Thursday, November 30, 2017

Corporation Finance director provides clarification on Staff Legal Bulletin 14I

By John Filar Atwood

Staff Legal Bulletin 14I (the SLB) encourages, but does not require, a company’s board to provide analysis on shareholder proposals under paragraphs (i)(5) and (i)(7) of Rule 14a-8, according to Bill Hinman, director of the SEC’s Division of Corporation Finance. At Practising Law Institute’s securities regulation conference, he said that the staff would like to see a board’s analysis of whether a proposal is of transcending importance, but not all companies have to provide it.

The SLB includes guidance on the application of paragraph (i)(7), which is the ordinary business exclusion, and paragraph (i)(5), which permits exclusion of a proposal based upon its economic relevance to the company. For both provisions, the SLB requests that companies provide a discussion that reflects the board’s analysis of the particular policy issue raised in a shareholder proposal and its significance.

Hinman said that judgment calls about whether a proposal is so significant to a company’s business that it should not be excluded from the proxy are difficult for the staff to make. The SLB is designed to provide the staff with more information to improve its decision-making process.

Board analysis. Hinman encouraged boards to provide the requested analysis for proposals that fall under paragraphs (i)(5) and (i)(7) and assured that it would be carefully considered by the staff. Asked how much detail the staff would like to see in the board’s analysis, Hinman said that companies can decide for themselves how much information they feel is compelling. Companies should analyze the issue with their specific shareholder base in mind, he advised.

He believes that much of the board’s analysis will take place at the nominating committee and governance committee level. The staff would like to see if these committees have considered the issue in the proposal, and whether a company has met with the affected shareholders, he said. The analysis process may result in more companies working out issues with shareholders before they reach the proposal stage, in his opinion.

Ronald Mueller, a partner at Gibson, Dunn & Crutcher, said that he was initially surprised by the SLB’s request for board input on the shareholder proposal issues. However, he acknowledged that when deciding whether a proposal rises to the level of significance under (i)(7), no one is more qualified to weigh in than the board of directors.

Michele Anderson, a deputy director in the Division of Corporation Finance, reiterated Hinman’s advice that the board analysis is welcome, but not required. A company may be able to argue its point and persuade the staff without the board analysis, she noted. Mueller said that since the board analysis is not required, it should not be seen as an additional burden, but rather as an additional avenue to make the case that a proposal qualifies as ordinary business.

Anderson believes that the SLB breathes new life into paragraphs (i)(5) and (i)(7). She noted that paragraph (i)(5) was adopted in 1983, but has only rarely been used since 1985. In her view, the SLB will enable (i)(5) to be used as it was intended.

Proposals by proxy. On the issue of proposals by proxy, Hinman said that the staff has heard that issuers were not sure who they were dealing with when proposals are submitted by proxy. The SLB outlines four elements that would be useful in providing a more complete record in determining who the proponent is. The proposal will not necessarily be excludable if a company does not hit on all four elements, he said.

Hinman told Wolters Kluwer that the SLB was not issued as a response to the CHOICE Act, which calls for a prohibition on proposals by proxy. The staff was mindful of the CHOICE Act, he noted, but included the proposal-by-proxy guidance in the SLB simply to make more information available on who is submitting the proposal. He emphasized that the staff believes that proposals by proxy are acceptable.

Wednesday, November 29, 2017

SCOTUS whistleblower debate focuses on plain language, Chevron deference

By Anne Sherry, J.D.

The Supreme Court held oral argument on whether Dodd-Frank protects an employee against retaliation even if the employee does not report misconduct to the SEC. The employer, who petitioned the Court, argues that the statute’s definition of “whistleblower” as requiring SEC reporting applies equally to the award and anti-retaliation provisions. Some Justices seemed skeptical of the employee’s counterarguments that the definition plainly does not apply to the retaliation portion or, if the law is ambiguous, that the SEC’s rule is entitled to deference (Digital Realty Trust, Inc. v. Somers, November 28, 2017).

Statutory definition. Exchange Act Section 21F, added by Dodd-Frank, bars employers from discriminating against “a whistleblower” for providing information to the SEC; being involved in an investigation or action based on the information; or (in the controversial subsection (iii)) making disclosures required or protected under the securities laws. That third category of protected disclosures includes certain categories of internal reporting and other reports that are not necessarily made to the SEC. But “whistleblower” is defined elsewhere in Section 21F as “any individual who provides … information relating to a violation of the securities laws to the Commission, in a manner established, by rule or regulation, by the Commission.” In light of this apparent tension, many employees argue that the statute is ambiguous, warranting Chevron deference to the SEC’s rule, which does not require reporting to the agency.

Circuit split. The Court granted certiorari to review the Ninth Circuit holding that internal whistleblowers are protected from employment retaliation, which deepened a circuit split. The Ninth Circuit agreed with the district court that the SEC’s rule aligned with Congress’s overall purpose to protect whistleblowers, whether they report violations internally or to the government. The language of subsection (iii) illuminates Congress’s intent to protect certain professionals, namely auditors and attorneys, who are required to report violations internally before they can do so externally. The fact that the statute describes whistleblowers as employees who report to the SEC did not dispose of the employee’s argument because terms can operate differently in different contexts, as the Supreme Court reasoned in upholding most of the Affordable Care Act (King v. Burwell (U.S. 2015)). One judge on the panel dissented on the grounds that this case should be “quarantined” to its specific facts.

Supreme Court contends with definition. The Justices focused much of their questioning on the operation of this whistleblower definition. In the view of the whistleblower/respondent and government (as amicus curiae in support of the respondent), the definition applies only to the award section of the statute. When used in the anti-retaliation provision, the word “whistleblower” carries its ordinary meaning. Respondent’s counsel also emphasized that the statutory definition does not say the report has to go to the Commission, but that it be made “in a manner established by rule or regulation by the Commission.” It makes sense for Congress to contemplate that the whistleblower award process be carried out in a particular way, to make it easy to track who is eligible for an award after an enforcement action is announced. But Congress did not need to limit the anti-retaliation section to a particular form of reporting to accomplish the core objective of the whistleblower legislation.

The employer/petitioner, however, asserted that the definition is clear and that its application to the anti-retaliation provision is consistent with the history, structure, and objectives of the whistleblower provisions. In this view, anyone who has reported to the SEC is protected from retaliation for any reason. The petitioner’s counsel said that subsection (iii) thus “reaches a situation in which an employee … reports to the SEC but is retaliated against because of an internal report or perhaps a report to another governmental entity.”

Tuesday, November 28, 2017

IOSCO issues report on hedge fund statistics, trends

By Amy Leisinger, J.D.

The International Organization of Securities Commissions (IOSCO) has published its biannual report on the global hedge fund marketplace, key regulatory changes, and the potential systemic risks posed by the industry. IOSCO’s survey assembles information from national authorities on hedge fund activities and is designed to enable regulators to share information and observe trends regarding exposure, leverage, liquidity management, funding, and trading activities in the hedge fund industry.

Using data as of September 30, 2016, IOSCO’s report notes that, in the span of two years, the global assets under management of 1,971 surveyed hedge funds increased by 24 percent to $3.2 trillion, likely as a result of enhanced reporting requirements, market performance, consolidation of smaller funds, and/or growth through net new investment. To avoid double counting, IOSCO scaled down data sets of other jurisdictions where hedge funds were likely also to have reported to the SEC on Form PF, but the data implies that 76 percent of the global total is held with primarily U.S.-based hedge fund managers, the organization reports. According to IOSCO, the Cayman Islands remains the domicile of choice for hedge funds, with 53 percent of the global total by NAV, and the portion of funds domiciled in Europe and Asia continues to be very limited.

IOSCO found that values for interest rate derivatives dominate as to gross exposures per asset class. After derivatives, equities represented the next highest total in both long and short exposure. Equity long/short was the most widely used investment strategy, followed by global macro and fixed income arbitrage, both of which might be expected to make extensive use of government bonds, according to the report.

Across the sample funds, IOSCO found total gross notional exposure to all asset classes (adding short positions to long positions) was $22.7 trillion, which, divided by the $3.2 trillion global NAV, shows a gross leverage of 7.1x—an increase from 5.1x in 2014. However, the report notes that one of the factors affecting the calculation is the inclusion of notional values of interest rate and FX derivatives, which may exaggerate the level of exposure. Recalculating to exclude those categories results in a gross exposure of $9.8 trillion and a more modest gross leverage of 3.1x, IOSCO explains. The amount of leverage used by hedge funds may vary widely depending on investment strategy, but the data show prime brokers still represent the largest source of financial leverage for hedge funds with an increased reliance on repo markets, according to the report.

Further, IOSCO found that, in the aggregate, hedge funds maintain liquidity buffers and portfolio liquidity exceeds investor liquidity by a wide margin across different time periods, suggesting that funds should be able to meet investor redemptions through orderly liquidation. In addition, 3.8 percent of hedge fund assets involve liquidity management tools, such as gates, suspensions, or side pockets, the report states.

IOSCO found that hedge funds across the sample posted total collateral of more than $2.7 trillion, with the amount posted in the form of cash and equivalents falling slightly. In the realm of trading and clearance, the portions of cash securities traded on exchange versus over-the-counter were relatively equal, except with respect to derivatives, which traded higher OTC, the report concludes.

Monday, November 27, 2017

Petition asks high court to curb SEC's dodging of statutes of limitations

By Rodney F. Tonkovic, J.D.

A petition for certiorari has been filed asking the Court to reign in a tactic used by the SEC to avoid statutes of limitations. The petitioner maintains that the Commission frequently takes portions of a continuous course of action in a way that allows it to commence an action after the limitations period has expired. The petition also raises a series of challenges to what it argues were erroneous factual findings and misapplications of properly-stated rules of law (Knight v. SEC, November 7, 2017).

From late 1999 through the summer of 2000, Internet start-up disseminated a private placement offering. The Commission filed an action in 2004, claiming that iShop Chairman Anthony M. Knight and others conducted a fraudulent and unregistered securities offering scheme that defrauded over 350 investors who invested approximately $2.3 million. In 2014, the matter came before a jury, which returned a verdict in favor of the Commission, finding that Knight violated the antifraud provisions of the securities laws and the securities registration provisions of the Securities Act.

No miscarriage of justice. In September 2015, Knight sought judgment as a matter of law or a new trial asserting, among other arguments, that the Commission engaged in misconduct, witnesses were not credible, and that others besides Knight made the alleged misrepresentations. In denying Knight's motion, the court said that his submission generally consisted of unsubstantiated attacks and Knight's "own, self-serving, interpretation of the facts." The court then found that the jury's finding was neither the result of surmise nor a miscarriage of justice. Knight was then permanently enjoined from violations of the registration and antifraud provisions. He was also ordered to disgorge $2.3 million and to pay a civil monetary penalty of $330,000.

On appeal, Knight (proceeding pro se) challenged the jury's findings and the remedies imposed by the district court. Knight first claimed that the Commission's allegations were time-barred, but the court disagreed, stating that the claims did not accrue until the earliest alleged violation in September 1999. The Commission filed its action in September 2004, so its claims were not barred under the five-year limitations period in 28 U.S.C. § 2462.

Knight also raised a number of challenges to the jury's findings, all of which were rejected by the panel. Among its conclusions, the court stated that the general disclosures contained in iShop's offering memoranda could not overcome proof that the description of the security was materially inaccurate. The court also rejected Knight's defense that he reasonable relied on the advice of counsel because the jury could reasonable have found that he failed to make a complete disclosure to counsel. Knight also argued under Janus that he was not the "maker" of the statements in the offering memoranda, but there was sufficient evidence, the court said, that he was. The panel found no error in the district court’s choice of remedies and affirmed the judgment.

Cert petition. The petition for certiorari first asks the Court to consider whether the SEC can choose, piecemeal, alleged actions in a continuous course of action so as to avoid prosecution being time-barred pursuant to 28 U.S.C. Code § 2462. According to Knight, the appellate court failed to consider that iShop's actions were part of an alleged course of conduct that began before the five-year statutory period and that the Commission commenced its action after the limitations period had passed. This, the petition, states, is a frequent tactic employed by the SEC to escape statutes of limitations, with dire consequences for Knight and "countless others."

The petition then asks the Court to assess whether a series of eight judicial errors merits a reversal. Knight concedes that certiorari is rarely granted when the asserted error consists of erroneous factual findings of the misapplication of a properly-stated rule of law. But, he requests consideration due to the "sheer enormity of the erroneous factual findings and misapplications of properly stated rules of law in conjunction with an important federal question." The district court departed from the accepted and usual course of judicial proceedings, Knight says, and the appellate court sanctioned this departure. This case, Knight concludes, presents a change to review the SEC's conduct and is important to every pro se litigant targeted by the Commission.

The petition is No. 17-734.

Friday, November 24, 2017

Kokesh fails to save adviser from disgorging ill-gotten gains

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

A former hedge fund adviser has been ordered to pay almost $2 million in disgorgement and penalties for fraudulently spending investors’ funds on luxuries and paying off investors from a prior scheme. The federal district court in Dallas summarily rejected the defendant’s contention that the Supreme Court’s decision in Kokesh v. SEC would make disgorgement an unlawful penalty in his case. The court also rejected the argument that a New Mexico court’s award of restitution against the defendant for his role in the prior scheme precluded an order of disgorgement in the present case (SEC v. Sample, November 20, 2017, Boyle, J.).

Lobo Fund scheme. The defendant, Matthew D. Sample, had raised $982,000 from investors in his hedge fund, Lobo Volatility Fund, LLC. The SEC charged Sample with using the invested funds for personal expenses while supporting his con by creating false IRS forms showing positive account balances and investment returns. In April 2014, Sample agreed to disgorge his ill-gotten gains, pay prejudgment interest on those gains, and pay a civil penalty. In a parallel criminal proceeding, a federal district court in New Mexico subsequently sentenced Sample to five years of probation and ordered him to pay approximately $1.1 million in restitution to the victims of the Lobo Fund scheme and a prior fraudulent scheme.

Kokesh unavailing. Although Sample had previously agreed to disgorge his ill-gotten gains, he responded to the SEC's motion for monetary remedies by arguing that the Supreme Court's June decision in Kokesh v. SEC would make ordering him to disgorge an unlawful penalty. Specifically, Sample’s argument hinged on footnote three of Kokesh, where the high court stated that nothing in its decision should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings.

The district court, however, flatly rejected Sample’s argument, noting that Kokesh had no effect on how courts apply disgorgement principles. Rather, Kokesh merely held that disgorgement claims are subject to 28 U.S.C. § 2462’s five-year statute of limitations. Moreover, the restitution ordered in Sample’s criminal proceeding did not prevent an order of disgorgement in his civil case. Accordingly, the court ordered Sample to disgorge an amount equal to $919,875 less what he pays the Lobo Fund victims in restitution.

Civil penalty. The court also granted the SEC's request for a third-tier civil penalty against Sample. Among other things, the court noted that Sample: (1) had misappropriated substantial amounts of his clients’ money for his personal use; (2) knew his conduct was illegal; (3) lied to his clients about losses he was incurring and created fake account statements; (4) was aware of the federal securities laws as a veteran of the securities industry; and (5) made Ponzi payments to pay alleged returns to an existing investor. Given the egregiousness of Sample’s scheme and the losses he caused his victims, the court imposed a civil penalty of $919,875.

The case is No. 3:14-CV-1218-B.

Wednesday, November 22, 2017

Oregon’s proposed crowdfunding amendments will enhance capital formation

By Jay Fishman, J.D.

The Oregon Finance and Securities Regulation Division has proposed amendments to its crowdfunding rules to better align them with federal requirements, and to capture changes providing small businesses with more leeway to raise capital from permitted investors without lessening investor protections.

Public comments. Interested persons may submit written comments about the rule proposals to Karen Winkel at the Department of Consumer and Business Services, Finance and Securities Regulation Division, Labor and Industries Building, 350 Winter St NE, Salem, Oregon 97301. Alternatively, comments may be emailed to Comments must be received by 5:00 pm on December 11, 2017.

Proposed crowdfunding rule changes. Highlights of the proposed rule amendments would include the following:

Exemption from registration. The “Oregon Intrastate Offering Exemption” (OIO) would provide Oregon businesses with an exemption from securities registration to facilitate investment by Oregon residents while simultaneously protecting investors. To be exempt:
  • the sale would be made by an issuer comprising an existing Oregon business that complies with all Oregon Secretary of State requirements for doing business in Oregon; 
  • the offer and sale would be conducted in accordance with SEC Rule 147A; note that issuers having properly filed an OIO offering before July 7, 2017 under federal Securities Act, Section 3(a)(11) and SEC Rule 147 would notify the Director that the continued offer and sale will comply with this subsection (2) [SEC Rule 147(A)]; 
  • OIO securities would be offered or sold only to natural persons who the issuer, salesperson, or broker-dealer reasonably believes are Oregon residents (and otherwise qualify under the OIO rules); and 
  • the issuer, salesperson or broker-dealer, before any sale under the OIO exemption occurs, would obtain reasonable documentary evidence that the prospective purchaser’s principal residence is in Oregon (reasonable documentary evidence proving Oregon residency could include a current Oregon-issued driver’s license or personal identification card, or a current voter registration, or evidence of Oregon principal residence ownership or occupancy, or official business mail from a state or federal agency); note that a signed statement without additional evidence does not sufficiently create a reasonable belief in a purchaser’s Oregon residency.
Aggregate offering amounts. An issuer could engage in multiple OIOs subject to integration, but the total amount raised in any 12-month offering period (or 24-month period if the issuer applies to extend the offering) would not exceed $250,000. The OIO could be used to raise a maximum aggregate amount of $500,000.

Single investor limit. The amount the issuer could accept from any individual investor would not exceed $2,500 unless the following alternative maximum investment (AMI) applies: A person whose income exceeded $100,000 for the two consecutive years and who reasonably expects their income to exceed $100,000 for the current year, and who has a $200,000 net worth, excluding their principal residence, may invest up to $10,000. For AMI purposes, an issuer, salesperson or broker-dealer must have formed a reasonable belief based on document review and the prospective purchaser’s signed declarations that the prospective purchaser meets the income and net worth thresholds. An issuer that sells a security under the AMI would be permitted to engage only in a single transaction at the AMI limit per spousal unit. The AMI-subject securities could be held jointly or individually.

Securities limitation. OIO securities would be limited to notes, stocks and/or debentures.

Notification of first sale. An issuer would notify the Director within five days of the first sale of an OIO security.

Duration of offering. An OIO offering would not exceed 12 months from the date the security is first sold under the OIO exemption. An OIO offering could be extended for one additional, consecutive 12-month period, but an offering period would not exceed 24 months from the date of the initial sale. An issuer could apply to extend the offering by submitting to the Director an amended filing on a Director-approved form that conforms with the OIO rules.

Offering proceeds. OIO sale proceeds would be used in accordance with both the issuer’s representations made to investors and with OIO rule disclosures.

Issuers must meet with business technical service provider. Issuers, before advertising, offering or selling OIO securities, would need to have reviewed their business plan in person with a business technical service provider.

Notice filing. Issuers would send the Director a written notice of the OIO offering not less than 15 days before any advertising, offer or sale of an OIO security occurs, whichever of the three events comes first. The notice filing requirement could be met by an issuer submitting either a Director-approved form or all the above-required numbered items individually.

The notice, accompanied by a $200 fee payable to the Department of Consumer and Business Service, would contain:
  1. the issuer’s name and address, as well as the names and addresses of the directors’, officers’ principals’, managing members’, and shareholders’ having a 20 percent (or more) interest in the Oregon business; 
  2. a copy of the proposed advertising template (including a URL if a website will be used for the offering) and the name of the third party platform provider (if applicable); 
  3. a brief description of the business and specific project comprising the offering; 
  4. the minimum amount needed to release funds to the issuer, and the maximum *offer amount; 
  5. a copy of the offering documents and a sample of the certificate or other evidence of the security; and 
  6. a Director-approved form verifying the issuer’s in-person meeting with a business technical service provider to review the issuer’s business plan, or an approved waiver. The filing would be signed by the issuer or by the issuer’s duly authorized representative verifying the filing’s material accuracy and completeness. 
* “Offer” would include every attempt to dispose of an OIO security for value. The publication of any information and statements, and publicity efforts—including any advertising materials—in advance or in connection with an OIO that contributes to the conditioning of the public mind or arousing public interest in the issuer or is intended to arouse public interest investing in the issuer or purchasing its securities—even though it does not contain an express offer—is an offer of OIO securities for purposes of this OIO exemption.

Tuesday, November 21, 2017

SCOTUS offered three competing interpretations of SLUSA jurisdiction

By Anne Sherry, J.D.

What effect did the Securities Litigation Uniform Standards Act have on state-court jurisdiction? Cyan, Inc., which successfully petitioned the Supreme Court for certiorari, argues that the statute withdraws, rather than continues, state courts’ concurrent jurisdiction over Securities Act class actions. The respondents counter that SLUSA does not strip state courts of concurrent jurisdiction. And the government, in an amicus brief, submits that defendants are authorized to remove Securities Act covered class actions involving covered securities to federal court (Cyan, Inc. v. Beaver County Employees Retirement Fund, November 13, 2017).

Cyan shareholders sued the company over weaker-than-expected results following its IPO. The complaint was brought as a class action to pursue strict-liability remedies under the Securities Act. It was brought in California state court, but alleged no state-law claims. Bound by California decisions holding that SLUSA continued state-court jurisdiction over class actions under the Securities Act, the state court denied Cyan’s motion for judgment on the pleadings.

SLUSA amended Securities Act Section 22 to close a loophole in the Private Securities Litigation Reform Act that many feared could lead to abusive litigation. The statute now provides that state courts have concurrent jurisdiction of Securities Act suits, “except as provided in [Section 16] with respect to covered class actions.” The parties and amici disagree on how this “except clause” operates.

Cyan’s take: excepting Securities Act claims. Cyan argues that its interpretation is the only one that gives effect to the “except” language of the statute. The clause must except some set of Securities Act claims from the concurrent jurisdiction of state courts, and its text makes clear that these excepted claims are Securities Act claims in “covered class actions,” as provided in Section 16. While Congress sometimes uses the words “as provided in” to refer to a self-operative limit from another statute, as the respondents and government argue, this is not always the case. Cyan presents a hypothetical parking sign that reads “No parking, except as provided in 5 U.S.C. §6103 with respect to legal public holidays.” That code section lists legal public holidays; it has nothing to do with parking, but a reader would understand that the sign bars parking except on the statutory holidays.

To the respondents’ argument that it would have been bizarre for Congress to prescribe different kinds of treatment for state-law class actions, mixed class actions, and Securities Act class actions, Cyan posits that the scheme works “just about as efficiently as possible.” State-law class actions, which are exempt from the PSLRA, are precluded entirely. Securities Act class actions must be filed directly in federal court, where the PSLRA applies. And a hybrid approach for mixed class actions authorizes defendants to remove the suits to federal court, where the state-law claims can be dismissed and the federal claims allowed to proceed subject to the PSLRA.

The less bad alternative: removal. If the Supreme Court does reject Cyan’s reading, Cyan urges it to adopt the government’s interpretation. Unlike Cyan, the government submits that the “except as provided in” language is naturally understood to mean that the cross-referenced provision provides the exception to the general principle. But nothing in Section 16 provides an exception to the general rule of concurrent state-court jurisdiction of a suit asserting only federal-law claims. Rather, Section 16(c) authorizes defendants to remove Securities Act covered class actions involving covered securities to federal court.

The government maintains that its interpretation is consistent with the text of Section 16(c), which does not turn on the source of law under which the removed claims arise. It is also consistent with the structure and purpose of SLUSA, through which Congress authorized removal of state-law actions because it was unwilling to leave preclusion decisions under Section 16(b) to state courts alone. Cyan disagrees, but concedes that while the government’s reading “is not as faithful to SLUSA’s text, structure, and purpose” as its own, it is closer than the respondents’ reading. It would ensure that Securities Act class actions could be heard in a federal forum and prevent circumvention of the PSLRA.

The case is No. 15-1439.

Monday, November 20, 2017

House FSC approves Dodd-Frank repeals plus capital formation, Fed bills

By Mark S. Nelson, J.D.

The House Financial Services Committee engaged in a two-day markup session of nearly two dozen securities and banking bills spanning a range of topics, including Dodd-Frank Act repeals, hedge funds and private equity, business development and closed-end companies, capital formation, proxy advisers, non-bank financial institutions, Fed oversight, and Iran disclosures. The markup and approval of all 23 bills followed a prior House FSC hearing that considered many of the same bills (See vote scorecard).

Dodd-Frank Act repeals. A trio of bills would repeal two of the specialized securities disclosure obligations imposed by the Dodd-Frank Act plus the settlement title of the reform bill. The provisions to be repealed would include:
  • Conflict minerals—Repeal of Dodd-Frank Act Section 1502 (H.R. 4248). 
  • Mine safety—Repeal of Dodd-Frank Act Section 1503 (H.R. 4289). 
  • Restoring Financial Market Freedom Act of 2017 (H.R. 4247)—Repeal of Dodd-Frank Act Title VIII regarding payment, clearing, and settlement. 
By comparison, the Financial CHOICE Act (H.R. 10) would repeal the entirety of the specialized disclosure provisions, including the authority for the SEC’s resource extraction issuer’s rule (Congress disapproved the SEC’s resource extraction issuers rule earlier this year via the Congressional Review Act), plus required studies of inspectors general and of core and brokered deposits. The Treasury Department's report on capital markets, published as part of a review of financial regulations in light of core principles announced by the Trump Administration, recommended repeal of provisions on conflict minerals, mine safety, and resource extraction issuers, and that related SEC rules be withdrawn. The report also urged Congress to transfer the subject matter of these provisions to other agencies if lawmakers were to continue the specialized disclosure regime.

With respect to conflict minerals, the SEC’s recent guidance rolling back the due diligence requirement did not otherwise eliminate the need for U.S. companies to comply with the conflict minerals rule and many firms continued to make the same level of disclosure in 2017 as they had in prior filings. Similar European regulations will come online in January 2021 and will impact European Union importers whose conflict minerals imports are above specified volume thresholds.

Hedge funds and private equity. The Investor Clarity and Bank Parity Act (H.R. 3093) would amend the Bank Holding Company Act to permit hedge funds and private equity funds to use the same name or a variation of a name that the fund has in common with a banking entity that is an investment adviser to the fund if the fund meets certain requirements, which include that the investment adviser not be an insured depository institution, share a name with such institution, or use “bank” in the fund’s name. Currently, BHCA Section 13 (12 U.S.C. §1851) provides that federal regulators can permit banking entities to engage in certain activities despite the Volcker rule ban on many forms of proprietary trading, including organizing or offering a private equity or hedge fund if, among other things, the fund does not share the banking entity’s name.

Friday, November 17, 2017

CFTC Commissioner Behnam reflects and inflects in Georgetown

By Brad Rosen, J.D.

“The CFTC is at an inflection point, where strategic regulatory decisions are critically important to determine the future of market transparency, resiliency, and systemic risk”, declared Commissioner Rostin Behnam, the newest member of the Commodity Futures Trading Commission in his first official speech as a commissioner. Behnam made his long- awaited remarks on November 14 before the Georgetown Center for Financial Markets and Policy at George University, Behnam’s undergraduate alma mater. Behnam was sworn in as a commissioner on September 6, 2017.

In the speech, titled The Dodd-Frank Inflection Point: Building on Derivatives Reform, Behnam provided a sweeping foundational survey of the history of futures regulation in the U.S., starting with the Futures Trading Act of 1921 through the current day, with stops along the way that included the passage of the Commodity Exchange Act in 1936, the establishment of the CFTC in 1974, as well as the 2009 G20 Pittsburgh Summit, which laid the framework for regulating the over-the counter-derivatives markets and the passage of the Dodd-Frank Act in 2010.

Behnam noted that the 2008 financial crisis and weaknesses in the global regulatory system it revealed led to Congress enacting the Dodd-Frank Act, which largely incorporated the international financial reform initiatives for over-the-counter derivatives laid out at the G20 Pittsburgh Summit. These initiatives included: (i) moving standardized contracts to exchanges or electronic trading platform (when appropriate); (ii) mandatory clearing for most bilateral contracts through central counterparties (“CCPs”); (iii) reporting executed trades to trade repositories; and (iv) instituting higher capital requirements for non-centrally cleared contracts.

Behnam argued that it is critical for the CFTC to continue supporting key Dodd-Frank reforms in a manner that is both reflective and forward looking. By this he means it is important to reflect on both the success and failures of policy changes that have been made to date and to keep a vigilant eye on new challenges, innovations, and threats to the financial markets. Behnam asserted, “[o]ur mission is to protect the market and the public from fraud, abuse, and systemic risk”, and recalled, “[w]e cannot forget that millions of jobs were lost and homes foreclosed upon before we were authorized to take action.”

With respect to the further implementation of Dodd-Frank reforms, Behnam identified four areas where the commission needs to make further progress as follows.

Mandatory clearing of standard swaps. Following the implementation of the CFTC clearing mandate in 2013, more than 80 percent of interest rate derivatives and credit default swaps are now centrally cleared. However, mandatory clearing has raised new challenges and concerns with regard to the role and size of the global portfolio of cleared derivatives. Accordingly, aggressive efforts to monitor and consider the potential systemic repercussions of the clearing mandate need to be analyzed and pursued by commission staff.

Exchange trading of standardized swaps. The trading of standardized swaps on CFTC-regulated exchanges (designated contract markets or “DCMs”) or on multi-participant trading systems or platforms first established in the Dodd-Frank Act (swap execution facilities or “SEFs”) is another key area of reform. The main policy goal of the exchange trading requirement is to further transparency in the OTC markets. Like the clearing mandate, the exchange trading policy initiative is sound and the market has moved swiftly to adapt to the regulatory changes.

Swap data reporting. Before Dodd-Frank, there simply was little, if any, relevant market data regarding the size, complexity, and potential risks underlying over-the-counter derivatives. Through robust data collection, market risks and unexpected events can be better assessed and possibly predicted. However, given the CFTC’s limited resources and technology capabilities, the Commission does not have the bandwidth to seek to collect or maintain data that does not serve a proven purpose of protecting markets, market participants, and customers. Nonetheless, the CFTC must prioritize building on the current data requirements established in Dodd-Frank in a way that sets clear parameters for what data must be collected and submitted, when it must be submitted; and, equally important, what form the data must take.

Capital and margin requirements for non-centrally cleared swaps. Capital serves as a loss absorbency mechanism in times of extreme market stress. The CFTC has completed its margin rules, but has yet to finalize capital requirements for the swap dealers who are not prudentially regulated. Regulators must continually monitor market ecosystems to ensure that regulations, including capital and margin requirements, are properly set to ensure market resiliency, safety, and liquidity in times of market stress.

Key priorities. Behnam also stated two of his key priorities and objectives that he will focus on during his early days as a Commissioner. The first is his sponsorship of the CFTC’s Market Risk Advisory Committee (MRAC), the Commission’s open forum to examine risk across broad swaths of the markets. The second, and following in the footsteps of Chairman Giancarlo, Commissioner Behnam will embark on a listening tour across the country and meet with market participants, such as commercial manufacturers, financial institutions, and farmers and ranchers. The stated goal of this undertaking is to get a better understanding of the risk management challenges that these various end users encounter.

Thursday, November 16, 2017

BakerHostetler hosts webinar on preparing for the 2018 proxy season

By Jacquelyn Lumb

National law firm BakerHostetler hosted a webinar on preparing for the 2018 proxy season during which panelists talked about the role of proxy advisers, SEC rulemaking, and emerging issues. The panelists agreed that, while many subscribe to a proxy advisory firm’s services, they do not necessarily follow its recommendations. Companies should engage with proxy advisory firms before the proxy season is underway and before their preliminary proxy has been filed.

Proxy advisory firms. Institutional Shareholder Services reports that it holds 61 percent of the market share with 1,700 clients. Glass Lewis has 1,200 clients. Egan Jones has a smaller shop and is the least influential of the three, but one panelist noted that its guidelines are much stricter. For example, in Egan Jones’ view, a director who has served for 10 years is an affiliated outsider who is no longer fully independent. The firm also has stricter guidelines on auditor ratification and over-boarding.

Shareholder proposals. Shareholder proposals seeking proxy access are in decline and by the end of the upcoming proxy season over 80 percent of the S&P 500 companies are expected to have a proxy access policy. Other hot topics include board refreshment, diversity, and the board’s skill matrix; environmental, social, and governance issues; and shareholder engagement. The panelists said they had the most success in negotiating the withdrawal of proposals relating to board diversity after providing assurances that the companies would look to a diverse pool of candidates with every new opening on the board. However, these companies now must follow their assurances with action.

Withhold recommendations. The panelists said that among the issues that may result in a withhold recommendation by a proxy advisory firm in the election of directors is where a director has attended less than 75 percent of the board meetings, where the director serves on too many boards, where the board has failed to take action on a shareholder proposal that gained majority support, and where the board either adopts or retains what is considered an anti-shareholder rights provision.

Say on pay. With respect to say on pay, both ISS and GL pay attention to pay for performance, the structure of the compensation program, problematic pay practices, and the compensation committee’s communications and responsiveness.

Pay ratio disclosure. 2018 will be the first year for the mandatory pay ratio disclosure. Advisory firms are not expected to react the first year, but one panelist predicted that the media will have a field day. Another panelist said that after the election, he thought the pay ratio rule would be revoked, and another wondered if the SEC would come up with a regulatory maneuver to delay the mandate. Instead, the SEC and the staff issued guidance on how to comply with the requirement.

Hedging and clawbacks. Two other Dodd-Frank Act rules that were proposed by the SEC but not yet adopted relate to hedging and clawbacks. One of the panelists said the hedging proposal was a bit more palatable but the clawback proposal was pretty prescriptive. Neither is likely to be adopted any time soon, in one panelist’s view, although some companies have adopted policies in those areas. If the SEC ultimately adopts a clawback provision, companies may have to amend existing policies to reflect the new rule.

Wednesday, November 15, 2017

ESMA joins chorus of warnings against ICOs

By John Filar Atwood

The European Securities Markets Authority (ESMA) has joined securities regulators from around the globe in issuing a formal warning about the risks of initial coin offerings (ICOs). Guidance on ICOs and cryptocurrencies in recent months has come from, among others, the U.S. SEC, the Canadian Securities Administrators, the Bank of Russia, and the Australian Securities and Investments Commission. China and South Korea have instituted an outright ban on ICOs.

ESMA warned that ICOs are highly speculative and could result in the total loss of investment. In addition, they may fall outside a country’s existing offerings rules, and therefore enjoy none of the protections that accompany regulated investments.

In addition, ICOs may be vulnerable to fraud or illicit activities, owing to their anonymity and their capacity to raise large amounts of money in a short timeframe. ESMA noted that several recent ICOs were identified as frauds, and it is possible that some ICOs are being used for money laundering purposes.

ICO definition. An ICO is a way to raise money from the public using coins or tokens. In an ICO, a business or individual issues coins or tokens and sells them in exchange for virtual currencies such as bitcoin or ethereum. ICOs are conducted online, and the tokens are typically created and disseminated using distributed ledger or blockchain technology.

Some tokens serve to access or purchase a service or product that the issuer develops using the proceeds of the ICO, according to ESMA. Others provide voting rights or a share in the future revenues of the issuing venture. Some tokens are traded and/or may be exchanged for traditional or virtual currencies at coin exchanges.

Few exit options. Among the risks identified by ESMA are that investors may not be able to trade their tokens or to exchange them for traditional currencies. Not all tokens are traded on virtual currency exchanges, EMSA noted, and when they are their price may be very volatile.

ESMA also noted that most ICOs are launched by businesses that are at an early stage of development with an inherently high risk of failure. Tokens generally have no intrinsic value other than the possibility to use them to access or use a service or product that is to be developed by the issuer. ESMA warned that there is no guarantee that the services or products will ever be successfully developed.

The information that is made available to investors is in most cases unaudited, incomplete, unbalanced, or even misleading, according to ESMA. ICO information tends to emphasize the potential benefits but not the risks, ESMA added, and is not easy to understand.

Finally, ESMA advised that the distributed ledger or blockchain technology that underpins the tokens is still mostly untested. The code used to create, transfer or store the tokens may be flawed, ESMA warned, preventing investors from accessing or controlling their tokens. The technology may not function quickly and securely during peak trading periods, and tokens may be susceptible to theft through hacking, ESMA concluded.

Tuesday, November 14, 2017

Strong FCPA enforcement levels the playing field for honest companies, say SEC, DOJ officials

By Lene Powell, J.D.

International bribery used to be commonplace in competing for overseas contracts. In some countries, it was even tax-deductible. As an accepted practice, bribery rewarded bad actors, punished ethical companies and individuals, facilitated organized crime and authoritarian rule, and weakened the rule of law.

But strong anti-corruption laws and increasing coordination between the SEC, Department of Justice, and foreign counterparts has achieved extraordinary results, said SEC and DOJ officials at a conference marking the 40th anniversary of the Foreign Corrupt Practices Act (FCPA) and the 20th anniversary of the Organization for Economic Cooperation and Development (OECD) Anti-Bribery Convention. As Steven R. Peikin, co-director of the SEC Enforcement Division, observed, international resolutions featuring criminal liability and massive fines are sending strong messages of deterrence to companies and individuals who might otherwise see bribery and corruption as a way of maximizing their commercial advantage.

And according to Acting Assistant Attorney General Kenneth A. Blanco, tireless work really has made a difference over the past few decades in changing international acceptance of corruption. “Because of the efforts of the OECD Working Group on Bribery, and our law enforcement partners at home and overseas, we have transitioned from a world in which bribery of foreign officials was considered a sound business strategy, to one in which bribery is treated like the corrosive crime that it is,” said Blanco.

International coordination. Peikin sees a “sharply upward trajectory” in the level of cooperation and coordination among regulators and law enforcement worldwide. In the past fiscal year alone, the Commission has publicly acknowledged assistance from 19 different jurisdictions in FCPA matters.

Peikin and Blanco both pointed to Odobrecht and Braskem, the largest FCPA case in history, as an outstanding success. In that case, a Brazilian petrochemical manufacturer agreed to pay $957 million as part of a global settlement including the SEC, DOJ, and authorities in Brazil and Switzerland. The company pleaded guilty in the U.S. and, importantly, must cooperate with the ongoing investigations of individuals in the respective countries. So far approximately 80 people have been charged in connection with the cases.

In addition to helping in gathering evidence and building the case, international coordination allowed penalties to be apportioned fairly between the countries and avoided duplicative fines, said Blanco. This fairness in applying penalties gives companies the proper incentives to cooperate fully with the relevant jurisdictions.

Another massive resolution was In the Matter of Telia Company AB, in which Swedish telecommunications giant Telia Company AB agreed to pay more than $965 million to settle charges that the company and a subsidiary violated the Foreign Corrupt Practices Act by paying bribes to win business in Uzbekistan. That case involved coordination with Dutch and Swedish law enforcement.

Individual accountability. Holding individuals accountable can be a challenge, said Peikin. Often, the individuals involved are foreign nationals who reside overseas. Even when they can be charged in the U.S., in many cases they have limited or no assets in the U.S., limiting the options for enforcing any monetary judgments obtained. But given that holding individuals accountable is critical to the goals of deterrence, incapacitation, and just punishment, he expects that the SEC continue to have “intense focus” on the question of individual responsibility in every FCPA investigation.

Blanco also noted a focus on individual accountability, and said that since 2016 the DOJ has brought more than 35 criminal cases against individuals and 17 cases against corporations in connection with foreign bribery charges. In 2017 so far, the DOJ has announced convictions or guilty pleas by 17 individuals in FCPA-related cases. This is more than in any previous year and there is more to come, he said.

Statute of limitations. One of the principal challenges in bringing an FCPA case is the interplay between the length of time it takes to conduct an FCPA investigation and the statute of limitations, said Peikin. The misconduct may have aged by the time the SEC learns of it, and FCPA cases often take a long time to develop because they are complex and require the collection of evidence abroad.

Compounding this is the recent Supreme Court decision in U.S. v. Kokesh, in which the Court held that Commission claims for disgorgement are subject to the general five-year statute of limitations, said Peikin. Kokesh has already had an impact and the SEC has had no choice but to redouble efforts to bring cases as quickly as possible. But this makes sense in any case, he said, because cases have the highest impact and litigation efforts are most effective when the SEC brings cases close in time to the alleged wrongful conduct.

Monday, November 13, 2017

Risk alert, roundtable offer guidance to municipal advisors

By Anne Sherry, J.D.

An SEC-hosted regulatory roundtable on the nascent regulatory regime for municipal advisors took an optimistic outlook, even as an OCIE risk report identified compliance deficiencies uncovered in examinations. Panelists from the MSRB, SEC, and FINRA see the rules as providing opportunities and a level playing field for firms, while mitigating issues in the marketplace and giving tools to regulators. Mark Zehner of the SEC’s Division of Enforcement quipped that he hopes the regime puts him out of a job.

Examination deficiencies. The risk alert is a short document that both identifies the forms and compliance obligations relating to municipal advisors and identifies OCIE staff’s observations in over 110 examinations of MAs. The regulatory roundtable closed out a compliance outreach program held at the SEC’s Atlanta office. When Ritta McLaughlin (MSRB) opened the discussion by asking what keeps the panelists up at night, OCIE examiner Nadine Sophia Evans referred to the risk alert. It is critical for advisers to understand their obligations, and the examinations revealed books-and-records deficiencies, inadequate policies and procedures, written supervisory procedures that do not reflect what the firm is actually doing in practice, and “the elephant in the room” of registration issues. Evans added that MAs should look at the spirit of the rules to focus on what the regulators were ultimately trying to achieve.

Other panelists echoed the concerns about failures to register and what FINRA examination manager Gene C. Davis called a “lackadaisical” approach toward compliance. Rebecca Olsen of the SEC’s Office of Municipal Securities questioned whether form documents are really being used thoughtfully, after reflection and customization for each particular deal.

A rosy outlook. Despite these qualms, the panel seemed unanimously optimistic about the regulatory regime’s impact on the industry. Zehner said that a good class of registered MAs is the antidote to the problem of clients getting railroaded into unsuitable investments. The regime should give MAs confidence that they will be protected and their interests will be addressed. Gail Marshall, chief compliance officer of the MSRB, hopes that MAs will see the entities represented by the panel as resources and not “mean regulators.” She cited OCIE’s risk alert and added that the MSRB has educational resources and webinars, a needs analysis example, training plan template, and FAQs.

Practical advice. The panelists also offered some practical advice focused around dynamic procedures and best practices. When asked what an MA should do if a client wants to take on more risk than the advisor thinks is suitable, Olsen said the advisor should go through the normal steps and diligence to come up with a recommendation for the client. If the client is unswayed, the advisor does not need to disengage, but may want to document the engagement well. Zehner added that the MA needs to remember that the client is not the individual, but the entity. He cited an enforcement example where a mayor was so adamant that the advisor had gotten the numbers for feasibility runs wrong that the advisor changed them. The mayor was happy and all was well—until the bonds went into default.

As for processes and procedures, Evans suggested that MA firms create a cheat sheet of compliance dates and requirements and do regular (monthly or bimonthly) checkups. Davis agreed, clarifying that when the panelists talk about processes, they don’t mean simply keeping a manual that states what fiduciary duties are owed. It means having a checklist, asking whether a particular procedure was followed or disclosure made. Making a point of documenting deals with memoranda and referring back to them later is another example of a process, he said. Zehner affirmed that documentation is critical, adding that if enforcement staff see a contemporaneous memo, it demonstrates that the firm was not trying to hide the ball.

Friday, November 10, 2017

SEC staff reminds registrants of availability of Rule 3-13 waivers

By Jacquelyn Lumb

Chief Accountant Mark Kronforst in the SEC’s Division of Corporation Finance, speaking at the Practising Law Institute’s conference on securities regulation, reminded registrants that the staff is willing to grant waivers from certain disclosures in order to facilitate capital formation. He referred to remarks by Chairman Jay Clayton to the Economic Club of New York last July in which Clayton advised that issuers can request modifications to their financial reporting requirements in certain circumstances under Regulation S-X Rule 3-13 where it may not be material to the total mix of information available to investors. Clayton said the staff is placing a high priority on responding with timely guidance.

The Division of Corporation Finance’s Office of the Chief Accountant has updated its Financial Reporting Manual to include contact information for waiver requests. According to the manual, the staff has the authority, where consistent with investor protection, to permit registrants to omit or to substitute required financial statements. The requests should be submitted via email and a link is provided in the manual.

One of the panelists noted that there was little transparency with respect to waivers that have been granted. Kronforst said to talk to the staff if there is a problem with the reporting requirements, especially if it affects capital formation, such as acquisitions under Rule 3-05. The staff has been responding in about five days. Kronforst reiterated that there is no need for a certified letter or a FedEx delivery for the request. The email link that is provided is fine, he advised.

John White, a former director of the division and now a partner at Cravath, Swaine & Moore, provided an example of a request in which he was involved. A foreign private issuer was seeking an initial listing in the U.S., but its auditor had a conflict from three years back that would impair its independence under the rules. A waiver was granted to permit the company to provide two years of audited IFRS financial statements with the third year’s financial statements provided but unaudited. White said it was a critical waiver in obtaining a listing in the U.S.

Kronforst added that the staff may request financial statements that have not been provided. That is fairly rare but it allows the staff to adapt the rule as it deems appropriate.

New GAAP. The panel discussed what SEC Chief Accountant Wesley Bricker refers to as new GAAP—the standards on revenue recognition, leasing, and financial instruments. Bricker said it is close to “exam time,” and these standards should be at or near the top of registrants’ agendas. Michael Gallagher with PricewaterhouseCoopers reported that most registrants are choosing the modified retrospective approach to the revenue recognition standard. The full retrospective method requires a lot more work, he noted.

The PCAOB issued an audit alert on the revenue recognition rules. Gallagher said the alert does not include any new requirements, but reminders of certain requirements that are relevant to the auditors’ consideration of companies’ implementation of the new standard in upcoming interim reviews and year-end audits, such as the SAB 74 disclosures about the transition. Gallagher said SAB 74 is a useful risk management tool. He emphasized the importance of internal controls and good processes during the transition.

Non-GAAP. Kronforst advised that the staff continues to pay attention to the use of non-GAAP measures, but the comments have slowed to a trickle, a status that he hopes will continue. Bricker noted that if there are any material changes in a company’s GAAP policy, the auditor is briefed about it, and he recommended that audit committees consider doing the same for any material non-GAAP changes.

Segment reporting. The staff continues to issue comments on segment reporting, according to Kronforst, but he predicted it will not be a major topic on this year’s speaking circuit. A lot of people are asking about comments on revenue recognition by early adopters. Kronforst said the sample size is too small at this time to provide any guidance.

In closing, the panelists were asked to provide their takeaways from the discussions. Gallagher said the new standard on leases has lots of sleeper issues and will be a lot of work. Kronforst reiterated the availability of Rule 3-13 waivers. He said there is a lot of lore out there, so rather than relying on guidance from 1992, ask the staff. Bricker highlighted the revised auditor’s report. He suggested that audit committees may want to try a dry run and flesh out their communication strategy.

Thursday, November 09, 2017

House tax reform: a closer look at carried interest and RSUs

By Mark S. Nelson, J.D.

House Ways and Means Committee Chairman Kevin Brady (R-Texas) offered a second set of amendments that deal directly with carried interest and restricted stock units. Chairman Brady had already introduced a substitute bill that made numerous conforming amendments to the original tax reform bill and removed a proposed limit on the exemption for income under treaty. The next step is for the committee to wrap up its days-long markup session and vote on whether to advance the reform package to the full House.

The Brady amendment (summary) would make numerous changes to the original tax reform bill text. Overall, the amendments will hearten some who fought for changes to the tax reform bill’s treatment of employee shareholders and songwriters, but may rankle others because of newly proposed anti-fraud measures related to the earned income tax credit and a five-year sunset for persons eligible for the dependent care assistance exclusion. The Brady amendment was adopted by a vote of 24-16. The Senate is expected to publish its tax reform bill soon and Sen. Tammy Baldwin (D-Wis) has already urged senators to include her bill on carried interest in the Senate’s tax reform package.

Carried interest. The House tax reform package initially did not include provisions for closing the carried interest loophole. The Brady amendment would lengthen the current one-year holding period for some partnership interests to three years in the case of certain applicable partnership interests. The Treasury Secretary could provide that the longer holding period would be inapplicable to assets not held for investment on behalf of others. The amendments to the Internal Revenue Code would be effective for taxable years after December 31, 2017.

Under the amendment, “Applicable partnership interest” would be defined as “any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.” But the definition would not apply to certain interests held by those employed by entities that only provide services to other entities. The definition also would be subject to exceptions for: (1) partnership interests held by a corporation; or (2) capital interests in a partnership entitling a taxpayer to a share of the partnership’s capital based on either capital contributions or the value of the interest under Code Section 83.

“Applicable trade or business” would mean a regularly-conducted activity that includes raising or returning capital and either investing in (or disposing of) or developing specified assets. “Specified assets” includes securities, commodities, and derivative contracts.

Representative Sander Levin (D-Mich) attempted to clarify the impact of the Brady amendment on carried interest in an exchange with the committee’s sole witness, Thomas Barthold, chief of staff for the Joint Committee on Taxation (JCT), a nonpartisan committee of the U.S. Congress. Representative Levin first asked what impact the longer holding period would have. Barthold said that sales of partnership interests within the three-year period would be treated as short-term sales and, thus, subject to ordinary income tax rates. As a result, Bathold said the amendment should be a revenue raiser.

Representative Levin then asked Barthold for the impact of the remainder of the carried interest amendment, specifically whether more or fewer entities would be subject to limits as compared to Rep. Levin’s bill on closing the carried interest loophole. Barthold replied by describing the outlines of the carried interest amendment, including its application to specified assets. When pressed by Rep. Levin, Barthold conceded that he had not yet completed a quantitative analysis of the amendment, but he said the amendment was likely narrower than Rep. Levin’s bill.

Wednesday, November 08, 2017

What is the level of proof needed to invoke the Basic presumption of reliance?

By Rodney F. Tonkovic, J.D.

A petition for certiorari asks the Supreme Court to consider the proof required to establish the Basic presumption of reliance. The petitioner, Brazilian oil giant Petrobras, maintains that in a decision granting class certification, the Second Circuit erroneously concluded that the Basic presumption can be based entirely on factors unrelated to whether the alleged misstatement had even an indirect impact on share price. The petition also asks the Court to address Rule 23's requirement that class membership can be ascertained through administratively feasible means (Petroleo Brasileiro S.A. - Petrobras v. Universities Superannuation Scheme Limited, November 1, 2017).

Kickbacks. The action was brought by purchasers of debt securities in Petrobras. Once one of the largest companies in the world, Petrobras's value plummeted after the exposure of a multi-year, multi-billion-dollar money-laundering and kickback scheme, carried out by a cartel of Brazilian construction contractors, suppliers, and corrupt Petrobras executives. According to the investors, Petrobras, which denied any wrongdoing, was complicit in concealing information about the kickback cartel from investors and the public.

The district court certified two classes for money damages: one asserting claims under the Securities Act, and the other under the Exchange Act. Petrobras appealed, arguing that court erred in finding a class-wide presumption of reliance under the "fraud on the market" theory. The company also challenged the court's conclusion that the proposed classes were ascertainable and administratively manageable.

The Second Circuit affirmed the district court’s ruling that the Exchange Act class was entitled to a presumption of reliance under Basic. Petrobras argued that the district court gave undue weight to the plaintiffs' empirical test, which measured the magnitude of responsive price changes in Petrobras securities without considering the direction of those changes. The panel, however, declined to impose a blanket rule requiring district courts to rely on directional event studies and directional event studies alone at the class certification stage. The panel also rejected the argument that the district court should have applied a "heightened" ascertainability requirement, under which any proposed class must be "administratively feasible." According to the panel, courts must weigh the competing interests inherent in any class certification decision, and a class is ascertainable if it is defined using objective criteria that establish a membership with definite boundaries.

Basic presumption. The petition first asks the court to consider whether the legal standard to invoke Basic's presumption of reliance at minimum requires empirical evidence that a security general reacted in a directionally appropriate manner to new material information, or can the presumption be based entirely on other factors unrelated to whether the alleged misstatement had price impact. Petrobras asserts that the Second Circuit's ruling has dramatically lowered the threshold for class certification in securities fraud class actions and conflicts with the Supreme Court's ruling in Halliburton II. According to the petition, under the Second Circuit's decision, a plaintiff can benefit from the Basic presumption without showing even indirect evidence of price impact, and a defendant is prevented from using even direct evidence of price impact to rebut the presumption.

Under the Second Circuit's ruling, the petition maintains, a plaintiff can establish reliance by showing that a security had any price reaction without showing a predictable cause-and-effect relationship between the news and the price movement. If the price movement is in the wrong direction, there is no basis to presume that the price reflects the fraud such that the plaintiff could be presumed to have purchased in reliance on the alleged misrepresentation. Further, the Second Circuit made the presumption effectively irrebuttable by implying that directional event studies are of limited utility due to "methodological constraints."

The petition goes on to note that, in the 29 years since Basic, district courts have struggled with the standard for the presumption of reliance and differ greatly as to how market efficiency must be established. While the Cammer test is influential, the petition says, it has come under criticism for uncertainty and imprecision. And, courts have added more factors to the Cammer test, resulting in an ad hoc approach with similar circumstances yielding different determinations of market efficiency. This case, the petition contends provides a rare opportunity to resolve almost 30 years of confusion on an important issue.

Administrative feasibility. The petition asks further whether Rule 23 requires proponents of class certification to show that class membership can be reliably ascertained through administratively feasible means. Three circuits (the Third, Fourth, and Eleventh) have held so, the petition says, while four more (the Second, Sixth, Seventh, and Ninth) have taken the contrary position. In this case, the Second Circuit held that Rule 23 does not contain an independent feasibility requirement and requires only that a class can be defined using objective criteria that establish a membership with definite boundaries.

Here, Petrobras noted that its notes are traded over-the-counter across four continents, and there is no administratively feasible means to ascertain whether the notes were purchased in "domestic transactions," as required by Morrison. If putative class members cannot determine whether they are members, the petition asserts, they are unable to make fundamental decisions affecting their rights. In addition to due process concerns, the Second Circuit's decision allows a named plaintiff to demand billions of dollars on behalf of "domestic" purchasers without worrying about whether class members can be ascertained. The Second Circuit, the petition states in closing, has abdicated an essential gatekeeping function by not requiring an administratively feasible means of ascertaining class membership.

The petition is No. 17-664.

Tuesday, November 07, 2017

Enforcement Director James McDonald expounds on self-reporting/cooperation guidelines at Chicago-Kent conference

By Brad Rosen, J.D.

CFTC Division of Enforcement Director James McDonald provided some additional insights, details, and color regarding the division’s recent efforts to encourage self-reporting and cooperation among industry participants at the 9th Annual Chicago-Kent College of Law Conference on Futures and Derivatives held during the first week of November. In his remarks to an audience consisting primarily of the legal and compliance professionals serving the futures and derivatives industry, McDonald echoed many of the themes he articulated in a speech made before the NYU Institute for Corporate Governance and Finance in September of this year.

While previously indicating that a prospective respondent would receive a “substantial reduction in the penalty” that would otherwise be applicable in exchange for self-reporting, cooperation, and remediation, McDonald went somewhat further, explaining that the discount in the civil monetary penalty would run in the 50-75 percent range, generally speaking, provided the self-reporting thresholds required by the division were satisfied.

Additionally, while noting that any cooperation must be full and substantial, McDonald indicated that the division will not require nor request that any party waive its attorney client or work product privileges, when queried by an audience member. However, he noted, a firm may be requested to share the non-privileged portions of an investigative report in connection any internal investigation.

McDonald echoed a number of other points which have been part and parcel of the division’s campaign to encourage self-reporting and cooperation, including:
  • a self-report must be made in a timely manner; 
  • there is no imminent threat or likelihood that the CFTC would otherwise learn of the purported wrongdoing; 
  • any cooperation must be full and substantial; 
  • the self-reporting cannot be otherwise mandated or required to be disclosed; 
  • the Division of Enforcement will expect remedial steps to be taken regarding the violation as well as undertakings to avoid similar occurrences in the future; 
  • an industry participant seeking the benefits associated with self-reporting should make contact directly with the Division of Enforcement (although a report to the NFA might suffice in some instances); and 
  • the Division of Enforcement will make it abundantly clear in terms of what it expects in order to be entitled to the self-reporting and cooperation benefits, and will apprise a prospective respondent if it views the party as veering off track. 
Whether or not to self-report and cooperate is the “question of the year,” according to Renato Mariotti, now a partner at Thompson Coburn, and formerly a federal prosecutor in the Securities and Commodities Fraud Section of the U. S. Attorney's Office.

Mariotti, who presented a session on conducting internal investigations at the conference, suggested that industry participants exercise caution when exploring self-reporting options, noting that CFTC’s approach lacks the specificity and mathematical certainty regarding the level of the benefit a respondent could expect in exchange for cooperation. “In a criminal case, I know exactly what type of credit my client will receive in exchange for his cooperation. And that’s important,” Mariotti observed.
While Director McDonald indicated that the division will not commit to specific penalty reduction amounts in exchange for cooperation, he insisted that industry participants who approach the division in connection with the self-reporting/cooperation initiative will be dealt with fairly. He reiterated, “The division will not play a game of ‘gotcha.’”

McDonald remains optimistic. He noted that in his travels and meeting with industry leaders, he continually hears that companies are striving to build “cultures of integrity.” When asked about industry response and feedback to the initiative and his remarks at NYU back in September, he responded, “It’s too early to tell, but the early indications look good.”

Monday, November 06, 2017

Enforcement forum participants discuss whistleblower developments

By Amanda Maine, J.D.

Jane Norberg, chief of the SEC’s Office of the Whistleblower, said that by the end of the 2016 fiscal year, her office had received more than 18,000 tips and expects to see an uptick in the number of tips for fiscal 2017. Norberg was a panelist on recent whistleblower issues at the Securities Docket’s annual enforcement forum.

Whistleblower award for government employee. Norberg was asked about a footnote in a recent whistleblower award order that stated that the award went to a government worker and how this could be reconciled with the prohibition on using one’s public office for private gain. Norberg, while stating that she could not provide confidential details on the award, assured that the government employee in this situation was covered under an exception. A member of the audience familiar with the case also spoke up, stating that the employee in question was not acting in his official capacity.

Circuit split on internal and external reporting. Panelists also discussed the implications of a federal circuit split on whether the Dodd-Frank Act’s whistleblower protections are available only to those who report misconduct to the SEC (Fifth Circuit) or whether they apply to both internal and external whistleblowers (Second and Ninth Circuits). The Supreme Court is set to hear arguments on November 28.

David Kornblau, formerly of the SEC’s Enforcement Division and currently a partner at Covington & Burling, explained that there will be risks for companies either way. He noted that the Chamber of Commerce has filed a brief siding with the Fifth Circuit interpretation, arguing that the more expansive interpretation would increase costs for companies. Kornblau also speculated whether requiring whistleblowers to first report wrongdoing to the SEC would be a disincentive to reporting their concerns within the company.

Norberg said that most whistleblowers are company insiders and that 80 percent of them reported the misconduct internally. If employees think they won’t be able to make a claim under the expanded Dodd-Frank whistleblower provisions without first reporting to the SEC, the likelihood of people reporting externally rather than internally will go up, she advised.

Phillips & Cohen partner Erika A. Kelton, who has extensive experience representing whistleblowers, said there needs to be a shift in corporate culture where employees are rewarded for reporting misconduct. Some companies may need to reconsider the structure of their incentive compensation policies to make sure that they are not unintentionally rewarding employees who do not report noncompliance.

Friday, November 03, 2017

No private right to sue FINRA for violations of its own rules

By Rodney F. Tonkovic, J.D.

An Eleventh Circuit panel has affirmed the dismissal of a complaint brought against FINRA for lack of a private right of action. The subject of FINRA disciplinary proceedings brought a number of tort claims against FINRA in a state court. The panel affirmed the district court's conclusion that removal to federal court was proper because a suit against FINRA for violating its own rules arises under the Exchange Act (Turbeville v. Financial Industry Regulatory Authority, November 1, 2017, Tjoflat, G.)

FINRA proceedings. Anthony Turbeville was a registered representative of a FINRA-affiliated broker. In 2009, FINRA filed a complaint alleging that Turbeville fraudulently recommended that elderly, unsophisticated buyers purchase certain collateralized mortgage obligations. A FINRA hearing panel barred Turbeville from association and assessed restitution and adjudication costs against him; FINRA's National Adjudicatory Council later affirmed this decision.

While the appeal to the NAC was still pending, Turbeville filed a defamation suit in Florida state court against the investors who had testified against him during the FINRA proceedings. A FINRA investigation concluded that there was cause to institute another disciplinary proceeding because Turbeville had violated FINRA rules against retaliatory action intended to influence ongoing FINRA proceedings. At the time FINRA issued its Wells notice regarding the investigation, Turbeville was not a member of a FINRA-affiliated firm and no longer worked in the industry. Turbeville disputed the investigator's findings and the Wells notice was removed from his BrokerCheck report.

Turbeville then filed suit against FINRA in the Florida state court, asserting that the investigation of the suit against his former clients exceeded FINRA's authority and jurisdiction under its own rules. He sued for defamation, abuse of process, intentional interference with a prospective advantage, and conspiracy.

District court dismisses. FINRA removed the suit to the federal district court and filed a motion to dismiss. The court determined that Turbeville's suit was a challenge to FINRA's application of its own rules, which were promulgated under the Exchange Act's grant of authority. So, a substantial federal question existed, and Turbeville's motion to remand was denied. The court then dismissed Turbeville's claims, concluding that FINRA had absolute immunity from liability in the exercise of its regulatory functions and that there was no private right of action for damages against FINRA.

Affirmed. The appellate panel affirmed. Removal to federal court was proper, the panel said, because a suit against FINRA for violating its own rules arises under the Exchange Act and thus falls within the Act's grant of exclusive jurisdiction to the federal courts. The panel also confirmed that no private right of action exists for members of self-regulatory organizations to sue the SRO for violating its internal rules.

Regarding the jurisdictional issue, the panel noted that while Turbeville's complaint invoked state tort law, it was on its face a challenge to FINRA's application of its internal rules in exercising its regulatory authority. The complaint's causes of action rested mainly on allegations that FINRA violated its own rules and exceeded its jurisdiction. To address the complaint, the court would necessarily have to interpret FINRA's rules and regulations, which are promulgated according to the Exchange Act's mandates. The interpretation of FINRA's rules, then, unavoidably involves answering federal questions, the panel said.

The panel then concluded that Turbeville's claim was properly dismissed because there is no private right of action for plaintiffs looking to sue an SRO for violations of its own rules. The panel noted that the Exchange Act is silent as to the existence of a private right of action, and the internal appeals and administrative-review processes created by the Exchange Act confirm further that no private right exists. Allowing an action like Turbeville's would, the panel remarked, authorize fifty state courts to supervise FINRA's conduct through the vehicle of state tort law. Ultimately, the panel stated, while the prescribed remedies might not fully assuage the reputational harm claimed by Turbeville, he chose to accept those limitations by affiliating himself with an SRO-governed firm.

The case is No. 16-11083.

Thursday, November 02, 2017

PCAOB official reviews broker-dealer inspection results

By Jacquelyn Lumb

PCAOB Enforcement Director Claudius Modesti reported at the American Law Institute’s recent conference on accountants’ liability that among his group’s priorities is firms that alter work documents and the associated failure to cooperate in board inspections or investigations. The enforcement group also has cross-border concerns that sometimes overlap with improper documentation. He noted that 40 percent of the enforcement cases in 2016 related to non-U.S. audits and the number remains on track in 2017.

Significant cases. Modesti reviewed a number of significant cases, including Deloitte Brazil, which involved a lot of “firsts.” The proceeding resulted in the largest penalty ever imposed by the PCAOB and 14 audit personnel were sanctioned. The board received what Modest characterized as a gift when a person who participated in the document alteration chose to cooperate with the investigation. He noted that the firm did not have a whistleblower line or a policy for reporting misconduct and emphasized the importance of providing such an outlet.

In a proceeding against BDO Spain, the audit personnel had no training in complying with PCAOB audits. “You do not get to do a trial run in the U.S. financial system,” Modesti said. In addition to censures and fines, the firm was required to adopt systems to ensure that it would only take engagements that it could complete with professional competence and to provide training to its personnel.

The PCAOB settled 20 cases in which the respondents admitted the findings. Modesti said the board seeks admissions to address the most egregious cases. When asked about receiving credit for extraordinary cooperation, Modesti said he couldn’t forecast the types of credit the board would give, but he suggested that interested parties discuss what they are willing to do and the staff will try to work with them.

Broker-dealer audits. Peter Bresnan, a senior adviser to the director of enforcement, talked about evolution of the PCAOB’s oversight of the audits of broker-dealers, which came about as a result of the Dodd-Frank Act in 2010. He said the real investor protection angle came when broker-dealer audits were required to conform to PCAOB standards and the SEC enhanced its broker-dealer rules related to customer protection. After the adoption of the revised SEC rules, the PCAOB adopted new attestation and auditing standards.

There have not been any individual reports on broker-dealer inspections, just annual reports summarizing the findings. Bresnan noted that 96 percent of the audit firms inspected under the interim broker-dealer program had deficiencies the first year and the next year it was a bit worse. There are important differences in protecting investors of issuers versus broker-dealers, he noted, so the broker-dealer inspections focus on independence and other investor protection areas.

In the first year of broker-dealer inspections, Bresnan said the enforcement staff applied a relatively light touch with censures, penalties and remedial measures. The next year, the sanctions increased a bit, particularly for firms that were told they could not prepare the financial statements of their broker-dealer clients but did so anyway.

A number of “firsts.” In 2016, two firms self-reported violations and remediated the matters. At the end of last year, the PCAOB brought its first case involving other types of violations including the alteration of documents and violations of the SEC’s financial reporting rules.

On August 2, 2017, the board brought its first action against a global network firm for violations during a broker-dealer audit (In the Matter of PricewaterhouseCoopers LLP, Release No. 105-2017-032). Registered carrying broker-dealer Merrill Lynch, Pierce, Fenner & Smith Incorporated was found to have held billions of dollars of its customers’ securities in accounts with third-party institutions that were subject to liens by the third parties in violation of the SEC’s customer protection rule. PricewaterhouseCoopers (PwC) failed to obtain evidence to support its opinion on whether Merrill’s internal controls over compliance with the customer protection rule were effective and whether supplemental information with respect to compliance with the rule were fairly stated in all material respects in relation to Merrill’s financial statements as a whole. PwC was censured and ordered to pay a $1 million civil money penalty.

Wednesday, November 01, 2017

CME Group to launch bitcoin futures contract amid significant market interest

By Brad Rosen, J.D.

The CME Group announced plans to launch a bitcoin futures contract later in 2017. The new contract will be cash-settled and based on the CME CF Bitcoin Reference Rate (BRR) which serves as a once-a-day reference rate of the U.S. dollar price of bitcoin, according to the CME’s release.

Terry Duffy, CME Group Chairman and Chief Executive Officer, noted, "[g]iven increasing client interest in the evolving cryptocurrency markets, we have decided to introduce a bitcoin futures contract." "As the world's largest regulated FX marketplace, CME Group is the natural home for this new vehicle that will provide investors with transparency, price discovery and risk transfer capabilities," he added.

Since November 2016, CME Group and Crypto Facilities Ltd., have calculated and published the BRR, which aggregates the trade flow of major bitcoin spot exchanges during a calculation window into the U.S. Dollar price of one bitcoin as of 4:00 p.m. London time. The BRR is designed around the IOSCO Principles for Financial Benchmarks. Bitstamp, GDAX, itBit and Kraken are the constituent exchanges that currently contribute the pricing data for calculating the BRR.

CME Group and Crypto Facilities Ltd., also publish the CME CF Bitcoin Real Time Index (BRTI), in an effort to provide price transparency to the spot bitcoin market. The BRTI combines global demand to buy and sell bitcoin into a consolidated order book, and it is intended to reflect a fair, instantaneous U.S. dollar price of bitcoin in a spot price. The BRTI is published in real time and is suitable for marking portfolios, executing intra-day bitcoin transactions and risk management.

The CFTC has also been playing an increasingly prominent role by providing traders, investors and other market participants with information on various hot topics which confront a rapidly evolving virtual currency marketplace. In mid-October 2017, the commission released a guide, A CFTC Primer on Virtual Currencies, which sets forth the CFTC’s role and oversight of virtual currencies, its enforcement authority, as well as identifying the potential risks and unique pitfalls associated with virtual currencies.

In July, 2017, the CFTC granted LedgerX, a New York-based institutional trading and clearing platform for digital currencies, registration as a derivatives clearing organization (DCO), a development described as a historical milestone in the development of derivatives trading. Meanwhile, in the enforcement realm, in September, 2017, the CFTC brought a federal court action in the Southern District of New York for the first time against a Ponzi operator involved in bitcoin related scheme.

Coincident with the CME’s announcement regarding the bitcoin futures launch, the price of bitcoin hit a record topping $6350, a daily increase of over four percent, reaching a market capitalization in excess of $105 billion. Cryptocurrency market capitalization has grown in recent years to $172 billion. The bitcoin spot market has also grown to trade roughly $1.5 billion in notional value each day.

The bitcoin futures contract will be listed on and subject to the rules of the CME. The particular launch date will depend on relevant regulatory review periods.