Friday, December 29, 2017

FINRA proposal far from solving unpaid arb award problem, says NASAA

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

NASAA has criticized a FINRA proposal for not going far enough to solve the problem of unpaid arbitration awards. In a comment letter concerning FINRA Regulatory Notice 17-33, NASAA offered support for FINRA’s efforts to expand customers’ litigation options when a broker-dealer or associated person becomes inactive. In NASAA’s view, however, the proposed amendments fail to address the core of the unpaid arbitration award issue or boost investor confidence in FINRA’s arbitration process.

NASAA noted that the problem of unpaid arbitration awards is well documented. NASAA cited a 2000 report by the Government Accountability Office (GAO) that identified issues with customers failing to collect on arbitration awards, as well as a 2016 report on the same subject by the Public Investors Arbitration Bar Association (PIABA). In response, FINRA offered the proposed amendments as a way to address the challenges faced by investors who are unable to collect monetary damages awarded to them through FINRA Dispute Resolution’s mandatory arbitration process.

NASAA praised FINRA’s attempts to provide investors with additional options to alter their litigation strategy when an industry member goes inactive, such as allowing investors to withdraw claims, amend the pleadings, postpone hearings, and receive a refund of filing fees. NASAA wrote that the proposal does little, however, to provide relief to investors left holding the bag when awards go unpaid and broker-dealers are not held responsible for their misconduct.

NASAA also worries that permitting a customer to withdraw a claim when a broker-dealer or associated person becomes inactive may pose a reporting issue when FINRA Dispute Resolution publishes statistics on customer claim withdrawals. Unless customer claim withdrawals are categorized in a way that references the reason a customer withdrew his or her claim, FINRA’s statistics concerning customer claim withdrawals may be misleading, leading investors and regulators to believe that a customer withdrew a claim because it lacked merit.

Accordingly, NASAA urged FINRA to create a new reporting mechanism providing transparency on industry participants who became inactive due to unpaid arbitrations or judgments in favor of customers. NASAA believes that this statistic would provide investors with important additional information when making a decision about whether to work with a specific FINRA member or associated person.

Thursday, December 28, 2017

Accounting firms and industry groups comment on proposed Reg. S-K modernization

By Jacquelyn Lumb

The SEC’s comment period on proposals to modernize and simplify disclosures under Regulation S-K closes January 2, 2018, with letters recently submitted by accounting firms Deloitte & Touche, PricewaterhouseCoopers, BDO USA, the Council of Institutional Investors, and the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness (CCMC). Among the areas of focus in the comment letters is a proposal to allow registrants to omit the earliest of the three years of MD&A in some situations (Release No. 33-10425, October 11, 2017).

Deloitte & Touche. Deloitte recommended that registrants be allowed to omit the discussion of the earliest of the three years in MD&A if that discussion was provided in any filing a registrant made on EDGAR rather than restricting it to disclosures that were made on Form 10-K. Deloitte also suggested that registrants be permitted to exclude a discussion of the earliest year even when there has been a change in the financial statements due to a retrospective adoption of a new accounting principle as long as the discussion of the third year was previously provided in a filing on EDGAR.

Deloitte also wrote that it supports cross-referencing and internal hyperlinks within a company’s filings and suggested that the SEC consider whether it is appropriate to permit cross-referencing in the financial statements of a foreign private issuer on Form 20-F where it is permitted by home country accounting standards, laws, or regulations.

PricewaterhouseCoopers. PricewaterhouseCoopers echoed Deloitte’s view regarding the earlier year discussion in MD&A, recommending that a registrant be permitted to omit from its current Form 10-K the discussion of the earliest of the three years if it was previously filed in any SEC filing, with disclosure of where that discussion appeared. PwC added that registrants should be allowed to omit the MD&A discussion of the earliest of three years in all filings other than initial registration statements, and urged the SEC to make conforming changes to Form 20-F for foreign private issuers.

BDO USA, LLP. BDO raised concerns that the requirement to include the earliest of the three years of financial statement based on an evaluation of its materiality would add unnecessary ambiguity to the decision. If the condition for omitting the discussion is challenging to apply, BDO said registrants would likely default to including the discussion. BDO also agreed with the other accounting firms that registrants should be permitted to omit the discussion of the earliest period if it was included in any previous filing under the Securities or Exchange Acts since it would already be part of the total mix of information available to investors.

BDO urged the SEC to consolidate its MD&A guidance in a single place since doing so may improve the disclosure. The guidance can currently be found in releases, sections of the financial reporting manual, and in compliance and disclosure interpretations. BDO agreed that the SEC should make conforming amendments to Form 20-F for foreign private issuers.

Council of Institutional Investors. The Council of Institutional Investors said the SEC should not allow registrants to exclude the discussion of the earliest year in their MD&A if there has been a material change to either of the two earlier years due to a restatement or a retrospective adoption of a new accounting principle. In those circumstances, CII said the context may be particularly useful in assessing a registrant’s financial condition. As an alternative, CII said the SEC could retain the earliest year requirement but allow registrants to hyperlink to the disclosure rather than repeat it.

CII said it does not support the proposed amendment to eliminate the risk factor examples that appear in Item 503(c). In CII’s view, the examples provide useful guidance and help focus the disclosure. CII also raised concerns about the proposal to permit registrants to omit confidential information from material contracts without submitting a confidential treatment request to the Commission, explaining that the amount of information that is redacted could increase significantly as a result.

Center for Capital Markets Competitiveness. CCMC noted that it has long been a supporter of the SEC’s disclosure effectiveness initiative and it is encouraged that the initiative appears to be back on track. In brief, CCMC said it supports the proposal relating to property disclosures but without any presumptive materiality thresholds; the streamlining of MD&A; the changes relating to the process for reviewing confidential treatment requests; and many of the technical amendments included in the proposing release. CCMC urged the SEC to consider more ambitious reforms to the delivery of periodic reports.

CCMC also urged the SEC to help resolve a split among the circuit courts of appeal resulting from the settlement in Leidos, Inc. v. Indiana Public Retirement System which has created uncertainty about the level of detail that is required in MD&A. The Second Circuit held that an omission of material information that must be disclosed in the MD&A of a quarterly or annual report can provide the basis for a claim of securities fraud even if the omission does not make an affirmative statement misleading. CCMC said the finding that Item 303 of Regulation S-K imposed a duty to disclose the omitted information departed from an earlier Ninth Circuit opinion which held that “pure omissions” are not actionable under Section 10(b) and Rule 10b-5.

In CCMC’s view, the amicus brief filed by the U.S. in Leidos further complicates the analysis for public companies by refuting the Ninth Circuit’s view, and suggested that the SEC provide a formal clarification of its position on the issues in dispute.

Wednesday, December 27, 2017

SEC proposes FOIA regs revamp

By Lene Powell, J.D.

The SEC is seeking comment on proposed amendments to Freedom of Information Act (FOIA) regulations. The amendments would reflect changes required by the FOIA Improvement Act of 2016 and update and clarify other procedural provisions. Comments will be due 30 days after publication in the Federal Register.

Required changes. The FOIA Improvement Act of 2016 amended FOIA to address various procedural issues, including records format, timelines, and appeals. The SEC proposes to make four changes to conform its regulations to the Act:
  • Revise Section 200.80(a) to provide that, for records that FOIA requires to be made available for public inspection, they will be made available in electronic format.
  • Revise Section 200.80(c) relating to grounds for request denial, including that disclosure would harm an interest protected by an applicable exemption.
  • Revise provisions relating to assistance from Office of FOIA Services’ FOIA Public Liaisons and dispute resolution.
  • Revise Section 200.80(g) relating to fee waivers.
Updates and clarifications. The proposed amendments would also make numerous other procedural changes, including updates and clarifications relating to submission methods, the 20-day statutory time limit for responses, and aggregation of related requests.

Tuesday, December 26, 2017

Caremark claim over Citigroup ‘corporate traumas’ dismissed

By Mark S. Nelson, J.D.

For the second time in a week Delaware courts have explained, in the words of former Chancellor Allen, the author of the Caremark decision, why the Caremark claim is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” Citigroup, Inc. shareholders had alleged that the bank’s officers and its board failed to conduct oversight with respect to anti-money laundering violations, fraud at a subsidiary bank, foreign exchange (FX) benchmark manipulation, and unlawful credit card practices. Days before the decision in the Citigroup case, the Delaware Supreme Court had reiterated the difficulties inherent in Caremark claims by rejecting a Caremark claim brought against Duke Energy for the company’s role in an environmental catastrophe, albeit over a dissent by Chief Justice Strine (Oklahoma Firefighters Pension & Retirement System v. Corbat, December 18, 2017, Glasscock, S.).

‘Red flags’ theory insufficient. The gist of the shareholders’ Caremark theory was that Citigroup’s officers and directors ignored red flags (the complaint said the board “sat like stones growing moss”) that should have alerted them to serious misconduct on the part of the bank. Vice Chancellor Glasscock set the stage. First, for purposes of demand futility analysis, the court turned to Rales for the proposition that the directors would not be liable unless they could not exercise independent and disinterested business judgment because of the risk they may face substantial personal liability. Second, with respect to the Caremark claim, the more recent exposition of Caremark in Stone v. Ritter requires allegations that the board failed to implement a system of controls, or that the board implemented such controls and then consciously disregarded them; scienter is required to show that the directors knew they acted contrary to their fiduciary duties.

As for the AML red flags, the court concluded that demand was not excused. The shareholders pointed to numerous regulatory orders, additional warnings, and a $140 million fine as evidence that Citigroup’s directors disregarded their duties. But the court said Caremark applies where a company’s board did “nothing” and not, as in the case of Citigroup, the board took imperfect actions but nevertheless acted on the information it had. The court also suggested that the documents cited in the complaint inaccurately described the Citigroup board’s actions; on this point, the court included a footnote reference to the recent Delaware Supreme Court decision regarding Duke Energy stating how to treat a plaintiff’s alleged exaggerations (“The plaintiffs unfairly describe the overall presentation, which we are not required to accept on a motion to dismiss,” said the majority in the Duke Energy case). Moreover, the court suggested that the shareholders would have alleged a Caremark claim if Citigroup’s board had in fact “sat like stones growing moss” (the court called this the plaintiffs’ “geologic metaphor”).

Demand also was not futile regarding two significant financial hits to Citigroup. Under one theory, the shareholders alleged that Citigroup’s board failed to oversee loans made by Banamex (a subsidiary) to a borrower that perpetrated a $400 million fraud on Citigroup by securing loans from Banamex based on fraudulent accounts receivable. The court said that Caremark claims based on the failure to monitor business risks related to a third party’s actions (as opposed to those of company employees) have not been clearly recognized. The other financial hit involved Banamex being fined $2.5 million by Mexican regulators for faulty controls. The court reviewed two sets of alleged red flags and determined that neither set was related to the shareholders’ Caremark allegations.

The third set of allegations against Citigroup posit that the bank’s board was aware of issues relating to the manipulation of FX benchmarks. Citigroup was ultimately fined $2.2 billion and pleaded guilty to conspiracy to violate federal antitrust laws. But the court examined the shareholders’ red flags and found them wanting because some were not red flags, some were red flags and the bank’s board took some good faith action on them, or the red flags never reached the board. As a result, the shareholders failed to state a Caremark claim and demand was not excused.

Lastly, the shareholders’ allegations about Citigroup’s credit card practices were insufficient to excuse demand. In one set of allegations, the shareholders recited how Citigroup enticed consumers to buy add-on services for which the bank was fined $35 million by the Consumer Financial Protection Bureau and the Office of the Comptroller of the Currency; the CFPB also ordered Citigroup to pay $700 million in restitution. But the court again found the alleged red flags wanting. One red flag involved alleged misconduct by two of Citigroup’s rivals. In another instance, Citigroup responded to warnings about control issues by requiring additional training. Yet another red flag related to Citigroup’s $1.95 million settlement with a state attorney general related to the marketing of consumer protections; the court concluded that the complaint failed to allege that at least half of the Citigroup board was aware of the settlement.

Holistic approach rebuffed. The court also took time to address two additional issues raised by the shareholders. First, the court rejected the shareholders’ request for a holistic examination of the cited red flags under Sanchez, a 2015 opinion by the Delaware Supreme Court discussing demand futility. According to the shareholders, the Citigroup defendants pursued a “divide and conquer” strategy with respect to the complaint, and they contended that the court should take a wider view of the shareholders’ red flags.

The court replied that not only was Sanchez inapt, but that it had performed the traditional Caremark analysis by asking if asserted red flags are in fact red flags and whether the company’s response to them was in bad faith. Said the court:
What emerges is a picture of directors of a very large, inorganically grown set of financial institutions, beset by control problems as it struggled to integrate. Those directors may be faulted for lack of energy, or for accepting incremental efforts of management advanced at a testudinal cadence, when decisive action was called for instead.
The court explained that such facts may indicate negligence but that the shareholders hold the remedy. As a result, the court reiterated its conclusion that the facts did not show bad faith by Citigroup’s board, even if the results from the board’s actions were less than perfect. Still, the court, again citing via footnote the Duke Energy case, noted that the shareholders were right that a series of events can help in the evaluation of a board’s scienter.

Second, the court rejected the shareholders’ attempt to compare Citigroup to other companies where shareholders brought Caremark claims. In those cases, the court said the boards and managers either engaged in “extreme” behavior or had “flout[ed]” the law (e.g. Massey, Pyott (Allergan), and Westmoreland (a Seventh Circuit case involving Baxter International).

The case is No. 12151-VCG.

Friday, December 22, 2017

Windy City blockchain lawyers gather in the Loop

By Brad Rosen, J.D.

"With respect to blockchain, we are seeing the rapid and mass adoption of a network of value, as well as a groundswell of demand that will not abate. This is a foundational technology that lawyers will need to become educated on sooner or later." So observed Nelson Rosario, a Chicago attorney who is the founder and main organizer for the Blockchain Lawyers of Chicago meetup and networking group. About 70 lawyers and other blockchain enthusiasts met up at a Chicago Loop watering hole recently to network, share experiences, and swap information on this nascent, but burgeoning, industry and area of the law.

The growth of the meetup group has mirrored the explosion in cryptocurrencies, ICO’s and blockchain itself in some respects. Rosario, a patent law specialist at Marshall Gerstein, a Chicago-based IP boutique, launched a LinkedIn group in April, 2017 that later evolved into the meetup group. The first meeting in October, 2017 attracted around 30 attendees according to Rosario. "I saw a market need developing. There were plenty of meetup opportunities for those involved in technical aspects of blockchain, but none for lawyers. It’s gratifying to see people connecting, lending support to each other, and sharing information," he noted.

Many of the meetup attendees were closely following the introduction of Bitcoin futures contracts at the CBOE Futures Exchange and the CME earlier in December, and the regulatory developments related to those product launches. Recent comments by SEC Chairman Jay Clayton on cryptocurrencies and ICOs were another a topic of intense interest and ongoing discussion as lawyers and laymen alike seek clues and clarification on how ICO’s are going to be addressed by the SEC in 2018.

The Blockchain Lawyers of Chicago meetup also captures the unique culture, energy and generosity that often accompanies blockchain related activities and innovation. One of the attendees, a cyptocurrency fund manager and trader, was intent on providing this writer with a comprehensive history of Bitcoin and its mythic inventor, Satoshi Nakamoto, who mysteriously disappeared from the scene around 2011. Nakamoto authored the legendary white paper, Bitcoin: A Peer-to-Peer Electronic Cash System in October, 2008. The fund manager noted, "this is the creation story for cryptocurrencies—its book of Genesis. I have read it many times."

Furthering blockchain history and lore, as well as promoting related education, appear to be at the core of this emerging community. Rosario is also playing a key role on this score as well. In January, 2018, he will be teaching a new course offering at Chicago-Kent College of Law titled Blockchain and the Law, along with Professor Daniel Katz, a leading authority on legal technology and innovation. According to Rosario, Kent is one of a handful of law schools that offers a course on legal issues associated with blockchain. "The course has been in high demand and filled up immediately. This is yet another sign of the growing interest in blockchain among members of the legal community," Rosario observed.

The Blockchain Lawyers of Chicago is scheduled to meet next on February 21, 2018.

Ropes & Gray attorney to head SEC’s New York office

By Anne Sherry, J.D.

The SEC has named Marc Berger as director of the New York Regional Office. Berger, a former federal prosecutor who currently co-leads Ropes & Gray’s global securities and futures enforcement practice, will join the agency in January 2018. He is filling the vacancy created by the departure of Andrew Calamari, who announced his own imminent move to Finn Dixon & Herling.

The New York office oversees more than 4,000 investment banks, investment advisers, broker-dealers, mutual funds, and hedge funds. Berger will lead a staff of nearly 400 professionals involved in investigating and prosecuting enforcement actions and conducting compliance inspections. Before joining Ropes & Gray, he spent 12 years as an assistant U.S. attorney in the Southern District of New York and led the Securities and Commodities Fraud Task Force. In a recent white paper published in Securities Regulation Daily, Berger analyzed a new Argentine law that subjects companies to criminal liability for corruption.

The two directors of the SEC’s Enforcement Division spoke favorably of Berger’s trial and appellate experience. Stephanie Avakian expressed confidence that Berger "will help the Commission provide rigorous oversight of Wall Street and be a strong contributor to its overall mission of investor protection," while Steven Peikin said he is known as "a strong and effective leader who has a keen mind and sound judgment."

Calamari stepped down as director of the New York Regional Office in October after 17 years of service with the SEC. In January, he will join Finn Dixon & Herling as a partner in three practice groups: Government & Internal Investigations; Commercial Litigation; and Investment Advisers & Broker-Dealers. He said that the firm’s practice is a "perfect fit" for his background in enforcement and broker-dealer and investment adviser compliance. The firm’s announcement explains that Calamari will be working closely with Jeffrey Plotkin, also an alumnus of the SEC’s New York office, as well as former federal prosecutors Michael English and Alfred Pavlis.

Thursday, December 21, 2017

FIA white paper explores the impact of a no-deal Brexit scenario and offers recommendations

By Brad Rosen, J.D.

In a white paper published by the Futures Industry Association (FIA), the impact of Brexit on the cleared derivatives industry in the event that the U.K. and the European Union (EU27) fail to reach an agreement prior to April, 2019 is explored. At the onset, the paper titled The Impact of a No-Deal Brexit on the Cleared Derivatives Industry, identifies the potential losses resulting from a no-deal scenario.

The absence of full market access for both U.K. and EU27 businesses and participants could lead to significant increases in costs for pension funds, asset managers, insurers, and other businesses as well as negative impacts on the real economy. The paper also considers ways in which policymakers and participants in the cleared derivatives industry could seek to mitigate the impacts of a no-deal scenario during a transition period.

In the white paper, FIA makes seven key recommendations in order to minimize disruption and maintain end user access to these global and interwoven markets. They are as follows.
  1. Transitional arrangements. The U.K. and EU27 should, as soon as possible, agree to a transitional arrangement comprised of a standstill period and a two-year adaptation period. Given the significant volume of adjustments required, an adaptation period of at least two years is needed to provide the industry with sufficient time take the actions required;
  2. European authorities grandfather and recognize U.K. CCPs. The parties should agree to grandfather U.K. CCPs, trading venues and trade repositories to preserve their European Market Infrastructure Regulation (EMIR) authorization and qualified central counterparty status before exit day;
  3. U.K. grant equivalence and recognition to European institutions. The parties should agree that UK regulatory authorities grant equivalence and recognition under English law effective on exit day to EU27 CCP’s authorized under EMIR, EU27 trading venues authorized under the Markets in Financial Instruments Directive II (MiFID II); and EU27 trade repositories registered under EMIR;
  4. Cooperation arrangements. The European Securities and Markets Authority (ESMA) and U.K. regulatory authorities should enter into arrangements to promote bilateral access to one another’s markets. As a result, clients in both the EU27 and U.K. could be serviced by execution and clearing brokers located in the other’s jurisdiction;
  5. EC grants equivalence for UK firms. The EC should grant equivalence to the U.K. under Markets in Financial Instruments Regulation (MiFIR) so that UK firms can register with ESMA as third country firms and, thereby, enable such firms to continue offering their services to EU27 clients from the U.K.;
  6. U.K. grants corresponding permission to EU27 firms. The U.K., under English law, should grant permission to EU27 firms so as to enable them to continue to offer their services to U.K. clients from the EU; and
  7. U.K. replaces bilateral recognition arrangements with third countries. Once exit day occurs, the U.K. will not be able to rely on the bilateral recognition arrangements previously struck between the EU and third countries. Accordingly, the U.K. should replace bilateral arrangements with such third countries in order to avoid loss of market access to and from such countries.
In introducing the white paper FIA, President and CEO Walt Lukken had this to say: "[a]lthough FIA members continue to execute their Brexit contingency plans, there are key steps that can immediately be taken by policymakers and regulators, as well as market participants, in order to minimize disruption, avoid fragmentation and maintain access to global markets." The FIA whitepaper goes a long way in identifying the myriad of issues and likely risks associated with Brexit for market participants, financial institutions and regulators alike. It also provides the various stakeholders with a set of tools and tangible advice to navigate the coming changes.

Wednesday, December 20, 2017

Commenters weigh in on proposed SEC disclosure requirements

By Amanda Maine, J.D.

A number of organizations have submitted comment letters to the SEC on the Commission’s proposed modernization of disclosure requirements under Regulation S-K. The proposed amendments, which the Commission approved for comment on October 11, 2017, are mandated by the FAST Act and include amendments to Management’s Discussion & Analysis (MD&A) and the use of cross-references and incorporation by reference of a company’s periodic reports.

Nasdaq. Nasdaq’s comment letter indicated that it supports the proposed rule amendments that reinforce the concept of materiality, which it believes is the “linchpin of public company disclosure.” In this vein, Nasdaq supports proposed amendments that would clarify that a description of property is required only to the extent that physical properties are material to a company’s business and that would reduce the period-to-period MD&A comparison requirement from three to the two most recent fiscal years, as long as the earlier period discussion is not material and is included in the company's previous Form 10-K.

Nasdaq also supports the modernization of financial reporting through the use of technology, in particular the proposed rule amendments allowing incorporation by reference and the use of cross-references. Regarding the proposal to require all information on certain filed forms’ cover pages to be tagged in Inline XBRL in accordance with the EDGAR Filer Manual, Nasdaq believes that this requirement will only impose a minimal incremental burden and does not object to it. However, it warned that it may not be able to rely on XBRL due to the subjective nature of XBRL tags as well as the ability of companies to use custom tags.

Nasdaq supports the proposed requirement to disclose trading symbols, but opposes the proposed required disclosure of a principal U.S. market that is not a national securities exchange. According to Nasdaq, requiring companies to disclose trading markets other than national securities exchanges may confuse investors by giving those other markets the “same imprimatur of a National Securities Exchange” without requiring that they satisfy the requirements of a regulated market.

FEI. In its comment letter, Financial Executives International reiterated its support for a principles-based approach to improving and simplifying disclosure. FEI echoed Nasdaq’s support to allow registrants discretion in determining whether to include MD&A related to the comparison of the two earliest years presented in the financial statements as well as the proposed amendment to the description of property.

FEI also praised the proposed amendments on exhibits as reflecting a principles-based approach that is focused on materiality. However, it does not support the proposed amendment requiring a new 10-K Exhibit detailing the rights and obligations of each class of registered securities because it is unnecessary given the disclosure obligations under Form 8-K and Schedule 14A. FEI also does not support requiring the disclosure of a legal entity identifier (LEI) of the registrant and each subsidiary.

Regarding cover page XBRL tagging, FEI does not believe that there is significant incremental value from tagging this information. FEI points out that registrants are currently required to tag most of these data points according to Regulation S-T and the EDGAR Filer Manual.

CAQ. The Center for Audit Quality (CAQ), while agreeing that materiality should be the primary consideration for disclosures, wrote it its comment letter that it is unnecessary to embed any explicit materiality reference within the respective disclosure requirements. As such, it recommended that the proposed amendment regarding criteria for omitting information about the third year in Item 303(a) be eliminated.

Regarding MD&A, CAQ recommended that as long as the SEC requires a three-year MD&A discussion, a registrant should only be permitted to omit from its current Form 10-K the discussion of the earliest of the three years if it was also previously filed in Securities Act filings on EDGAR or Exchange Act filings. CAQ supports the SEC’s proposal to revise instruction 1 to Item 303(a) to eliminate the reference to year-to-year comparisons and five-year selected financial data to encourage companies to take a fresh look at their MD&A.

CAQ supports streamlining information through the use of cross-referencing, but it does not believe that any benefits would result from amending the Commission’s rules to clarify or expand when financial statement disclosure may be used to satisfy other disclosure requirements. CAQ recommends that the SEC consider requiring disclosure to identify any information which has been cross-referenced in the financial statements, particularly in regards to the use of International Financial Reporting Standards (IFRS) used by foreign private issuers. It does not believe that it is necessary to change the information that may be incorporated by reference into a prospectus under any of the Commission’s forms. CAQ did emphasize that it is important that the SEC consider professional standards when an auditor is associated with “other information” contained in a document that includes the independent auditor’s report, drawing attention to the PCAOB’s auditing standard regarding other information in documents containing audited financial statements.

Tuesday, December 19, 2017

Duke Energy D&Os evade coal ash lawsuit over Strine’s dissent

By Anne Sherry, J.D.

The Delaware Supreme Court dismissed a derivative Caremark action against the Duke Energy board for breach of fiduciary duties related to the 2014 coal ash spill. Presuit demand was not excused because, at most, the directors breached their duty of care, for which they were exculpated from liability. Chief Justice Strine dissented, excoriating Duke for its "business strategy … to run the company in a manner that purposely skirted, and in many ways consciously violated, important environmental laws" (City of Birmingham Retirement and Relief System v. Good, December 15, 2017, Seitz, C.).

Spill. The derivative plaintiffs filed suit in the wake of the 2014 disaster, which sent toxic coal ash and wastewater into the Dan River in North Carolina. In 2015, Duke pleaded guilty to criminal violations of the Federal Clean Water Act and paid a fine exceeding $100 million. The complaint sought to hold certain directors and officers of Duke Energy liable for these and other damages that the company incurred following the spill. The plaintiffs argued that demand was futile because the board’s mismanagement rose to the level of a Caremark violation, but the chancery court disagreed, reasoning that the plaintiffs failed to allege that the directors intentionally disregarded their oversight responsibilities to the point of bad faith.

Demand futility standard. Under Delaware’s Rales test for demand futility, which applies to alleged violations of oversight duties under Caremark, plaintiffs must raise a reasonable doubt as to the board’s independence and disinterest to evaluate a demand that would expose the board to a "substantial likelihood of personal liability." Because the Duke directors were exculpated from liability for due care violations, the plaintiffs were required to allege scienter with particularity.

Insufficient evidence of oversight violations, collusion. On appeal to the Supreme Court, the plaintiffs argued that the chancery court improperly discredited their interpretation of board presentations and minutes, which they claimed showed Duke was violating environmental laws and avoiding remediation. But the high court was not required to accept the plaintiffs’ "unfair" construction of the presentations. Instead, the court’s overall assessment was that the presentations were updates on environmental problems associated with coal ash disposal sites and steps Duke was taking to address the concerns. The court wrote that the plaintiffs "conflate the bad outcome of the criminal proceedings with the actions of the board."

The plaintiffs also argued that the chancery court failed to draw the proper inferences from the plaintiffs’ alleged evidence of collusion between Duke Energy and its regulator, the North Carolina Department of Environmental Quality (DEQ). The Supreme Court noted that it would not be enough to allege cooperation with a "too-friendly" regulator; the plaintiffs were required to allege that Duke illegally colluded with a corrupt regulator, and then tie the improper conduct to an intentional oversight failure. The complaint fell short in several respects.

First, by focusing on the consent decree negotiated with DEQ and its "meaningless" $99,000 fine (and no remediation), the plaintiffs isolated one part of a bigger picture. In addition to the fine, Duke estimated spending $4 to $5 million to enforce the decree at all North Carolina sites, as well as additional costs to identify and characterize seeps, conduct groundwater studies, and reroute flows or treatment. Duke also expected to negotiate a compliance schedule with regulators and remained vulnerable to not-yet-final EPA rules that could affect remediation costs. The fact that DEQ imposed a relatively small fine did not lead to an inference of corruption or that the board ignored evidence of alleged misconduct.

Furthermore, the consent decree was subject to state court approval, and the public and environmental groups that had intervened in the action were able to comment on and object to the decree before it took effect. The plaintiffs’ allegations that DEQ generally did not aggressively enforce environmental laws did not lead to an inference of illegal collusion with Duke and the board’s complicity. Several other statements and board minutes had innocuous implications. Finally, a federal decision holding that DEQ was not diligently prosecuting a case against Duke did not establish bad faith by the company or the board.

Strine’s dissent. Chief Justice Strine dissented from the decision, finding that the allegations raised a pleading stage inference that it was Duke’s business strategy to skirt and even consciously violate the environmental laws. "Duke’s executives, advisors, and directors used all the tools in their large box to cause Duke to flout its environmental responsibilities, therefore reduce its costs of operations, and by that means, increase its profitability," Strine wrote.

The Chief Justice’s primary disagreement was based in litigation procedure. Particularized pleading is required at this stage, but not conclusive proof. In his view, the plaintiffs do not yet have to prove collusion, merely facts supporting an inference that Duke was consciously violating the law, believing that its lack of good faith compliance "would be given a blessing by a regulatory agency whose fidelity to the law, the environment, and public health, seemed to be outweighed by its desire to be seen as protecting Duke and the jobs it creates." He supplied a list of facts supporting such an inference:
  • The board knew that Duke illegally, and sometimes intentionally, discharged toxic water from its coal ash ponds into the groundwater;
  • Testing dating back at least ten years confirmed that the coal ash ponds were contaminating groundwater at illegal levels;
  • Duke’s board continued to operate coal ash ponds without proper permits, sometimes with none at all;
  • Duke and affiliated donors spent over $1.4 million to secure the election of officials who would overlook violations, including a governor, Pat McCrory, who had been a longtime Duke employee;
  • Duke’s board supported the strategy to enlist DEQ (overseen by McCrory) to file complaints that preempted citizen suits seeking substantial remediation;
  • Duke was caught illegally dumping wastewater into the Cape Fear River in amounts far exceeding what would be considered routine maintenance.
"Sadly," the Chief Justice came to the "reluctant conclusion that the facts as pled support a fair inference that the board was all too aware that Duke’s business strategy involved flouting important laws, while employing a strategy of political influence-seeking and cajolement to reduce the risk that the company would be called to fair account."

The case is No. 16, 2017.

Monday, December 18, 2017

Katten Muchin gears up for pay ratio disclosure in 2018 proxy season

By Lene Powell, J.D.

Despite perhaps fond hopes, the SEC’s Pay Ratio Disclosure rule remains in force and many companies will be dealing with it for the first time in the 2018 proxy season. Between lack of experience, data headaches, and potential public backlash, the required disclosures might be a real challenge for many companies. In a recent webinar, Katten Muchin partner Lawrence Levin and Amy Bilbija, a managing director at Strategic Governance Advisors, gave tips on preparing the disclosures and releasing the news to the public.

Pay ratio disclosure. Adopted in 2015, the Pay Ratio Disclosure rule amended Item 402 of Regulation S-K to require covered registrants to disclose (1) the median of the annual total compensation of all employees of a registrant (excluding the CEO); (2) the annual total compensation of the registrant’s CEO; and (3) the ratio of these two numbers.

Registrants must comply for the first fiscal year beginning on or after January 1, 2017. Therefore, calendar-year companies must include pay ratio disclosures in their 2018 proxy statements, said Levin.

The rule and accompanying September 2017 guidance specify:
  • Which companies do not need to disclose pay ratio, including emerging growth companies, smaller reporting companies, foreign private issuers, Canadian MJDS filers, and registered investment companies;
  • Which communications must contain pay ratio disclosures, including Form 10-Ks, registration statements, proxy and information statements;
  • How to determine the “median employee”, including methodology, statistical sampling and reasonable estimates; U.S. vs. foreign employees; included employees versus contractors, consultants, “leased employees”, and other excludable individuals.
Regarding potential liability, Levin said that pay ratio disclosures will be treated as “filed” for purposes of the Securities Act and Exchange Act, not “furnished.” As a result, the disclosures are subject to potential liabilities under the statutes.

However, it doesn’t look like the SEC is looking to play “gotcha” for any inadvertent mistakes. Bilbija said the September guidance gives assurances that flexibility is genuinely allowed, and as long as companies have a reasonable rationale they should be okay.

What are peers doing? In surveys, companies reported:
  • Most companies (56 percent) expect to disclose a pay ratio of over 100 to 1. The largest group (35 percent) expects to disclose a ratio between 101-250 to 1. One compensation consultant told Levin that one of her clients, a worldwide retailer with over 100,000 employees, will report a ratio of 1800 to 1.
  • For respondents that have decided on their approach, many plan to provide either the bare minimum disclosure (22 percent) or expanded disclosure with some explanations and clarifications (22 percent ). Six percent plan to provide expanded disclosure with alternate ratios, and 4 percent will provide expanded disclosure with carve-outs. Bilbija noted that although she’s mostly hearing companies taking the “less is more” tactic, expanded disclosure can help companies provide important context. For example, large international companies might want to provide a supplemental disclosure of U.S.-only numbers, or companies might additionally disclose figures by employee strata.
  •  For the employee determination date, many respondents plan to use the fiscal year end (35.7 percent) or October 31 or equivalent for non-calendar-year companies (25.7 percent). In addition, 7.1 percent plan to use November 30 or equivalent for non-calendar-year companies, and 31.4 percent will use some other date 
  • In using a consistently applied compensation measure (CACM), most respondents plan to use taxable wages (25.3 percent), base salary (24.0 percent), or total gross compensation (21.3 percent). 14.7 percent will use total cash compensation, and 14.7 percent will use some other measures. No respondents planned to use total annual compensation.
In preparing disclosures, Levin pointed out it can be helpful for companies to review filings by voluntary adopters and early filers. However, so far these have tended to skew toward unusually low ratios, so are not necessarily representative.

Breaking the news. Although the SEC might not pounce on innocent mistakes, legal missteps aren’t the only potential hazard. Given that more than half of companies in a recent survey expect to disclose a ratio of over 100 to 1, companies might well face public backlash. Employee morale and retention may suffer, and employees may use the information to bargain for higher pay.

Given potential negative reaction, it’s critical to develop messaging ahead of time. For companies opting to communicate directly to employees, rather than through human resources, Bilbija said companies should be make sure to explain why they are required to disclose the numbers, provide assurance that employees are being fairly compensated, and encourage employees not to read too much into it. Further, companies can emphasize other pieces of compensation like 401K contributions, pensions, etc.

If disclosing through human resources, managers should be given big-picture corporate and competitive data, as well as training so they know how to manage disappointment, bitterness, anger, etc. Managers should also anticipate possible backlash through possible increased sick time and decreased productivity. As a mitigating measure for the future, companies may want to consider pushing profit-sharing down through the ranks, said Bilbija.

Though probably not as strong a focus in the first year, proxy advisors and institutional investors are expected to take an interest as well. A recent survey by Institutional Shareholder Services (ISS) found that nearly three-quarters of institutional investor respondents said they will use pay ratio information in some way, including (1) comparing ratios across companies and industry sectors; (2) assessing year-on-year changes at an individual company; or (3) using it as background material for engagement with companies.

Finally, regarding media coverage, Bilbija expects there will not be a lot of coverage at first except for outliers. Companies should look at disclosures by peers as they start to come out. If it looks like a company will be an outlier, on either a local or industry basis, then it would be wise to prepare a written statement in case the media calls for comment.

Friday, December 15, 2017

Allegations in another case's complaint were plausibly corrective disclosures

By Rodney F. Tonkovic, J.D.

A Sixth Circuit panel has reversed and remanded a district court's holding that a complaint in a different suit did not constitute a corrective disclosure. The district court held that claims that a medical provider illegally boosted Medicare revenues were time-barred and that the shareholders failed to adequately allege that the alleged misstatements had caused their losses. The panel reversed, finding that the new claims in an amended complaint related back to the original complaint and that it was plausible that the allegations from the other suit constituted corrective disclosures (Norfolk County Retirement System v. Community Health Care Systems, Inc., December 13, 2017, Kethledge, R.).

Community Health Systems. Community Health Systems (CHS) runs the largest for-profit hospital system in the U.S., with 131 hospitals making over $13 billion in revenue in 2011. These profits depended largely on reimbursements for treating patients covered by Medicare.

To determine whether a patient needed inpatient or outpatient care, CHS used a system written by itself, and unique to its hospitals, called the Blue Book. The Blue Book directed CHS doctors to provide inpatient services for many conditions that most other hospitals would treat as outpatient cases. Since inpatient cases require over 24 hours of constant care, Medicare pays hospitals far more for those patients than outpatient cases. During the relevant period, however, CHS, without mentioning the Blue Book, attributed its strong revenues to "synergies" and "efficiencies."

Tenet takeover. In 2011, another medical provider, Tenet Healthcare Corp., sued CHS after being made the subject of a hostile takeover attempt by CHS. Tenet alleged that CHS made statements in its SEC filings that omitted that the source of its profits was Blue Book-mandated practices that essentially defrauded Medicare by unnecessary inpatient admissions.

That suit became the basis for the action brought by Norfolk County after the complaint publicly revealed that CHS’s successful track record of increasing revenues at acquired hospitals was attributable to improper and unsustainable admission practices, according to the complaint. In response, CHS issued a press release denying the allegations. But, at the same time, CHS's CFO revealed the use of the Blue Book.

District court dismissed. The initial complaint in this case was filed in May 2011, claiming that CHS had inflated its share price through false and misleading statements. The complaint was amended twice, the last amendment raising new allegations about misrepresentations. The district court found that the newest allegations were untimely. Also, while the CHS defendants had made misleading statements, the court concluded that the shareholders failed to adequately allege that these statements had caused their losses.

Timely. On appeal, the appellate panel found that the allegations in the amended complaint were timely because they related back to those in the original complaint. According to the panel, under FRCP 15(c), the allegations, which would otherwise have been untimely, were timely because both the original and amended complaints alleged the same "general conduct" and "general wrong." That is, the original complaint alleged that CHS defrauded investors by concealing the role of the Blue Book in boosting CHS's bottom line, and the amended complaint built on that by alleging that, after the Tenet suit was filed, CHS continued to make "lulling misrepresentations that were designed to preserve the fraud’s effect."

Corrective disclosures. The panel then found that the complaint adequately alleged loss causation via corrective disclosures. The complaint plausibly alleged that the Tenet complaint, plus the admission of the use of the Blue Book by CHS's CFO, revealed the antecedent fraud to the market and caused the shareholders’ economic loss. These disclosures, plus the speed at which CHS's share price fell afterwards, made a causal link between the two at least plausible, the panel said.

CHS argued, as the district court held, that the Tenet complaint could not "reveal the truth" because complaints only contain allegations. While the panel saw some merit in that proposition as a general rule, it noted that some allegations are more credible than others. The Tenet complaint had two aspects that set it apart from most complaints: CHS's CFO admitted the truth of one of the complaints core allegations (the use of the Blue Book), and the complaint contained expert analysis of the Blue Book's effect. It was plausible, the panel concluded, that the market first learned the full extent of the alleged fraud from the Tenet complaint.

The case is No. 16-6059.

Thursday, December 14, 2017

Katten webinar surveys the vast legal and compliance landscape for cryptocurrencies

By Brad Rosen, J.D.

In a webinar titled Trading Bitcoin: Legal and Compliance Considerations for Trading and Facilitating Transactions in Bitcoin, a team of Katten Muchin Rosenman attorneys explored the vast, murky and ever-expanding terrain surrounding cryptocurrencies and CFTC, SEC, FinCen, and NY Department of Financial Services regulation. The Katten team also explored emerging litigation issues, as well as providing practical insights and advice to industry players dealing with these issues. Below are some highlights from the webinar:

Three types of cryptocurrencies. The webinar kicked off with a discussion of the three basic types of cryptocurrencies. First, there are those that serve as a medium of exchange and store of value, like Bitcoin. Second, there are those that reflect an interest in an enterprise that is generally be deemed to be a security and might be offered as part of an initial coin offering (ICO). Third there are utility tokens that are associated with the rights to use a product or service. These can also be deemed to be securities. A particular cryptocurrency may possess more than one of these qualities and can morph from one function to another during its lifetime.

CFTC regulation and potential manipulation. Gary DeWaal led the discussion regarding CFTC-regulated exchanges and the recently launched futures products related to Bitcoin at the CBOE Futures Exchange on December 10, as well as the CME product, which will launch on December 17. Two other futures exchanges also have Bitcoin related products in the pipeline. Two swap execution facilities (SEFs) currently host Bitcoin related swap products, although retail customers do not have access to the SEFs.

In response to a question about the potential for manipulating the settlement price for the Bitcoin futures contracts, DeWaal noted that both sets of exchange traded futures contracts were cash settled and that the underlying Bitcoin exchanges were not subject to functional regulation. He explained that these exchanges do not have trade practice requirements, nor is there an obligation to monitor for manipulation by those exchanges. He observed, though, that these exchanges might be subject to some forms of prudential regulation which would include anti-money laundering, capital, and cyber security requirements.

Practical concerns related to Bitcoin futures trading. DeWaal raised a number of practical considerations for firms trading in or facilitating trading in Bitcoin futures, including:
  • How adequate are the firm's disclosures related to unusual characteristics of Bitcoin futures? (For example, a customer’s margin requirements may routinely increase when a customer's long positions increase in value) 
  • Do the firm's disclosures adequately describe unusual conditions the firm may have imposed on customers trading Bitcoin futures? (For example, naked short positions may not be allowed, no give-in trades be permitted, or a premium to exchange-minimum margin may be required). 
  • Has the firm considered highlighting exchanges' authority, if applicable, to set market prices unrelated to market activity under extraordinary circumstances? 
  • Is the firm's customer agreement adequately drafted to authorize the firm to take actions it may deem warranted should Bitcoin futures experience extraordinary volatility?
  • How should an account be liquidated when a client defaults in a margin payment related to positions in Bitcoin futures or under other circumstances? 
SEC regulation. In contrast with the CFTC’s approach regarding the unregulated underlying Bitcoin markets, the SEC has taken a hard line with respect to approving Bitcoin-related products. As one of the presenters noted, in March 2017, the SEC denied the application of the Bats BZX Exchange for it to list and trade shares of the Winklevoss Bitcoin Trust. The SEC cited that the exchange must have surveillance sharing agreements with the significant markets where the underlying Bitcoin was transacted. The SEC concluded there was not sufficient visibility in connection with the underlying markets.

Similarly, in October 2017, the SEC encouraged two sponsors of exchange traded funds (ETFs) tied to Bitcoin to withdraw their applications. The webinar presenters noted, however, the SEC may be revisiting the Winklevoss Trust and other potential ETF Bitcoin related products sometime in the coming year.

Litigation. One of the webinar presenters observed that, while there has been some litigation related to cryptocurrencies, the activity has not been substantial. Looking ahead, he foresees much of the litigation will mirror regulatory enforcement actions. Additionally, significant market losses will also likely trigger an increase in litigation activity. Other particular areas he saw that will likely be subject of litigation might be related to the resale of unregistered securities, forced liquidations, trading and delivery issues, as well IPO related fraud and Ponzi related actions where investor funds have seemingly disappeared.

Wednesday, December 13, 2017

Clayton cautions both investors and market professionals about ICOs

By Jacquelyn Lumb

Jay Clayton has emphasized that his focus as SEC chairman will be on capital raising and the protection of retail investors. Following a recent enforcement action against Munchee Inc. for an offering of digital tokens that constituted an illegal unregistered securities offering, Clayton released a statement in which he outlined his general views on cryptocurrency and the ICO markets. The SEC is committed to promoting capital formation, he said, and investors should be open to these opportunities, but they must ask good questions, demand clear answers and apply common sense.

For Main Street investors, Clayton advised that there is much less investor protection in the cryptocurrency and ICO markets than traditional markets, which creates more opportunities for fraud and manipulation. No ICOs have been registered with the SEC, and no cryptocurrency type products have been approved for listing and trading, he advised. In addition, the SEC has not approved for listing any exchange-traded products that hold cryptocurrencies or other assets related to cryptocurrencies.

In a footnote to his statement, Clayton noted that the CFTC has designated bitcoin as a commodity. He said that fraud and manipulation involving bitcoin which is traded in interstate commerce is appropriately within the purview of the CFTC, as is the regulation of commodity futures tied directly to bitcoin. However, products that are linked to the value of underlying digital assets, including bitcoin and other cryptocurrencies, may be structured as securities products subject to registration under the Securities Act or the Investment Company Act.

He urged investors to read the investor alerts, bulletins, and statements issued by the SEC regarding the marketing of these offerings. Because these instruments may trade on systems and platforms outside the U.S., Clayton said it heightens the risk that the SEC and other regulators may not be able to recover any lost funds.

For market professionals, including securities lawyers, accountants, and consultants, Clayton urged them to read the SEC’s Section 21(a) investigative report on The DAO that was issued on July 25, 2017. The report describes how the SEC applied longstanding securities law principles to demonstrate that a token was an investment contract, and therefore a security under the federal securities laws. Clayton said that offerings which incorporate features and marketing efforts that promote the potential for profits based on the efforts of others contain the hallmarks of a security. Market professionals should be guided by the intent of the SEC’s registration, offering process, and disclosure requirements, he said, which includes the protection of Main Street investors.

Before launching a cryptocurrency or a product with its value tied to cryptocurrencies, Clayton said that promoters must be able to demonstrate that the product is not a security or they must comply with the applicable registration and other requirements of the federal securities laws. Broker-dealers and other market participants that allow payments in cryptocurrencies, allow customers to purchase cryptocurrencies on margin, or otherwise use cryptocurrencies in securities transactions should exercise caution to ensure that they are not undermining their anti-money laundering or know-your-customer obligations, he added.

Clayton’s statement closed with a list of questions that investors may wish to consider before engaging in a cryptocurrency or an ICO investment opportunity. He has asked the Division of Enforcement to focus on this area and to bring enforcement actions when they find ICOs that violate the federal securities laws.

Tuesday, December 12, 2017

Oral agreement to settle proxy contest is enforceable

By Amy Leisinger, J.D.

The Delaware Chancery Court has ordered specific performance of an oral agreement between shareholder funds and a company to settle a proxy contest by expanding the company’s board and appointing two of the shareholder nominees. According to the court, the shareholder funds demonstrated that the oral settlement agreement constituted a binding contract regardless of documentation, and the individual negotiating on behalf of the company had actual and apparent authority to bind the firm (Sarissa Capital Domestic Fund LP v. Innoviva, Inc., December 8, 2017, Slights, J.).

Proxy contest and settlement. Dissident shareholders of Innoviva, Inc. mounted a proxy contest in February 2017 to elect three nominees to the company’s seven-member board of directors. The shareholder funds’ proxy materials contended that Innoviva’s incumbent directors were overpaid in comparison to performance and failed to properly execute their oversight responsibilities and that the company was not being run for the benefit of shareholders. Three proxy advisory firms recommended votes in favor of the shareholders’ nominees.

When these recommendations came out, the parties began discussing a potential settlement of the proxy contest. During several calls, the founder of the shareholder funds and the vice chairman of Innoviva’s board negotiated terms, which were discussed with and approved by Innoviva’s board throughout the process. Upon learning of the likelihood that large Innoviva shareholders would vote in favor of the funds’ nominees, Innoviva agreed to expand its board from seven members to nine members, to appoint two of the shareholder funds’ nominees to the board, and to forgo a standstill in exchange for dismissal of the shareholders’ pending action and discontinuation of the proxy contest. The parties also agreed to issue a conciliatory joint press release announcing the settlement. The vice chairman and the funds’ founder confirmed they “had a deal” and would leave the paperwork to others.

As the parties were working to finalize the written agreement and the press release, Innoviva learned that BlackRock had voted in favor of the board’s slate of directors and backed out of the deal.

The shareholder funds filed an action seeking declaration that the parties entered into a binding settlement agreement during the telephone call and asked for specific performance of the contract. Innoviva argued that the parties never reached a meeting of the minds on material terms and understood that any contract would have to be memorialized in an executed written agreement. In addition, Innoviva contended that the vice chairman did not have actual or apparent authority to bind the company to the alleged oral contract.

Actual and apparent authority. The court found that Innoviva’s vice chairman had authority to bind the company to an oral settlement agreement. Innoviva’s board had appointed him to act as its “lead negotiator” in settlement discussions, and he agreed to do so, creating a specific agency relationship and actual authority, the court stated. Moreover, if the board thought it needed to “reapprove” the agreed-upon terms, it would have done so quickly (before learning about BlackRock’s decisive vote) to protect the company from losing face with regard to the proxy contest, the court noted. “The board well understood that the deal had been struck,” the court stated.

The evidence also clearly demonstrated that the vice chairman had apparent authority to bind Innoviva because the shareholders’ principal reasonably believed that he was speaking on behalf of Innoviva’s board and thus was authorized to enter into a settlement agreement, the court found. This reasonable belief was traceable to Innoviva’s own manifestations, particularly with regard to its appointment of the vice chairman as the “lead negotiator,” according to the court.

Valid contract. The court noted that a valid contract exists when the parties have made a bargain with “sufficiently definite” terms and manifested mutual assent to be bound and found that the parties’ representatives formed a binding contract during their phone call. During the call, they reached agreement on the essential terms of the settlement and confirmed that they “had a deal,” the court stated. Neither party indicated that the settlement was contingent upon the execution of a written agreement or the finalization of the press release, the court explained.

Concluding that the shareholder funds lack an adequate legal remedy, the court decreed specific performance, ordering Innoviva to perform its obligations under the settlement agreement, and declared the two shareholder nominees rightful members of Innoviva’s board.

The case is No. 2017-0309-JRS.

Monday, December 11, 2017

FIA warns on risks of cryptocurrency derivatives, calls for more CFTC oversight

By Lene Powell, J.D.

Given the extreme volatility of bitcoin and a lack of historical data, the CFTC should not have given the go-ahead to several exchanges to list bitcoin futures contracts and binary options through the expedited self-certification process, FIA CEO Walter Lukken said in an open letter to the CFTC. Without a robust public discussion of the risks, FIA is concerned that important issues may not have been fully considered, including whether there should be a separate guarantee fund for the unproven products.

“While we greatly appreciate the CFTC’s efforts to receive additional assurances from these exchanges, we remain apprehensive with the lack of transparency and regulation of the underlying reference products on which these futures contracts are based and whether exchanges have the proper oversight to ensure the reference products are not susceptible to manipulation, fraud, and operational risk,” Lukken wrote.

Products self-certified by exchanges. On December 1, 2017, the CFTC announced that the Chicago Mercantile Exchange Inc. (CME) and the CBOE Futures Exchange (CFE) had self-certified new contracts for bitcoin futures products, and the Cantor Exchange (Cantor) had self-certified a new contract for bitcoin binary options.

Under the self-certification process, a designated contract market (DCM) must determine that the new product complies with the Commodity Exchange Act (CEA) and CFTC regulations, including that the contract is not readily susceptible to manipulation. If the Commission does not find that the product would violate the CEA or regulations, the DCM may then list the new product one full business day later. Completion of this process does not constitute Commission approval, nor endorsement of the use or value of the products.

According to the CFTC, the “vast majority” of new products are brought to market through this process, and CFTC staff held “rigorous discussions” with the exchanges for weeks and months before the self-certifications. CFTC Chairman J. Christopher Giancarlo noted that the exchanges agreed to changes requested by staff on contract design and settlement, as well as to information-sharing and surveillance commitments. The CFTC said that after the products are launched, the agency will monitor risks, conduct reviews of designated contract markets, derivatives clearing organizations (DCOs), clearing firms and individual traders, and will also work closely with the National Futures Association (NFA).

FIA concerns. The price of bitcoin, the underlying reference product, has shot up over the past year. According to Coindesk, an information services provider for the digital asset industry, the price of one bitcoin passed $1,000 for the first time on January 1, 2017, and reached $16,601 on December 1, 2017. In addition, prices can swing wildly intraday and sometimes diverge significantly between bitcoin exchanges.

Given the extreme volatility of the underlying reference product and the novel, untested nature of the self-certified derivatives products, FIA is concerned that clearing firms bear the brunt of the risk through guarantee fund contributions and assessment obligations, rather than the exchanges and clearinghouses who list them. According to FIA, the one-day self-certification process did not allow for proper public transparency and input.

In particular, FIA believes the CFTC should have had public discussion on whether a separate guarantee fund for the products was appropriate or whether exchanges put additional capital in front of the clearing member guarantee fund. In addition, not all risk committees of the relevant exchanges were consulted before the certifications, per FIA’s understanding. FIA said that CPMI-IOSCO guidance and good governance would suggest that this should have happened.

FIA said it looks forward to a “healthy public discussion” on how to improve the self-certification process in the future, as well as the CFTC’s continued oversight of the emerging instruments.

Friday, December 08, 2017

Tennessee proposes exempt employee benefit plan rule amendments

By Jay Fishman, J.D.

The Tennessee Securities Division has proposed amendments to its exempt employee benefit plan rule. The anticipated effective date of the rule is February 28, 2018 if no hearing is requested.

As proposed, issuers wishing to offer securities from, in or into Tennessee under the Tennessee Securities Act’s employee benefit plan exemption would file with the Tennessee Securities Commissioner no later than 15 days after the first sale: 
  1. a complete, properly executed Form IN-1461, Notice of Sale of Securities Pursuant to Employee Stock Purchase/Option Plan Exemption
  2. a complete, properly executed Form U-2, Uniform Consent to Service of Process (or another Division-approved form);
  3. a complete, properly executed Form U-2A, Uniform Form of Corporate Resolution, if the issuer is a corporation; 
  4. a $500 fee; and 
  5. a statement specifying the date of the first sale, if any, of securities from, in or into Tennessee.

Thursday, December 07, 2017

E.U. recognizes U.S. derivatives trading venues for purposes of MiFID II/MIFIR

By Lene Powell, J.D.

Heading off possible fragmentation of E.U. and U.S. derivatives markets, the European Commission announced that it will recognize CFTC-authorized Designated Contract Markets (DCMs) and Swap Execution Facilities (SEFs) as eligible for compliance with EU derivatives trading requirements under MiFID II/MIFIR. The decision ensures that E.U. counterparties can trade derivatives instruments subject to the requirements, including interest rate swaps and index-based CDS, on U.S. trading venues after the new framework goes into effect as of January 3, 2018.

In a joint statement, Valdis Dombrovskis, European Commission Vice-President in charge of Financial Stability, Financial Services, and Capital Markets Union said, “Today's decision on equivalence, together with the CFTC staff's recommendation for an exemption order, confirms how global cooperation can bring tangible benefits to market operators on both sides of the Atlantic.”

CFTC Chairman J. Christopher Giancarlo encouraged his fellow commissioners to approve a pending staff recommendation for exemption from the CFTC’s SEF registration requirement for multilateral trading facilities (MTFs) and organized trading facilities (OTFs) authorized in the E.U.

MiFID II/MiFIR and equivalence. Under the new MiFID II and MiFIR framework, as of January 3, 2018, EU financial and non-financial counterparties must execute derivatives transactions subject to the trading obligation on E.U. trading venues or third-country trading venues recognized by the European Commission as “equivalent.” Derivatives that have been designated by E.U. regulators as subject to the E.U. trading obligation include euro, dollar, and pound interest rate swaps in the most common benchmark tenors, as well as index-based CDS.

On October 13, 2017, the CFTC and European Commission agreed to a “Common Approach” framework allowing for mutual recognition of derivatives trading facilities in the U.S. and E.U. Under the Common Approach, the two jurisdictions agreed that:
  1. The European Commission intended to adopt an equivalence decision covering CFTC authorized SEFs and DCMs that are notified to it by the CFTC, provided the requirements of the Markets in Financial Instruments Regulation (MiFIR), the Markets in Financial Instruments Directive (MiFID II), and the Market Abuse Regulation (MAR) are met. 
  2. The CFTC intended to propose, and the chairman would support, the CFTC's exemption from the SEF registration requirement, through a single exemption order, of the trading venues authorized in accordance with the MiFID II/MiFIR requirements that have been identified to the CFTC by the EC, provided they satisfy the standard in Commodity Exchange Act Section 5h(g).
The European Commission’s equivalence decision and annex on December 5, 2017 provide further details and list the specific DCMs and SEFs that have been deemed equivalent.

Pending CFTC exemption. According to the joint statement, the exemption recommendation for EU-authorized MTFs and OTFs, currently pending before the CFTC, is the first time the CFTC has adjudicated an exemption from the SEF registration requirement.

“I thank Vice President Dombrovskis and his staff for all of their work in reaching this positive result. I also welcome and support the CFTC staff recommendation to the Commission for an exemption order applicable to EU trading venues and encourage my fellow Commissioners to act expeditiously in approving the order,” said Giancarlo.

Wednesday, December 06, 2017

AICPA conference panelists discuss SEC comment letter process

By Amanda Maine, J.D.

Current and former officials from the SEC’s Division of Corporation Finance offered their views on the SEC’s comment letters on issuer filings at the AICPA’s Annual Conference on Current SEC and PCAOB Developments. Former Corp Fin director Brian Lane, now with Gibson Dunn, noted that the makeup of the staff has changed since he left in 1999. During his tenure, the vast majority of the staff consisted of attorneys, but there has been a big shift to accountants since then, he observed.

Review of outside information. Christine Davine of Deloitte & Touche, who moderated the panel, noted that more comment letters have been referring to information in company press releases or on a company website and inquired as to how the staff considers that information in the review process. Associate Director Kyle Moffatt, who will take over the role of acting chief accountant when the Division’s current chief accountant, Mark Kronforst, departs in January, says that the Division takes a number of things into account, including company websites, investor slides, what analysts are saying, and what goes on in the industry itself. If necessary, he said, the staff will request more details or insight on items to be considered for disclosure.

Lane said that some of his clients have received comments where the SEC staff had reviewed an investor presentation. These clients might try to tell him that the information in the investor presentation isn’t important, but he noted that during the presentation itself, the client “made it sound like the second coming.” He urged issuers to be very mindful of these investor presentations because they are fertile ground for SEC staff to review.

Process. Lori Locke, who served at CorpFin and is currently VP and corporate controller at Gannett, was asked what happens when her company receives an SEC comment letter. Locke explained that they will assemble a working group who will assess the time it will take to complete the review, look at the nature of the comment, and put together a schedule. She warned that formulating a response to a comment letter takes longer than one might think, but she also advised that if an extension is needed, the company can contact the SEC staff. A one or two week extension is fine, she said, but a month extension is probably too long. She also recommended pulling together contemporaneous documentation to make it easier and faster to respond to the SEC’s comments.

When asked why the average number of comment letters received and the number of comments per review have gone down, Lane said that experience is a good teacher. There have been fewer IPOs recently, resulting in a more mature collection of public companies that have gone through the process and know what to do, he said.

Communicating with staff. Locke said that when it comes to communicating with SEC staff, the first time to reach out is to seek clarification. Issuers should also contact the staff if they want to provide additional context to the filings that were reviewed. Locke advised that anything told to the staff over the phone should be put in writing as well.

Davine inquired when a client should request a face-to-face meeting with the SEC rather than communicating over the phone. Lane said that there are practical reasons that the staff prefers phone calls, such as bringing in people who work remotely. However, in-person conferences may be useful for situations such as a pre-IPO or if it is something really important, such as discussing a new segment.

Moffatt assured that the staff is always willing to listen. Counsel should let the staff know if they feel they’re not being heard, or if they want to appeal, or if they want others involved, he said.

Non-GAAP and MD&A. Davine noted that management discussion and analysis (MD&A) has historically been the top area for SEC comments, but it has been supplanted by comments on non-GAAP measures this year. According to Moffatt, companies have been doing a good job of complying with the revised Compliance & Disclosure Interpretations (C&DIs) on non-GAAP financial measures issued in May 2016, so for the most part, these staff comments are in clean-up mode. However, the staff will continue to monitor these kinds of disclosures, he advised, noting that the staff does look outside the filings to statements like earnings releases.

When asked about what kinds of issues registrants should focus on in MD&A, Lane pointed to the recent efforts to reform the tax code. Issuers should take into account how taxes might affect business and if the impact of any legislation should be disclosed in the company’s risk factors.

Tuesday, December 05, 2017

Corporation Finance staff is working on update to cybersecurity disclosure guidance

By John Filar Atwood

The staff of the Division of Corporation Finance is developing new guidance for companies’ handling of cybersecurity disclosure. Division Director Bill Hinman said at Practising Law Institute’s securities regulation conference that when Chairman Jay Clayton first asked him if the existing guidance needed to be refreshed, he did not think so. After reviewing the disclosure on more recent cyber events, Hinman changed his mind.

The existing cybersecurity guidance on disclosure is principles-based and was developed in 2011. Hinman said the 2011 guidance is still relevant, but the staff is working on updates in certain areas. The staff will look carefully at what companies are disclosing about their preparation for an attack and how they handled the event itself.

Among other things, the new guidance will ask companies to look at their disclosure controls in the area of cybersecurity, he said. The staff believes that a hallmark of good controls is a procedure that ensures that the IT department and management are talking to each other when a cyber event happens, he noted. The staff wants to see that when a breach occurs, the event is being reviewed by the proper levels of management, he added.

The new guidance also will include a reminder that with escalation procedures in place, a breach could rise to the level of a “material” event, Hinman said. As a result, companies would be wise to review their insider trading policies, and to re-emphasize the restrictions on insider trading, he noted.

Non-GAAP disclosure. Hinman was joined in a panel discussion on Corporation Finance hot topics by the Division’s director of disclosure operations, Shelley Parratt. She said that after much activity in the area of non-GAAP disclosure, she believes the staff is moving into a period where it will largely leave the issue alone. There will still be comments provided on non-GAAP financial measures that the staff finds troubling, she noted, but it will not be as prominent an issue as in the recent past.

Personally identifiable information. Parratt also discussed the October 11 FAST Act-related proposals, particularly the proposal dealing with personally identifiable information (PII). The proposed rule changes would create efficiencies in the process to seek confidential treatment for commercially sensitive or confidential information, including PII. The proposals would permit registrants to omit from material contract exhibits confidential information that is not material and would cause competitive harm if publicly disclosed, without having to request confidential treatment from the Commission.

Companies would be permitted to omit PII in all cases without submitting a confidential treatment request. Under the proposals, exhibits would continue to be subject to review, and the staff would assess whether redactions appear to be appropriate.

Parratt said that the proposal seeks to codify what has already been staff practice. The staff wants companies to redact the exhibit information for which they otherwise would ask for confidential treatment, and to eliminate the long explanation process otherwise associated with the confidential treatment request, she said.

According to Parratt, the proposal is designed to lessen the compliance burden on companies, and to lessen the information protection burden on the staff. The staff has protocols in place to maintain confidential information, and uses very rigorous procedures to protect the information, she said. Not having that information in-house will make it easier on the staff, she noted. She cautioned that if the proposals are adopted, the staff will monitor their use to ensure that companies are “not getting greedy with their redactions.”

Resource extraction. Hinman also briefly touched on the issue of resource extraction disclosure, noting that the staff is working on a proposal in this area. The existing rule was disapproved under the Congressional Review Act in February, giving the SEC one year to develop a new rule. Hinman said that the staff has met with interested groups, and is working to come up with a proposed new approach to resource extraction disclosure by February 14.

Monday, December 04, 2017

REIT controllers owed fiduciary duties to public stockholders

By Joanne Cursinella, J.D.

Claims that certain defendants in a convoluted REIT scheme violated their fiduciary duties to stockholders survived a motion to dismiss. The court found that the plaintiff sufficiently alleged that the defendants set up a structure whereby they profited at the expense of the stockholders, maximizing the profits at the first entity they created to the detriment of the non-controlling stockholders of another entity they created and took public (RCS Creditor Trust v. Schorsch, November 30, 2017, Glasscock, S.).

Ownership structure exploited. The essence of the plaintiff’s claim is that, pursuing a convoluted scheme, certain of the defendants created an entity, AR Capital LLC, to develop and manage REITs. They formed another entity, RCS Capital Corporation (RCAP), which, through subsidiaries, was responsible for marketing and distributing, and providing other services, in connection with AR Capital investment products. These defendants owned 100 percent of AR Capital, but took RCAP public, retaining only a minority interest in RCAP.

Through retention of a single share of super-voting common stock, however, they ensured that they retained control of RCAP. Thereafter, they structured operation of the entities in a way that maximized profits at AR Capital, and that assigned expenses to RCAP, to the detriment of the non-controlling stockholders of that entity. The plaintiff claimed that the defendants owed fiduciary duties to the non-controlling stockholders of RCAP, which they breached, aided and abetted by an entity they controlled and an officer of one of RCAP’s subsidiaries.

Present action. The complaint contains three counts. Count I was brought against some of the defendants alleging that they breached their duties of care and loyalty in connection with the conduct outlined above. The second count, against these same defendants alleged that they are at least liable for aiding and abetting breaches of fiduciary duty by other defendants. Count III was brought against other defendants, and it alleged that each of these defendants was unjustly enriched by the conduct described above, and that such conduct warrants the imposition of a constructive trust.

Core claim remains viable. This complaint focused primarily on a series of allegedly self-dealing transactions in which the certain defendants caused RCAP, which they collectively controlled but in which they held only a 25 percent economic stake, to serve as a cost center for AR Capital, in which they (along with a non-party) retained a 100 percent ownership interest. These allegations adequately stated a claim for breach of the duty of loyalty against those defendants the court said, since the plaintiff also adequately alleged that the defendants owed fiduciary duties to RCAP. Further, these duties were breached by the defendants by their actions and the core claim, the allegation that these defendants used their control over RCAP to cause it to enter into off-market arrangements with AR Capital, which they wholly owned, remained viable despite the defendants’ objections.

Other claims. A proxy claim against these defendants was dismissed because the allegations that they received an ancillary benefit not shared by all stockholders required pleading that the benefit received was sufficiently material to overcome fiduciary duties, and here it was not, the court said. The decisions made, therefore, receive the protection of the business judgment rule, so any fiduciary duty claim premised on them was dismissed. However, the court reserved decision on the arguments for dismissing unjust enrichment and aiding and abetting claims, pending supplemental briefing, given that the core fiduciary duty claim remains.

The case is No. 2017-0178-SG.

Friday, December 01, 2017

Commissioner Quintenz focuses on the promise of transformative technologies at ISDA gathering in London

By Brad Rosen, J.D.

CFTC Commissioner Brian Quintenz shared an optimistic vision for the future, and the power of technology to transform the financial markets, in a keynote address before the ISDA Technology & Standards: Unlocking Value in Derivatives Markets conference in London, United Kingdom. Quintenz’s remarks, which were tempered by a measure of caution and skepticism, spanned a wide range of tech-related topics including block chain technology, LabCFTC, the British regulatory sandbox, and the challenge of international coordination in an increasingly complicated world.

Blockchain technology in the derivatives context. Quintenz observed that rapid and widespread acceptance and adoption of distributed ledger technology (DLT) in the financial setting promises to transform a range of business operations in the derivatives industry. This includes how firms handle trade execution, processing, and reporting and recordkeeping of derivatives.

Quintenz noted these innovations are already starting to take shape, and pointed to the example of the Depository Trust Clearing Corporation (DTCC) which recently announced that it is transferring records for more than $11 trillion of cleared and bilateral credit derivatives transactions to its own DLT platform.The platform will provide market participants with real-time access to a single recordkeeping system for their swap transactions. It is expected to go live in early 2018.

According to Quintenz, "the further actualization of DLT in the derivatives space will depend on the ability of market participants to digitize all aspects of their financial transactions. Once the terms of a swap can be reduced to a completely digital, industry-accepted standard, then automatic trade reporting, centralized recordkeeping, and, ultimately, smart contracts become possible." "ISDA’s common domain model, which aims to capture all post-execution trade lifecycle events in a digital format, is an indispensable step toward the fulfillment of blockchain’s full potential," he continued.

LabCFTC and the British regulatory sandbox. Quintenz discussed the CFTC’s LabCFTC initiative which was launched in May of this year as a pathway by which the CFTC can develop and foster dialogue with the FinTech community. He noted that LabCFTC plans to host a series of prize competitions in 2018, and that these competitions are meant to encourage the development of beneficial technologies within the private sector. Quintenz described the prize competitions, in conjunction with the CFTC’s ability to provide no-action relief when necessary, as two powerful tools at the agency disposal to promote innovation.

Quintenz also took the opportunity to laud the British for their approach to promoting FinTech through their regulatory sandbox initiatives. In particular, he pointed to the Financial Conduct Authority’s (FCA) "Project Innovate," which was established in 2014, and the Bank of England’s "FinTech Accelerator" launched last year. Quintenz noted that the FCA’s sandbox initiative, in its first year, reduced the time and cost of getting innovative ideas to market. Specifically, 75 percent of firms that participated in the sandbox successfully completed testing, and 90 percent of those firms are preparing for a wider market launch.

Bitcoin related instruments. Commissioner Quintenz stated that "[p]erhaps one of the most prominent ideas associated with FinTech are digital currencies, led by bitcoin." He described the new bitcoin futures products being proposed by the Chicago Mercantile Exchange Inc. (CME) and the CBOE Futures Exchange (CFE), and how these instruments will provide a new platform to gain or hedge exposure to bitcoin’s volatility. However, his comments on this score were neutral and agnostic. He noted "the Commission does not endorse any particular futures contract, including bitcoin."

Quintenz also described the market oversight roles to be played by both the exchanges and the commission. He noted, "exchanges have a duty to monitor market activity on an ongoing basis to detect and prevent manipulation, price distortions, and, where possible, disruptions in the cash-settlement process." Moreover, he added, "the Commission staff will engage in a variety of oversight activities. These activities include monitoring and analyzing open interest, initial margin, and variation payments, as well as stress testing positions. Commission staff also will conduct reviews of exchanges, clearing firms, and individual traders involved in the trading and clearing of bitcoin futures."

International coordination. Quintenz also highlighted the importance of the CFTC’s coordination with other international regulators, not just on novel FinTech issues, but more generally on the myriad of issues that impact global derivatives markets. He recognizes that progress has been made regarding comparability and equivalence determinations relative to trading venues, as well as harmonizing data standards for swaps trade reporting. However, Quintenz believes more work and discussions are necessary, especially around governance issues. Moreover, the supervision of cross-border CCPs is of paramount importance to both the EU and the CFTC, according to the commissioner.

In his final remarks, Quintenz concluded, "[w]ith the right outlook, we can help guide advancement…promote it...and capture it. The opportunities, as well as the challenges, ahead of us are immense. But, through gatherings like this, on-going dialogue, partnerships, and trust, we will find the wisdom, commitment, and vision to benefit innovators, consumers, and the markets with thoughtful and appropriate regulation."