Friday, March 30, 2012

House and Senate Ag Committee Chairs Urge CFTC to Adopt Narrow Swap Dealer Regulations

In a letter to CFTC Chair Gary Gensler, House and Senate oversight committee chairs expressed concern that the breadth of the proposed rule further defining swap dealers will result in the registration of many entities that Congress never intended to be regulated as dealers. Senator Ag Committee Chair Debbie Stabenow (D-MI) and House Ag Committee Chair Frank Lucas (R-OK) advised the CFTC that the final swap dealer regulations should not be overly broad and should not impose significant new regulations on entities that Congress did not intend to be regulated as swap dealers. The final CFTC rule further defining swap dealing should clearly distinguish swap activities that end users engage in to hedge or mitigate the commercial risks associated with their businesses, said the chairs, including swaps entered into by end users to hedge physical commodity price risk from swap dealing.

In providing an exemption for hedging activities, said the oversight chairs, the CFTC should be consistent when defining hedging across regulations, such that the definition of hedging or mitigating commercial risk as proposed in the major swap participant definition and in the end user clearing exception. In addition, the oversight chairs urged the CFTC to consider that many commercial end users, especially those with inherent physical commodity price risk, actively trade in swaps to facilitate the hedging of those risks and to otherwise anticipate changing market prices. These entities do so for their own trading objectives and not for the benefit of others, noted the legislators, and the final CFTC regulations should clarify that these activities do not constitute swap dealing and will not require swap dealer registration.

The oversight chairs posited that enhancing transparency in the derivatives markets and mitigating systemic risk are critical to ensuring the safety and soundness of the financial system. Thus, Dodd-Frank Title VII requires that all swaps be reported and gives the CFTC additional authority to collect data to facilitate its surveillance of and enforcement authority over large trader positions. At the same time, most swaps will be mandated for central clearing, a critical component of reducing systemic risk. Moreover, entities that do not engage in swap dealing, but take positions that are so substantial they pose a threat to the stability of the financial system must be designated and regulated as major swap participants. The chairs asked that the CFTC recognize that the swap dealer designation is not its singular means for overseeing entities in the swaps market. The activities of non-swap dealers will be subject to the authority and oversight of regulators and cannot rise to a level of systemic significance without drawing additional regulatory oversight.

It is also critical that businesses have access to the credit they need to fuel the economic recovery. Hedging against the risks businesses face, such as rising commodity prices or interest rates, is an important component of their ability to secure credit. Recognizing this, Congress provided an exception for credit institutions offering swaps in connection with loans from designation as swap dealers. This provision ensures that the credit flow can continue between businesses and small to mid-size lenders and farm credit institutions.
While applauding the CFTC’s efforts to ensure that any exclusion is not abused, the oversight chairs believe that the loan exclusion can be narrowly defined to reflect commercial lending realities. They share the concerns that the Comptroller of the Currency voiced in his July 1, 2011 comment letter to the CFTC that the Commission’s interpretation of the loan exclusion may interfere with risk management in connection with commercial credit. The oversight chairs ask that these issues be dealt with in the final regulations.

Georgia Makes Small Issuer Registrations under 1973 Securities Act Qualification Registrations under 2008 Securities Act

The Georgia Uniform Securities Act of 2008, unlike the previous Georgia Securities Act of 1973, does not have a registration provision for small issuers, and so the Securities Commissioner, by administrative order effective March 15, 2012, declares that small issuer registrations not having expired as of December 8, 2011 will be treated as registrations by qualification under the 2008 Act when they expire. Upon expiration, small issuers may renew their registrations by qualification, by sending the Securities Commissioner an updated prospectus under Georgia securities rule 590-4-3-.11 [on registration statement renewals] that complies with rule 590-4-3-.06(3)(c)(2) [on prospectus contents and delivery].

Filings made in accordance with this administrative order must be made within 30 days of the order's effective date (March 15, 2012) or within 30 days from the anniversary of the effective date of the registration statement being renewed.

Note that registration statements renewed in accordance with this administrative order will be subject to the Georgia Uniform Securities Act of 2008 and corresponding securities rules as if the original registration statements were filed under the 2008 Act rather than under the 1973 Act.

Colorado Adopts Private Fund Adviser Exemption

A private fund adviser exemption was adopted by administrative order of the Colorado Securities Division, effective March 30, 2012.

Colorado is the ninth state to promulgate a private fund adviser exemption after California, Indiana, Maine, Massachusetts, Michigan, Rhode Island, Virginia and Wisconsin.

Colorado's private fund adviser exemption is like the other states' exemptions in that it: (1) makes the exemption unavailable for advisers subject to the "bad boy" disqualification provisions of Rule 262 of federal Regulation A; and (2) exempts from licensing investment adviser representatives of private fund adviser-exempt investment advisers.

Colorado's exemption differs from the other states' by exempting an investment adviser to a "family office" as defined in Rule 202(a)(11)(G)-1 of the Investment Advisers Act of 1940 and by exempting a "foreign private adviser" as defined in Section 202(a)(3) and Rule 202(a)(30)-1 of the Advisers Act.

Lastly, the exemption applies to investment advisers falling with the venture capital fund exemption of Section 203(l) of the Advisers Act who comply with the SEC Rule 204-4 reporting requirements. Note, however, that advisers relying on this state licensing exemption are not required to file the SEC Rule 204-4 reports with the Colorado Securities Commissioner. And note also that Colorado incorporates by reference into this state licensing exemption the "grandfathering" provision of Rule 203(l)-1(b) in the Advisers Act.

Georgia Clarifies Recently Adopted Securities Rules

Clarifications to some of the rules adopted on December 8, 2011 to conform to the Georgia Uniform Securities Act of 2008 were adopted by the Georgia Office of the Secretary of State, effective March 29, 2012.

The following descriptions comprise the effective clarifications:

* The filing date for Georgia's limited offering exemption corresponding to SEC Rule 505 was changed to 15 business days after the receipt of consideration or the delivery of a subscription agreement.

* The new non-profit organization securities exemption mandates that NASAA's Church Bond and Church Extension Fund Policy Statements be applied to offerings made under the exemption.

* The new Invest Georgia exemption is available only to for-profit business entities.

* The "electronic filing with designated entity" and "application renewal" rules for investment advisers and investment adviser representatives eliminated the "grace period" for filings due each December.

* Investment adviser contract, written exam, recordkeeping and supervision rules clarify that these rules apply to investment advisers or investment adviser representatives registered or required to register in Georgia.

* Typographical errors were corrected in investment adviser application and abandoned application rules.

Thursday, March 29, 2012

House Passes Legislation Codifying Derivatives End User Exemption

The House passed by a 370-24 vote the Business Risk Mitigation and Price Stabilization Act, HR 2682, providing clarity to the derivatives title of the Dodd-Frank Act by reconfirming the end-user exemption from margin and capital requirements. End-users are firms and companies that use derivatives to manage their risks, not to speculate. During the debate on Dodd-Frank, Congress made its intent clear that the derivatives title was not meant to impose margin requirement on end users. Yet, regulators have interpreted the derivatives title to give them authority to impose margin requirements on end-users. The legislation was sponsored by Representatives Michael Grimm (R-NY), Gary Peters (D-MI), Austin Scott (R-GA), and Bill Owens (D-NY).

The end users exemption in HR 2682 allows end-users to continue to use derivatives to maintain low and stable prices for consumers and will free up capital. The legislation is based on the consensus view that the use of derivatives by commercial end-users did not pose a risk to the larger economy, said Rep. Peters. The narrowly crafted legislation clarifies that Congress intended that commercial end-users who are not engaged in harmful speculation should not be required to divert capital away from job creation. The legislation will ensure that community banks, agriculture co-ops and energy utilities can continue to hedge risk, said Rep. Owens.

As envisioned by the legislation, true end-users are companies that use derivatives to manage an actual business risk, generally to hedge against fluctuating prices, currency rates, or interest rates, and not to speculate. HR 2682 clarifies that end-users employing derivatives to hedge legitimate business risk are exempt from posting margin, consistent with the Congressional intent of Dodd-Frank. Forcing true end-users to post margin can have several negative consequences, said the sponsors, including pushing the costs of hedging so high that firms stop hedging, resulting in a detrimental rise in prices for consumers. In addition, capital would be restricted and the high costs of hedging could drive business overseas to foreign derivatives markets. H.R. 2682 eliminates the margin requirement and thus helps prevent these negative consequences from occurring.

The Dodd-Frank Act does not require regulators to impose margin requirements on end users and the legislative history clarifies that Congress did not intend to impose margin requirements on non-financial end users. Nonetheless, the legislation was driven by end user uncertainty about whether they will be subject to margin requirements.

At the markup of the bill in the House Ag Committee, Chairman FRank Lucas (R-OK)said that, while the CFTC has followed congressional intent, the banking regulators have proposed to require margin in the form of cash or highly liquid securities from non-financial end users, thereby ignoring congressional intent. Thus, he viewed this legislation as critical to reaffirming congressional intent to expressly and clearly provide an end-user exemption. In this regard, Chairman Lucas noted a letter sent by Senators Chris Dodd (D-CT) and Blanche Lincoln (D-AK) to House oversight chairs stating that the Dodd-Frank Act does not authorize federal regulators to impose margin on end users that use swaps to hedge or mitigate commercial risk.

Rep. Grimm said that HR 2682 clarifies the intent of Congress to provide an explicit exemption on the posting of margin by end users. He emphasized that the legislation ensures that federal regulators will not impose margin requirements on true ends users that use swaps to manage their business risks, like to lock in the cost of raw materials.

Forcing true end-users to post margin can have several negative consequences, he noted, such as the costs of hedging could be become so high that they stop hedging, resulting in a detrimental rise in prices for consumers. Also, capital would be restricted that would otherwise be used for job creation or reinvestment to make US companies more competitive in the global economy. Further, the high costs of hedging could drive business overseas to foreign derivatives markets and could also increase regulatory arbitrage

Wednesday, March 28, 2012

Market Manipulation Not Shown in ARS Case

The 2nd Circuit found, in a summary order that a purchaser of auction-rate securities failed to state a manipulation claim against Citigroup. The market was not misled, concluded the court, because the transactions' terms were adequately disclosed. Finn v. Smith Barney.

The core allegation in the complaint was that the plaintiffs purchased Citigroup auction-rate securities based on their belief that auction clearing rates were determined solely by investor supply and demand when, in fact, the defendants were increasingly intervening in the ARS market without plaintiffs’ knowledge. Howver, the claims were not actionable in light of Citigroup's disclosures that "in its sole discretion” could routinely place one or more bids in an auction for its own account to prevent a failed auction. The disclosures noted that "bids by Citigroup...are likely to affect (i) the auction rate...and (ii) the allocation of ARS being auctioned.

Accordingly, the court found that the plaintiffs could not plausibly allege that Citigroup was intervening in the ARS market without their knowledge or that they reasonably believed that auction clearing rates were determined by “the natural interplay of supply and demand."

The court also rejected the purchasers' arguments that notwithstanding the disclosures, the conduct was misleading due to the increasing frequency with which Citigroup placed support bids. However, the Citigroup statement that it "may routinely" place support bids precluded recovery on the claims.

NASAA Announces Online Resource for IA State Registration Requirements

The North American Securities Administrators Association (NASAA) announced today the launch of an online resource to help investment advisers switching from federal to state securities regulatory oversight identify individual state registration requirements. The Dodd-Frank Act requires investment advisers with assets under management of between $25 million and $100 million to switch from federal to state registration by June 28, 2012.

As discussed in a news release this morning, NASAA's IA Switch Resource Center contains information about individual state registration fees, financial and bonding requirements, requirements for sole proprietorships and branch offices, de minimis requirements and other required documents. NASAA President Jack Herstein cautioned, however, that NASAA is providing the information as a convenience and not as legal advice.

NASAA also announced that it has extended its investment adviser coordinated review initiative by one month to April 30, 2012. According to the release, the Investment Adviser Coordinated Review Program is open to SEC-registered investment advisers switching their registration to between four and 14 states. Investment advisers who are eligible to participate must complete and submit the Coordinated Review Form found in the IA Switch Resource Center in addition to filing all materials required by the states in which the adviser is applying for registration. There is no additional cost to use the program, NASAA stated.

House Agreed to Senate Crowdfunding Amendment But May Try to Change It Later

In concurring with the Senate amendment to the Jumpstart Our Business Startups (JOBS) Act HR 3606, the House accepted the Merkley Amendment replacing the House version of crowdfunding with the Senate version, which added a number of investor protections, including a requirement for SEC registration. However, there were indications that some prominent House members will later make an effort to change the Senate crowdfunding provisions. Rep. David Schweikert, a primary author of parts of the legislation, said that the Senate amendment does great damage to the goal of a much more egalitarian, technologically advanced, using-the-Internet way for people to invest, for being able to reach out and gain that capital for very small companies. Rep. Schweikert added that he favored fixing what the Senate did in future legislation. (Cong Rec. (March 27, 2012) p. H1590).

Similarly, Rep. Patrick McHenry (R-NC), the author of the House crowdfunding provisions, said that, while the essential House framework is preserved for crowdfunding, the Senate did not recognize that crowdfunding could create new markets and opportunities for small businesses and start-ups. Rather, the Senate was misguided in simply seeing crowdfunding as unregulated activities. This misperception caused the Senate to design a crowdfunding title that is riddled with burdens on issuers, investors, and intermediaries and limits general solicitation and enhances SEC rulemaking authority. Noting the Senate changes to the House crowdfunding provisions were ill-conceived and burdensome, Rep. McHenry is committed to working in a bi-partisan way to ensure that Congress fixes this after the President signs the bill. (Cong Rec. (March 27, 2012) p. 1592)

Defending the Senate amendment, Rep. Jim Himes (D-CT), a strong supporter of the legislation, emphasized that the Senate changes to the crowdfunding provisions added more protection to small investors who might be subject to being fooled by an Internet predator. These are retail investors, he noted, who are not necessarily financially sophisticated. They are not the big financial players who get labeled accredited investors or institutional investors and who have the capability to take care of themselves. Rep. Himes said that crowdfunding, which sits at the nexus of potentially unsophisticated investors and people who see an opportunity, is open to retail investors who might be subject to the temptations of a deal that in fact is too good to be true offered on the Internet. This is a concern both for Congress and for the SEC, which must ultimately write the regulations around crowdfunding. (Cong Rec. (March 27, 2012), pps. 1590 and 1592).

Senator Merkley has defended the investor protections that the Senate added to crowdfunding. Title III now provides within the 21 days prior to the first day on which securities are sold to any investor, or such other period as the SEC may establish, the intermediary must make available to the Commission and to potential investors any information provided by the issuer pursuant to Section 4A(b) of the Securities Act.

Senator Merkley said the 21-day period allows for the opportunity for the sort of oversight that a portal can provide or the SEC can provide to stop known bad actors fraudsters. (Cong Rec. (March 20, 2012) p. S1829) He said the provision is a key distinction from the House version of Title III, under which one could have listed their offering and closed their offering within a single day, providing no feedback loop to detect deception. In contrast, the Act now has a 21-day period from one’s listing to their closing. In his view, this will provide time for a feedback loop regarding any sort of fraudulent activity. (Cong Rec. (March 21, 2012) p. S1887)

The crowdfunding provisions also set out basic rules of the road to protect investors
and ensure the accuracy of information companies post, companies participating in this marketplace must disclose their basic financial information, a business plan, a target offering amount, and the intended use. The web sites are subject to oversight by the SEC. There are also aggregate annual caps, which Senator Merkley said are a key predatory protection to prevent pump-and-dump schemes. (Cong. Rec. (Mar 20. 2012) S1829).

California Extends De Minimis Exemption

The California de minimis exemption for investment advisers who do not hold themselves out generally to the public as investment advisers and have had fewer than 15 clients during the preceding 12 months is being extended by emergency from April 17 to July 16, 2012. During this time period, the California Department of Corporations will be reviewing the comments it received on its proposed private fund adviser exemption to prepare that rule for final adoption. Adoption of the private fund adviser exemption will repeal the de minimis exemption.

Tuesday, March 27, 2012

House Agrees to Senate Amendment to the JOBS Act, Thereby Clearing the Jumpstart Our Business Startups Act for the President

The House has agreed to the Senate Amendment to HR 3606, the Jumpstart Our Business Startups (JOBS) Act and sent the bill to the President for his signature. Financial Services Chair Spencer Bachus (R-AL) requested a recorded vote to be taken later today. The Act is designed to get small businesses and entrepreneurs back into the game by removing costly regulations and making it easier for them to access capital. This legislation also paves the way for more start-ups and small businesses to go public, which will attract new investors and will allow small businesses to grow and create jobs.

The legislation creates a new category of what is called emerging growth companies that will reduce costs for small companies to go public. Emerging growth companies are exempted from certain regulatory requirements until the earliest of three dates: (1) five years from the date of the emerging growth company’s initial public offering; (2) the date an emerging growth company has $1 billion in annual gross revenue; or (3) the date an emerging growth company becomes a large accelerated filer, which is defined by the SEC as a company that has a worldwide public float of $700 million or more. The legislation thus provides temporary regulatory relief to small companies, which encourages them to go public, yet ensures their eventual compliance with regulatory requirements as they grow larger.

Title I is the Reopening American Capital Markets to Emerging Growth Companies Act, which would help more small and mid-size companies go public. During the last 15 years, fewer and fewer start-up companies have pursued initial public offerings because of burdensome costs created by a series of one size-fits-all laws and regulations. These changes have driven up costs and uncertainty for young companies looking to go public. Not going public deprives companies of the needed capital to expand their businesses, develop innovative products, and hire more American workers.

Title I would create a new category of issuers called emerging growth companies companies that have less than $1 billion in annual revenues when they register with the SEC and less than $700 million in public float after the IPO. Emerging growth companies will have as many as 5 years, depending on size, to transition to full compliance with a variety of regulations that are expensive and burdensome. This on ramp status will allow small and midsize companies the opportunity to save on expensive compliance costs and create the cash needed to successfully grow their business and create jobs. It will also make it easier for potential investors to get access to research and company information in advance of an IPO in order to make informed decisions about investing. This is critical for small and medium-sized companies trying to raise capital that have less visibility in the marketplace.

The Act creates an expanded on-ramp for newly public companies by exempting a new
category emerging growth companies with less than $1 billion in revenues or $700 million in public float for up to five years from a variety of securities law requirements, including: say-on-pay votes; certain executive compensation reporting; requirements to provide 3-years of audited financials (companies would only need 2 years worth), Sarbanes-Oxley Act Section 404(b) auditor attestation of management’s report on internal controls over financial reporting; and any future auditor rotation or other auditor requirements. The Act also eases restrictions on communications and research related to an IPO.

Title II is the Access to Capital for Job Creators Act, which amends section 4(2) of the Securities Act to permit the use of public solicitation in connection with private securities offerings, provided that the issuer or underwriter verifies that all purchasers of the securities are accredited investors. In addition, the SEC would have to share offering materials and documentation with the states.

Title III contains the crowdfunding provision designed to enable aspiring entrepreneurs to access investment capital via the Internet from small dollar investors across America. Title III came by way of a Senate Amendment, authored by Senator Jeff Merkley (D-OR), whihc reolaced the original HOuse Title III. Senator Merkley said that the possibility for capital formation through the Internet through crowdfunding is enormous, noting that, in 2011, Americans had invested $17 trillion in retirement funds. Imagine, continued the Senator, if one percent of those investments went into crowdfunding. The result would be $170 billion of investment in startups and small businesses. (Cong. Rec. (Mar 20, 2011) H1828-1829)

Title IV creates a new and larger exemption, effectively raising the limit from $5 million to $50 million for Regulation A security offerings and permitting a more streamlined approach for smaller issuers. The current limit is $5 million, but the mechanism is little used due to the small size of issuances permitted. The legislation would permit the SEC to impose conditions on issuance under the rule, and would require periodic review of the limit.

Title V of the Act is the Private Company Flexibility and Growth Act, authored by Rep. David Schweikert (R-AZ), which increases the number of shareholders that can invest in a private company from 500 to 2,000 without triggering SEC reporting duties, only 500 of which can be non-accredited investors, with 1500 having to be accredited investors as defined by the SEC. Originally, Title V raised the 500-shareholder threshold to 1000. The threshold was raised to 2000 pursuant an amendment offered by Rep. Brad Miller (D-NC). Title VI of the Act raises the number of shareholders permitted to invest in a community bank from 500 to 2,000.

Title VII of the Jumpstart Our Business Startups Act directs the SEC to provide online information and conduct outreach to inform small and medium sized businesses, women owned businesses, veteran owned businesses, and minority owned businesses of the changes made by the Act. This provision came by way of a House-approved a floor amendment offered by Rep. Dave Loebsack (D-Iowa). The amendment is designed to ensure that small businesses that may face unique challenges are fully aware of the benefits of the legislation.

Missouri Sets Time-Table for SEC Adviser Switch to State Registration

The time-table for SEC-registered investment advisers with $100 million or less in assets under management ("mid-size advisers") to report their amount of assets under management to the SEC on a Form ADV amendment and then begin the state registration process was released by the Missouri Securities Division on March 23, 2012. The Division conducts a pre-registration examination requiring mid-size advisers to correct in a timely manner the deficiencies found in their applications, to become registered in Missouri by June 28, 2012, the date all mid-size advisers must be withdrawn from SEC registration. Since Missouri's pre-registration examination may be lengthy because of the approximate 120 applicants going through this process, the Securities Division encourages applicants to apply for state registration immediately after filing their Form ADV amendment with the SEC by March 30, 2012.

House Passes Legislation Requiring the CFPB to Preserve the Confidentiality of Privileged Information

The House unanimously approved by voice vote legislation, HR 4014, that would protect confidential bank examination information provided to the Consumer Financial Protection Bureau. Senator Tim Johnson (D-SD), Chair of the Banking Committee, and Senator Richard Shelby (R-Ala), the Committee’s Ranking Member, have introduced a companion piece of legislation, S 2099, to create a single and consistent standard for the treatment of privileged information submitted to all federal agencies that supervise banks.

The bi-partisan legislation fixes the omission in the Dodd-Frank Act that opens the door for third parties to obtain privileged information provided by financial institutions to the Consumer Financial Protection Bureau. The legislation would require the CFPB to preserve the confidentiality of privileged information it receives from financial institutions, as other banking regulators do.

The American Bankers Association supports the legislation. The ABA, working through its Task Force on Financial Markets Regulatory Reform, has developed key principles for financial regulatory reform. The legislation advances three of those principles: 1) the regulation of financial intermediaries, products, and services should be integrated and comprehensive to protect investors and consumers; 2) functionally similar products and services should be subject to the same or essentially equivalent regulation; and 3) the regulation of the financial services industry should operate in a complementary and coordinated manner.

Currently, privileged materials shared with federal banking agencies remain privileged as to all other parties. Under 12 U.S.C. § 1828(x), the submission by any person of any information to any federal banking agency must not be construed as waiving, destroying, or otherwise affecting any privilege such person may claim with respect to such information under federal or state law as to any person or entity other than such agency.

The creation of the Bureau required that this statute be updated. The term federal banking agency is defined in the Federal Deposit Insurance Act, and that definition does not include the CFPB. Although the CFPB issued guidance asserting that 12 USC 1828(x) applies to its receipt of privileged materials, Bureau Director Richard Cordray has acknowledged that there is real concern over the issue. He expressed support for legislation to resolve any doubt. See testimony of Richard Cordray before the House Subcommittee on TARP, Financial Services and Bailouts, Jan. 24, 2012 and the Senate Banking Committee, Jan 31, 2012.

By explicitly applying the same privilege standards to information submitted to the CFPB that currently apply to any submissions to a federal banking agency, said the ABA, the legislation fosters a more integrated, consistent and coordinated approach to the regulation of financial services providers. In particular, the legislation would align current law with past practices by promoting uniform treatment of privileged materials by the Federal banking regulators and the CFPB.

Prior to the creation of the Bureau, noted the ABA, the Federal banking agencies examined depository institutions for compliance with consumer protection laws and such examinations could include the review of privileged materials without causing a waiver of the privilege. See 12 U.S.C. § 1828. Unfortunately, when the Bureau examines the same institutions today for compliance with the same consumer protection laws, there is uncertainty over whether the examination may include the review of privileged materials without causing a waiver of the privilege. The legislation would place CFPB examinations on the same footing as prior consumer protection examinations conducted by Federal bank regulators with regard to privilege.

Monday, March 26, 2012

Supreme Court Rejects Section 16(b) Tolling Based Solely on Failure to File Insider Disclosures

The U.S. Supreme Court held in a unanimous decision (Chief Justice Roberts did not participate in the case) that in a Section 16(b) case, equitable tolling ceases when fraudulently concealed facts are, or should have been, discovered by the plaintiff. The court rejected the claim by the plaintiff that the statute’s two-year limitations period was tolled by the failure to make Section 16(a) filings even if the the plaintiff was aware of the potential claim.

In an opinion authored by Justice Scalia, the court stated that “[u]nder long-settled equitable tolling principles, a litigant must establish “(1) that he has been pursuing his rights diligently, and (2) that some extraordinary circumstances stood in his way.” Allowing tolling to continue beyond that point would be inequitable and inconsistent with the general purpose of statutes of limitations, concluded the court.

This case presented a novel application of Section 16(b). Unlike most cases which involve management or large investors in public companies, this case involved underwriters in initial public offerings. As described by Justice Scalia, this theory of liability is “so novel that petitioners can plausibly claim that they were not aware they had to file a §16(a) statement,” and "would be compelled either to file or to face the prospect of §16(b) litigation in perpetuity."

The high court did not resolve the question of the application of tolling in general to Section 16 cases. The court remanded the case for consideration of how the usual rules of equitable tolling apply to the facts of this case. Justice Scalia noted that "we are divided 4 to 4 concerning, and thus affirm without precedential effect, the Court of Appeals’ rejection of petitioners’ contention that §16(b) establishes a period of repose that is not subject to tolling."

The decision reflects the view of the SEC, as expressed in a brief filed with the Solicitor General, that supported neither party. The Commission urged the court to recognize equitable tolling in Section 16 cases, but did not support the extension of such tolling in cases based on failure to file insider reports where the plaintiff had knowledge of the claim.

The amicus brief stated that like any federal statute of limitations, Section 16(b) is normally subject to a rebuttable presumption’ in favor of equitable tolling. That presumption is strengthened, said the SEC and the Solicitor General, in this context because Section 16(b) and related provisions of the securities laws expressly preserve room for the operation of traditional equitable doctrines.

The underwriters’ arguments for treating Section 16(b) as a statute of repose did not overcome the background presumption that equitable tolling applies. First, the text of Section 16(b), like a typical federal statute of limitations, establishes a time period for bringing suit but does not address the operation of traditional equitable doctrines. Second, the text and structure of Section 16(b) are different from other statutory time limits that the court has found not to be subject to equitable tolling.

In addition, noted the brief, the core purposes of Section 16(b) would be defeated if its limitations period could run while insiders fail to file Section 16(a) reports to conceal their short-swing transactions, and thereby insulate themselves from liability.

Accordingly, urged the brief, Section 16(b)’s limitations period should be tolled until a reasonably diligent security holder knows or should know the facts that would form the basis of a short-swing claim. Tolling was not appropriate, however, in this instance, argued the SEC and the Solicitor General. Although a Section 16(a) report will usually provide the first public notice that a short-swing transaction has occurred, that information may come to light in other ways as well. If other public disclosures adequately inform security holders that particular transactions have occurred, further tolling of the time for bringing suit to disgorge profits from those transactions is unwarranted, concluded the brief.

Credit Suisse Securities (USA) LLC v. Simmonds (No. 10-1261)


Medical Device Firm Consents to Multi-Million Dollar FCPA Settlement

The SEC charged Biomet Inc., an Indiana-based medical device company, with violating the Foreign Corrupt Practices Act. As alleged, the company’s subsidiaries and agents bribed public doctors in Argentina, Brazil, and China over an 8-year period to win business.

Biomet, which primarily sells products used by orthopedic surgeons, agreed to pay more than $22 million to settle the SEC’s charges as well as parallel criminal charges announced by the U.S. Department of Justice. The charges arise from the SEC and DOJ’s ongoing proactive global investigation into medical device companies bribing publicly-employed physicians.

Biomet consented to the entry of a court order requiring payment of $4,432,998 in disgorgement and $1,142,733 in prejudgment interest and the entry of permanent injunctions against future violations. Biomet was also ordered to retain an independent compliance consultant for 18 months to review its FCPA compliance program, and agreed to pay a $17.28 million fine to settle the criminal charges.

The SEC complaint alleged that Biomet and its four subsidiaries paid bribes from 2000 to August 2008, and employees and managers at all levels of the parent company and the subsidiaries were involved along with the distributors who sold Biomet’s products. Biomet’s compliance and internal audit functions failed to stop the payments to doctors even after learning about the illegal practices.

According to the SEC’s complaint filed in federal court in Washington D.C., employees of Biomet Argentina SA paid kickbacks as high as 15 to 20 percent of each sale to publicly-employed doctors in Argentina. Phony invoices were used to justify the payments, and the bribes were falsely recorded as “consulting fees” or “commissions” in Biomet’s books and records. Executives and internal auditors at Biomet’s Indiana headquarters were aware of the payments as early as 2000, but failed to stop it.

The SEC alleged that Biomet’s U.S. subsidiary Biomet International used a distributor to bribe publicly-employed doctors in Brazil by paying them as much as 10 to 20 percent of the value of their medical device purchases. Payments were openly discussed in communications between the distributor, Biomet International employees, and Biomet’s executives and internal auditors in the United States.

The investigation into bribery in the medical device industry is continuing.

Sunday, March 25, 2012

Former SEC Chairs Pitt and Levitt Discuss Auditor Rotation at PCAOB Roundtable

In testimony before the PCAOB roundtable on auditor independence, former SEC Chair Harvey Pitt said that mandatory audit firm rotation is one way to achieve auditor independence, but another way is to require company audit committees to regularly review the outside auditor’s performance under PCAOB standards with an eye towards not retaining an auditor that fails to meet the standards. It would be unfortunate, he said, if mandatory audit firm rotation deprives the audit committee of exercising real judgment.

Audit committees would have to develop a systemic methodology to assess the performance of the outside auditor and the circumstances under which a firm must be discharged. As part of this methodology, he noted, the audit committee would need generic information beyond its individual circumstances that only the SEC and PCAOB can provide. While the audit committee of a public company has knowledge of only its own auditor as it relates to the company, the PCAOB sees audit firms in multiple context.

The former SEC Chair urged the Board to find a way, with SEC assistance and there may need to be legislation, for the generic data to be communicated to the audit committee. The Board could communicate generic descriptions and statistical analyses, as well as the factors that are causing the Board concern. Armed with this data, audit committees could be requited at set an interval, Mr. Pitt suggested every five years, to make an affirmative finding that the company’s outside auditor exceeds whatever standards the Board articulates. The Board could spell out the conditions under which an outside auditor could remain in that role.

Mr. Pitt believes that requiring audit committees formally to consider whether, and then to explain and document the reasons that they have determined, to retain their outside auditors can be an effective short-term method of addressing auditor independence and the quality of audits, but only if two conditions precedent are satisfied. First, the Board should articulate the general standards it wishes to see audit committees apply, and second, the Board and the SEC should share information with audit committees in the possession of both bodies that could prove important to audit committees in making an independent judgment whether to retain the company’s outside auditors.

Former SEC Chair Arthur Levitt said that investors deserve the perspectives of different audit professionals every so often, especially when an auditor’s independence can be reasonably called into question. The former SEC Chair detailed three situations arguing for mandating auditor rotation: 1) if the audit firm has been employed by the client for a significant period of time, such as 10 years; 2) if one or more former partners or managers from the audit firm now work for the client; 3) if the audit firm performs significant non-audit services, even if approved by the audit committee.

The major criticism of auditor rotation mandates is the damage to institutional memory among the audit teams. But former SEC Chairman Levitt noted that most of the billable work of an audit is done by front-line staff who themselves rotate from audit firm to audit firm. Noting that the only continuity is among the partners and managers who oversee the work, the former Chair said the concern about lost institutional memory is misplaced.

Friday, March 23, 2012

SEC Establishes New Supervisory Cooperation Arrangements with Foreign Counterparts

The SEC announced that it has established comprehensive arrangements with the Cayman Islands Monetary Authority (CIMA) and the European Securities and Markets Authority (ESMA) as part of long-term strategy to improve the oversight of regulated entities that operate across national borders.

The two memoranda of understanding (MOUs) reached this month follow on a similar supervisory arrangement that the SEC concluded with the Quebec Autorité des marchés financiers and the Ontario Securities Commission in 2010 and expanded to include the Alberta Securities Commission and the British Columbia Securities Commission last September.

The SEC’s latest supervisory cooperation arrangements will enhance SEC staff ability to share information about such regulated entities as investment advisers, investment fund managers, broker-dealers, and credit rating agencies. The Cayman Islands is a major offshore financial center and home to large numbers of hedge funds, investment advisers and investment managers that frequently access the U.S. market. ESMA is a pan-European Union agency that regulates credit rating agencies and fosters regulatory convergence among European Union securities regulators.

“Supervisory cooperation arrangements help the SEC build closer relationships with its counterparts to cooperate and consult on each other’s oversight activities in ways that may help prevent fraud in the long term or lessen the chances of future financial crises,” said Ethiopis Tafara, Director of the SEC’s Office of International Affairs.

The SEC’s approach to supervisory cooperation with its overseas counterparts follows on more than two decades of experience with cross-border cooperation, starting in the late 1980s with MOUs facilitating the sharing of information between the SEC and other securities regulators in securities enforcement matters. The SEC’s enforcement cooperation arrangements — which now encompass partnerships with approximately 80 separate jurisdictions via bilateral MOUs and a Multilateral MOU under the auspices of the International Organization of Securities Commissions (IOSCO) — detail procedures and mechanisms by which the SEC and its counterparts can collect and share investigatory information where there are suspicions of a violation of either jurisdiction’s securities laws, and after a potential problem has arisen.

In contrast, the SEC’s supervisory cooperation arrangements generally establish mechanisms for continuous and ongoing consultation, cooperation and the exchange of supervisory information related to the oversight of globally active firms and markets. Such information may include routine supervisory information as well as the types of information regulators need to monitor risk concentrations, identify emerging systemic risks, and better understand a globally-active regulated entity’s compliance culture. These MOUs also facilitate the ability of the SEC and its counterparts to conduct on-site examinations of registered entities located abroad.

Although they are designed to achieve different things, enforcement and supervisory cooperation arrangements are complimentary tools. Supervisory cooperation involves ongoing sharing of information regarding day-to-day oversight of regulated entities. Enforcement cooperation MOUs, by contrast, help the Commission collect information abroad that is necessary to help ensure that the SEC’s enforcement program deters violations of the federal securities laws, while also helping to compensate victims of securities fraud when possible.

The ESMA memorandum may be found here and the CIMA memorandum here.

Thursday, March 22, 2012

Congress Clears STOCK Act on Federal Official Insider Trading for Presidential Signature

The Senate has passed, by a 96-3 vote, and cleared for the President the Stop Trading on Congressional Knowledge (STOCK) Act, S 2038, barring members of Congress and their staffs, as well as executive branch and judicial branch officials and their staffs, from trading on inside information they obtain as part of the job and that is not readily available to the public. The House earlier passed the legislation by a vote of 417-2. The Act provides that no federal government official may use nonpublic information that they learn about by virtue of their office for the purpose of trading and making a profit in the securities or commodities markets.

In a Statement of Policy, the Obama Administration strongly supported passage of S 2038. The Administration said that the legislation makes it clear that Members of Congress may not engage in insider trading and will help to limit the corrosive influence of money in politics and ensure that the Congress is playing by the same set of rules as everyone else, an important component of the President’s Blueprint for an America Built to Last. (Statement of Administration Policy, Jan. 30, 2012)

S 2038 clarifies that Members and employees of Congress are subject to the prohibitions arising under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5, including the prohibition on insider trading. In particular, it makes clear that Members and employees of Congress owe a duty arising from their position of trust and confidence not to use nonpublic information obtained by virtue of their position for personal benefit. It also requires reporting of various transactions, including purchases and sales of stock, within 30 days.

In addition, the Administration observed that S 2038 requires the Comptroller General in consultation with the Congressional Research Service to prepare a report for submission to the Congress on the role of political intelligence in the financial markets. This report would address, among other things, the effects of the sale of political intelligence on the financial markets, related legal and ethical considerations, and the merits of imposing disclosure requirements on those who engage in political intelligence activities.

The Act provides that the insider trading ban applies to all legislative, executive and judicial branch officials and their staffs. All three branches should be held to the same standard because all three branches must be worthy of the public’s trust, said House Judiciary Committee Chair Lamar Smith (R-TX). Cong. Record, Feb. 9, 2012, p. H649.

The dispute over the applicability of insider trading laws to Congress centers largely on the issue of whether Congress owes a legally enforceable fiduciary duty to the source from which they receive material, non-public information. The Stop Trading on Congressional Knowledge (STOCK) Act makes it explicit that Members and staff owe such a duty under the federal securities laws. A floor amendment offered by Senator Richard Shelby (R-Ala) extending the prohibition on insider trading to the executive branch and independent agencies was approved by a 58-41 vote; and was retained in the final version. The House added the judicial branch to the legislation.

While members of Congress and other federal officials are not exempt from the federal securities laws, including prohibitions on insider trading, it was unclear if there existed a fiduciary duty to the United States. Misappropriating information gained through an employment relationship is illegal, but there is conflicting case law on whether members of Congress actually constitute employees of the federal government. The Act establishes a fiduciary duty against insider trading by all three branches of government. The Act authorizes the SEC, CFTC and Department of Justice to bring and prosecute insider trading cases throughout the federal government.

Specifically, the legislation provides that, for purposes of insider trading prohibitions under the Securities Exchange Act, the prohibition against Members of Congress and employees of Congress, and executive and judicial branch employees, using inside information for personal benefit states a duty of trust and confidence. The Act authorizes the SEC to issue regulations implementing the legislation and otherwise ensuring that Members and staff are subject to insider trading prohibitions. Nothing in the Act diminishes an existing legal obligation of Members and staff and makes clear that the STOCK Act does not limit or otherwise alter existing securities laws.

S 2308 also makes conforming changes to the Commodity Exchange Act to ensure that the insider trading prohibitions under that Act apply.

The legislation amends Section 21A of the Securities Exchange Act to provide that persons covered by the legislation may not purchase securities that are the subject of an initial public offering in any manner other than is available to members of the public generally. This provision prevents federal officials from receiving special early access to securities IPOs, which can result in significant profits for the well connected.

The legislation enhances financial disclosure rules for federal public officials. Financial disclosure forms will be made publicly available in searchable, downloadable databases on government websites.

The Act also requires prompt reporting, within 30 days, of significant securities transactions by key federal officials and employees in order to bring the financial dealings of public servants into the light of day. According to Senator Joseph Leiberman (D-CT), the SEC has indicated that that kind of required disclosure of securities trades will help the Commission ensure that insider trading laws are not being violated. Cong. Record, Feb. 2, 2012, S299.

A number of political intelligence firms obtain inside information from members of Congress and their staffs and sell that information to investment firms.
The House removed a provision in S 2038 requiring political intelligence practitioners to disclose their activities for the first time and make them adhere to the same registration requirements of lobbyists. This provision was added to the legislation by Senator Charles Grassley (R-Iowa) and was approved by a vote of 60-39 in the Senate. The House version of S 2038 replaced the Grassley Amendment with a study of the industry, which is in the final legislation.

The Act requires the GAO to submit a report to Congress that must include a discussion of what is known about the prevalence of the sale of political intelligence and the extent to which investors rely on such information, as well as the effect that the sale of political intelligence may have on the financial markets. The report must also detail the extent to which information which is being sold would be considered inside information, as well as the legal and ethical issues that may be raised by the sale of political intelligence. The report must also list any benefits from imposing disclosure requirements on those who engage in political intelligence activities; and the legal and practical issues that may be raised by the imposition of disclosure.

For purposes of the study, the Act defines political intelligence as information that is derived by a person from direct communications with an executive branch employee, a Member of Congress, or an employee of Congress; and provided in exchange for financial compensation to a client who intends, and who is known to intend, to use the information to inform investment decisions.

The House also removed an amendment sponsored by Senator Patrick Leahy (D-VT) that would have amended the US criminal code to give prosecutors new tools to identify and prosecute corruption by public officials. The Leahy Amendment is not in the final legislation.

The Act prevents Fannie Mae and Freddie Mac from paying lucrative bonuses to their executives who bear so much responsibility for the housing crisis.

Washington State Proposes Mortgage Paper Securities Amendments

Rules providing an optional method for registering mortgage paper securities were proposed for amendment by the Washington Department of Financial Institutions. The rules as amended would strengthen investor suitability requirements, revise the calculation of the number of investors that may participate in a loan, establish requirements for participation agreements, revise net worth and bonding requirements, revise provisions regarding escrow accounts and escrow agreements, establish requirements for servicing agreements, codify the requirement for a disclaimer in advertisements, clarify the fiduciary duties of a mortgage broker-dealer, include additional “dishonest and unethical practices” in WAC 460-33A-090, clarify the requirements for appraisals, clarify investors’ rights to receive information and access records concerning their investments, and update recordkeeping requirements in WAC 460-33A-115.

Interested persons may submit written comments about the proposals to Jill Vallely at

Senate Passes JOBS Act, But With New Title III on Crowdfunding

The Senate passed the Jumpstart Our Business Startups JOBS Act, HR 3606, 73-26, but with a significant amendment by Senator Jeff Merkley (D-OR) that inserted a new Title III on crowdfunding that is different from the House version of Title III. The Jumpstart Our Business Startups (JOBS) Act, HR 3606, reduces the costs of going public by providing companies with a temporary reprieve from SEC regulations by phasing in certain regulations over a five‐year period, thereby allowing smaller companies to go public sooner. The measure also removes an SEC regulatory ban preventing small businesses from using advertisements to solicit investors. HR 3606 would also remove SEC restrictions that prevent crowdfunding so entrepreneurs can raise equity capital from a large pool of small investors.

Moreover, the legislation amends SEC Regulation A, increasing the offering threshold for companies exempted from SEC registration from $5 million to $50 million. The legislation also removes barriers to capital formation for small companies by raising the shareholder registration requirement threshold from 500 to 1,000 shareholders. Similarly, the legislation increases the number of shareholders permitted to invest in a community bank from 500 to 2,000 without triggering SEC filing duties.

The Merkley Amendment would, among other things, require crowdfunding intermediaries to register with the SEC as a broker or a funding portal. The House version of Title III does not require such registration or even envision it.

Title I of the legislation is the Reopening American Capital Markets to Emerging Growth Companies Act, which is designed to promote job creation and further economic growth by making it easier for more companies to access capital markets by reducing the cost of going public for small and medium size companies. The measure, co-authored by Rep. Stephen Fincher (R-TN) and Rep. John Carney (D-DE), would create a new category of issuer, the emerging growth company, which would retain that status for five years or until it exceeds $1 billion in annual gross revenue or becomes a large accelerated filer. H.R 3606 ensures investors are protected by requiring emerging growth companies to provide audited financial statements as well as establishing and maintaining internal
controls over financial reporting.

The Act would allow emerging growth companies to defer compliance with Section 404(b) of the Sarbanes-Oxley Act until the company is no longer considered an emerging growth company. The exemption from Section 404(b) would delay the hiring of an additional outside auditor to verify the company's internal controls for the five year on ramp period.Section 404(b) requires the company's auditor to report on and attest to management's assessment of the company's internal controls.

Title II of HR 3606 is the Access to Capital for Job Creators Act, authored by Rep. Kevin McCarthy, (R-CA), which would remove the prohibition against general solicitation or advertising on sales of non-publicly traded securities, provided that all purchasers of the securities are accredited investors.

The Securities Act requires that any offer to sell securities either be registered with the SEC or meet an exemption. Rule 506 of Regulation D is an exemption that allows companies to raise capital as long as they do not market their securities through general solicitations or advertising. This prohibition on general solicitation and advertising has been interpreted to mean that potential investors must have an existing relationship with the company before they can be notified that unregistered securities are available for purchase. Congress believes that requiring potential investors to have an existing relationship with the company significantly limits the pool of pool of potential investors and severely hampers the ability of small companies to raise capital and create jobs.[H. Rep. No. 112-263]

The legislation would allow small companies offering securities under Regulation D to utilize advertisements or solicitation to reach investors and obtain capital. The SEC’s ban on solicitation, first adopted in 1982, limits the pool of potential investors and hampers the ability of small companies to raise capital.

Title IV is the Small Company Formation Act, authored by Rep. David Schweikert (R-AZ), which would increase the offering threshold for companies exempted from SEC registration under Regulation A from $5 million to $50 million. The SEC has the authority to raise this threshold but has not done so for almost two decades. Congress believes that amending Regulation A to make it a viable channel for small companies to access capital will permit greater investment in these companies, resulting in economic growth.

Title V of the Act is the Private Company Flexibility and Growth Act, authored by Rep. David Schweikert (R-AZ), which increases the number of shareholders that can invest in a private company from 500 to 2,000, only 500 of which can be non-accredited investors, with 1500 having to be accredited investors as defined by the SEC. Originally, Title V raised the 500-shareholder threshold to 1000. The threshold was raised to 2000 pursuant an amendment offered by Rep. Brad Miller (D-NC).

GAO Submits Interim Report on SIPC Madoff Liquidation Proceeding

In an interim report, the GAO determined that the Securities Investor Protection Corporation (SIPC) generally followed its past practices in selecting the trustee for the Bernard Madoff liquidation. SIPC maintains a file of trustee candidates from across the country, but given the anticipated complexities of the case, officials said the field of potential qualified trustees was limited. SIPC has sole discretion to appoint trustees and, wanting to act quickly, SIPC senior management considered four trustee candidates.

After three of the four candidates were eliminated for reasons including having a conflict of interest or ongoing work on a large financial firm failure, SIPC selected Irving H. Picard, who has considerable securities and trustee experience. However, SIPC has not documented a formal outreach procedure for identifying candidates for trustee and trustee’s counsel, or documented its procedures and criteria for selecting persons for particular cases, as internal control standards recommend. Having such documented procedures could allow SIPC to better assess whether it has identified an optimal pool of candidates, and to enhance the transparency of its selection decisions, stated the GAO.

The report noted that a key goal of broker-dealer liquidations is to provide customers with the securities or cash they had in their accounts. However, because the Trustee determined that amounts shown on Madoff customers’ statements reflected years of fictitious investments and profits, he chose to determine customers’ net equity using the “net investment method” (NIM), which values customer claims based on amounts invested, less amounts withdrawn. SIPC senior management and officials of the SEC, which oversees SIPC, initially agreed on the appropriateness of NIM. Over the course of 2009, however, SEC officials continued to consider alternative approaches for reimbursing customers.

Although some customers have challenged the Trustee’s use of NIM, two courts have held that the Trustee’s approach is consistent with the law and with past cases, with both courts indicating that using the values shown on customers’ final statements would effectively sanction the Madoff fraud and produce “absurd” results. In November 2009, SEC commissioners voted to support the use of NIM, but with an adjustment for inflation, in an approach known as the “constant dollar” method. However, after an SEC official’s conflict of interest was made public in February 2011, the SEC Chairman directed SEC staff to review whether the commission should revote on the constant dollar approach. The matter is currently pending.

As of October 2011, costs of the Madoff liquidation reached more than $450 million, and the Trustee estimates the total costs will exceed $1 billion by 2014. Legal costs, which include costs for the Trustee and the trustee’s counsel, are the largest category. While the estimated total cost for the Madoff liquidation is double the total for all completed SIPC cases to date, the Trustee, SIPC, and SEC note that the costs reflect the unprecedented size, duration, and complexity of the Madoff fraud. SIPC senior management also said the liquidation costs are justified, as litigation the trustee has pursued has produced $8.7 billion in recoveries for customers to date.

Through various reports, court filings, and a website, the Trustee has disclosed information about the status of the liquidation. SIPC senior management, SEC officials, and the U.S. Bankruptcy Court have concluded that the Trustee’s disclosures sufficiently address the requirements for disclosure under the Bankruptcy Code and the Securities Investor Protection Act.

The GAO recommended that the SEC should advise SIPC to (1) document its procedures for identifying candidates for trustee or trustee’s counsel, and in so doing, to assess whether additional outreach efforts should be incorporated, and (2) document a process and criteria for appointment of a trustee and trustee’s counsel. SEC and SIPC concurred with the recommendations.

Wednesday, March 21, 2012

House Financial Services Committee Details HR 3606 Investor Protections

As the Senate considers the JOBS Act, the House Financial Services Committee issued a report detaiing the numerous investor protections in the Act in both the on ramp and crowdfunding titles. Although emerging growth companies would benefit from certain temporary exemptions under H.R. 3606, the majority of compliance obligations associated with public company status are still applicable during the on-ramp transition period. For example, on-ramp companies that are listed on a national securities exchange must have a majority of independent members on their boards of directors, just as large companies do. They are also required to provide management discussion and analysis and executive compensation disclosure.

A on ranp company’s certifying officers can be held personally liable for any untrue statement of material fact or material omission necessary to ensure that statements contained in the reports or other statements to the SEC are not misleading. Also, Sections 11 and 12 of the Securities Act still impose liability for any material misstatements or omissions made in connection with registered offerings conducted under the Securities Act.

Section 5(b)(1) of the Securities Act prohibits the use of any prospectus that does not satisfy SEC requirements. In addition, Section 5(b)(2) of the Securities Act prohibits any registered sale of a security unless the security is preceded or accompanied by a prospectus that satisfies SEC requirements.

Further, under Section 13(a)(2) of the Exchange Act, companies must, within 90 days of the end of each fiscal year, file with the SEC annual reports that include: Audited Financial Statements; Description of the Company’s Business; Market Information; and a description of the company’s Corporate Governance Policies.

On ramp companies must also maintain an audit committee and retain an independent auditor and will have a duty to deliver poxy statements. Like other public companies. emerging growth companies must comply with Regulation FD’s prohibition on selective disclosure of material nonpublic information.

On ramp companies must still comply with Section 404(a) of Sarbanes-Oxley and,thus, Certifying officers are responsible for establishing, designing and maintaining effective internal controls, must annually assess and report on the effectiveness of the internal controls, and must disclose any change in the company’s internal controls in annual and quarterly reports.

Former Fed Chair Volcker and former US Comptroller Bowsher Endorse Mandatory Audit Firm Rotation

At a PCAOB roundtable on auditor independence, Former Federal Reserve Board Chair Paul Volcker endorsed mandatory audit firm rotation, noting that the audits of company financial statements should not become a long-term annuity for the audit firm. It must be remembered that the true client of the firm is the investing public, he emphasized. While conceding a reluctance to disrupt relationships between company and auditor, the former Fed Chair said that audit firm rotation would be a powerful incentive for professional discipline since the audit firm would know that its work would be looked at by another audit firm.

Also supporting auditor rotation, former US Comptroller General Charles Bowsher noted that the first consideration is that there is an inherent conflict of interest when the corporate client pays the audit fees to the firm auditing its financial statements. The challenge is how to address the conflict and enhance auditor independence. Sarbanes-Oxley Act has been successful in enhancing audit independence in small and medium sized companies, he noted, but not as successful with the largest companies.

It is overdue for SEC and PCAOB to consider post-Sarbanes-Oxley auditor independence measures. He recommended that any mandatory audit firm rotation begin by limiting rotation to the 40-50 largest companies, including largest financial institutions, who are clients of the Big Four audit firms, which would help obviate concerns about increased costs. He praised the comment letter of John Biggs to the PCAOB as showing a need for the periodic rotation of audit firms.

According to the former Comptroller, the two main benefits of audit firm rotation are an incentive to resist management pressure and a fresh viewpoint. The downside of a steep learning curve can be addressed by requiring a dual audit in the last year of the audit term and by requiring the outgoing audit firm to submit a report on the overall condition of financial statements and the system of internal controls. Mr. Bowsher dismissed the concern that mandatory rotation is disruptive to audit firms by noting that the independent look is more important. He also noted that if mandatory rotation is limited to the top 40-50 companies, the Big Four would lose one or two clients a year and pick up one or two.

The former Comptroller endorsed a letter to the PCAOB from John Biggs, former Chair of TIAA-CREF, stating that mandatory auditor rotation produces a kind of real time peer review. The outgoing auditor wants the work papers to be complete and of high quality with all problems clearly resolved, said Mr. Biggs, while the new firm reviews them and could either challenge their results, or start with fresh eyes.

Former SEC Chair Richard Breeden, while not taking a definitive position on mandatory audit firm rotation, agreed with Mr. Bowsher that mandatory rotation should begin with the largest companies. He said that mandatory rotation will benefit some companies and harm others. The issue of auditor concentration is important, he said. For both companies and their audit committees, the lack of competitive choices limits them. Chairman Volcker noted that you do not have a problem of auditor concentration with small and medium-sized companies, adding that they have a number of audit firms to select from.

Tuesday, March 20, 2012

European Commission Proposes New EU Securities Settlement Regime

As part of its ongoing efforts to create a sounder financial system, the European Commission has proposed a common EU regulatory framework for the institutions responsible for securities settlement, called Central Securities Depositories (CSDs). The proposal will bring more safety and efficiency to securities settlement in Europe. It also seeks to shorten the time it takes for securities settlement and to minimize settlement fails.

Commissioner for Internal Market Michel Barnier is committed to ensuring that all financial markets are properly regulated and supervised. He said that settlement is a crucial process for the securities markets and the financing of the economy, and as such its safety and efficiency needs to be ensured. The proposal will introduce, in line with international partners, common standards across the EU for securities settlement and CSDs to ensure a true single market for the services provided by national CSDs.

Settlement is an important process, which ensures the exchange of securities against cash following a securities transaction, for instance an acquisition or a sale of securities). CSDs are systemically important institutions for the financial markets because they operate the infrastructures, the securities settlement systems, that enable the settlement of virtually all securities transactions. CSDs also track how many securities have been issued, by whom, and each change in the holding of such securities. CSDs are still regulated only at the national level, and cross-border settlement is less safe and efficient than domestic settlement.

Specifically, the Commission proposes to harmonize the settlement period and set at a maximum of two days after the trading day for the securities traded on stock exchanges or other regulated markets, Currently, two to three days are necessary for most securities transactions in Europe. In addition, market participants that fail to deliver their securities on the agreed settlement date will be subject to penalties, and will have to buy those securities in the market and deliver them to their counterparties. Further, issuers and investors will be required to keep an electronic record for virtually all securities, and to record them in CSDs if they are traded on stock exchanges or other regulated markets.

For their part, the CSDs would have to comply with strict organizational, conduct of business and prudential requirements to ensure their viability and the protection of their users. They will also have to be authorized and supervised by their national regulators. Authorized CSDs will be granted a passport to provide their services in other Member States; and users will be able to choose between all 30 CSDs in Europe. In turn, EU CSDs would have access to any other CSDs or other market infrastructures such as trading venues or Central Counterparties (CCPs), whichever country they are based in.

The proposal now passes to the European Parliament and the Council for negotiation and adoption. CSDs may be subject to the rules of the MiFID Directive for certain services they provide, such as the provision of securities accounts and, possibly, collateral management services. It would be for the European Parliament and the Council to decide, in the context of the current review of MiFID, whether, similarly to banks, CSDs should be exempted from certain rules of MiFID.

Senate Will Act on House Version of STOCK Act

Senate Majority Leader Harry Reid (D-NV) has moved to accept the House version of the Stop Trading on Congressional Knowledge (STOCK) Act, S 2038. The House passed the legislation barring members of Congress from profiting on inside information they obtain as part of the job and that is not readily available to the public. The vote was 417-2. A different version of the legislation earlier passed the Senate by a vote of 96-3.

The dispute over the applicability of insider trading laws to Congress centers largely on the issue of whether Congress owes a legally enforceable fiduciary duty to the source from which they receive material, non-public information. The Stop Trading on Congressional Knowledge (STOCK) Act, S 2038, makes it explicit that Members and staff owe such a duty under the federal securities laws. A floor amendment offered by Senator Richard Shelby (R-Ala) extending the prohibition on insider trading to the executive branch and independent agencies was approved by a 58-41 vote; and was retained in the House version.

Specifically, the legislation provides that, for purposes of insider trading prohibitions under the Securities Exchange Act, the prohibition against Members of Congress and employees of Congress using inside information for personal benefit states a duty of trust and confidence. HR 2038 authorizes the SEC to issue regulations implementing the legislation and otherwise ensuring that Members and staff are subject to insider trading prohibitions. Nothing in the Act diminishes an existing legal obligation of Members and staff and makes clear that the STOCK Act does not limit or otherwise alter existing securities laws.

HR 2308 also makes conforming changes to the Commodity Exchange Act to ensure that the insider trading prohibitions under that Act apply.

The House bill, but not the Senate, amends Section 21A of the Securities Exchange Act to provide that persons covered by the legislation may not purchase securities that are the subject of an initial public offering in any manner other than is available to members of the public generally.

The House removed a provision in S 2038 requiring political-intelligence practitioners to disclose their activities for the first time and make them adhere to the same registration requirements of lobbyists. This provision was added to the legislation by Senator Charles Grassley (R-Iowa) and was approved by a vote of 60-39The House legislation replaces Grassley’s disclosure requirements with a study of the industry.

The HOuse also removed an amendment sponsored by Senator Patrick Leahy (D-VT) Leahy, that would have amended the US criminal code to give prosecutors new tools to identify, investigate, and prosecute criminal conduct by public officials.

Maryland Federal Judge Says Demand Not Excused on Directors Who Failed to Rescind Compensation Package after Negative Say on Pay Vote

A federal judge (DC Md) has ruled that demand was not excused as futile in a shareholder derivative action simply because board members and the compensation committee participated in the decision to go forward with an executive compensation plan after the plan was rejected in a shareholder advisory vote. Although it can be reasonably argued that a say on pay vote provided the board an opportunity to reconsider its decision regarding executive compensation, conceded the court, it should not be seen as the equivalent of a pre-suit demand. (Weinberg v. Gold, DC Maryland, Civil No. JKB-11-3116, March 12, 2012)

Applying the Maryland common law standard on demand futility, the court said that, although a say on pay vote may be considered as a factor in the demand futility analysis, it was not conclusive in this case. A shareholder advisory vote is fundamentally different from a demand for litigation, explained the court, with the former producing unfavorable publicity, but not inevitably resulting in a lawsuit. The latter is much more likely to result in a lawsuit if the shareholder concerns are not resolved.

The shareholder cited a say on pay decision from the Southern District of Ohio in which the court found demand futile because the directors devised the challenged executive compensation, approved the compensation, recommended shareholder approval of the compensation, and suffered a negative shareholder vote on the compensation, thus establishing reason to doubt that the challenged transaction was the result of a valid business judgment. (NECA-IBEW Pension Fund ex rel. Cincinnati Bell, Inc. v. Cox, SD Ohio, Sept. 20, 2011).

The court noted that the Ohio case was analyzed under Ohio and Delaware standards for demand futility, neither of which is comparable to the Maryland standard. Under Ohio law, according to Cincinnati Bell, demand is presumptively futile where the directors are involved in the transactions attacked. But in Maryland, however, mere involvement by directors in the challenged transaction does not excuse demand. The Delaware standard was previously noted to focus on the merits of the transaction at issue, contrary to the standard set forth in the leading Maryland case, which eschewed consideration of the merits in analyzing demand futility. Thus, the Cincinnati Bell case was not persuasive.

The court also rejected the shareholder’s contention that the directors exhibited antipathy towards the relief being sought by recommending approval of the executive compensation plan and then failing to rescind their decision following the say on pay vote. This reason falls within the category of generalized or speculative allegations that the directors would be hostile to the action, which the leading Maryland case considered inadequate to excuse demand.

Similarly rejected was the contention that the company has not sought recovery of the
amounts the shareholder believes ought to be recovered. This is only marginally different from the allegation that the board has not rescinded its approval of the executive compensation plan, noted the court, or the allegations that the board’s actions are not the result of a valid business judgment, noted the court, neither of which is sufficient to excuse demand under the Maryland standard.

Stanford Fraud Schemes May Proceed in State Court

A 5th Circuit panel held that investors can proceed with state class actions arising from the Allen Stanford fraud scheme. The appellate court held that the Securities Litigation Uniform Standards Act did not bar the state actions.

According to the 5th Circuit panel, the preclusion analysis under SLUSA is slightly more complex in cases where the fraudulent scheme alleged involves a multi-layered transaction. In these cases, the plaintiffs often are fraudulently induced into investing in some kind of uncovered security, like a CD or a share in a “feeder fund,” which has some relationship either through the financial
product’s management company or through the financial product itself to transactions (real or purported) in covered securities, such as stocks.

The court stated that the proper standard for "in connection with" analysis in Uniform Standards Act cases was whether “there is a relationship in which the fraud and the stock sale coincide or are more than tangentially related." The court determined that the purchase or sale of securities was only “tangentially related” to the Stanford fraud. The fact that the instruments in question may have been marketed as backed by Uniform Standards Act covered securities did not meet the "more than tangentially related" standard. Similarly, the fact that some investors may have liquidated covered securities in their retirement accounts to fund their Stanford investments was not determinative, because these sales were not a necessary part of the fraud.

Roland v. Green, Dkt. No. 11-10932.

Dutch Corporate Governance Watchdog Examines Proxy Advisory Services

Against the backdrop of a growing global consensus on the regulation of proxy advisory firms, a Dutch watchdog group that monitors the Netherlands Corporate Governance Code examined how and to what extent large institutional investors use proxy advisory services. This was part of an overall review of the Code, which contains a best practice providing that shareholders must vote as they see fit. Shareholders who make use of the voting advice of a third party are expected to form their own judgments on the voting policy of the adviser and the voting advice provided by the adviser.

Proxy advisory firms are typically retained by mutual fund and hedge fund asset managers, pension plans, and other institutional investors to provide voting recommendations and otherwise assist in voting by these institutional investors, which range widely in size of assets under management.

The survey by the Monitoring Committee of the Dutch Corporate Governance Code revealed that the influence of proxy advisory services is perhaps not as great as the overall picture suggests. Foreign asset managers indicate that they use proxy advisory services mainly to gather information they can take into account when making their own decision on how to vote. They also state that they do not always subscribe to the voting advisory services and instead confine themselves to the proxy service. If they do subscribe to the voting advisory service, this is often done on the basis of a customized voting policy under which the voting advice is based not only on the internal policy guidelines of the proxy advisory service but also on the specific guidelines for casting a vote on behalf of the investor.

The Committee cautioned that the sample included institutional investors that pursue a more active or activist investment policy and should for this reason be regarded as less inclined to rely blindly on proxy advisory services. The Committee suspects that more passive investors and smaller investors do less research of their own and tend to rely more on the advice of the proxy advisory services, possibly using information available on the websites of the services. Nor has the nature of the customized voting policies been examined in more depth.

To what extent such policies take account of provisions that are specific to the Dutch Corporate Governance Code is as yet unclear. Based on the interviews it held, the Committee perceived a trend in which investors are becoming more aware of their own responsibility for deciding how to vote. The Committee intends to carry out a follow-up survey next year into the role of proxy advisory services in order to obtain a more complete picture of how they influence voting at general meetings of shareholders in the Netherlands.

The Committee noted, incidentally, that only a small number of proxy advisory services give advice relating to Dutch companies. The capacity for advising on Dutch companies is limited, but is supplemented by better equipped organizations or departments of some large Dutch institutional investors, Eumedion and the Association of Stockholders (VEB).

In the US, comments received by the SEC on its proxy voting concept release reveal a growing consensus in the corporate community that proxy advisory firms should be subject to federal regulation requiring greater transparency and accountability with respect to the formulation of voting recommendations and potential conflicts of interest.

The Shareholder Communications Coalition has asked the SEC to erect a regulatory framework for firms providing proxy advisory services to institutional investors in connection with annual or special shareholder meetings. The Coalition is composed of the Business Roundtable, National Investor Relations Institute, and the Society of Corporate Secretaries & Governance Professionals.

In a letter to the SEC, the Coalition urged the Commission to adopt regulations on conflicts of interest by proxy advisory firms, disclosure by these firms regarding the standards, procedures, and methodologies used to formulate voting recommendations, and the correction of factual errors in the information used by these firms to develop their recommendations. The Coalition also asked the SEC to consider requiring proxy advisory services to register as investment advisers under the Investment Advisers Act.

Monday, March 19, 2012

GAO Report Reveals How Defined Benefit Plans Meet Challenges of Hedge and Private Equity Fund Investing

A GAO report reveals that most defined benefit plans have taken actions to address challenges related to their investments in hedge funds and private equity funds, including such steps as allocation reductions, modifications of investment terms, and improvements to the fund selection and monitoring process. Plan managers have also taken steps to improve investment terms, including more favorable fee structures and enhanced liquidity. However, smaller plans would likely not be able to take some of these steps.

The Department of Labor has provided some guidance to plans regarding investing in derivatives, but has not taken any steps specifically related to hedge fund and private equity investments. In recent years, however, other entities have addressed this issue. For example, in 2009, the President’s Working Group on Financial Markets issued best practices for hedge fund investors. Further, both GAO and a Department of Labor advisory body have recommended that the department publish guidance for plans that invest in such alternative assets. To date, it has not done so, in part because of a concern that the lack of uniformity among such investments could make development of useful guidance difficult. In 2011, the Department of Labor advisory body specifically revisited the issue of pension plans’ investments in hedge funds and private equity, and a report is expected in early 2012.

Private sector pension plan investment decisions must comply with the Employee Retirement Income Security Act (ERISA), which sets forth fiduciary standards based on the principle of a prudent standard of care. Under ERISA, plan sponsors and other fiduciaries must act solely in the interest of the plan participants and beneficiaries and in accordance with plan documents; invest with the care, skill, and diligence of a prudent person familiar with such matters; and diversify plan investments to minimize the risk of large losses. Under ERISA, the prudence of any individual investment is considered in the context of the total plan portfolio, rather than in isolation.

The GAO found that most defined benefit plans have modified their investment strategies in recent years to make significant changes to their hedge fund or private equity strategies, and in some cases, reduced the overall allocation to hedge funds or private equity. Several plans have discontinued or reduced the use of certain hedge fund strategies. But shifting strategies did not mean that the plans abandoned hedge fund investments. Rather, they simply shifted to less aggressive hedge fund strategies.

In contrast to the general trend, some plans eliminated or substantially reduced their use of funds of hedge funds. However, the GAO concluded that funds of funds may be necessary for smaller pension plans and plans that lack well-developed internal investment and risk management that wish to invest in alternatives such as hedge funds and private equity.

Defined benefit plans have met some of the challenges of hedge fund investing and increased transparency and control through the use of separate accounts in place of commingled funds. Under a commingled hedge fund arrangement, the investor owns a certain number of shares in the fund, but the hedge fund manager determines what assets to invest in, and the partnership collectively owns the underlying assets.

In contrast, under a separate account, the hedge fund manager essentially serves as a consultant who manages the assets in a way that generally parallels the hedge fund itself, but the investor may specify investment guidelines that result in differences between the commingled hedge fund and separate account. Plan representatives cited multiple benefits of separate accounts, including precise knowledge of the nature of underlying assets, the ability to exclude certain assets in the commingled hedge fund from its share of the rest of the hedge funds assets, and much greater liquidity because plan sponsors own and can sell the underlying assets at will.

NASAA Considers Policy Statement on Business Development Companies

The Corporation Finance Section Committee of the North American Securities Administrators Association (NASAA) has informally solicited comments concerning the adoption of a new Statement of Policy Regarding Business Development Companies. Although specific proposals have not yet been developed, the Committee is requesting advance comments and suggestions from fellow regulators and members of the public. In particular, the Committee is seeking comments concerning whether NASAA should develop a Statement of Policy specifically tailored to offerings involving business development companies, or whether the existing Statements of Policy provide an adequate framework for these offerings.

Additionally, the Committee has requested comments regarding whether NASAA should revise the existing Statement of Policy Regarding Real Estate Investment Trusts. If so, the Committee has asked whether the Statement of Policy should adopt a standardized minimum offering requirement, and what standards should be used in assessing a minimum offering amount. The Committee has also asked for comments on the need to revise the following provisions:

- Suitability and concentration standards

- Provisions relating to Net Asset Value

- Provisions relating to non-GAAP financial measures

- Gross offering proceeds as a source to fund distributions

- Other provisions

Comments should be submitted via email to NASAA Deputy General Counsel Rick A. Fleming at on or before Monday, May 21, 2012. Comments will be forwarded to all members of the NASAA Corporation Finance Section Committee and Direct Participation Plan Project Group for consideration. If the Committee determines to move forward with specific proposals, they will be subject to additional internal and public comment in accordance with NASAA Policies and Procedures.

Senators Leahy and Grassley Call for Conference Committee to Reinsert Their Amendments into the STOCK Act

In a letter to Senate leaders, Senator Patrick Leahy (D-Vt.) and Senator Chuck Grassley (R-Iowa) urged the convening of a House-Senate conference committee on the congressional insider trading bill, the STOCK Act, to restore two key amendments to the legislation. Senator Leahy, Chair of the Judiciary Committee, wants the Senate to restore his amendment to give prosecutors new tools to identify, investigate, and prosecute criminal conduct by public officials. Senator Grassley, Ranking Member of the Judiciary Committee, wants a conference committee to renew his amendment requiring political intelligence agents to register as lobbyists. The Senate overwhelmingly passed both amendments but the House of Representatives’ version of the bill excluded the provisions.

Senators Leahy and Grassley wrote to the Senate Majority Leader Harry Reid (D-NV), and the Senate Minority Leader Mitch McConnell (R-KY), urging a conference committee to resolve the differences between the Senate and House bills or alternatively, the opportunity to offer their amendments if the Senate takes up the House bill instead of convening a conference committee.

The Stop Trading on Congressional Knowledge Act (STOCK Act) passed the Senate with these two critical provisions, which the Senators say would improve transparency and give law enforcement more effective tools to combat corruption. The Grassley Amendment requiring political intelligence agents to register as lobbyists would strengthens the STOCK Act by ensuring that lawmakers, congressional staff, and the public know who is feeding information to Wall Street. The Leahy Amendment would give prosecutors new tools to identify, investigate, and prosecute criminal conduct by public officials, and thereby further the STOCK Act’s goals of stopping public corruption and holding public officials accountable for wrongdoing.

Rhode Island Proposes Exemption for Private Fund Advisers

An exemption from investment adviser registration for private fund advisers was proposed by the Rhode Island Securities Division. A public hearing on the proposed rule will be held on April 19, 2012 at 10:00 a.m. at 1511 Pontiac Avenue, Cranston, Rhode Island 02920. Please submit written comments about the proposed rule to Dennis Murray at Comments must be received by April 19th, the date of the public hearing.

The text of the proposed rule is as follows:

Rule 204(3)-3 REGISTRATION EXEMPTION FOR INVESTMENT ADVISERS TO PRIVATE FUNDS. (A) DEFINITIONS. For purposes of this regulation, the following definitions shall apply:

(1) "Value of primary residence" means the fair market value of a person’s primary residence, subtracted by the amount of debt secured by the property up to its fair market value.
(2) Private fund adviser" means an investment adviser who provides advice solely to one or more private funds.
(3) "Private fund" means an issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940, 15 U.S.C. 80a-3, but for section 3(c)(1) or 3(c)(7) of that Act. Page 9 of 43
(4) "3(c)(1) fund" means a private fund that is excluded from the definition of an investment company under section 3(c)(1) of the Investment Company Act of 1940, 15 U.S.C. 80a-3(c)(1).
(5) "Venture capital fund" means a private fund that meets the definition of a venture capital fund in SEC Rule 203(l)-1, 17 C.F.R. § 275.203(l)-1.

Subject to the additional requirements of paragraph (c) below, a private fund adviser shall be exempt from the registration requirements of Section 203 of the Rhode Island Uniform Securities Act of 1990 ("RIUSA"), § 7-11-101 et seq. of the Rhode Island General Laws, 1989, as amended (the "RIUSA"), if the private fund adviser satisfies each of the following conditions:

(1) neither the private fund adviser nor any of its advisory affiliates are subject to a disqualification as described in Rule 262 of SEC Regulation A, 17 C.F.R. § 230.262;
(2) the private fund adviser files with the state each report and amendment thereto that an exempt reporting adviser is required to file with the Securities and Exchange Commission pursuant to SEC Rule 204-4, 17 C.F.R. § 275.204-4; and
(3) the private fund adviser pays the same fee as that specified for a federal covered adviser in Section 7-11-206(a)(5) of the RIUSA;

(C) ADDITIONAL REQUIREMENTS FOR PRIVATE FUND ADVISERS TO CERTAIN 3(C)(1) FUNDS. In order to qualify for the exemption described in paragraph (b) of this regulation, a private fund adviser who advises at least one (3)(c)(1) fund that is not a venture capital fund shall, in addition to satisfying each of the conditions specified in paragraphs (b)(1) through (b)(3), comply with the following requirements:

(1) The private fund adviser shall advise only those 3(c)(1) funds (other than venture capital funds) whose outstanding securities (other than short-term paper) are beneficially owned entirely by persons who, after deducting the value of the primary residence from the person’s net worth, would each meet the definition of a qualified client in SEC Rule 205-3, 17 C.F.R. § 275.205-3, at the time the securities are purchased from the issuer;

(2) At the time of purchase, the private fund adviser shall disclose the following in writing to each beneficial owner of a 3(c)(1) fund that is not a venture capital fund:

(A) the fund, rather than the individual beneficial owners, is the investment adviser’s client;
(B) all services, if any, to be provided to individual beneficial owners;
(C) all duties, if any, the investment adviser owes to the beneficial owners;
(D) any other material information affecting the rights or responsibilities of the beneficial owners.

(3) The private fund adviser shall obtain on an annual basis audited financial statements of each 3(c)(1) fund that is not a venture capital fund, and shall deliver a copy of such audited financial statements to each beneficial owner of the fund.

(D) FEDERAL COVERED INVESTMENT ADVISERS. If a private fund adviser is registered with the Securities and Exchange Commission, the adviser shall not be eligible for this exemption and shall comply with the state notice filing requirements applicable to federal covered investment advisers in Section 203 of the RIUSA.

(E) INVESTMENT ADVISER REPRESENTATIVES. A person is exempt from the registration requirements of Section 203 of the RIUSA if he or she is employed by or associated with an investment adviser that is exempt from registration in this state pursuant to this regulation and does not otherwise act as an investment adviser representative.

(F) ELECTRONIC FILING. The report filings described in paragraph (b)(2) above shall be made electronically through the IARD. A report shall be deemed filed when the report and the fee required by Section 7-11-206(a)(5) of the RIUSA are filed and accepted by the IARD on the state's behalf.

(G) TRANSITION. An investment adviser who becomes ineligible for the exemption provided by this rule must comply with all applicable laws and rules requiring registration or notice filing within ninety (90) days from the date the investment adviser’s eligibility for this exemption ceases.

(H) GRANDFATHERING FOR INVESTMENT ADVISERS TO 3(C)(1) FUNDS WITH NON-QUALIFIED CLIENTS. An investment adviser to a 3(c)(1) fund (other than a venture capital fund) that is beneficially owned by one or more persons who are not qualified clients as described in subparagraph (c)(1) may qualify for the exemption contained in paragraph (b) of this regulation if the following conditions are satisfied:

(1) the subject fund existed prior to the effective date of this regulation; and,
(2) as of the effective date of this regulation, the subject fund ceases to accept beneficial owners who are not qualified clients, as described in subparagraph (c)(1) of this regulation.