Wednesday, November 21, 2018

KISS leads to a final uncleared swap margin rule

By Brad Rosen, J.D.

The CFTC has approved a final rule to amend its uncleared swap margin requirements (CFTC Margin Rule) to clarify that master netting agreements are not excluded from the definition of “eligible master netting agreement,” thereby harmonizing CFTC requirements with those of other regulatory bodies as well as providing further regulatory certainty to market participants.

Alignment with Prudential Regulators. The final rule, which grew out of the Commission’s Project KISS initiative, is aligned with certain rules related to qualified financial contracts (QFC Rules) adopted by the Board of Governors of the Federal Reserve System (FRS), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC). As a result of the Project KISS initiative, the Commission received suggestions to harmonize its uncleared swap margin rule with that of the aforementioned Prudential Regulators, as well as the Farm Credit Administration and Federal Housing Finance Agency.

Master netting agreements will not be excluded under the margin rule. According to the CFTC’s release, the rule amendments ensure that master netting agreements are not excluded from the definition of “eligible master netting agreement” under the CFTC Margin Rule based solely on such agreements’ compliance with the QFC Rules. They also ensure that any legacy uncleared swap that is not subject to the CFTC Margin Rule would not become so subject if it is amended solely to comply with the QFC Rules.

CFTC role and authority. The CFTC is required to establish margin requirements for uncleared swaps for all CFTC registered swap dealers (SD) and major swap participants (MSP) for which there is not a Prudential Regulator. A Prudential Regulator imposes similar margin requirements on SDs and MSPs for which there is a Prudential Regulator with respect to its prudential margin rule.

The CFTC Margin Rule was issued in January 2016 and establishes minimum requirements for SDs and MSPs to collect and post initial and variation margin for certain swaps that are not cleared by a registered derivatives clearing organization or a derivatives clearing organization that the CFTC has exempted from registration. The CFTC Margin Rule is designed to help ensure the safety and soundness of SDs and MSPs while being appropriate for the risk associated with the uncleared swaps.

Chairman Giancarlo weighs in. Chairman J. Christopher Giancarlo had this to say about the final rule: “Through the Commission’s Project KISS initiative, the Commission received suggestions to harmonize its uncleared swap margin rule with that of the Prudential Regulators. In response, this final rule does so and provides market certainty, specifically with respect to amending the CFTC’s definition of “eligible master netting agreement” and amending the CFTC Margin Rule.”

The final rule amendments will be effective 30 days after publication in the Federal Register.

Tuesday, November 20, 2018

Proxy voting mechanics and technology examined at SEC roundtable

By Amanda Maine, J.D.

In the first of three panel discussions on the U.S. proxy process, representatives from industry and investor groups shared ideas on how to improve the accuracy, transparency, and efficiency of the proxy voting and solicitation system and how technological advances might be used to enhance the voting process. The SEC hosted the proxy roundtable, which also featured discussions on improving shareholder engagement and the role of proxy advisory firms.

Corporation Finance Director William Hinman welcomed the panelists, advising that private market solutions can be faster, more flexible, and less intrusive than regulatory solutions, so the SEC benefits greatly from industry feedback. He also drew attention to a concept release published by the Commission on the proxy process in 2010, noting that many of the issues raised in the concept release still exist today.

Advisory committee input. Professor John Coates of Harvard Law School acknowledged that of the three topics to be discussed by the roundtable, this topic was the “most boring,” but he also said that it was the least partisan and the most important. He outlined some of the main themes gleaned from a recent meeting of the Commission’s Investor Advisory Committee (IAC), which had discussed the proxy process at length. There is a general concern that retail participation in proxies is down, even in contested elections where voting can play a pivotal role, he said. One reason for this is the OBO/NOBO system that creates differences in communications with retail investors. Non-objecting beneficial owners (NOBOs) allow intermediaries to release their names and addresses to the issuer, while OBOs are shareholders who do not allow their identities to be disclosed. Coates suggested that the SEC conduct a survey to determine why some shareholders do not choose to be NOBOs and then think about how the industry can respond.

Members of the IAC had also emphasized that shareholders want to know that their votes were actually counted, Coates said. He noted that there are solutions that currently exist, and urged Broadridge Financial Solutions, which provides proxy voting services, to think how it can make its system simpler. In addition, the IAC observed that the many layers of intermediation can produce mismatches in information, which can lead to the disqualification of votes, Coates said.

Systemic change needed, but short-term fixes are available. Nudges from regulators alone will not be sufficient to improve the system, according to Ken Bertsch, executive director of the Council of Institutional Investors. In CII’s view, it is time for a fundamental rethink of the proxy voting system. In terms of regulation versus market forces, the SEC should lead the thought process to find out what makes sense, Bertsch said. While the technology is available that can be used in this area, a fundamental change will take time, and the Commission should look at short-term fixes.

In the near-term, the SEC should, through rulemaking or guidance, require all intermediaries to take steps to transmit all the necessary information to provide routine and reliable vote confirmation, Bertsch advised. The Commission should also issue guidance that leads to pre-reconciliation of discrepancies between broker-dealer and DTC positions to minimize differences.

OBO/NOBO issues. Katie Sevcik, executive vice president and COO of transfer agent EQ, suggested that many shareholders who are currently OBOs actually would prefer to be NOBOs. Even issuers that do have access to shareholders who are NOBOs find it expensive to gain access to the shareholder list, noting that one issuer recently paid $70 per name. She also observed that NOBO lists do not use email addresses, meaning issuers can only reach out to these shareholders via postal mail.

Lawrence Conover, vice president at Fidelity Investments, pointed out that the largest percentage of OBOs are institutional investors. For them, it is a privacy issue, he said, and they will do anything to protect their privacy. Comparatively, most retail investors are NOBOs, he added.

Blockchain. Several roundtable participants expressed support for using blockchain or other distributed ledger technology to reform the proxy voting system. Robert Schifellite, president of investor communications at Broadridge, said that his company is making very significant investments in blockchain, including a pilot program with Bank Santander as well as blockchain pilots in the U.S. with five issuers and a couple of custodians. He highlighted Broadridge’s platform and invited those interested to come see how it works, the controls that have been implemented, and audits that take place to ensure that the process is accurate and reliable.

Alexander Lebow of A Say Inc. was more cautious to embrace blockchain, although he acknowledged that the technology holds great promise with regards to proxies. According to Lebow, there is a spectrum of approaches to blockchain, with one end being the complete reconstruction of the equity markets with distributed ledger technology and the other end involving certain layers of blockchain on top of a pre-existing system. In his view, the more you move away from an all-in reconstruction of the system towards “layers of veneer,” the fewer the benefits will be and the less clear the advantages are over existing database technologies. “If you’re going to do it, you need to go all-in on blockchain,” he advised.

Chairman Jay Clayton praised the roundtable’s participants and said he was heartened to hear about technology and stressed that the technology should not drive the structure; rather, we should outline our goals and then find the technology that can help address these goals.

Monday, November 19, 2018

Cyber, Brexit are among SEC disclosure review priorities in coming filings season

By John Filar Atwood

In the upcoming filings season, the staff of the SEC’s Division of Corporation Finance will be looking closely at disclosure on the degree to which the board oversees the management of the company’s cybersecurity risks. At Practising Law Institute’s conference on securities regulation, both Deputy Director Shelley Parratt and Associate Director Cicely LaMothe emphasized that the staff expects this year’s cyber disclosure to adhere to the 2018 staff guidance in this area.

LaMothe said the staff will expect to see disclosure on the cyber risks a company faces and the board’s oversight of managing that risk. She noted that the staff reads press reports, and if it sees a cyber incident mentioned, it will look for a discussion of the incident in the company’s disclosure documents. The information disclosed must make sense in terms of what is going on with a company, she added.

Parratt agreed, and opined that cyber disclosure is improving overall. She advised companies to be sure to discuss their internal controls surrounding cybersecurity and their policies to prevent insider trading before an incident is made public. Northrop Grumman’s Jennifer McGarey said that her company puts certain employees on a no-trade list so that if a cyber breach occurs, the company can act quickly. At Northrop Grumman, cybersecurity is a board-level disclosure, she noted.

Sidley & Austin’s Thomas Kim remarked at how the Commission’s 2011 cyber guidance was a little tentative, but the 2018 has a very different tone. After reading the 2018 guidance, companies should conclude that cybersecurity and data management must be treated as a material risk by all entities, he said.

Yahoo! case. Former CorpFin Director Meredith Cross, a partner at WilmerHale, advised companies to learn some lessons from the 2018 cyber disclosure case against Yahoo! The Commission found that the company’s risk factor disclosure was materially misleading for failure to disclose a massive data breach in 2014.

Importantly, Cross said, the SEC criticized Yahoo! for not consulting with outside auditors and experts on the matter. She wondered whether prior to the Yahoo! case corporate counsel would have thought of outside consulting as part of the controls and procedures process. She advised companies to be mindful going forward of the Commission’s critique of Yahoo!.

Brexit. Another area of focus for the CorpFin staff in upcoming filings will be Brexit disclosure, according to Parratt. As the March 2019 deadline nears, she noted, the staff is monitoring the disclosure on the topic. So far the quality of reporting is wide ranging, she said, with some companies covering very thoroughly supply chain and personnel issues, and whether Brexit will cause them to have to relocate. Division Director William Hinman added that if a company is still providing generic Brexit disclosure, it should think about whether its shareholders will be surprised about it after it happens.

The LIBOR phase-out could have a significant impact on some companies, Parratt said, so the staff will want to see adequate disclosure if it is a material issue for a company. She added that the staff expects LIBOR-related reporting to improve as more information becomes available on the transition to other reference rates.

LaMothe said that the top areas on which the staff comments remain consistent from year to year. This year the staff issued numerous comments on revenue recognition, fair value disclosure, and MD&A. She advised that when the staff is drafting comments, it tries to understand what a company’s accounting method is and then examines how the company has applied the relevant staff guidance.

Staff reviews are not limited to the filings themselves, LaMothe said. The staff also looks at analyst reports, news stories, and web sites. The staff’s objective to understand the story of a company, she noted, and then to make sure the company’s MD&A coveys that.

Fewer comment letters. Cross said that overall it seems the staff is issuing fewer comment letter, but that they are harder and more well-informed. LaMothe agreed that there are fewer letters issued, noting that the staff is moving away from sending out generic comments. In addition, the staff is being more proactive in the comment process by calling companies to discuss its questions, she said.

In her opinion, companies also engage in a lot of self-correction. They take into account the comments the staff has issued and adjust their disclosure accordingly, which cuts down on the need for comment letters, LaMothe said.

She emphasized that the staff does not always require an amendment when it has questions about a company’s filing. She advised companies to call the staff for clarification. The staff can hopefully help a company target its responses to the staff’s questions, she added, and avoid having to prepare an amended filing.

Friday, November 16, 2018

SEC enforcement co-directors discuss approach to crypto assets, impact of Supreme Court decisions

By John Filar Atwood

The SEC’s Division of Enforcement has tried to take a measured approach to enforcement in the crypto asset space in order to address violations without stifling innovation, according to co-directors Stephanie Avakian and Steven Peikin. The division’s cyber unit is closely watching the space, and looking for situations where investors do not have adequate disclosure about crypto products, they said at Practising Law Institute’s conference on securities regulation.

Peikin said the crypto cases generally involve outright fraud, where entities do not have the product they claimed to have, or trading suspensions because there was not enough information about the product in the marketplace. The staff also is beginning to bring actions for regulatory violations such as a failure to register, such as the December 2017 case against Munchee Inc., which was selling digital tokens through unregistered offers and sales.

More recently, the division has started cracking down on the operation of unregistered digital exchanges, Peikin said. He cited the first unregistered exchange case brought last week against an individual that operated EtherDelta, an online platform that had executed more than 3.6 million orders for tokens over an 18-month period.

Given the uncertainty surrounding regulation of the digital asset space, Peikin was asked if the Enforcement Division is engaging in regulation by enforcement. He said the staff is sensitive to that concern, but argued that the division’s work in this area has been incremental and has progressed logically. As evidence, he cited the decision to issue a Section 21(a) report in the DAO investigation instead of bringing an enforcement action, and the decision not to impose penalties on Munchee because it quickly and fully cooperated and gave all of the money back. Those were responsible approaches to the two cases, in his opinion.

Supreme Court decisions. Avakian and Peikin also discussed the impact on enforcement of the Supreme Court decisions in Kokesh v. SEC and Lucia v. SEC. In Kokesh, the Supreme Court ruled that the SEC’s imposition of disgorgement constitutes a penalty and, as a result, is subject to a five-year statute of limitations. In Lucia, the Court determined that administrative law judges are officers of the U.S. and so must be appointed by the full Commission.

Peikin said that Kokesh has had a dramatic impact on the division, noting that it has had to forego about $900 million in disgorgement. The staff is more thoughtful about case selection because of Kokesh, he added, and looks at the age of a case before deciding whether to proceed.

Avakian agreed, saying that if misconduct in a pending case is four years old, the enforcement staff may bypass it. However, if the fraud in the case is ongoing, then the division will certainly take action, she stated. If the agency is only going to get an injunction and no remedies at the end of a case, it is hard to decide it is worth the resources, she said. The staff is not at a loss for cases, she added, noting that it received 20,000 tips and referrals last year, and so must choose where to put its resources.

Lucia also has had a measurable impact on the SEC’s enforcement program, according to Avakian, who noted that more than 200 cases came back to the division because of the ruling. She said the staff will work through those cases over the coming year, and may have to use a significant amount of litigation resources to retry some of them. She believes that the backlog caused by Lucia should clear out it about a year.

2018 annual report. The Enforcement Division released its fiscal 2018 annual report recently, and Avakian said observers should not read too much into the decrease in the number of financial fraud cases during the past year. Fraud cases remain a high priority for the staff, she insisted, citing the litigation in significant cases such as those against Theranos and Rio Tinto.

Peikin emphasized the importance of the share class selection disclosure initiative that the staff implemented last February. Under the program, the staff agreed to recommend favorable settlement terms for investment advisers that self-reported their failure to make required disclosures relating to their selection of mutual fund share classes that paid the adviser a fee when lower-cost share classes were available.

It was a big concession by the division not to pursue these cases, Peikin said. However, the initiative generated dozens of reports that will allow the Commission to return money to investors. The conduct involved is extraordinarily hard to detect, he noted, so the self-reporting program was a huge help to the division.

Avakian said the enforcement staff tries to be as responsive as possible, while managing the work in a way that enables the division to pivot to a new case if necessary. Peikin noted that the staff works through tips and referrals as quickly as possible. The division will not make the right call every time about whether to pursue a particular matter, he said, but it tries to get the important ones right.

Thursday, November 15, 2018

Sentences upheld in double jeopardy dispute

By R. Jason Howard, J.D.

On the heels of the Supreme Court holding in Kokesh v. SEC that disgorgement, “as it applied in SEC enforcement proceedings, operates as a penalty,” the Sixth Circuit, in a criminal sentencing appeal, held that SEC civil disgorgement is not a criminal punishment (U.S. v. Dyer, November 13, 2018, Suhrheinrich, R.).

Broad Street. For more than eight years, the defendants owned and managed Broad Street Ventures, LLC, which they used to embezzle investor funds by paying the funds out to themselves as nontaxable distributions and underreported income to evade paying taxes on it. In all, the government estimated that the amount of the loss or fraud totaled over $4.9 million.

On July 20, 2016, the SEC began a civil enforcement suit against the defendants and nine months later, in April 2017, the government filed an information charging the defendants with conspiracy to commit mail and wire fraud and tax evasion. In May 2017, the defendants pleaded guilty to the conspiracy to commit wire fraud and mail fraud, and tax evasion. As part of their plea deals, the defendants stipulated that the amount of loss caused by their conduct was greater than $3.5 million, waived any double jeopardy defenses, and agreed to pay over $538,000 in restitution to the IRS.

In May 2017, the defendants consented to entry of a final judgment in the civil case, where they agreed that the court would order disgorgement of ill-gotten gains, pre-judgment interest, and a civil penalty. In the criminal case, sentencing guidelines after all considerations left the defendants with between 46 and 71 months of imprisonment. The defendants objected to the guideline calculations, arguing that the 18-level increase of their base offense level per the guidelines, violated the Double Jeopardy Clause because the defendants were already punished by disgorgement in the civil case. The defendants also argued that the five-year statute of limitations from Kokesh prevented the court from considering conduct the occurred more than five years before the indictment.

District court holding. The district court ruled that Kokesh did not apply and that it “was allowed to consider ‘relevant conduct’ that could not be prosecuted separately because of the statute of limitations.” The court also ordered the defendants to pay restitution in the full amount of the loss, over $4.9 million.

Appeal. Despite their attempts, the Sixth Circuit explained that the holding in Kokesh was narrow and that “nothing from Kokesh serves as the ‘clearest proof’ we require to transform a civil remedy into a criminal punishment for Double Jeopardy purposes.” The court continued, stating that if anything, “Kokesh reinforces the long-held understanding that SEC disgorgement is civil in nature.”

Even if the SEC disgorgement were a criminal punishment, the Sixth Circuit explained that it would affirm the defendants’ sentences for two reasons. First, with the civil complaint alleging securities violations, the SEC had to prove that the purchase or sale of a security was involved and in the criminal case, where the defendants were charged with conspiracy, the government had to prove the defendants joined in the agreement. Those elements are exclusive to the civil and criminal cases and, as such, there is no double jeopardy. Secondly, the Sixth Circuit said that “the consideration of relevant conduct resulting in an 18-level enhancement is not ‘punishment’ for Double Jeopardy purposes.”

Holding. The defendants’ other arguments met with a similar fate and the Sixth Circuit affirmed the lower court’s ruling that the SEC’s civil disgorgement is not a criminal punishment and affirmed the defendants’ sentences.

The case is No. 17-6174.

Wednesday, November 14, 2018

CorpFin director expects digital asset guidance to be ready by early 2019

By John Filar Atwood

The staff of the Division of Corporation Finance is working on plain English guidance on tokens and other digital assets, and expects it to be released later this year or early in 2019, according to division director William Hinman. In remarks at Practising Law Institute’s securities regulation conference, he noted that the guidance will take his June 14 “When Howey Met Gary” speech and elaborate on the issues therein.

Among other things, the guidance will provide the staff’s current thinking on custody and disclosure issues surrounding digital assets, he said. It also will discuss issues that should be considered by entities thinking about registering their tokens or other digital assets.

There are some no-action letter requests pending in the digital asset space, and Hinman was asked if the staff plans to resolve various crypto-related issues this way. He said that it is too early to provide a safe harbor that says if a digital asset or offering has certain characteristics, then it is exempted from registration. He advised entities that think their digital assets are exempt to approach the staff and discuss it with them.

Hinman said that there are a few dozen draft filings at the Commission in the digital asset space. The filings are moving forward, he noted, but the staff is taking its time because the issues presented are complex.

Quarterly reporting. Other items on the division’s agenda in the coming year include the development of a concept release on quarterly reporting, according to Hinman. The release will explore whether quarterly reporting promotes short-termism, among other issues, he said.

The concept release also will ask for feedback on the value of a Form 10-Q that is filed after an earnings release, which contains much of the same information, he noted. The staff plans to ask whether the Commission can somehow piggyback on the earnings release for Form 10-Q reporting, he added.

The staff plans to move forward with the FAST Act proposing release, which was written prior to Hinman’s arrival at the SEC. Of particular interest to industry participants is the proposed new approach to confidential treatment of certain documents and information, he noted.

Currently if a company wants to redact portions of its public filings, it has to file a request to do so with the SEC, Hinman said. Under the FAST Act proposals, companies will be allowed to redact pieces of filings without filing the formal request. He noted that the staff already encourages companies to exclude personally identifiable information from their public filings.

Hinman advised that the staff will review the use of this provision closely to see if it thinks companies are over-redacting. The staff will issue comments when appropriate, he added.

Testing the waters. Another initiative on the staff’s agenda is expanding the test-the-waters capabilities to more companies, Hinman said. The ability to gauge interest in a potential offering without publicly filing with the Commission is currently available to emerging growth companies. EGCs have found testing the waters very useful, he noted, and the staff feels that it may help other entities such as unicorns that want to find their valuation by testing market interest.

The staff thinks it can expand test-the-waters privileges without new legislation, Hinman said. However, he acknowledged that expansion will bring up some Reg. FD issues that could limit the applicability of broadening the test-the-waters provision.

Hinman indicated that the division also will work to move forward the Commission’s efforts to expand companies’ use of stock compensation under Rule 701. The comment period on the concept release on this issue recently closed, so rulemaking is the next step. Among other things, the initiative recognizes the changes in how companies pay their employees, and the evolving relationships between companies and the individuals who work for them, and will likely propose to broaden the rule’s definition of employee in light of the “gig economy.”

Dodd-Frank rulemaking. Hinman said the staff will be working on the Dodd-Frank-mandated rules on hedging, which were initially proposed back in 2015. The rules call for proxy statement disclosure of whether employees or members of the board of directors are permitted to engage in transactions to hedge or offset any decrease in the market value of equity securities granted to the employee or board member as compensation, or held directly or indirectly by the employee or board member.

Asked about possible progress on other unfinished Dodd-Frank rulemaking, Hinman said that Chairman Clayton wants to do them serially, so once the hedging proposals are out the staff will move on to the others. He noted that the market has been working out some issues with regard to clawbacks and pay-versus-performance metrics, so any proposals will benefit from that.

Other projects the division expects to undertake in the coming year, according to Hinman, are proposals on Item 3-05 of Regulation S-X, harmonizing the private placement exemptions, codifying Guide 3, and extending Regulation A exemptions to more companies. With regard to the Reg. A initiative, he said that the staff plans to follow Congress’s instructions very closely on that effort.

Tuesday, November 13, 2018

IM Director Blass praises ‘symphony of participants,’ vibrancy of financial markets

By Joanne Cursinella, J.D.

Speaking recently at the ALI CLE 2018 Conference on Life Insurance Company Products, Division of Investment Management Director Dalia Blass discussed variable products, investor choice, and regulatory consistency, while commenting on the “symphony of participants” she sees in the market, from investors of all ages, financial situations, and preferences to financial services providers with a variety of investment products and services that can meet unique investor needs.

Variable products and modernized framework. In prepared remarks, Blass pointed out that variable products represent $2 trillion in investor assets and that investors often turn to these products for their combination of capital market exposure and insurance guarantees that they can’t get elsewhere. Blass believes that investors benefit from a diversity of choices. “The products and services that you offer add to the symphony of choice that makes our markets vibrant,” she told her audience. The companion to choice is information, she added. The Commission has just proposed reforms to the disclosure framework for variable contracts that would introduce a layered disclosure to insurance products, update the registration forms, take a fresh look at addressing discontinued contracts and leverage technology.

Disclosure framework reform. The layered disclosure framework, which forms the core of the proposal, is similar to the layered disclosure that mutual funds have used since 2009, but are tailored to variable contracts, Blass said. The proposal features an initial summary prospectus for new investors and an updating summary prospectus for existing investors.

The initial summary prospectus would explain a contract’s features, costs, and risks, while the updating summary prospectus would provide information on changes that occur in subsequent years. This proposed framework would also permit layered disclosure about the underlying mutual funds in contracts. Certain information about the funds would be included in the summary prospectus and the full prospectus would be placed online. “This approach could allow investors to navigate the information in a way that responds to their needs,” Blass commented.

The proposal also includes a number of changes to modernize the rulebook for insurance products. The changes reflect the Division’s efforts to engage in retrospective review of the regulatory framework as the Division staff looks ahead, Blass said. Division staff reviewed statutory prospectus requirements, past Commission temporary rules, and prior staff statements to see where the framework for variable contracts could be modernized, she added.

Division staff is also looking to the future and the use of technology, Blass said. For example, the proposed amendments would require the use of structured data for certain disclosures, including the fee tables. This structured data would allow an investor to more easily compare the investment options offered by different variable contracts and assess whether a contract’s investment options meet the investor’s needs or goals, Blass pointed out.

What is needed now is constructive feedback on the proposal. Blass wants to know where the proposal “hit the mark” and where it didn’t. But in submitting comments, Blass made one request—not to approach comment letters as just a legal exercise. This rule, if adopted, could be on the books for a long time, she said, and Blass doesn’t want a rule that will be outdated the minute it is adopted. “[W]e want to future-proof it,” she added.

Investor choice and regulatory consistency. Blass next turned to the standards of conduct for financial professionals. In April, the Commission proposed a package of rulemakings including Form CRS, Regulation Best Interest, and the fiduciary duty interpretation for investment advisers, Blass reported. These proposals are intended to serve Main Street investors by bringing the legal requirements and mandated disclosures of financial professionals in line with investor expectations, Blass said. She highlighted two topics that she said are particularly important for this audience—investor choice and regulatory consistency.

Broker-dealers and investment advisers are different, and their compensation models are different; each offers its own features, advantages, and conflicts, Blass said. In addition, just as investors can benefit from a variety of financial services, they can also benefit from a variety of investment options. “For one investor, a mutual fund may check all the boxes; for another, an insurance product may work better,” Blass added.

Blass also believes that consistent rules are important, especially for products where multiple federal and state rules can apply. In her view, coordination among regulators is central to having an efficient, effective and rational framework.

Looking ahead. Blass concluded by pointing out that the Division has been involved in a number of other key policy initiatives. For example, Division staff recently issued no-action relief to permit issuers of structured indexed annuities to file audited financials in their registration statements that are prepared according to SAP (state statutory accounting principles) instead of GAAP (generally accepted accounting principles).

The Division also monitors the implementation of recently adopted rules. One of the key rules being monitored is the liquidity risk management rule, Blass said. She has heard concerns about the possible impact of this rule on fixed income markets if a fund holds more than 15 percent in illiquid investments. Some funds may be concerned that the rule forces them to sell assets immediately, possibly in a down market, but the rule does not require forced sales, only responsible actions, Blass said. Further, the staff has actively engaged on questions regarding the implementation of this rulemaking and will remain available to advise and assist as needed, Blass added.

Monday, November 12, 2018

OCIE announces risk-based exam initiatives focused on funds and advisers

By Amy Leisinger, J.D.

The SEC’s Office of Compliance Inspections and Examinations has issued a risk alert announcing its intention to conduct a series of examination initiatives focused on issues affecting certain registered investment companies and investment advisers. According to the alert, examiners will focus on mutual funds and ETFs, adviser activities, and oversight by fund boards of directors and target compliance potential problems that could directly affect retail investors.

In particular, examinations will focus on index funds tracking custom-built indexes and assess the unique challenges associated with the selection and weighting of the custom-built or bespoke index components. Examiners will also review how portfolios are managed in comparison with disclosures describing strategy and the adequacy of disclosures made to the fund boards regarding index providers, as well as efforts to address conflicts of interest between index providers and advisers.

In addition, OCIE will focus on small ETFs and ETFs with minimal secondary-market trading volume and assess whether board oversight incorporates a given fund’s ability to continue as an ongoing concern and whether tracking errors are effectively monitored. The staff will also evaluate whether ETFs adequately disclose investment risks, including liquidation risks, to investors and, as necessary, whether portfolios are appropriately liquidated for distribution to shareholders upon liquidation.

With regard to underperforming funds, the staff will review the effectiveness of the funds’ compliance programs and board oversight activities and assess whether the funds are investing in a manner consistent with disclosed objectives and strategies and using marketing materials containing complete and accurate statements. OCIE staff also will evaluate whether funds with higher allocations to certain securitized assets adhere to applicable requirements when borrowing or investing in instruments that may leverage the funds and examine risk identification, monitoring, and mitigation activities to evaluate how advisers are managing the portfolio holdings and liquidity. Examiners will also consider valuation and pricing policies and procedures, particularly with respect to illiquid or difficult-to-value securities.

OCIE has also determined that side-by-side management of mutual funds and private funds may present certain risks to retail investors and, as such, will evaluate advisers’ policies and procedures for addressing conflicts of interest and other risks associated with the practice and controls designed to ensure appropriate brokerage, best execution, and trade allocation practices. Advisers new to the industry will be evaluated to ensure that their fund boards are provided with sufficient information to perform their duties and to assess the effectiveness of compliance programs of both the advisers and their funds under management.

OCIE urges registrants to reflect upon their own practices to consider improvements as appropriate., as the adequacy of supervisory, compliance and risk management systems can be determined only with reference to the circumstances of a specific firm.

Friday, November 09, 2018

IAC approves recommendation to clarify Reg. BI

By Amy Leisinger, J.D.

By a 16-3 vote, the SEC’s Investor Advisory Committee approved a recommendation to the Commission to strengthen and clarify certain aspects of proposed Regulation Best Interest. According to the IAC, the standard for broker-dealers and investment advisers should be clarified with regard to the obligation to act in customers’ best interests, and the best interest standard should be characterized explicitly as a fiduciary duty under which specific obligations vary with regard to different business models. In addition, the committee recommended that the best interest obligation be expanded to cover initial rollover and account-type recommendations to customers and that the Commission conduct usability testing of the proposed Form CRS disclosures to ensure that they enable investors to make informed choices.

Recommendations. According to the IAC, the proposal should be modified to clarify what is meant by the requirement that brokers and investment advisers act in their customers’ best interests by specifically requiring them to recommend the investments, strategies, accounts, or services that they reasonably believe represent the most favorable options for each investor. This determination should involve a careful review of the investor’s needs and goals as well as reasonably available products and services and associated costs, the committee states. More than one available option may satisfy this standard, the recommendation notes, and compliance should be measured based on whether the broker or adviser had a reasonable basis for the recommendation when it was made. As the Commission moves forward with its rulemaking, the IAC believes it should provide additional guidance to help brokers and advisers understand how to best meet their obligations.

In addition, the IAC notes that some of the most crucial investor decisions occur at the outset of a relationship with a broker or and adviser, well before recommendations are made regarding specific transactions. Decisions about rollovers and account types and the scope of services to be provided set up the parameters of the relationship and could have an even more substantial impact than subsequent investment recommendations, the committee explains. As such, the committee recommends that these recommendations also should be subject to a best interest standard.

The Commission should also explicitly clarify that the best interest standard of Regulation BI is a principle-based fiduciary obligation and adopt an approach to implementation that would be uniform with the Advisers Act standard in principle but vary in application with regard to particularized facts and circumstances, according to the committee. The IAC notes that this can be accomplished without sacrificing all differentiation between brokers and advisers; the same flexibility that makes it possible for the Advisers Act fiduciary duty to be adapted to varying services and business models can be adapted to broker-dealers.

“Making it clear that both broker-dealers and investment advisers, regardless of business model, are working as fiduciaries under a standard tailored to the functions they perform would simplify the issues for investors and the regulated community alike,” the IAC states.

Finally, the IAC recommends that the Commission test the effectiveness of Form CRS disclosures for investors. The recommendation opines that the testing should include unsophisticated investors without a clear understanding of the differences between brokerage and advisory accounts. If usability testing reveals that the disclosures do not achieve the intended purpose of reducing confusion and promoting informed decision-making, the Commission may need to make changes before finalizing the form, the committee explains.

Thursday, November 08, 2018

Updated C&DIs conform to new definition of ‘smaller reporting company’

By Mark S. Nelson, J.D.

The SEC’s Division of Corporation Finance issued a number of revised Compliance and Disclosure Interpretations regarding filings related to the definition of “smaller reporting company.” Although the changes are mostly non-substantive, they do purport to bring existing C&DIs into conformity with the Commission’s June 2018 release in which it re-defined “smaller reporting company.” Additionally, the Division re-organized how its collection of C&DIs are displayed on the SEC’s website.

Most of the revisions to the C&DIs alter the numerical thresholds and/or the date references mentioned in the existing C&DIs. The Commission recently adopted a new definition of “smaller reporting company” that would include a company that had public float of less than $250 million, or had annual revenues of less than $100 million and either had no public float or had public float of less than $700 million. The revised definition seeks to promote capital formation and reduce compliance costs to smaller companies. The definition of “smaller reporting company” was last revised by the Commission in 2007 and became effective in 2008. The 2018 changes to the definition became effective September 10, 2018.

The revised C&DIs also withdraw six C&DIs. The withdrawn C&DIs cover a range of topics, including when a smaller reporting company can remain a non-accelerated filer, the eligibility of smaller reporting companies for the prior delayed phase-in regarding Exchange Act Rule 14a-21, and the provision by a smaller reporting company of the audit committee financial expert disclosure.

For comparison purposes, the old text of the affected C&DIs includes the following: (1) Exchange Act Rules Question 130.04 and Questions 169.01 to 169.03; (2) Exchange Act Forms Question 104.13; (3) Regulation S-K Questions 102.01 and 102.02, Question 110.01, Question 133.09, and Question 202.01.

Wednesday, November 07, 2018

NASAA proposes amending policy on small company offering registrations

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

NASAA has released for public comment a proposal to update its statement of policy governing state registration of small company offerings. The proposed amendments to the SCOR Statement of Policy would increase the offering limit from $1 million to $5 million and incorporate many of the investor protections mandated under state and federal crowdfunding laws, including requirements pertaining to investment limits, sales reports, and ongoing reporting. Proposed amendments to the SCOR Form (Form U-7) include updates drawn from intrastate crowdfunding forms, federal Form C, word processing features, and changes in federal law.

SCOR Statement of Policy. NASAA’s current SCOR Statement of Policy seeks to provide for the uniform treatment of registrations of small company offerings which are exempt from federal registration under Rule 504 of Regulation D, Regulation A, or Rule 147 of the Securities Act. Forty-four U.S. jurisdictions have, either officially or unofficially, adopted the SCOR registration program or recognize the filing of Form U-7.

NASAA's proposing release, however, notes that the current policy statement was last updated in 1996, prior to the widespread use of the Internet for capital formation, while the SCOR Form was last updated in 1999. Importantly, the SEC amended federal Rule 504 to increase the offering amount limitation from $1 million to $5 million, effective January 20, 2017. In addition, the SEC amended the intrastate offering exemption in federal Rule 147 and adopted a new intrastate exemption as Rule 147A

SCOR availability and investment limits. In light of these changes, the proposal amends the types of federally exempt offerings that can be registered at the state level under the SCOR Statement of Policy. The offering amount limit in the amended Statement of Policy would be increased from $1 million to $5 million to reflect the increase in the federal offering amount limit under Rule 504. Further, the proposal would allow SCOR registration of intrastate offerings exempt under new federal Rule 147A. Regulation A offerings would no longer be permitted under the Statement of Policy, however, because offerings made under Regulation A must now be made using the federal Form 1-A and the offering amount is no longer capped at $5 million.

The proposed amended SCOR Statement of Policy would incorporate the individual investment limits from federal Regulation Crowdfunding. NASAA believes that this limitation is appropriate to balance investor protection concerns with the simplified disclosure and financial statement requirements provided for in SCOR offerings.

Financial statement requirements. Among the other updates, the proposed amended Statement of Policy institutes three important changes regarding requirements for financial statements. First, the amended policy statement would require the issuer’s CEO and CFO to certify that the annual financial statements are true and complete in all material respects. Second, interim financial statements must be provided if the annual financial statements are dated more than 120 days prior to the date of filing. Third, the proposed amended Statement of Policy provides tiered compilation, review, and audit requirements for the financial statements based on the amount of the offering:
  • $0 to $500,000: Unaudited
  • $500,001 to $999,999: Compilation
  • $1,000,000 to $1,999,999: Review
  • $2,000,000 to $5,000,000: Audit
Although the tired approach to financial statements is based in part on the approach required under federal Regulation Crowdfunding, the release observes that NASAA’s proposed tiered requirements are less onerous because offerings under the SCOR Statement of Policy would be registered and subject to review and comment by state examiners, as opposed to federal crowdfunding offerings that are not reviewed by SEC staff.

Bad actor disqualification. The amended policy statement would also include a more complete bad actor disqualification provision that merges aspects of the federal bad actor provisions applicable to Rule 506 and Rule 504 offerings with the bad actor disqualification under the existing SCOR Statement of Policy. The release notes that the new disqualification provision seeks to capture individuals materially participating in the offering or the issuer’s operations, as well as events that may indicate the potential for fraud, given the nature of the offerings. Unlike similar federal provisions, however, the proposed provision does not grandfather any bad acts that occurred prior to the adoption of the SCOR Statement of Policy.

Sales reports and ongoing reporting requirements. The proposed policy statement would incorporate a sales reporting requirement similar to that contained in intrastate crowdfunding laws and federal Regulation Crowdfunding. The proposal would also require an issuer to provide annual financial statements to the issuer’s security holders, and upon request to the jurisdictions where the offering was registered, no later than 120 days after the end of the issuer’s fiscal year. The financial statements, which must be be certified by the issuer’s CEO and CFO, could be posted to the issuer’s website. While the financial statements would not be required to be audited, the issuer would be required to provide reviewed or audited financial statements if otherwise available.

Request for comments. Comments on the proposed updated SCOR Statement of Policy and SCOR Form are due December 3, 2018. After the comment period has closed, NASAA will post to its website the comments it receives as submitted by the authors.

Tuesday, November 06, 2018

CFTC approves final swap dealer de minimis threshold level; disagreement prevails over proposed SEF and trade execution rules

By Brad Rosen, J.D.

The first Sunshine Act meeting attended by the current slate of CFTC commissioners revealed a mixed picture of positions and opinions among its members. In its first order of business, the Commission unanimously approved the final rule amending the de minimis exception to the swap dealer definition by keeping the threshold unchanged at $8 billion. On a 4-1 vote, the Commission also approved the proposed rule amendments to regulations on swap execution facilities (SEFs) and the trade execution requirement, the vehement dissent of Commissioner Dan Berkovitz notwithstanding. He asserted this type of oversight looked very much like the “light-touch” approach to regulation that was discredited by the financial crisis. Lastly, the Commission unanimously approved putting forth a request for public comment regarding the practice of “post-trade name give-up” on SEFs.

The commissioners weigh in. Each of the commissioners had plenty to say in connection with the events of the day. Chairman Giancarlo offered remarks on the swap dealer de minimis rule as well as regarding the proposed SEF rule and request for comments. Commissioner Quintenz offered his remarks as did Commissioner Stump. Commissioner Behnam provided an opening statement, as well as a statement of concurrence regarding the proposed SEF rule and execution requirements. Commissioner Dan Berkovitz also provided a statement on the final swap de minimis rule.

Permanent $8 billion de minimis exception to the swap dealer definition approved. With yesterday’s action, the Commission approved the amendment to the definition of the term “swap dealer” to set the permanent aggregate gross notional amount (AGNA) threshold for the de minimis exception at $8 billion in swap dealing activity entered into by a person over the preceding 12 months.

Based on analysis of the data, as well as comments by market participants, an $8 billion threshold would help ensure that nearly all swap transactions as measured by AGNA, or transaction count, benefit from the protections set forth in the Commission’s swap dealer regulations, and advance the public policy interests of promoting competition, encouraging new swap market participants, and increasing efficiency for market participants. A swap transaction would still have to comply with the CFTC’s mandatory clearing, trade execution, and reporting requirements, subject to certain exceptions and whether or not a swap involves a registered swap dealer as a counterparty.

SEF, trade execution requirement, and request for comment indicate a new direction. The rule proposal, which amends existing requirements and proposes new requirements pertaining to swap execution facilities (SEFs) and the trade execution requirement, include the adoption and/or codification of many existing staff guidance documents and staff no-action relief letters. Additionally, the Commission is considering a request for comment on the practice of post-trade name give-up for intended-to-be-cleared swaps that are executed on SEFs.

The proposed rules would apply the statutory SEF registration requirement to certain swaps broking entities, including interdealer brokers, and aggregators of single-dealer platforms. Domestic swaps broking entities would receive a six-month delay from the SEF registration requirement. Foreign swaps broking entities would receive a two-year delay from the SEF registration requirement.

The proposed rules would also amend the SEF registration requirement to clarify that entities that meet the SEF definition would be required to register as a SEF, irrespective of whether the swaps that they list for trading are subject to the trade execution requirement. The proposed rules would also eliminate the “made available to trade” (MAT) determination process for SEFs and DCMs and establish a new approach based on a revised interpretation of the trade execution requirement in the CEA . The trade execution requirement would apply to swaps that are both:(1) subject to the clearing requirement; and (2) listed by a SEF or DCM for trading.

Commissioner Berkovitz takes a stand. In issuing his dissent to the proposed rule, Berkovitz asserted, “This Proposal is a fundamental overhaul of the SEF regulatory regime. The changes create a trading system that is so flexible that all swaps traded on SEFs—including the most liquid—could be traded the same way they were before the Dodd-Frank reforms were adopted.” Berkovitz noted that the proposal would also allow the largest dealers to establish separate dealer-to-dealer liquidity pools through exclusionary access criteria. He noted that competition would be reduced and price transparency diminished. He concluded “This is not what Congress intended when it passed the Dodd-Frank Act.”

The comment period for the proposed rule will run for 75 days and begin when it is published in the Federal Register. Both Commissioners Berkovitz and Behnam expressed their reservations that not enough time was being afforded for comments, and observed that most complex rules are provided at least 90 days for comment.

Monday, November 05, 2018

Lorenzo case to test boundaries of scheme liability

By Mark S. Nelson, J.D.

The upcoming battle over the intersection of scheme liability and Janus “maker” liability has been joined now that SEC respondent Francis Lorenzo has filed his reply to the government’s merits brief. The case is set for oral argument on December 3 and there is at least the possibility that the outcome could result in a tie vote given that Justice Kavanaugh has recused himself because he participated in the case as a judge on the D.C. Circuit and dissented from the panel majority opinion that upheld most of the Commission’s opinion finding Lorenzo liable for securities violations (Lorenzo v. SEC, November 1, 2018).

The road to oral argument. The SEC, in an administrative proceeding, charged Lorenzo, director of investment banking at registered broker-dealer Charles Vista, LLC, with violating Securities Act Section 17(a)(1), Exchange Act Section 10(b), and Exchange Act Rules 10b-5(a), (b), and (c) for sending emails that contained false or misleading statements to investors at the behest of Lorenzo’s boss. (Charles Vista and its owner, Gregg Lorenzo—no relation to petitioner Francis—previously settled with the SEC). The emails asserted that Charles Vista’s only client, Waste2Energy Holdings, Inc., had $10 million in assets, had purchase orders or letters of intent for $43 million in orders, and that the company could raise funds to repay convertible debentures (the offering was to be for $15 million). The emails were labeled as being sent per the request of Lorenzo’s boss, urged clients to call Lorenzo with any questions, and were signed by Lorenzo with an indication of his title. Meanwhile, Waste2Energy’s prospects soured and its intangibles related to its gasification technology were worthless.

Lorenzo’s case was assigned to an SEC administrative law judge who found Lorenzo liable for the charged conduct. The Commission then upheld the ALJ and imposed on Lorenzo a permanent industry bar and a civil monetary penalty of $15,000. Lorenzo filed a petition for review in the D.C. Circuit and the panel majority held that substantial evidence supported the Commission’s conclusions that Lorenzo’s emails contained false or misleading statements and that Lorenzo acted with scienter. A key factor was Lorenzo’s position that he believed the statements in the emails were truthful. But the majority rejected the Commission’s conclusion that Lorenzo was the “maker” of the emailed statements (the person with “ultimate authority” per the Supreme Court’s Janus opinion was Lorenzo’s boss). Moreover, because the Commission’s sanctions were partly the result of its consideration of Lorenzo’s Rule 10b-5(b) violation, which specifically mentions “statement” and evokes Janus, the sanctions had to be remanded to the Commission for further consideration because Lorenzo could not be liable under that provision.

Then-Judge Kavanaugh dissented from the panel opinion. Judge Kavanaugh first suggested that the panel ignored the ALJ’s finding that Lorenzo never read or otherwise considered the statements contained in the emails he sent. Moreover, while agreeing that Lorenzo was not a “maker” of the statements at issue, Judge Kavanaugh said he would have gone further and found no liability for Lorenzo because scheme liability requires more than false or misleading statements. According to Judge Kavanaugh, the panel decision could upset the distinction between primary and secondary liability.

As a result, the question that will be before the Supreme Court this December is whether a person who knowingly disseminates false or misleading statements in connection with a securities transaction, but who did not “make” those statements, can nevertheless be held liable for violations of Securities Act Section 17(a)(1), Exchange Act Section 10(b), and Exchange Act Rules 10b-5(a) and (c). Although Lorenzo and the government differ somewhat in how they phrase this question, they both raise essentially the same question.

A “backdoor” to primary liability? Much of the case will turn on the questions implied by Justice Kavanaugh’s dissent from the Lorenzo panel opinion. As a general proposition, the Supreme Court’s Central Bank opinion foreclosed aiding and abetting liability in private securities suits because of the possibility that the plaintiff might not have relied on the aider and abettor’s statements. Likewise, in Stoneridge, the justices declined to extend private securities liability to the acts of persons upon whom investors did not rely. The Janus “maker” holding also will play an important role in the outcome of Lorenzo.

Chief among the government’s arguments for affirmance it its contention that while Janus applies to Rule 10b-5(b), it does not apply to other statutory or regulatory provisions that do not explicitly reference the term “statement.” For comparison purposes, here is the text of the applicable provisions in the Lorenzo case (emphasis added):
  • Securities Act Section 17(a)(1)—"(a) It shall be unlawful for any person in the offer or sale of any securities … by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly—(1) To employ any device, scheme, or artifice to defraud..." 
  • Exchange Act Section 10(b)—“ It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange: *** (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” 
  • Exchange Act Rule 10b-5—“ It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange: (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” 
By contrast, Lorenzo argued that the government wants the justices to read Janus too narrowly, a point Lorenzo made more fully in his merits brief. Specifically, Lorenzo said that Rules 10b-5(a) and (c) apply to conduct other than statements, the main focus of the SEC’s case against Lorenzo. “Adopting the SEC’s argument would permit every inadequate misstatement claim to be repackaged as a claim under Rules 10b-[5](a) and (c) and 17(a)(1) for employing a deceptive ‘device,’ ‘act,’ or ‘artifice to defraud,’” explained Lorenzo.

The government and Lorenzo also differ regarding the significance of Lorenzo’s own actions. According to the government, Central Bank and Stoneridge are inapt because the SEC charged Lorenzo for his own conduct, which made him primarily liable; Lorenzo argued before the D.C. Circuit that he believed the truthfulness of the statements in the emails he sent. The government noted that Central Bank specifically left open the possibility of primary liability if the elements of such liability were properly alleged. The government also observed that the SEC, in an enforcement action, is not required to prove reliance.

Lorenzo countered that he was being held liable for securities violations based on the “ministerial” act of forwarding emails. From Lorenzo’s viewpoint, the D.C. Circuit established a much lower threshold for primary liability and, thus, made it more difficult to distinguish primary and secondary liability as required by, for example, Central Bank, Janus, and Stoneridge. Moreover, Lorenzo argued that the government’s view could breathe life into the implied cause of action for aiding and abetting.

On this last point, the government’s merits brief emphasized the potential consequences of Lorenzo’s theory: (1) the government could not bring primary liability cases unless the respondent made the misstatement; and (2) in cases where all elements of primary liability could not be proved against the maker of a false statement, the government might be unable to bring an aiding and abetting case against a person who had fraudulently disseminated the false statements. The government, urging the justices to reject Lorenzo's policy arguments, ended its brief thus: "A clear statement by this Court reiterating that the antifraud provisions at issue here should be interpreted according to their plain text would promote rather than undermine certainty and predictability."

The case is No. 17-1077.

Friday, November 02, 2018

Commissioner Behnam proposes “test track” to vet FinTech innovations

By Lene Powell, J.D.

Looking to salvage a key feature of the CFTC’s stalled Regulation Automated Trading (AT) proposal, Commissioner Rostin Behnam urged stakeholders to develop a “stress test track” for FinTech providers to test their models for resiliency and stability before introducing them to the market. Likening the markets to street races and market participants to racers, Behnam called for regulators to create safety features to limit the impact of FinTech failures.

Behnam’s remarks, “FinTech, Friction, and Formula 1: A Learning Journey”, were presented at the Asia Securities Industry and Financial Markets Association (ASIFMA) Annual Conference in Singapore.

Stress “test track.” Behnam acknowledged the common critique that overly vigorous regulation can stifle innovation and risk picking winners or losers, particularly at early stages of FinTech development. But, he said, “we cannot engage so late that we leave our markets, infrastructures, and the public unprotected.” And, regulation can actually benefit innovators by providing “a little necessary friction,” lowering development costs by reducing the need for legal counsel to clarify legal status or defend in litigation resulting from innovation gone awry.

Drawing on metaphors of self-driving cars and glitchy racetracks, Behnam said that “humans are generally terrible overseers of highly automated systems.” But he contended that it is feasible to build safety features to mitigate FinTech accidents. One way would be for regulators, self-regulatory organizations, and private industry to develop a closed environment or “test track” for simulation, stress testing, and training new technologies. FinTech providers would use this environment to stress test their models to demonstrate market readiness. This idea comes from the Regulation AT proposal, which CFTC Chairman Giancarlo has announced will not advance in its current form due to disagreements over registration requirements and access by regulators to firms’ proprietary algorithmic source code.

The “test track” environment would include privacy protections for users’ techniques, practices, products, and processes, said Behnam. Stakeholders would be able to share feedback to enhance and continue the environment’s evolution and inform plans for standard setting and best practices.

Next steps. Behnam said he plans to give the idea more thought and socialize it within the Commission and stakeholders he has met on his FinTech “listening tour.” He noted that the CFTC recently signed a Cooperation Arrangement on Financial Technology Innovation with the Monetary Authority of Singapore (MAS), which has consistently shown thought leadership in the FinTech space. The CFTC’s LabCFTC will participate in the Singapore FinTech Festival 2018 in a few weeks.

Thursday, November 01, 2018

Review of new IFRS standards in 2018 financials will be priority for European enforcement officials

By John Filar Atwood

How companies apply new reporting standards on financial instruments and revenue from contracts will be a priority for European enforcement authorities as they review 2018 financial statements, according to the European Securities and Markets Authority (ESMA). The group released its annual public statement on European common enforcement priorities, which is designed to promote the consistent application of IFRS and other financial and non-financial reporting requirements.

ESMA noted that the priorities reflect the relevance and magnitude of the change introduced by new reporting standards. They also take into account issues identified by national regulators through their enforcement activities.

IFRS 9 and 15. The public statement indicates that the 2018 enforcement priorities include the application of IFRS 15, Revenue from Contracts with Customers, and IFRS 9, Financial Instruments, for the first time in the 2018 IFRS financial statements. In addition, disclosure on the implementation and expected impact of IFRS 16, Leases, will be examined since it goes into effect in 2019.

EMSA Chair Steven Maijoor noted that ESMA expects issuers to provide a sufficient level of transparency on the application of new IFRS 15 and 9. In particular, he believes issuers should focus on the application and recognized impact of the new accounting models for revenue recognition and for impairment of financial assets.

ESMA’s public statement recommended that issuers focus on the identification and satisfaction of performance obligations, the disaggregation of revenue, and the disclosure of significant judgments related to recognition of revenue. For credit institutions, ESMA pointed to the application of the new expected credit loss model (ECL). It suggested that credit institutions give careful consideration to, and provide disclosure on, inputs used in the assessment of a significant increase of credit risk and in the determination of ECL.

Environmental disclosure. The public statement also highlights the requirements to disclose non-financial information, with a focus on environmental matters, and specific aspects of ESMA’s Guidelines on Alternative Performance Measures. Maijoor noted that environmental reporting is gaining momentum in Europe as part of a broader EU initiative to achieve a more sustainable financial system. He urged companies to provide investors with high quality disclosure in this area.

In the public statement, ESMA also highlighted the importance of providing disclosures on the possible impacts of Brexit. ESMA noted that the details of the exit scenario might become clearer by the date the 2018 annual financial reports, so issuers should provide sufficient transparency on its impact. This should include potential exposures and activities, as well as risks and sources of estimation uncertainty and the way these are managed by individual issuers, ESMA said.

ESMA and European regulators plan to monitor the application of the new IFRS requirements, and all other relevant provisions outlined in the public statement. National regulators should incorporate them into their reviews and take corrective actions where appropriate, ESMA stated. For its part, ESMA will collect data on how European issuers have applied the priorities, and plans to report on findings regarding the priorities in its report on the 2019 enforcement activities.

Wednesday, October 31, 2018

Peirce urges ‘healthy skepticism’ in regulating derivatives markets

By Anne Sherry, J.D.

Calling back to the 2009 G20 summit in Pittsburgh, SEC Commissioner Hester Peirce urged attendees at the International Regulators Conference to exercise caution when regulating the derivatives markets. Poorly designed regulations played a part in the financial crisis, she said, and the stakes are higher when mistakes occur at the regulatory level rather than by individual market participants. Peirce added that while it is not always easy to identify badly designed regulations, regulators owe it to the public to examine their own efforts for possible vulnerabilities or distortions.

Regulatory shortcomings. AIG is the poster child for the financial crisis, Peirce said, but not for the often cited reasons. Contrary to the popular narrative, AIG was not unregulated: its life insurance subsidiaries and their involvement in the securities lending program had many regulators, and AIG as a whole had many more. Likewise, the financial crisis “was not neatly attributable to one cause and clearly implicates both the private and the public sectors.”

Peirce noted that it is possible that the Pittsburgh reforms would not have prevented the financial crisis, and that it is important to recognize the limits of those reforms. It is unrealistic to think that the G20 reforms will bring about a world in which everything is centrally cleared. The AIG swaps were not standardized, so central clearing would be unlikely. The G20 reforms also could fail to address factors that were critical in the last crisis or likely to create the next.

Central clearing is also not a panacea, Peirce continued, citing the recent member default at Nasdaq Clearing. This default was relatively simple—it involved a single person trading in the Nordic and German power markets. Regulators must envision a more complex default involving interconnected members, large portfolios, or more complicated products, and occurring during a time of market stress.

Peirce cautioned that regulators are at an informational disadvantage relative to the markets, a fact that is easy to forget in the wake of a crisis. Regulators’ errors in judgment also cause more problems than those of individual market participants. For example, assigning an inappropriate risk weight to certain assets or sovereign debt can create severe consequence at the worst time.

The SEC’s role going forward. The commissioner closed by addressing what she called the elephant in the room: the SEC’s failure to promulgate its framework for security-based swaps. The Dodd-Frank and JOBS Act mandate created “approximately 100 good excuses” for this delay, Peirce said, and she noted that Chairman Clayton has made it a priority to finish the regulatory framework for security-based swaps. In early October, the agency reopened the public comment period on its proposal on capital, margin, and segregation requirements for security-based swap dealers and major security-based swap participants.

Beyond that first step, the SEC has adopted many of its security-based swap dealer rules and finalized the security-based swap reporting rules, but compliance is conditioned on the finalization of three remaining security-based swap dealer rules. Peirce is guided by three principals throughout this process: remaining open to reconsidering elements of the proposed or final requirements; articulating clear rules and Commission-level guidance rather than relying on no-action relief or staff-level guidance; and accounting for the challenges market participants will face as they come into compliance with this new, complicated regime. The SEC can mitigate the compliance burden on parties such as dealers’ counterparties by ensuring that the compliance deadlines allow for adequate preparation.

Peirce also seeks solutions to other issues that may prevent an efficient transition to Title VII regulation. For example, she would like the SEC to address questions around the ability of dealers to rely on representations made in connection with CFTC external business conduct requirements and to resolve issues affecting foreign dealers. The SEC may also consider possible alternative approaches to arrange-negotiate-and-execute requirements. Many of these issues will involve joint work with the CFTC and international regulators. When it comes to the SEC’s implementation of Title VII, that will mean substituted compliance with foreign requirements, in Peirce’s view.

Tuesday, October 30, 2018

SEC advisory committee recommends ETP classifications, centralized ETF database

By Amanda Maine, J.D.

The SEC’s Fixed Income Market Structure Advisory Committee (FIMSAC) approved two draft recommendations prepared by its ETFs and Bond Funds Subcommittee. The first recommendation outlines potential classifications of exchange traded products (ETPs) aimed at establishing clarity around the term “ETF” by categorizing the risks associated with different ETPs. The second draft letter recommends that the Commission form an industry-wide group to promote investor education and create a centralized and widely accessible database that can be used to compare and analyze ETFs.

Classifications. The subcommittee’s classification recommendation notes that while ETPs share certain characteristics, the term “ETF” is currently used to describe many products that have a wide range of different structures, investment objectives, and risk profiles. Citing “truth in labeling” as its guiding principle, the subcommittee stated that proposed Investment Company Act Rule 6c-11, which was issued for comment in June and would establish a framework for certain ETFs to operate without applying for individual exemptive orders, offers a timely opportunity to consider more consistent terminology for ETPs. To avoid potential problems of investors assuming that all products referred to as ETFs are structured like Rule 6c-11 ETFs, the subcommittee recommends that the Commission amend Rule 35d-1 to require that a registered investment company with “Exchange Traded Fund” or “ETF” in its name comply with Rule 6c-11.

The use of a more clear-cut and consistent naming convention for ETPs can better serve retail investors, according to the subcommittee. The draft letter recommends a superset classification for ETPs with four subsets: ETFs, exchange-traded notes (ETNs), exchange-traded commodities (ETCs), and exchange-traded instruments (ETIs). ETP would be a generic term for any portfolio exposure product that trades on an exchange.

ETFs would be registered investment companies required to comply with Rule 6c-11 and whose underlying securities include stocks, bonds, futures, or other investment instruments (such as bank loans and exchange-traded options). The ETF category would exclude funds with embedded leverage or inverse features. The subcommittee recommends that existing ETFs that were structured as Unit Investment Trusts or share class ETFs be grandfathered into this classification.

ETNs and ETCs are not registered investment companies and, thus, would not be subject to Rule 6c-11. ETNs would be debt instruments that provide an index-based return and may or may not be collateralized. As its name suggests, ETCs would include commodity futures and physical commodities listed under different Exchange Act rules than Investment Company Act funds.

The term ETI would refer to a registered investment company that seeks to provide a leveraged or inverse return, a return with caps on upside or downside performance, or “knock-out” features. ETIs could include products designed to outperform a specific index (such as active funds) but not by a particular multiple of a period’s return.

Subcommittee member Lynn Martin of ICE Data Services noted that ETFs have become increasingly popular with retail investors, but as the markets have developed, so has the complexity of the instruments. The classification system recommended by the subcommittee attempts to take into account how the market has evolved as well as considering future developments, Martin said, adding that as the complexity increases, ETPs have embedded risk characteristics that deviate from the original ETFs that gained popularity among the retail segment.

FIMSAC member and former SEC Chief Economist Larry Harris, now at the University of Southern California’s Marshall School of Business, inquired why the proposed classification does not identify a difference between actively and passively managed funds. According to Professor Harris, there is a simple way to differentiate between the two: actively-managed products involve ongoing judgment, whether it is human or machine-based; while passive funds involve criteria that can be easily enumerated, even if the criteria are complex.

Ananth Madhavan of BlackRock, who chairs the subcommittee, noted that the active versus passive distinction is increasingly hard to make. There is a blurring of the lines where many index products have features that could be considered active, such as intelligent currency hedging, he explained. He did agree with Harris that there is room in the education component of the subcommittee’s recommendations to help investors make these distinctions.

Education and data. The subcommittee’s recommendation on education and data advised that an investor education group should address the education of financial advisors, including robust and detail training modules within existing required certifications; adapt financial advisor education content to suit a retail audience; and identify standard information concerning ETFs, focusing on common data and formatting standards with key information regarding ETF portfolio and trading data. To facilitate availability and standardization, a centralized and widely accessible database should be created to host these key data elements, the subcommittee recommended.

Subcommittee member Kumar Venkataraman of Southern Methodist University's Cox School of Business advised that in the subcommittee’s discussions with industry participants, academics, and regulators, the members found that it is frequently difficult for investors to compare even structurally similar ETPs because various market data services, broker-dealers, and ETF issuers have historically used metrics derived from their own methods, making it difficult to compare fixed-income ETFs with other fixed-income investments, he said. With this in mind, the industry-wide group described under the education component of the recommendation should create a primer presenting the most basic elements for analyzing ETFs, focusing on identifying key data aspects along with common definitions for the use of investors, regulators, and academics.

The Rule 6c-11 proposing release outlined specific potential areas for consistent disclosures, which the subcommittee believes will be effective in improving investor awareness, Venkataraman said. The subcommittee also supports the proposal to expand disclosure of historical bid/ask spreads associated with ETFs and would also like the Commission to consider disclosure of additional historical information.

FIMSAC member Sonali Theisen of Bank of America Merrill Lynch asked how the group would track active authorized participants, who would provide the information, and whether it would be made available publicly and with what frequency. Venkataraman replied that perhaps the ETF issuer could collect the data because they have the information and the expertise. Regarding the dissemination of the data, he understands that some of the information could be sensitive, and the public availability of this information could be delayed for a year or 18 months.

Monday, October 29, 2018

Director Blass focuses on key developments, encourages participation at ICI Securities Law Developments Conference

By Joanne Cursinella, J.D.

Dalia Blass, director of the Division of SEC’s Division of Investment Management, discussed three areas that her staff has been focused on during the last year: improving fund disclosure; fund use of derivatives; and staff guidance in her recent keynote address at the ICI Securities Law Developments Conference in Washington, D.C. Encouraging participation, she said that the Division values and uses the input of all interested parties.

Improving fund disclosure. The Division is seeking opportunities to improve the quality and usefulness of information that investors receive about funds and advisers, Blass said, and the approach it takes differs from other recent work on fund disclosure because it focuses on how information serves investors, not on how the Commission uses information. Division staff is “making every effort to connect directly with individuals and also to bring their views into the comment process,” she added. The efforts include a “feedback flier” that allows investors to submit comments without needing to review the entire rulemaking proposal or write a letter, and the new “Tell Us” website, which provides a portal for this feedback. So far, the Division has received 140 comments using the new fliers, Blass said.

“We have also seen glimpses of the future,” Blass claimed, as asset managers have given demonstrations of their “latest investor-facing technology and shared thoughts on what may come next.” Blass believes that asset managers and data aggregators, among others, have the potential to develop tools that layer, enrich, connect and analyze disclosure to meet investors “where they are.” The key question for the Division is whether changes in rules or forms would help unlock these opportunities for investors, she said.

In addition to informal outreach, the Division has worked with the Commission to take several concrete rulemaking steps, Blass pointed out, including the adoption of Rule 30e‑3, issuing a request for comment on the framework for fees that intermediaries charge to deliver disclosure documents, and proposing a short-form summary to explain the terms of an investor’s relationship with a broker-dealer or investment adviser. While this is a “good start” she said, she also pointed out that while the Division oversees a framework, it is not part of the investment relationship. She recommended that when it comes to fund disclosure, tell a clear story; write clearly and concisely; and engage with disclosure staff. “I also invite you to engage with staff on fund-specific questions,” Blass said.

Derivatives rulemaking. “We can, at least in my view, do better than the current guidance,” for funds and derivatives, Blass claimed. A few of the questions that the Division is now “grappling” with are: How should we think about leverage risk in a dynamic market? What role should risk management play? What role should asset segregation play? What are funds doing today? Are additional, risk-based buffers common? What role should these practices play in a rule?

Blass said that the Division welcomes any thoughts from sponsors, scholars, risk managers and others on these issues. So far, the staff has learned the most from simply hearing risk managers talk about current practice, Blass said, but “we are also open to creative and thoughtful ideas.”

Staff guidance. Statements of the staff are not statements of the Commission, and they do not have the force of law, Blass said. Last month, Chairman Clayton issued a statement about staff views pointing this out, Blass added. The chairman explained that all staff statements are nonbinding on the Commission and create no enforceable legal rights or obligations of the Commission or other parties.

The chairman also noted that the Division has been and will continue to review whether prior staff statements should be modified, rescinded, or supplemented in light of market or other developments, Blass added. As part of the review of prior statements, she said, the Division has withdrawn two staff letters issued in 2004 to proxy advisory firms.

The Division’s next steps in this process is to continue to review and assess prior staff statements, considering whether there need to be any changes. This is a priority for the Division, but will not be accomplished quickly, Blass said. In the meantime, the staff will continue to “advise and assist remain available to advise and assist just as we always have,” Blass assured.

Blass closed by reminding the audience that she only “touched on a small slice” of what the Division is doing and mentioned that the Division staff reviewed thousands of fund filings and exceptive requests; issued letters addressing protection of seniors, risk retention for BDCs, and board duties under affiliated transaction rules; reviewed fund board responsibilities generally; developed data analytic tools and conducted focused outreach on fund practices; worked on developing recommendations on advertising, valuation, ETFs, fund research, BDC and closed-end fund offering reform and liquidity disclosure; and engaged in dialogue with sponsors on crypto-asset funds.

Friday, October 26, 2018

ISDA and FIA weigh in on proposed Volcker Rule changes

By Brad Rosen, J.D.

The International Swaps Dealer Association (ISDA) and the Futures Industry Association (FIA) were two of 60 interested parties that recently submitted comment letters in response to proposed amendments published earlier this year by the SEC, the CFTC, and banking regulators (the “Volcker Agencies”) that would modify the language of the Volcker Rule’s prohibition on many forms of proprietary trading. ISDA’s comments centered around the theme that that the Volcker Rule should be revised to focus on its core purpose—prohibiting short-term speculative proprietary trading.

Meanwhile, FIA’s comments focused on the principal captured in the proposed amendments clarifying that FCM clearing services to covered funds is not the type of activity that was intended to be prohibited under the Volcker Rule. Public comments on the proposal were originally due September 17, 2018 but the time for submission was extended into October.

ISDA comments aimed at avoiding unnecessary interference in using derivatives. ISDA’s comments focused around eight points aimed at avoiding a final rule that would unnecessarily interfere with the ability of banking entities to use derivatives to engage in underwriting transactions, market-making related activities, and risk-mitigating hedging transactions. These eight points are as follows:
  1. The “accounting test” set forth in the Proposal should not be implemented. This test, which captures all financial instruments recorded at fair value on a recurring basis under applicable accounting standards, is thought to exacerbate over-inclusive scoping problems, be inconsistent with the statute, and entail further unintended consequences.
  2. All derivatives entered into hedge long-term liabilities, and investments in and cash flows from affiliates, should be excluded from the trading account definition.
  3. The Volcker Agencies should expand the list of derivatives covered by the liquidity risk management exception and remove unnecessary and prescriptive compliance requirements from the liquidity risk management exception.
  4. The Volcker Agencies should ensure that any final rule promotes and does not further prohibit or restrict the ability of banking entities to provide underwriting and market-making related services, and to engage in risk mitigating hedging activities.
  5. ISDA supports those aspects of the proposal that would allow a banking entity to acquire an interest in a covered fund as a risk-mitigating hedge in connection with derivatives related to the covered fund.
  6. ISDA supports the proposed revisions to the definition of “trading desk."
  7. Trading derivatives in connection with U.S. and foreign government and agency securities should be permitted without further restriction.
  8. ISDA supports the efforts of the Volcker Agencies to improve the TOTUS (trading outside the United States) exemption. 
FIA seeks regulatory clarity. In its comment letter, the FIA indicated its support of those provisions of the proposed amendments which are intended to clarify the activities in which banking entities may engage that are prohibited under applicable regulatory rules. Among such activities identified in the Federal Register release accompanying the proposed amendments are clearing services provided by FCMs to covered funds for which affiliates of the FCM are engaged in the services identified in CFTC Rule 75.14(a). This includes serving, directly or indirectly, as the investment manager, investment adviser, commodity trading advisor, or sponsor to the covered fund.

FIA noted that in 2017 the CFTC’s Division of Swap Dealer and Intermediary Oversight (DSIO) issued a no-action letter to an FCM in which the DSIO stated that it would not recommend that the CFTC take an enforcement action against the FCM, if the FCM were to provide clearing services to a covered fund notwithstanding Commission Rule 75.14(a). FIA also indicated that the Volcker Agencies have indicated its desire to extend the stated no-action relief all FCMs that provide futures, options and swaps clearing services to customers of affiliates. The other agencies further recognized that FCM clearing services to covered funds do not appear to be the type of activity that was intended to be limited under the Volcker Rule.

The FIA also asserted that modifications called for in the proposed amendment would enhance risk management efficiencies, as well as providing greater legal certainty to the market than would a simple extension of the existing no-action relief. Accordingly, FIA favors an amendment to Rule 75.14, which would specifically authorize an FCM to provide clearing services with respect to covered funds.