  5. Sparkco Inc. d/b/a Librium ICO planned to expand its existing freelance platform operations by pre-selling its services through an initial cryptographic token offering on December 8, 2017. The company, however, postponed the offering indefinitely upon received a Division subpoena on February 5, 2018 (In the Matter of Sparkco, Inc., March 27, 2018). 
The docket numbers are E-2081-0010, E-2018-0016, E-2018-0011, E-2018-0029 and E-2018-0017.