Friday, September 29, 2017

ALJ says Enforcement Division case against Tilton unproven

By Mark S. Nelson, J.D.

An SEC administrative law judge has dismissed the Enforcement Division’s in-house case against Lynn Tilton. The agency had alleged that Tilton and her firm Patriarch Partners, LLC ran afoul of the Investment Advisers Act’s antifraud provisions as a result of disclosure issues and accounting irregularities regarding collateralized loan obligations (CLOs). But the ALJ concluded after a lengthy hearing that the Division’s allegations were unproven (In the Matter of Lynn Tilton, Release No. ID-1182, September 27, 2017).

Tilton and Patriarch had set up a series of entities that were either investment advisers or relying investment advisers to act as collateral managers for three funds designated Zohar I, II, and III. The funds consisted of CLOs and issued notes to investors whose funds were then used to buy or to make loans to a portfolio of distressed companies. Investors included large institutions known as qualified institutional buyers or qualified purchasers, entities the ALJ would refer to as "...not, in the words of Commission Chairman Jay Clayton, ‘Mr. and Ms. 401(k)’" (referring to a speech Clayton gave outlining his principles of securities regulation).

Unique approach and star witness. During the 14-day hearing nearly a year ago, the ALJ heard testimony from nine experts: three for the Division and six for Tilton and Patriarch. The Division’s experts collectively opined that Tilton and Patriarch received $208 million in improper fees for a variety of reasons, including providing financials that were hard for investors grasp, employing a method of categorizing loans contrary to fund governing documents, and by deviating from GAAP accounting principles.

Three of Tilton’s and Patriarch’s experts focused on one Division expert’s opinion that Tilton did not "amend" loans when she accepted interest amounts below what was due under contract. Tilton’s and Patriarch’s experts said Tilton and her firm possessed wide discretion to modify loans to avoid defaults. One of these experts included a legal analyst for the Zohar II and III funds, who was accepted by the ALJ as an expert on interpretation of the Zohar indentures.

But Tilton and Patriarch also brought out the star power. R. Glenn Hubbard, Dean of Columbia University’s Graduate School of Business and former chairman of the President’s Council of Economic Advisers during the second Bush Administration, and who is often mentioned as a candidate for Fed chairman if Janet Yellen is not re-nominated, offered a set of four conclusions about the Zohar funds.

Hubbard agreed with another Tilton/Patriarch expert that the Zohar funds were atypical CLOs (the other expert had said the Zohar funds should be viewed through the lens of funds with Zohar-like characteristics, not a "typical CLO manager"). Hubbard also noted Tilton’s unique approach to investing in distressed properties and disputed a Division expert’s conclusions that some metrics were hard to replicate from fund valuation reports. Hubbard also disputed the completeness of calculations performed by a Division expert because they did not consider future periods.

Based on the testimony, the ALJ first concluded that items allegedly not disclosed to investors were disclosed and that Tilton and Patriarch had amended loan agreements. As a result, there was no material misrepresentation or omission of a material fact. The ALJ also found the Division’s GAAP allegations similarly unproven. For one, the facts did not support charges regarding impairment. Moreover, GAAP violations by themselves cannot establish securities fraud (the ALJ noted that even if Tilton and Patriarch violated GAAP, there was no material misrepresentation).

With respect to accounting standards for fair value, the ALJ observed that the types of assets Tilton and Patriarch dealt with were Level 3 assets because of the lack of observable inputs. Still, the ALJ concluded that the fund’s financial statements disclosed the variable nature of the fair value techniques employed by the funds.

Appointments clause. For a time, Tilton became one of the more prominent targets of SEC probes to challenge the constitutionality of in-house proceedings before the SEC’s ALJs. These cases were brought in multiple district courts around the U.S. and achieved some initial traction in a few court rooms only to falter in a series of appellate decisions denying access to the federal district courts to respondents seeking to halt the SEC’s proceedings. Tilton pursued her case until the Supreme Court declined to hear it.

But the Appointments Clause issue that Tilton and others had raised may yet find its way to the Supreme Court in one or more cases that followed the statutory scheme of the federal securities laws and, thus, present fewer vehicle issues than did the earlier district court cases. Currently, there is a split of authority between the D.C. Circuit (upholding the SEC’s ALJs and later producing a per curiamorder denying the respondent’s petition for review by an equally divided en banc court) and the Tenth Circuit (rehearing denied), which found the agency’s ALJs were appointed in violation of the Appointments Clause.

The respondent in the D.C. Circuit case petitioned the Supreme Court to decide whether prior circuit law correctly interpreted the Court’s Freytag decision, which had prompted a concurrence the circuit’s seminal Landry opinion upholding the FDIC’s ALJs against constitutional challenge. That petition is still pending. The Tenth Circuit case also could reach the Supreme Court if the government opts to appeal. As of publication, the government had received two extensions of time to file a certiorari petition, the most recent until September 29.

Alleged Division misconduct. The ALJ’s initial decision also rejected assorted claims by Tilton that the Division had engaged in prosecutorial misconduct. Tilton’s claims focused on the Division’s use of experts during the pre-OIP period before the agency brought formal charges against her, alleged failures to disclose information to Tilton, a concurrent engagement with Tilton’s only accounting firm in another matter, and alleged collusion between the Division and one of the fund’s investors in a related matter brought by the investor against Tilton.

The release is No. ID-1182.

Thursday, September 28, 2017

CFTC’s chief enforcer underscores benefits of self-reporting and cooperation in NYU address

By Brad Rosen, J.D.

CFTC Enforcement Director James McDonald reiterated and clarified the benefits that can accrue to commission registrants who elect to self-report violations and offer substantial cooperation in connection with regulatory investigations in an address he made before NYU’s Institute for Corporate Governance and Finance.

In his remarks, McDonald noted, "we at the CFTC are committed to working together with the companies and individuals we regulate to identify and prosecute wrongdoing that has occurred, and to stop future wrongdoing before it starts. In particular, we’re committed to giving companies and individuals the right incentives to voluntarily comply with the law in the first place—and to look for misconduct and report it to us when they see it." He continued, "[w]e know the vast majority of businesses and market participants want to obey the law. We know they work hard to do the right thing—not because they’re afraid of getting caught. But because they want to run their businesses the right way. These businesses know that misconduct within a company diminishes confidence in management. It undermines the company’s culture.

According to Gary DeWaal, special counsel in Katten Muchin Rosenman’s financial services group and long-time industry observer, the framework articulated by McDonald is a welcome development. "For many years, it has been the perception across the industry that there has been no reward for coming clean and bringing a problem to the attention of the agency. McDonald has made it clear there will be benefits for doing so," he noted.

However, DeWaal cautioned that industry participants must be mindful that self-reporting and cooperation may result in benefits with the CFTC, but exposures and liabilities relative to exchanges, foreign regulators, and the U.S. attorney may remain. Notwithstanding, DeWaal observed, "the CFTC has limited resources combined with an expanded mandate. This is a practical response to economic realities, and it is the right thing to do." To be sure, the CFTC has been encouraging registrants to embrace notions of cooperation and self-reporting for some time, even prior to McDonald’s appointment in March of this year. In January, the agency issued two advisories on cooperation that noted factors considered in providing cooperation credit to companies and individuals. In June, trader David Liew was able to completely avoid a civil monetary penalty for spoofing and manipulation in the gold and silver futures markets by providing "substantial assistance" to the enforcement division. Later that month, the CFTC entered into its first-ever Non-Prosecution Agreements (NPAs) with three former Citigroup traders who provided "timely and substantial cooperation" relating to their spoofing misconduct.

In August, McDonald noted that a $600,000 penalty imposed against The Bank of Tokyo-Mitsubishi for spoofing was a "substantially reduced penalty" in exchange for self-reporting and other cooperation. Later that month, McDonald was a guest on CFTC Talks, the recently introduced podcast hosted by Chief Market Intelligence Officer Andy Busch, where he touted the substantial benefits of self-reporting.

In his remarks, McDonald articulated specific details regarding the cooperation and self-reporting framework envisioned by the division and the benefits that could be expected including:
  • Disclosure must be truly voluntary. Cooperation must occur before an imminent threat of disclosure or of a government investigation and it must be made independent of any other legal obligation. A disclosure must also be made in a clear and prominent manner.
  • Disclosure must be made within a reasonable period of time. A company must make its disclosure in a reasonably prompt time after becoming aware of a problem and all relevant facts known at the time must be disclosed.
  • Cooperation must be complete and continue during the course of the investigation. The company must disclose all facts relevant to the misconduct as the company becomes aware of them during its own investigation—including facts related to the involvement of any individuals.
  • Cooperation must be proactive, not reactive. It’s not enough just to be responsive to Division staff during the course of an investigation. Full cooperation requires an active effort to find all related wrongdoing and not taking a squinty-eyed view of the facts to minimize the misconduct or avoid disclosures.
  • Remediation is required to ensure the misconduct doesn’t happen again. This means the company must work to fix the flaws in its compliance and internal controls programs that allowed the misconduct in the first place. The Division indicated it will work in tandem with companies to achieve remediation solutions.
  • Division of Enforcement commitments. The Division indicated it will clearly communicate with the registrant—at the outset—its expectations regarding self-reporting, cooperation, and remediation. The division noted that its self-reporting program is not going to be a game of gotcha—where only once you’re at the settlement table do you learn there’s been one slip up in the process that takes you out of the self-reporting lane.
  • Expected benefits to registrants. A registrant can expect concrete benefits in return for its self-reporting, cooperation, and remediation. If a company does those three things, the Division of Enforcement will recommend a substantial reduction in the penalty that otherwise would be applicable. In truly extraordinary circumstances, the Division may even recommend declining to prosecute a case.
In his conclusion, Director McDonald asserted that the self-reporting and cooperation program outlined should shift the incentive structure in favor of self-reporting and cooperation. If so, he believes great strides will have been made toward stopping misconduct in the markets.

Wednesday, September 27, 2017

Petition asks: Does American Pipe tolling also apply to class actions?

By Rodney F. Tonkovic, J.D.

A petition for certiorari askes the Supreme Court to address whether American Pipe tolls not just individual actions, but also class actions. The Ninth Circuit construed American Pipe to toll the limitations period for class action plaintiffs who were unnamed class members in previously uncertified classes. Unlike the Ninth Circuit, at least six others have held that American Pipe applies only to individual actions. A new class action brought by previously absent class members would have been dismissed as untimely in these circuits, the petition asserts (China Agritech, Inc. v. Resh, September 21, 2017).

Tolling permitted? This petition involves the third identical securities fraud class action brought by shareholders of the petitioner, China Agritech, Inc. Class certification for both previous actions was denied, and the respondents did not seek to participate as named plaintiffs or appear in those actions. The underlying action was filed in June 2014, seventeen months after the applicable two-year statute of limitations had lapsed. The district court dismissed the new complaint as time-barred. The judge, who also presided over the two earlier class actions, held that American Pipe tolling permitted the filing of new individual claims, but not an entirely new class action based on a substantially identical class.

On appeal, the Ninth Circuit reversed and held that the statute of limitations was tolled during the pendency of two prior class actions. Permitting unnamed class members in previously uncertified classes to avail themselves of American Pipe tolling "would advance the policy objectives that led the Supreme Court to permit tolling in the first place," the panel concluded. Further, the pendency of the prior actions would alert defendants to the substantive claims, so there would be no unfair surprise, and the rule promotes economy of litigation. The court acknowledged the possibility of abuse, but said that plaintiffs and attorneys would not risk bringing successive nonviable suits and that the ordinary principles of preclusion and comity would further reduce incentives to re-litigate frivolous or already dismissed class claims. The appellate court subsequently denied both rehearing and rehearing en banc.

The petition. The petition asks whether the American Pipe rule tolls statutes of limitations to permit a previously absent class member to bring a subsequent class action outside the applicable limitations period. The petition asserts that up to now, appellate courts have uniformly rejected attempts to extend American Pipe to permit absent class members to bring claims on behalf of a class. According to the petitioner, the First, Second, Third, Fifth, Eight, and Eleventh Circuits have held that American Pipe tolling does not apply to serial class actions, particularly when an attempt to certify a materially identical class has already been rejected. The Sixth, Seventh, and now the Ninth Circuits, however, have adopted rules that would extend the statute of limitations for class actions indefinitely, the petition says.

The petition explains that the First, Second, Fifth, and Eleventh Circuits flatly reject extending American Pipe tolling to otherwise untimely class actions. In these circuits, tolling only applies to the individual claims of absent class members. In some circumstances, the Third and Eight Circuits allow tolling for successive class actions, but not when class certification has previously been denied on the basis of the lead plaintiffs' deficiencies as class representatives.

The Sixth, Seventh, and Ninth Circuits, on the other hand, permit "endless relitigation" of class certification determinations, the petition claims. According to the petition, while the Sixth and Seventh Circuits generally extended American Pipe tolling to class actions, neither applied the rule in a case where certification of an identical class had already been denied. In this case, the Ninth Circuit has applied American Pipe where certification was denied, leaving "no limit to a plaintiff's ability to stack class actions" and inviting "endless, vexatious litigation" of the sort Congress intended to prevent in enacting statutes of limitations.

The petition concludes by arguing that the Ninth Circuit's decision is an ideal vehicle for resolving this recurring question of national importance. The Court's review is needed to eradicate opportunities for forum shopping and to establish uniformity. Moreover, the Ninth Circuit's decision is at odds with Supreme Court precedent holding that American Pipe applies to individual claims. Finally, there are adverse policy consequences to the Ninth Circuit's holding such as an essentially indefinite extension of the statute of limitations that would also make it much more difficult to timely settle disputes.

The petition is No. 17-432.

Tuesday, September 26, 2017

Deputy chief accountant urges registrants to ramp up efforts to implement new standards

By Jacquelyn Lumb

SEC Deputy Chief Accountant Sagar Teotia shared some of the staff’s observations regarding the implementation of the new GAAP standards at an event in San Diego. He said a significant amount of work remains, but also cited a great deal of progress and credited the collaborative efforts of preparers, auditors, audit committees, standard setters, and regulators.

Revenue recognition. Teotia urged registrants that are in the process of implementing the revenue recognition standard to “finish strong.” For companies in the early stages of implementation, he encouraged them to ramp up their efforts in order to be successful. Teotia added that it may be easier and more efficient if all of the new standards are implemented concurrently, or partially concurrently, where system enhancements will be needed.

The new standards are likely to impact registrants’ internal control over financial reporting which will take time to implement, according to Teotia, so it is important to resolve implementation and application issues as they arise.

SAB 74 disclosure. As the effective dates near for the new standards, Teotia said the staff expects the disclosures under Staff Accounting Bulletin 74 regarding their likely impact to become more informative. The disclosure should discuss the status of registrants’ implementation efforts. For companies that have not made sufficient progress, Teotia said the disclosure will give audit committees, auditors, and investors the opportunity to hold management accountable.

The staff will accept reasonable judgments in the application of the new standards, Teotia advised, but well-reasoned judgments require time to gather facts, consider accounting alternatives, and come to a sound conclusion. This is why having enough time to implement the standards is so crucial, he explained. With the application of the new standard on revenue recognition just a few months away, Teotia said the time to ask question is now in order to avoid a massive backlog at the end of the year.

Leases. The new standard on leases is effective beginning in 2019, but can be adopted earlier. As with revenue recognition, Teotia encouraged companies to assess the status of their implementation plans and their ability to achieve the standard’s financial reporting objectives. The steps that are required to adopt the lease standard may be time-consuming, he warned, so getting started early is a best practice.

Unlike the new revenue recognition and credit impairment standards, Teotia noted that FASB did not appoint a transition resource group to help in the implementation of the new lease standard. He said it is important to raise accounting questions as soon as possible and urged a dialogue with the staff as questions arise. The questions that the Office of the Chief Accountant has received so far mostly relate to scoping and transition matters, he advised.

Credit losses. The staff has spent significant time evaluating the requirements of the new standard on credit losses. Teotia reported that the staff is actively monitoring the implementation efforts that are underway. Based on its monitoring activities, Teotia said the staff has seen the importance of coordination among all stakeholders, including preparers and auditors in implementing the standard. The transition resource group is assisting stakeholders as they work through the implementation issues that have arisen. Just as with revenue recognition and leases, Teotia said the staff will accept well-reasoned judgments in the application of the new credit loss standard.

Monday, September 25, 2017

EC issues plan to revise EU financial industry supervision, give more power to ESMA

By John Filar Atwood

In an effort to further the transition to a capital markets union with integrated financial supervision, the European Commission has issued plans to reform the European Union’s financial industry supervisory structure. Among other things, the proposals would give the European Securities Markets Authority (ESMA) direct supervisory authority over several aspects of the capital markets such as benchmarks, market entry and market abuse cases.

The EU overhauled its financial system after the global financial crisis by introducing a single rulebook for financial regulation in Europe and creating the European Supervisory Authorities (ESAs) and the European Systemic Risk Board (ESRB). The new proposals would further the reform effort by enhancing regulatory and supervisory convergence within the single market.

To ensure the uniform application of EU rules and promote a capital markets union, the EC proposed to give ESMA direct supervisory power in specific financial sectors that are highly integrated, have important cross-border activities and which are regulated by directly-applicable EU law. The EC is not proposing to change the responsibilities of national authorities to supervise other areas such as central depositories, money market funds, trading venues, UCITS or alternative investment funds.

ESMA’s role. Under the reform plan, ESMA will authorize and supervise the EU’s critical benchmarks and endorse non-EU benchmarks for use in the EU. In addition, ESMA will be in charge of approving certain EU prospectuses and all non-EU prospectuses drawn up under EU rules.

The EC proposed to have ESMA authorize and supervise certain investment funds with an EU label with the aim of creating a genuine single market for the funds. They include European Venture Capital Funds, European Social Entrepreneurship Funds and European Long-Term Investment Funds.

Finally, ESMA will be given a greater role in coordinating market abuse investigations. It will have the right to act where certain orders, transactions or behaviors give rise to suspicion and have cross-border implications or effects for the integrity of financial markets or financial stability in the EU.

Stronger coordination. A primary objective of the reform proposals is to strengthen coordination of supervision across the EU. The ESAs will set EU-wide supervisory priorities, check the consistency of the work programs of individual supervisory authorities with EU priorities and review their implementation. They also will monitor regulators’ practices in allowing market participants such as banks, fund managers and investment firms to delegate and outsource business functions to non-EU countries, to ensure that rules are followed and risks are properly managed. The functioning of the ESRB will be made more efficient in order to strengthen its oversight of risks for the financial system as a whole.

The plan provides that ESAs will make decisions more independently from national interests. Under the new governance system, newly-created executive boards with permanent members will lead to quicker EU-oriented decisions. In addition, interested parties will be able to ask the EC to intervene if the majority consider that the ESAs have exceeded their competences when issuing guidelines or recommendations.

The EC also proposed to make the funding of the ESAs independent from national regulators to improve the autonomy and independence of the ESAs. The EU would continue to contribute a share of the ESAs’ funding, but the rest would be funded by contributions from the financial sector.

Fintech and sustainability. The reform proposals also include steps to foster the development of financial technologies (fintech), and to ensure that sustainability considerations are taken into account in supervisory practices at the European level. The EC’s vice president for financial stability, financial services and capital markets union said in a news release that the reform package will make it easier for EU companies to operate across borders, and to take advantage of new opportunities in fintech and sustainable and green finance.

Friday, September 22, 2017

CFTC pursues its first action against alleged Bitcoin Ponzi operator

By Brad Rosen, J.D.

The CFTC has filed a civil enforcement action in the U.S. District Court in the Southern District of New York against defendants Nicholas Gelfman of Brooklyn, New York, and his company, Gelfman Blueprint, Inc. (GBI), a New York corporation. The complaint charges them with fraud, misappropriation, and issuing false account statements in connection with soliciting investments in the cryptocurrency Bitcoin (CFTC v. Gelfman, September 21, 2017).

The CFTC alleges that from approximately January 2014 through approximately January 2016, Gelfman and GBI, a company where Gelfman served as chief executive officer and head trader, operated a Bitcoin Ponzi scheme in which they fraudulently solicited more than $600,000 from approximately 80 persons. Virtually all of the fraudulently solicited funds were misappropriated by the defendants.

The Commission claims that the defendants induced customers to invest in a pooled commodity fund that purported to employ a high-frequency, algorithmic trading strategy, executed by a computer trading program called “Jigsaw.” The CFTC charges, in reality, the strategy was fake, the purported performance reports provided to investors were false, and, as is the case in all Ponzi schemes, payouts of supposed profits to GBI customers in actuality consisted of other customers’ misappropriated funds.

Misrepresentations. The CFTC’s complaint specifically alleges that the defendants made the following misrepresentations in their solicitation materials, asset and performance reports, and other collateral:
  1. that GBI Customers averaged a 7-9 percent monthly increase in their Bitcoin balances net of all fees through Defendants’ risk-protected strategy, when in fact they did not; 
  2. provided individualized performance and balance reports showing that GBI Customers owned specific amounts of Bitcoin, when in fact those customers did not; and
  3. that GBI’s assets and performance were audited by a certified public accountant (“CPA”), when in fact they were not.
The CFTC also asserts that Gelfman staged a fake computer “hack” designed to further conceal trading losses and misappropriation.

Director’s comments. The CFTC’s Director of Enforcement, James McDonald, commented, “[a]s alleged, the Defendants here preyed on customers interested in virtual currency, promising them the opportunity to invest in Bitcoin when in reality they only bought into the Defendants’ Ponzi scheme. We will continue to work hard to identify and remove bad actors from these markets.” He also noted, “the CFTC has demonstrated its continued commitment to facilitating market-enhancing FinTech innovation. Part of that commitment includes acting aggressively and assertively to root out fraud and bad actors in these areas.”

Relief sought. In its continuing litigation, the CFTC seeks, among other relief, restitution to defrauded pool participants, disgorgement of benefits from violations of the Commodity Exchange Act and CFTC Regulations, civil monetary penalties, trading bans, and a permanent injunction against future violations of federal commodities laws, as charged. While separate criminal charges have not been instituted against the defendants, in its release the CFTC expressed its appreciation for the cooperation and assistance it received from the New York County District Attorney’s Office in this matter.

The case is No. 17-7181.

Thursday, September 21, 2017

New C&DIs target Regulation D and Rule 147

By Mark S. Nelson, J.D.

The SEC’s Division of Corporation Finance issued a set of new and revised Compliance & Disclosure Interpretations covering various aspects of Regulation D and Securities Act Rule 147. Regulation D had been significantly updated by provisions in the Jumpstart Our Business Startups (JOBS) Act and by the Commission’s implementing rules release. The Commission more recently adopted changes to Rule 147. The new C&DIs include eight substantive revisions or additions plus 22 revisions the Division characterized as non-substantive.

Rule 506. Securities Act Rules Question 257.08 has been updated to reflect the policy choice made by Congress in JOBS Act Section 201 with respect to Rule 506 of Regulation D. The prior version of this C&DI, issued in 2009, provided that an offering would not lose its “covered security” status if a notice of an exempt offering was not filed with the SEC. The staff then opined that such a filing was not a condition of satisfying the Securities Act Section 4(a)(2) exemption with respect to Rule 506. Similarly, the revised C&DI states that the filing of Form D is not a condition that must be met under Rule 506.

When Congress enacted the JOBS Act, Section 201 required the Commission to adopt rules to allow general advertising and general solicitation in a new type of offering, which the Commission provided for in Rule 506(c). Section 201 also included language characterizing Rule 506:
Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)).
The JOBS Act separately amended Section 4(2) to add the “(a)” in “4(a)(2),” the current locus of the exemption.

Rule 504. The Division clarified that Rule 504 of Regulation D may not be available to private funds in some circumstances. Revised Securities Act Rules Question 258.03 observed that Rule 504 offerings can be either public or non-public. Public offerings by a private fund would bring the fund within the ambit of the Investment Company Act and, thus, the fund would be unable to invoke Rule 504. Prior Question 258.03 had concluded that Rule 504 was unavailable to investment companies.

The staff also noted the differences between offerings under Rule 504 and Rule 506(c), the latter having been deemed not to be “public offerings” by JOBS Act Section 201(b)(2). Specifically, the JOBS Act provision said Rule 506 offerings would not be public offerings “as a result of general advertising or general solicitation.”

A second change involved the staff withdrawing Question 258.04, which previously dealt with the calculation of the aggregate offering price. But the staff added Question 258.05 regarding whether an instruction in Rule 504 concerning the calculation of the aggregate sales price also would imply that offerings must be integrated. The staff said “No.”

Lastly, the Division’s new Question 258.06 reiterated that Rule 504 would be unavailable to an issuer subject to a bad actor disqualification on or after January 20, 2017. After this date, an issuer must consider its bad actor status any time it relies on Rule 504.

Rule 147. Securities Act Rules Question 541.02 has been withdrawn. That C&DI had concluded that a family trust located in the state where a Rule 147 offering was to occur could not be offered securities or purchase securities where the trust had a non-resident beneficiary that held a 50 percent interest in the trust. However, the staff added Question 541.03, reflecting the Commission’s latest rulemaking in this area, which posits a somewhat similar scenario and concludes that a family trust could be offered securities or purchase securities under Rule 147. Specifically, a Rule 147 offering could take place where a family trust (not a separate legal entity) has two trustees of whom one is a non-resident of the state where the offering takes place.

Rule 505 C&DIs withdrawn. The Division also withdrew C&DIs regarding Rule 505 of Regulation D, which had been contained in Securities Act Rules Questions 259.01 to 259.05. The withdrawal was prompted by changes the Commission made to Rule 504 to raise the aggregate amount of securities that can be offered and sold from $1 million to $5 million, thus eliminating the need for Rule 505, which the Commission has repealed. The Division also withdrew the related Question 659.01 regarding censure of an issuer that was a broker-dealer.

Wednesday, September 20, 2017

Stein calls for global approach to cybersecurity challenges

By Jacquelyn Lumb

Commissioner Kara Stein spoke at the Eurofi financial forum in Tallinn, Estonia, about developments in technology, the challenges of cybersecurity, and their impact on internationally connected markets. She emphasized the importance of working together to solve market problems, including cyber threats, which can spread rapidly due to interconnected computer systems. We live in an age of internationalism as well as nationalism, she said, in which countries and continents are bound together.

Stein said that technology was once merely a tool but now it has reshaped some traditional financial firms. She cited, for example, one major financial firm that has reportedly reduced its equity traders from 600 to two, and one-third of its 9,000 employees are computer engineers. Another major firm has reported spending $9.5 billion on technology in 2016 alone. Many financial firms are now technology firms, she advised, and that has a powerful impact on the markets.

As technological developments have redefined the markets, Stein said the exploitation of technology has increased, particularly in the area of security breaches. In her view, this challenge cannot be addressed alone given how the markets are intertwined. One cyberattack victim can affect the entire marketplace. She called for collaboration in finding solutions that make the global financial markets more secure.

Technological changes and challenges are affecting economies, markets, and financial institutions, Stein said. She called on institutions to work together in thoughtful and creative ways for the benefit of all.

Tuesday, September 19, 2017

ISDA offers suggestions for cross-border harmonization, CCP recovery and resolution

By Lene Powell, J.D.

To reduce cross-border regulatory conflict and duplication, the International Swaps and Derivatives Association, Inc. (ISDA) published a framework to allow for substituted compliance based on risk-based principles. Separately, ISDA also published recommendations for a comprehensive recovery and resolution framework for central counterparties (CCPs).

Risk-based comparability. ISDA’s new paper, “Cross-border Harmonization of Derivatives Regulatory Regimes: A Risk-based Framework for Substituted Compliance via Cross-border Principles,” proposes risk-based principles for making comparability determinations and analyzes the derivatives regulatory frameworks of certain G-20 countries against those principles. The goal is to smooth the process for assessing regulatory comparability, reducing the risk of failure and resulting market fragmentation.

“By assessing only those rules that are meant to tackle risk, and determining whether they achieve comparable outcomes with the rules of another jurisdiction, it avoids an unnecessary, granular rule-by-rule analysis that takes a lot of time and can ultimately result in failure,” explained ISDA chief Scott O’Malia.

ISDA suggests that the CFTC’s cross-border jurisdiction is too broad and its substituted compliance approach overly burdensome. The paper offers five principles covering capital and margin requirements, risk management, recordkeeping, swap data reporting, and clearing and settlement. Together with associated policy goals, the principles form a framework focused on reducing risk.

Noting that comparability simply means that regulations achieve the same overarching goals, the paper also analyzes the CFTC legal framework and compares the regulatory frameworks of several G-20 jurisdictions (the EU, Australia, Canada, Hong Kong and Japan) and Singapore against the cross-border principles, illustrating similarities and highlighting regulatory gaps. The paper also includes a section on derivatives regulations in G-20 emerging markets, using Brazil and Mexico as examples.

CCP recovery and resolution. According to ISDA, the volume of cleared derivatives has increased significantly over recent years, with the Bank of International Settlements reporting a clearing rate of 76 percent of interest rate derivatives notional outstanding. Although the largest global banks and their clearing member units have increased capital by an estimated $1.5 trillion since the financial crisis, comprehensive resilience, recovery and resolution strategies are still critically important.

Recovery refers to measures a central counterparty can take to ensure continued viability upon extreme distress. Resolution refers to measures a resolution authority would take in accordance with a statutory resolution regime to resolve a CCP if a recovery is not successful. Building on work by the Committee on Payments and Market Infrastructures (CPMI), the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB), ISDA published a paper entitled “Safeguarding Clearing: The Need for a Comprehensive CCP Recovery and Resolution Framework”.

In the paper, ISDA makes 10 recommendations to increase CCP resilience and implement robust, unambiguous and predictable recovery and resolution mechanisms. The recommendations address haircutting, position allocation, and tear-ups, among other subjects. In addition to the recommendations, ISDA provides detailed questions to be considered in creating a regime that will provide maximum transparency and predictability, determine when the process should proceed from recovery to resolution, allocate default and non-default losses, rebalance a CCP’s book, and ensure adequate liquidity.

“These recommendations should serve to strengthen CCP oversight, and serve as a global and trusted foundation on which regulators can reliably base equivalence decisions,” said O’Malia.

Monday, September 18, 2017

ABA panel seeks clarity on finders

By Mark S. Nelson, J.D.

The broker-dealer panel at the ABA’s 2017 Business Law Section Annual Meeting in Chicago urged regulators and Congress to clarify the legal status of finders. Panelists said greater certainty is needed because of the disparate no-action letters issued by the SEC and potentially conflicting court decisions that leave finders in limbo. The panel’s timing matched that of the SEC’s soon-to-expire Advisory Committee on Small and Emerging Companies (ACSEC), which earlier this week reiterated its view that the Commission should take action on finders and asked its successor, the Small Business Capital Formation Advisory Committee, to follow-up on seeking clarification of finders’ status.

No one answers the phone. The ABA panel noted that even in the post-Jumpstart Our Business Startups (JOBS) Act environment, many of the nation’s smallest businesses still cannot get the assistance they need to raise adequate levels of capital to fund future growth. One panelist recalled clients complaining that no registered broker member of the Financial Industry Regulatory Authority would take their calls. A draft of the ACSEC’s latest report would confirm that many registered broker-dealers are uninterested in riskier, small transactions.

The alternative to using registered broker-dealers for capital raising brings many risks, including that despite the presence of some reputable non-registered finders, other finders may be unscrupulous. Faith Colish, counsel at Carter Ledyard & Milburn LLP, one of the speakers on the panel, formally titled Finding Capital: Broker-Dealer Registration After Paxton and Kramer, said capital raising had been “neglected” for a long time. Another panelist, Martin Hewitt, noted that inconsistent state laws further complicate the situation for finders.

Lack of clarity. The panels’ moderator, Marlon Paz, partner at Seward & Kissel LLP, explained that Exchange Act Section 3(a)(4) is the starting point for determining if someone must be registered with the Commission. That section defines “broker” as “any person engaged in the business of effecting transaction in securities for the account of others.” The question is where finders fit into this definition, if at all.

Colish and Linda Lerner, senior counsel at Crowell & Moring LLP, engaged in a mock debate in which they analyzed guidance from the SEC and court decisions that potentially conflict with the SEC’s views. On one side are the several SEC no-action letters that may suggest the possibility that finders, who introduce parties that may engage in a securities transaction, would not have to be registered as brokers. But some of these no-action letters also have subsequent histories that could make them challenging to apply in practice.

For example, in the 1985 Dominion Resources, Inc. no-action letter, the Division of Trading and Markets (then called the Division of Market Regulation) said it would not recommend enforcement to the Commission under Exchange Act Section 15 if Dominion Resources, which had developed expertise in placing taxable and tax-exempt securities, offered these services to other businesses seeking advice on how to structure similar transactions. But five years later, the Division revoked its prior position noting “somewhat similar” instances where the staff had denied no-action requests.

The Division also noted changed circumstances since it issued its original reply to Dominion Resources. “In the intervening years, technological advances, including the advent of the Internet, as well as other developments in the securities markets, have allowed more and different types of persons to become involved in the provision of securities related services.”

Also aligned with finders’ interests, the panelists noted the 1991 Paul Anka no-action letter in which Anka had entered into an agreement with two Canadian entities to buy shares related to a hockey club and was later to use his efforts to introduce potential accredited investors to the hockey club. The Division recommended against enforcement if Anka engaged in the specific activities stated in the no-action request letter.

The panelists said courts also have arrived at varied decisions in several recent cases. For example, the Eighth Circuit in Collyard, a case involving Paul Crawford, who founded a business to aid small companies in capital raising, and whose related license had previously been suspended, invested his own funds in a small company and then entered into an agreement with a third party to refer investors to the company he had invested in for a commission; Crawford later agreed with the company itself to refer investors for a fee. The SEC sued claiming Crawford was a broker.

The Eighth Circuit applied a non-exclusive set of six factors previously adopted by the Sixth Circuit. Of those factors, the court said the SEC presented “undisputed” evidence that Crawford met all but the one regarding employment by the issuer (Crawford was not an employee of the company he had invested in and to which he was to refer investors). Ultimately, the court concluded there was no genuine issue of material fact that Crawford was a broker. The court also rejected Crawford’s assertion that there is a “finder exception” or “finder defense” regarding registration under Exchange Act Section 15.

By contrast, the two featured cases on the ABA panel suggest that finders can limit their activities in a manner that does not implicate Exchange Act registration. In Kramer, a case with numerous evidentiary issues, the district court determined that the SEC failed to show by a preponderance of the evidence that a person was a broker. In Collyard, Crawford had raised Kramer in his defense, but the Eighth Circuit had rejected the comparison because the alleged broker in Kramer engaged in more limited activities.

The other featured case was that of Texas Attorney General Ken Paxton, whom the SEC had alleged was a broker with respect to his efforts to recruit investors for a technology company while serving as a Texas state representative. The SEC had argued that “control” over accounts is just a factor, while Paxton argued that control is an element of “broker” and that the SEC fell short of alleging that he “effected transactions” “for the account of others.” The district court leaned heavily on Kramer and one other case in concluding that “control” is an element (not a factor) and that Paxton did not have “authority” over accounts and, thus, was not a broker under the Exchange Act.

ACSEC recommendation. The ACSEC’s draft final report echoed much of what the ABA panelists said about the uncertainty for unregistered finders. According to the ACSEC, only 13 percent of Regulation D offerings involve brokers or finders, which the committee said likely results from two factors: “(a) a lack of interest from registered broker-dealers given the legal costs and risks involved in undertaking a small transaction and (b) the reluctance of those not registered as broker-dealers to provide assistance because of the ambiguities in the definition of ‘broker.’”

The ACSEC report also noted the ABA’s involvement in urging the Commission to adopt clearer rules for brokers and finders. In 2005, the ABA’s Business Law Section (and other ABA sections) issued a report from the ABA’s Task Force on Private Placement Broker-Dealers (panelist Colish was a member of the ABA task force) that urged the SEC and FINRA to provide desired clarity. The report provides a detailed explanation of why, under current laws, persons might be reluctant to engage in the activities of a finder. Chief among those reasons was the task force’s observation that the SEC’s Division of Trading and Markets appeared to be wary of finders, especially when they may receive transaction-based compensation.

Friday, September 15, 2017

MSRB cautions issuers on selective disclosure

By Jay Fishman, J.D.

The Municipal Securities Rulemaking Board (MSRB) released an advisory on selective disclosure, cautioning municipal securities issuers, dealers and advisors of their potential liability even though not being subject to the SEC’s Regulation FD for corporate issuers. The MSRB explained that these municipal market participants do remain subject to the Securities Act’s and the Exchange Act’s antifraud provisions, thereby creating liability for them in the following ways:
  1. The municipal dealer or advisor selectively discloses nonpublic material information that was known to the issuer at the time the disclosure was made, but that information was not included in a preliminary official statement or other required disclosure: the relevant documents likely suffer from a material omission or misstatement. 
  2. An individual selectively discloses nonpublic material information in breach of a duty to the issuer, and the recipient of that information buys or sells the issuer’s securities based on the information: this transaction could constitute insider trading. 
To avoid the above liabilities, the MSRB advisory asks municipal securities issuers, dealers and advisors to consider adopting Regulation FD’s dissemination principles to address how to handle instances of selective disclosure if they occur and, moreover, advocates posting the principles on the MSRB’s EMMA website. The MSRB additionally provides a set of guiding principles for issuers seeking to enhance their disclosure practices.

The advisory’s overall message, as stated by the MSRB’s Executive Director Lynnette Kelly, is to encourage municipal securities issuers and their financial professionals to protect the integrity of the municipal market by making full and fair disclosures to all investors. She declared that even inadvertent selective disclosure can disadvantage certain investors.

Thursday, September 14, 2017

Small business committee goes out urging revisit of registration exemption for compensatory plans

By Amy Leisinger, J.D.

In its last meeting before the transition to a permanent successor Small Business Capital Formation Advisory Committee, the SEC’s Advisory Committee on Small and Emerging Companies explored the need for updates to modernize Securities Act Rule 701, a registration exemption for securities issued by non-reporting companies pursuant to compensatory arrangements. In response to suggestions by industry participants, the committee agreed to recommend that Commission staff take an in-depth look at the requirements of the rule and their impact on private companies, particularly in connection with recent legislation moving Rule 701’s cap from $5 million to $10 million.

Rule 701. Under Rule 701, a company can offer its own securities as part of compensation agreements to employees, executives, or consultants without complying with registration requirements if total stock sales do not exceed certain limitations. For sales over $5 million to specified individuals during a 12-month period, a company must disclose additional information regarding the plan, related risk factors, and certain financial statements. Financial statements must be not more than 180 days old, and stock option disclosures must be delivered within a reasonable period before the date of exercise. If the threshold is exceeded and disclosures are deemed untimely, the Rule 701 exemption is lost for all stock and options granted, not just those exceeding $5 million.

Recommended modifications. During the meeting, Christine McCarthy of Orrick, Herrington & Sutcliffe LLP’s Compensation and Benefits Group noted that many private and startup companies need to compensate with equity in order to incentivize talent and hire for growth and development of the company. However, she explained, private companies at early stages lack the resources to comply with the requirements of Rule 701 and similar rules. Although the SEC staff has provided some clarification on Rule 701, she expressed the importance of further efforts to avoid undue complications to best serve private companies and small startups, as well as employee-investors.

As such, McCarthy recommended a number of modifications to Rule 701 to increase its usefulness. First, she suggested removal of the requirements that consultants be natural persons in order to fall within the exemption. Early-stage companies with minimal resources use a lot of consultants as opposed to hiring full-time at the outset, she stated, and most individual consultants will organize as entities for tax and other legal purposes, she explained. McCarthy also advocated clarifying that a material change to a previously issued Rule 701 security does not result in a new grant or sale for purposes the rule and that restricted stock units are considered “sales” on the date of grant (like options) and should be valued for Rule 701 purposes based on share value on the date of grant. While many of these limitations were put in place to address the threat of Rule 701 use for non-compensatory purposes, they really do not do much to curb abuses, she said. Many companies end up using “accredited investor” exemptions because repricing can lead to Rule 701 issues, and the better solution is to enforce the rule itself, McCarthy opined.

She also suggested a number of changes to Rule 701’s disclosure obligations. Because the $5-million limit could be exceeded at the end of a 12-month period and expanded disclosure could need to be provided for any sales during the period, a company must generally “guess” whether it will go over the threshold and begin providing disclosure before the limit is reached, McCarthy noted. As such, she recommended changing the rule to state that expanded disclosure is only required for sales occurring after the threshold is actually exceeded and to provide a buffer compliance period. Moreover, the rule should be amended to clarify the timing and delivery requirements applicable to disclosures, she said; it is important to specify what constitutes a “reasonable period of time prior to sale” and what level of certainty is required as to the completion of delivery, McCarthy stressed. To reduce the burdens on small and startup companies and simplify the process, the SEC should also consider decoupling the expanded disclosure requirements from Regulation A and other similar disclosure obligations and limiting financial disclosure updates to once a year unless a material event results in material value change, she concluded.

Steve Miller, CFO of online eyeglasses retailer Warby Parker, echoed McCarthy concerns and noted that, at the outset, a startup can face a number of challenges in incentivizing talent to work with a new company. The provision of equity under rules like Rule 701 can be a solution to the dilemma, he said, but people need flexibility in a startup and can inadvertently run afoul of exemptions. It takes time to put a structure in place, and confidentiality can be crucial as a private company begins its journey, Miller explained. Regulators need to avoid imposing onerous requirements on companies least suited to meet them and make efforts to adjust exemptions to ensure that they are truly effective for the benefit of small businesses, he opined.

Wednesday, September 13, 2017

Private equity fund adviser, principal settle fee and expense failures for $300K

By Amy Leisinger, J.D.

The SEC has charged an investment adviser and its principal with improperly charging fees to two private equity funds and using fund assets to cover certain fees and expenses. According to the Commission, the respondents failed to disclose these activities and violated the custody rule by failing to disclose associated related-party transactions in the funds’ audited financial statements. To settle the matter, the respondents agreed to cease and desist from further violations and to pay a $300,000 civil penalty (In the Matter of Potomac Asset Management Company, Inc. and Goodloe E. Byron, Jr., Release No. IA-4766, September 11, 2017).

Improper fees and expenses. Potomac Asset Management Company, Inc. provides investment advisory and management services to two private equity fund clients under limited partnership agreements and private placement memoranda The LPAs provided terms for calculation and payment of capital contributions and the payment of management fees paid to Potomac. The adviser had responsibility for paying manager expenses, including the compensation, rent, and regulatory expenses.

The SEC alleged that, from 2012 and 2013, the adviser and its principal improperly charged $2.2 million in fees to one of the funds and failed to disclose the use of fund assets to pay the fees to the fund’s limited partners. In addition, according to the SEC, after the fund’s portfolio company reimbursed the fees, Potomac failed to offset them against the management fees it charged. Neither the LPA nor the PPM authorized Potomac to charge the portfolio company fees to the fund, the Commission alleged, and the respondents did not disclose the misuse of fund assets to the limited partners.

From 2012 and 2015, according to the SEC, the respondents also used fund assets to pay Potomac’s adviser-related expenses in a manner not authorized by or disclosed in the funds’ governing documents or Forms ADV. The funds’ audited financial statements also failed to disclose these payments as related-party transactions in violation of GAAP, and, as a result, Potomac improperly relied on an exception to the Advisers Act custody rule.

Finally, the SEC stated, Potomac failed to maintain written policies and procedures reasonably designed to prevent violations of the Advisers Act arising from the allocation of fees and adviser-related expenses, and the principal failed to make timely capital contributions to the funds on behalf of the funds’ general partners and did not disclose the issue to the funds’ limited partners.

By this conduct, the SEC alleged, the respondents violated the antifraud provisions of the Advisers Act, as well as the custody rule’s requirement that client assets be maintained with a qualified custodian that provides GAAP-compliant audited financial statements to investors. In addition, they violated Rule 206(4)-7 by failing to adopt and implement appropriate policies and procedures and Section 207 of the Act by making untrue statements in SEC filings, according to the Commission.

Sanctions. Without admitting or denying the SEC’s findings, Potomac and its principal agreed to a cease-and-desist order, as well as censure. They also agreed to jointly and severally pay a civil money penalty of $300,000. In determining to accept the settlement offer, the Commission noted Potomac’s remedial acts and cooperation, particularly its creation of a limited partner advisory board and its retention of a new CCO and an independent compliance consultant.

The release is No. IA-4766.

Tuesday, September 12, 2017

Giancarlo lauds regulatory deference as key to CCP supervision

By Anne Sherry, J.D.

In an op-ed published in the French financial daily Les Echos, CFTC Chairman Chris Giancarlo stressed that regulatory deference will be the path forward to cross-border supervision of central counterparties. Giancarlo noted in particular that in the wake of the financial crisis, G-20 leaders committed at the Pittsburgh Summit to work towards consistent, rather than identical, implementation of global standards. Mutual deference to foreign regulatory frameworks follows from this pact, he wrote.

The CFTC’s regulatory framework for futures gives non-U.S. firms direct access to U.S. customers provided they comply with the rules of their home jurisdiction. The agency has some similar provisions with respect to non-U.S. swaps dealers and major swaps participants, and recently allowed certain E.U.-based CCPs seeking to operate in the U.S. to comply with corresponding E.U. regulatory requirements.

Giancarlo wrote that this arrangement allows market participants to hedge risks in efficient and resilient global markets and promotes financial stability by holding CCPs based in different jurisdictions to the same high standards. It also allows the CFTC to “work smarter, not harder” under budget constraints. In addition to supporting the cross-border activities of actors in the financial markets, deference arrangements avoid fragmentation, protectionism, and regulatory arbitrage.

The Commission’s staff is exploring how to incorporate deference into other parts of the regulatory framework and form stronger alliances with other regulators, Giancarlo added. He acknowledged that in some circumstances where the CCP is systemically important in a few jurisdictions, deference may not be possible. In those cases, joint supervision between the applicable authorities may be a better solution.

Monday, September 11, 2017

SEC hosts dialogue on exchange-traded products

By Jacquelyn Lumb

The SEC and New York University hosted a dialogue on exchange-traded products during which academics, practitioners and regulators discussed the effect of ETPs on financial markets, their implications for investors, and the future of ETPs. Commissioner Michael Piwowar opened the dialogue with some background on ETPs and their enormous growth since their introduction in 1993. Today, there are nearly 2,000 ETPs in the U.S. with over $2.7 trillion in investments. ETPs are among the fast growing asset classes, he advised.

Piwowar characterized ETPs as one of the most significant financial innovations in recent decades. They allow both institutional and retail investors to tailor their portfolios to take advantage of changing market conditions that arise throughout the day, he explained. One of the panelists described ETPS as the most democratic investment available because anyone with a brokerage account can access a broad range of asset classes and the costs are often very low.

Piwowar noted that ETPs are popular with retail investors because they provide a way to increase their portfolio diversification at a low price, while institutional investors appreciate the ability to lend shares, sell them short, and trade them on margin. He noted that ETPs constitute about 30 percent of all trading volume, which reflects active trading by both retail and institutional investors every day. Given the importance of this market, Piwowar said it is critical that the SEC identify emerging issues that may affect investors and market participants.

Piwowar noted that the industry and academics have raised concerns about ETPs’ effect on the value of the underlying securities and on the quality of the financial markets, and whether the acceleration of index investing is leading to reduced capital market efficiency. The evidence is mixed, he said, with some studies showing that securities prices reflect available information more efficiently when they are included in ETPs, while others suggest that prices of securities with stronger ETP ownership are more volatile, reflecting increased "noise" rather than information.

The SEC has seen an increase in the amount of research about the effects of ETPs on capital formation, market efficiency, and investor protection, according to Piwowar, but he called for more discussion and discovery such as the NYU dialogue. Academicians from Ohio State University, New York University, and the University of Maryland discussed the available research on ETPs’ effect on the financial markets, followed by a panel discussion on their implication for investors led by Investor Advocate Rick Fleming. The investors’ panel agreed that education is paramount. Investors must read the prospectuses and they must understand what they are reading, they advised.

Friday, September 08, 2017

No award for whistleblowers who filed late claims

By Anne Sherry, J.D.

The Second Circuit affirmed an SEC order denying a whistleblower award to two claimants who applied two years past the claim deadline. The court would not set aside the SEC’s interpretation of its rule as requiring timeliness unless the delay is due to factors beyond the claimant’s control. The Commission was also not required to provide the petitioners with actual notice of their potential eligibility for an award (Cerny v. SEC, September 7, 2017).

The notice of covered action posted on the SEC’s website listed the deadline to file a claim as June 3, 2012, but the petitioners did not apply for awards until 2014. Last March, the Commission entered a final order concluding that the claims were untimely and that the claimants had not demonstrated extraordinary circumstances warranting relief from the time bar. The claimants timely appealed to the Second Circuit.

Under the SEC’s whistleblower rules, an award claim is barred if the application is not submitted within ninety days of the notice of covered action. The Commission retains the sole discretion to waive any of its award procedures “based upon a showing of extraordinary circumstances.” It has consistently interpreted this to mean that the failure to timely file was beyond the claimant’s control.

The petitioners argued that the quality of information they provided to the agency, and the agency’s failure to properly catalog their submissions, constituted extraordinary circumstances. But they failed to demonstrate how the SEC’s interpretation of its regulation was plainly erroneous or inconsistent with the rule. The appeals court concluded that the SEC’s interpretation was controlling, and the agency did not abuse its discretion by determining that the petitioners had not established extraordinary circumstances.

The second argument before the appeals court was that the lateness should be excused because the petitioners never received actual notice of their eligibility for a whistleblower award. The court noted that under the relevant regulation, the SEC is not required to provide actual notice. The rule simply provides that when an SEC action results in monetary sanctions exceeding $1 million, “the Office of the Whistleblower will cause to be published on the Commission’s Web site a ‘Notice of Covered Action.’” The SEC did not abuse its discretion by declining to excuse the lateness based on a lack of actual notice, and to the extent the petitioners challenge the notice rule itself, that is beyond the scope of the appeals court’s review.

The case is No. 16-934-ag.

Thursday, September 07, 2017

House passes Reg. A compliance bill; FSOC bill advances ahead of Senate mark-up

By Mark S. Nelson, J.D.

The House easily passed a bill that would require the SEC to amend Regulation A with respect to issuer qualifications and Exchange Act reporting requirements. The House also passed a bill by an equally large margin that would extend the term of the independent insurance member on the Financial Stability Oversight Council.

Regulation A offerings. The Regulation A bill (H.R. 2864), sponsored by Kyrsten Sinema (D- Ariz) advanced by a vote of 403-3 after moving through the House Financial Services Committee 59-0 in July. Rule 251 of Regulation A currently provides that an issuer of securities must satisfy a variety of requirements, including that the issuer is not subject to reporting under Exchange Act Sections 13 or 15(d) immediately before the offering. The Sinema bill would direct the Commission to revise Rule 251 to remove this requirement.

Moreover, the Sinema bill would direct the Commission to amend Rule 257 of Regulation A to provide that an issuer in a Tier 2 offering that is subject to Exchange Act Sections 13 or 15(d) meets the reporting requirements of Rule 257 if the issuer meets the requirements of Exchange Act Section 13. Currently, Rule 257 requires a Tier 2 issuer to file periodic and other reports with the Commission on Forms 1-K, 1-SA, and 1-U. Tier 2 offerings are the result of changes the Commission made to Regulation A in 2015 to provide for offerings to qualified purchasers of up to $50 million with state Blue Sky registration and qualification laws preempted for these offerings.

FSOC independent member term. The Financial Stability Oversight Council Insurance Member Continuity Act (H.R. 3110) likewise passed by a wide margin. The bill, sponsored by Randy Hultgren (R-Ill), was reported by the House FSC unanimously in July and would amend the Financial Stability Act of 2010 to provide that the FSOC’s independent member with insurance expertise may continue to serve until the earlier of 18 months after his term ends or his successor is confirmed.

According to a statement by Hultgren, the bill offers lawmakers a chance to fill a gap in the Dodd-Frank Act. “Absent the appointment and confirmation of a successor, the expiration of the Independent Member’s term would leave the Council without a voting member who has insurance expertise because Dodd-Frank did not make clear if the position can be filled by an acting official.”

As enacted, the Dodd-Frank Act includes among its voting members an independent member who, in addition to having an insurance background, must be appointed by the president and confirmed by the Senate and who serves for a six-year term. A related Senate bill (S. 1463) is due to be marked-up tomorrow.

Wednesday, September 06, 2017

Court declines to bar "professional plaintiff" from serving as lead

By Rodney F. Tonkovic, J.D.

A district court has appointed an institutional plaintiff as lead plaintiff in a securities fraud class action, despite its being a "professional plaintiff." The court concluded that the presumption that a group consisting of two retirement associations was the most adequate lead plaintiff was not overcome. While another movant argued one of the group members was a "professional plaintiff" barred under the PSLRA, the court exercised its discretion to find that the group was not lawyer-driven and would be able to actively participate in the litigation (Oklahoma Law Enforcement Retirement System v. Adeptus Health Inc., August 31, 2017, Mazzant, A.).

This action was filed in late October 2016 on behalf of purchasers of certain common shares of Adeptus Health, Inc. The action was later consolidated with three others, all alleging that the company had failed to disclose material weaknesses in its internal control over financial reporting. While the claims have been stayed after Adeptus filed for bankruptcy, the parties urged the court to decide the instant motions for appointment as lead plaintiff in order to represent the class in the bankruptcy proceedings.

Professional plaintiff okayed. Of the three movants, the court appointed the Alameda County Employees’ Retirement Association and Arkansas Teacher Retirement System (collectively, the "Retirement Group") as lead plaintiff and approved the selection of counsel. One of the three movants was eliminated at the outset because it had filed its motion too late. The court then found that the Retirement Group was the presumptive lead plaintiff because it had the largest financial interest.

The other movant, however, maintained that the Retirement Group would not fairly and adequately represent the class because it was an improper group under the PSLRA. The Retirement Group, however, was able to persuade the court that it would be able to function cohesively and efficiently manage the litigation together. Moreover, the Retirement Group had participated in the bankruptcy proceeding by filing objections and hiring attorneys who have made appearances. There was little concern, the court said, that the Retirement Group was a lawyer-driven group that the plaintiffs would be unable to control.

Next, the movant argued that the Arkansas Teacher Retirement System was a professional lead plaintiff and thus barred under the PSLRA from serving as lead. Here, the court noted a split among the courts as to whether the PSLRA's restriction on professional plaintiffs applies to institutional investors like Arkansas Teacher. There is no blanket exception for institutional investors in the statute, the court said, and that status is merely a factor to consider when the court is using its discretion to apply the bar.

Exercising its discretion, the court declined to bar Arkansas Teacher from serving as lead plaintiff. The court again pointed to the PSLRA's aim to prevent lawyer-driven litigation, but did not find that to be the case here. The court explained that there was sufficient evidence to show that the Retirement Group as a whole would be able to actively participate in the litigation and control its attorneys. The court accordingly appointed the Retirement Group as lead plaintiff and approved its choice of Bernstein Litowitz and Kessler Topaz as co-lead counsel.

The case is No. 4:17-CV-00449.

Tuesday, September 05, 2017

Rep. Waters asks SEC to make conflict minerals enforcement a priority

By Mark S. Nelson, J.D.

House Financial Services Committee Ranking Member Maxine Waters (D-Calif) and Rep. Gwen Moore (D-Wis) asked the Commission to ensure that the conflict minerals rule will be enforced despite the issuance of additional guidance from the Division of Corporation Finance earlier this year that recommended against enforcement if companies do not comply with the due diligence provisions of the rule. Waters and Moore expressed their views in a letter to SEC Chairman Jay Clayton.

Guidance reconsidered. Former Acting Chairman Michael Piwowar had instructed SEC staff to review the April 2014 guidance on conflict minerals. That guidance provided detailed instructions for compliance following a D.C. Circuit decision invalidating part of the rule. The resulting April 2017 guidance did not supersede the earlier guidance, but it added that enforcement would not be recommended if companies do not file due diligence disclosures. Specifically, the new guidance said:
In light of the uncertainty regarding how the Commission will resolve those issues and related issues raised by commenters, the Division of Corporation Finance has determined that it will not recommend enforcement action to the Commission if companies, including those that are subject to paragraph (c) of Item 1.01 of Form SD, only file disclosure under the provisions of paragraphs (a) and (b) of Item 1.01 of Form SD. This statement is subject to any further action that may be taken by the Commission, expresses the Division’s position on enforcement action only, and does not express any legal conclusion on the rule.
Piwowar had previously noted his own visit to Africa, which he said informed his view that the rule is “misguided.” He would later conclude that “[i]n light of the foregoing regulatory uncertainties, until these issues are resolved, it is difficult to conceive of a circumstance that would counsel in favor of enforcing Item 1.01(c) of Form SD.”

Friday, September 01, 2017

NYSE seeks delay in important company news releases to prevent market disruption

By R. Jason Howard, J.D.

The NYSE has filed a Notice of Proposed Rule Change with the SEC to amend Section 202.06 of the NYSE Listed Company Manual to limit the issuance of material news by listed companies in the period immediately after the official closing time for the Exchange’s trading session (Release No. 34-81494, August 29, 2017).

Proposal. The proposed rule change seeks to halt the release of material information until the earlier of publication of such company’s official closing price on the Exchange or five minutes after the official closing time.

The Designated Market Maker (DMM) registered in a security facilitates the close of trading after continuous trading ends at the official closing time of 4:00 p.m. The proposal explains that “because there is trading after 4:00 p.m. Eastern Time on other exchange and non-exchange venues, if a listed company releases material news immediately after 4:00 p.m., but before the closing auction on the NYSE is completed, there can be a significant price difference in nearly contemporaneous trades on other markets and the closing price on the Exchange.”

Statutory basis. The proposal addresses the statutory basis for the proposed rule change and suggests that it is consistent with Section 6(b) and Section 6(b)(5) of the Act in that it is “designed to promote just and equitable principles of trade by ensuring that participants in the closing auction at the Exchange do not have their trades executed at a price that is inconsistent with contemporaneous trading prices on other markets that reflect material news that was released after the NYSE’s official closing time.”

The Commission is seeking comments on the proposed rule change from interested persons and within 45 days of the date of publication of this notice in the Federal Register or up to 90 days (i) as the Commission may designate if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which the self-regulatory organization consents, the Commission will: (A) by order approve or disapprove the proposed rule change, or (B) institute proceedings to determine whether the proposed rule change should be disapproved.

The release is No. 34-81494.