Thursday, November 14, 2019

Chamber of Commerce questions effects of bill to reform private fund industry

By Amy Leisinger, J.D.

The U.S. Chamber of Commerce has released a study exploring the economic effects of legislation introduced by Sen. Elizabeth Warren (D-Mass) on the private fund industry. Private equity firms make substantial contributions to the economy, and legislation such as the Stop Wall Street Looting Act imposing tax increases and additional liabilities on private funds that invest in businesses would ultimately harm the American workforce and the businesses that rely on private fund capital.

"Private equity firms make valuable, long-term investments in U.S. companies, supporting over 26 million U.S. jobs and driving economic growth by contributing over $475 billion in annual tax revenues," U.S. Chamber Center for Capital Markets Competitiveness Executive Vice President Tom Quaadman noted.

The legislation. Among other things, the Stop Wall Street Looting Act (S. 2155/H.R. 3848) would impose additional leverage caps on private equity firms and tax private equity profits at ordinary tax rates as opposed to those applicable to capital gains. In addition, private equity firms would be held liable for debts and other obligations of their underlying companies. In addition, the legislation changes bankruptcy law to place additional focus on workers’ interests in the bankruptcy process. The legislation is designed to bring greater transparency to the private fund industry while also enhancing related investor protections.

According to a press release issued by Sen. Warren, the bill would "empower[] workers and investors" and help to protect markets regarding high risk forms of debt.

Economic concerns. In its report, the Chamber of Commerce notes that the private equity funds created by private equity firms invest in various companies and play a major role in their development. These companies employ millions of people in the U.S., and, as such, the private fund industry drives economic growth and supports the American workforce. In addition, the report states, the firms contribute billions in annual federal and state and local tax revenue and support investments by pension funds and public retirement systems.

However, according to the report, the Stop Wall Street Looting Act would impose significant restrictions, liabilities, and tax increases on the private fund industry, including by capping private equity leverage and taxing profits at ordinary tax rates. In its study, the Chamber of Commerce found that these changes could cause a loss in the range of 6.9 million to 26.3 million jobs and decrease combined tax revenues from $109 billion to $475 billion per year.

Further, the report continues, the increased restrictions and enhanced liabilities could disincentivize business formation and growth and impose risks for private equity managers and investors. Discouraging private equity investment in companies could result in increased business failures, as well diminished returns for private equity investors, according to the report. Because most taxes in private equity are paid by business partners on their individual tax returns, the increased taxes act as a tax on efforts of those who help grow businesses, the Chamber of Commerce opines.

Increasing restrictions, risks, taxes, and liabilities could potentially drive participants out of the industry, leaving firms seeking private equity financing unable to find necessary capital, the report concludes.

Wednesday, November 13, 2019

SEC Investor Advisory Committee debates securities offering reforms

By Lene Powell, J.D.

In a panel of the Investor Advisory Committee, speakers spiritedly discussed a recent Concept Release on securities offering reform that raises issues for capital formation, investor protection and market integrity.

Concept Release. In June 2019, the SEC issued a Concept Release on Harmonization of Securities Offering Exemptions. Jennifer Zepralka, Chief of the SEC Office of Small Business Policy, explained that the release broadly reviewed the available exemptions to the registration requirements and examined the state of registered versus deregistered offerings.

According to the release, significantly larger amounts of new capital have been raised in deregistered offerings in recent years. An estimated $2.9 trillion has been raised in exempt offerings in 2018, compared to $1.4 trillion raised in registered offerings. In 138 specific requests for comment, the release explores whether overlapping exemptions are confusing for issuers trying to navigate the most efficient path to raise capital; whether there are any gaps in the framework that may make it difficult for companies to find the right exception from registration at key stages of their business cycle, and looking whether integration could help issuers to transition from one exempt offering to another and ultimately to a registered public offering.

The comment period closed on September 24, and the SEC has received more than 150 letters so far. The most popular topic for comment has been the definition of "accredited investor."

Risks of easing restrictions. Several speakers explored risks to investors and the markets that may arise from relaxing restrictions in securities offerings.

According to Renee Jones, associate dean of academics and professor at Boston College Law School, new transaction exemptions created by Congress and the SEC and the past 15 years have strayed dramatically from their statutory and traditional bases. This trend towards increasingly relaxed conditions for exemption has created new risks for investors. Further, the expansion of these exemptions has also created unfortunate spillover effects that have spread to all corners of the economy, and have impacted the welfare of corporate employees, consumers and even broader society.

Jones also took issue with several "flawed" premises. In her view, it has not been adequately shown that retail investors would likely gain superior returns if allowed to invest more easily and privately offered securities. Jones also believes it a "strange" assumption that there is an inherent conflict between the objectives of investor protection and capital formation, when comprehensive disclosure is the hallmark of efficient capital markets and transparent security markets have served as the engine of the U.S. economy and are the envy of the world. Moreover, the lack of information transparency has been associated with serious economic problems, including poor investment decisions, even by sophisticated investors, misallocation of capital and increased opportunities for misconduct and fraud.

According to Andrea Seidt, Ohio Securities Commissioner, private offerings have been and remain the most common source of state enforcement action, and a recent paper showed that this was the case not just in Ohio but across the nation. Companies take advantage of the relaxed filing reporting requirements to perpetrate fraud, with minimal pre or post sale disclosure. Exemptions have become so attractive that most companies to very little or no upside to going public at all, and retail investors have not been all that interested in the private or quasi private deals that the JOBS Act has made available to them—possibly in part due to financial capacity, as half of American households have less than $10,000 in savings.

Yet proposals are being discussed to make these exemptions even more attractive. Seidt believes this would cause public markets to shrink even further, since companies will be able to stay private and gain the same access to capital as public companies with none of the cost. Further, Seidt believes that "Mom and Pop investors might get fleeced," though this is not definite, due to the lack of data as to how investors on the whole actually fare in private markets.

According to Tyler Gellasch, Executive Director, Healthy Markets Association the concept release is a continuation of a decades long trend where Congress and the commission have created exemptions and exceptions from a regulatory framework, and these changes have siphoned off trillions of dollars from capital from the public markets and the private ones. Two thirds of offerings are outside of the public realm, and there are 500 companies in the private markets valued at more than a billion dollars.

Without basic information on securities, it's impossible to make for even the most sophisticated investors in the world to make informed decisions about where and how much to invest, said Gellasch. The consequence of reduced disclosure requirements has led to many IPOs significantly underperforming. This has ramifications for investors and the economy. For example, this year, one company went from a predicted valuation of $120 billion dollars to an IPO of $80 something, and yesterday was trading under $45 billion. That's a $75 billion range for one company in what it's worth, over the course of a few months. This was because the company had to make more disclosure following the IPO, and as investors started asking questions and learning things, the valuation dropped. There were similar valuation issues with WeWork and Peloton.

"If you're an investor and you can choose anywhere in the world to invest, do you really want to invest in IPOs when they've got that track record over the last 10 years?" Gellasch asked.

Gellasch also noted that the securities laws were adopted not just for investor protection, but so the government can gain basic information about companies, such as whether they are paying their taxes or violating laws.

Promoting capital formation. In the view of Sara Hanks, CEO, Crowd Check, Inc., it is just too hard for small companies to go public, given information and filing requirements. Hanks believes that more companies might go public if were an entry level reporting tier, possibly based on regulation, that they could comply with until they could move to a higher level of reporting at the time of their choosing. She recommends to shift regulation from the time of offer to the time of sale, and that there should be no prohibitions on general solicitation anywhere in the exempt offering framework.

As to the accredited investor definition, Hanks recommends:
  • Keep the existing financial qualification, but index it to inflation from now on;
  • Add accreditation by means of a securities specific educational qualification, such as holding CFA designation or certain FINRA licenses;
  • Add accreditation by reference to a specific test developed for private investors; and
  • Add accreditation by chaperone.
According to Catherine Mott, CEO, Founder and Managing Partner, BlueTree Capital Group, LLC, entrepreneurs can get tripped up by regulations. They are focused on how to raise capital at the lowest cost and protect their ownership and might not always be aware of the potential for unintended consequences due to the form of offering they choose. For example, after an entrepreneur in Jacksonville, Mississippi raised $500,000 in startup capital via a crowdfunding portal, he learned that he could not raise an additional $3 million from venture capitalists because he raised the capital under a Rule 506(c) offering. Venture capitalists will not invest in a 506(c) offering, and this entrepreneur could not go back and change the offering to a 506(b) offering. Thus, his ability to grow his enterprise and add the 10 jobs he intended to add was lost.

Mott believes that offerings policy should not be driven by "unicorns" which are outliers that don’t reflect the majority of angel and VC funding. In particular, she believes that the general solicitation rules need to be modernized and demo days should be carved out. Further, the Angel Capital Association recommends creating a definition of qualified private sale that covers sales of minority positions in private companies with limited trading volume.

Tuesday, November 12, 2019

SEC’s Enforcement Division is staying the course after recent court decisions

By John Filar Atwood

The decision by the Supreme Court in Kokesh v. SEC, the High Court’s grant of certiorari in Liu v. SEC, and the ruling in SEC v. Gentile will not deter the SEC’s Enforcement Division from pursuing appropriate cases, according to Division Co-Director Steven Peikin. At the Practising Law Institute’s securities regulation conference, Peikin and Co-Director Stephanie Avakian said that they have not backed off from bringing any cases because of legal challenges or risks.

In 2017, the Supreme Court held in Kokesh that disgorgement is a penalty and therefore is subject to a five-year statute of limitations. In Liu, the High Court will address the question left open in Kokesh about whether the SEC can seek disgorgement as "equitable relief" for a violation of the securities laws. The Third Circuit recently reversed the district court’s decision in Gentile, finding that a penny stock bar and an "obey the law" injunction are not penalties. The court cautioned the SEC to ensure the injunctions it seeks are narrowly tailored and serve a preventive purpose.

Peikin said that although Gentile was initially a setback, the Third Circuit’s reversal was welcome. Although the decision requires properly tailored injunctive relief, the staff intends to continue to pursue "obey the law" injunctions, he noted.

King & Spalding’s Carmen Lawrence said that she was surprised by the ruling in Liu. Her prediction about which way the Supreme Court will decide is that the Court will limit the SEC’s disgorgement authority.

Peikin said that he hopes Lawrence’s prediction is wrong because disgorgement is a very important remedy for the Enforcement Division. Avakian agreed, noting that the staff has tried to keep a running tally of what Kokesh has cost the Commission in disgorgement. The current ballpark estimate is $1.1 billion, she said.

Digital assets. The co-directors also discussed areas of focus for the Division and cited digital assets and cybersecurity. In the cryptocurrency space, Avakian said that her sense is that there are fewer initial coin offerings and that entities are trying to find other exemptions for the issuance of tokens.

Avakian said the Division generally has seen two types of misconduct with initial coin offerings: straight-up frauds where issuers did not actually provide what they said they would and regulatory violations such as touting. The staff saw a drop in the regulatory violation cases in the last fiscal year, she said.

Peikin discussed the three token registration cases that the Division settled this year against Paragon Coin, AirFox, and Gladius Network. In these cases, the staff required the issuers to make a rescission offer for the issued tokens, he noted.

In an action against Block.one, the Division did not require rescission, but Peikin said that Block.one involved very unusual circumstances. The underlying tokens were fixed and non-transferable, he noted, so the staff felt that rescission did not make sense. In addition, the Block.one tokens did not lose value after the offering, he said.

Some observers have suggested that perhaps the Block.one sanctions were a little light. Peikin reiterated the Division’s procedure for determining penalties, which is to consider duration of the offer, the amount raised, efforts to target U.S. investors, and the size of penalties in other recent cases. He believes there has been a steady progression of sanctions over time and advised that if an entity creates a platform for the exchange of tokens, it is responsible for complying with the federal securities laws.

Cybersecurity. In the area of cybersecurity, Avakian discussed the division’s case against Altaba, formerly known as Yahoo!. The company failed to disclose a major data breach resulting in the unlawful acquisition of hundreds of millions of its users’ data. Altaba paid a $35 million penalty. Avakian described this as an "extreme disclosure failure," and advised that the division is not looking to pursue actions where there is a good faith effort at disclosure.

Peikin said that the Division’s cyber enforcement also involved a few risk disclosure cases this year, notably those against Facebook and Mylan. These were episodic, facts-and-circumstances cases, he said, and do not represent a trend.

Avakian added that the Facebook case was a situation where one group within the company knew of the breach, but another group was responsible for the disclosure of it. The take away from the Facebook matter is that companies should have a process in place to ensure that these two groups can come together and provide adequate disclosure.

Monday, November 11, 2019

A week of spoofing by newbie trader results in $500,000 fine

By Brad Rosen, J.D.

The CFTC issued an order filing and settling charges against Mitsubishi Corporation RtM Japan Ltd., a company incorporated under the laws of Japan, with its main office in Tokyo, for engaging in multiple acts of spoofing contracts on the New York Mercantile Exchange for platinum and palladium futures. The order found that RtM Japan engaged in this spoofing activity through an inexperienced trader who utilized a trading platform located in RtM Japan’s Tokyo office. The order requires RtM Japan to cease and desist and imposes a civil monetary penalty of $500,000. The order also notes that company promptly suspended the trader from trading upon learning of the spoofing activities (In the Matter of Mitsubishi Corporation RtM Japan Ltd., November 7, 2019).

Spoofing trader lacked experience. According to the order, for an approximate one-week period, from April 5, 2018 through April 13, 2018, the company, thorough one of its traders, engaged in spoofing in connection with various precious metals futures products traded on the NYMEX and thereby violated Sections 4c(a)(5)(C) and 6c(a)(5)(C) of the Commodity Exchange Act. The order also found that the trader in question had no trading experience and was placed on the precious metals as part of a training rotation. Furthermore, the order found that during the trader’s time on the desk, the novice trader placed multiple orders for futures contracts with the intent to cancel the orders before their execution.

A typical spoofing scheme. The order found that the trader typically first placed a large order with the intent to cancel it before execution (the spoof order). Soon thereafter, in the same market, the trader entered a smaller order which the trader intended to execute (the genuine order), while the spoof order rested. In many instances, the trader received a partial or complete fill on the genuine order, and then cancelled the spoof order before it was filled. At times, the trader layered the spoof orders, entering multiple genuine orders in conjunction with spoof orders. The trader engaged in this spoofing activity in order to test how the market would react.

Cooperation and remediation led to reduced penalties. The order found that RtM Japan cooperated with the Division of Enforcement’s investigation and engaged in proactive remedial measures, including implementing an electronic trading monitoring system to screen for suspicious trades and retaining a third-party expert to develop and implement a comprehensive risk assessment for precious metals trading. Moreover, the company overhauled its training program and conducted relevant training sessions and seminars on market misconduct in the U.S. futures markets. According to the order, this cooperation and remediation is reflected in a reduced civil monetary penalty.

Director comments. James McDonald, the CFTC’s Director of Enforcement, had this to say about this matter: "Today’s enforcement action shows, once again, that the Commission will aggressively pursue spoofing in our markets. It also demonstrates that participants who allow their employees to test the markets for training or other inappropriate purposes will be held accountable when employees do not trade lawfully."

Parallel CME disciplinary action. The CME Group’s Market Regulation Department independently conducted a parallel investigation, and also announced a disciplinary action brought against RtM Japan based upon substantially the same set of facts as set forth in the CFTC order. The company agreed to pay a fine in the amount of $250,000 as part of its settlement with the exchange.

The order is CFTC Docket No. 20-07.

Friday, November 08, 2019

SEC advisory committee examines ESG disclosures

By Amanda Maine, J.D.

The SEC’s Investor Advisory Committee heard from industry and academic representatives on the role environmental, social, and governance (ESG) disclosures play in investment decisions and the difficulties of quantifying ESG data for investors. Some of the panelists said that SEC action on ESG disclosures could improve their consistency and as a result, their comparability to the benefit of investors.

Need for ESG disclosures. The panelists agreed that the disclosure of ESG information is necessary regardless of whether investors are specifically seeking that information. Professor Satyajit Bose of Columbia University said that studies have shown a robust correlation between sustainability measures in corporations and financial performance. He also noted that while the numbers on sustainability investment are highly correlated with financial operating performance, market performance is a different matter. This suggests that it can take many years of sustainability investment before the market recognizes it, Bose said.

Michelle Dunstan, a portfolio manager at AllianceBerstein (AB), said that her firm incorporates ESG analysis in all its portfolios, not just those with an ESG mandate. She described AllianceBernstein as having a three-pronged approach to ESG. The prongs include "portfolios with a purpose" that target specific ESG goals for investments, as well as how the firm measures up to its own ESG policies. The other prong relates to portfolios with no explicit ESG mandate, she said. However, ESG considerations are still taken into account in these portfolios, Dunstan explained. For example, with heavy carbon emitters, analysis will examine if a carbon tax applies to a company or if one might be imposed in the future.

Where to get ESG data. Dunstan also emphasized the importance of engaging with companies on ESG matters. AB cannot rely solely on ESG rating firms; its representatives meet with management and boards of directors to discuss their approaches to dealing with ESG, she explained. She added that AB has its own ESG specialists as well as ESG training programs for its analysts.

Jonathan Bailey, head of ESG Investing at Neuberger Berman, also stressed the need for multiple sources of insight on ESG. He said that his firm seeks dialogue with companies, as well as NGOs and academics, to inform their decision-making regarding ESG investing. Like the other panelists, Neuberger Berman analysts examine ESG disclosures whether or not "sustainable" is in the portfolio’s name. He also advised that when it comes to ESG matters, the focus is on disclosure and not making a normative judgment about a company’s ESG policies.

Rakhi Kumar, head of ESG Investments and Asset Stewardship at State Street Global Advisors, described how State Street measures ESG through its R-Factor scores (Responsibility Factor), which leverage multiple data sources and aligns them to widely accepted, transparent materiality frameworks to generate a unique ESG score for listed companies. Kumar said that State Street also uses data from third party sources and integrates R-Factor data and specialized data to provide its clients insights about their holdings at the fund level.

Need for SEC action? Some of the panelists cited a need for standardization and consistency as a reason for SEC action on ESG disclosures. Commissioner Allison Herren Lee noted that the Commission last issued guidance related to climate issues in 2010 and that a lot has changed since then. Bailey described the current state of ESG disclosures by public companies as "patchy and inconsistent." He also said that he has heard from management who privately say they have collected the necessary data internally, but would prefer not to share it with investors over concerns relating to the actions of competitors and possible legal ramifications.

Jessica Milano, vice president and director of ESG Investment Research at Calvert Research and Management, said that any ESG disclosure framework must not rely on boilerplate disclosures because that would not be useful to investors. She said she supports a combination framework that takes into account different industry sectors, such as those of the Sustainability Accounting Standards Board (SASB). For example, a company in the consumer finance sector (such as a credit card company) may face environmental impacts mainly related to the energy uses of the facility, the disclosure of which would not be material. In contrast, disclosures related to personal data go to the core of the business and is material to investors.

Committee discussion. Committee member Barb Roper of the Consumer Federation of America asked about the definition of materiality when it comes to ESG disclosures. Bailey responded that SASB provides a framework for minimum standards, but his firm has clients that may have different expectations based on their portfolio choices. Dunstan agreed, advising that what is material can be a different decision based on the same information depending on how much weight a client attaches to it. She added that that her firm looks at materiality not only on a company level but also at a portfolio level to study the cumulative effects of a particular risk.

Committee member Prof. J.W. Verret of Antonin Scalia Law School at George Mason University thanked the panel for its input but lamented that there were no panel members who are skeptical of SEC involvement over ESG matters. Forced ESG disclosure can actually be counterproductive and harmful, including requiring the disclosure of proprietary information or increasing the regulatory and litigation risks that a company can face, according to Verret. As for materiality, Verret said that the appropriate denominator is not global; it should be particularized to a company. He also took aim at investment advisers and pension funds who use ESG as a means to advance a personal political preference.

Thursday, November 07, 2019

Division of Corporation Finance will roll out new no-action letter procedures this month

By John Filar Atwood

The Division of Corporation Finance is already receiving no-action requests for the 2020 proxy season, so the new approach to responding to those inquiries is underway, according to Shelley Parratt, a deputy director in the division. In remarks at Practising Law Institute’s conference on securities regulation, she said that the process will involve some oral responses from the staff, as well as a new chart tracking the staff’s no-action positions that will be posted on the Commission’s website.

Parratt said that the chart will indicate the company’s name and whether the staff granted, denied or chose not to comment on its no-action request. The staff currently plans to update the chart once or twice each week, she added.

In some cases, the staff will notify companies and proponents of its decision by email, and then later the same day make the decision publicly available in the chart, she said. While some responses will be oral, others will still receive a letter. Any staff response letters will be linked in the chart, she noted.

September announcement. The new approach, which was announced in September, involves responding to some no-action requests orally instead of in writing. In the summer, division director Bill Hinman discussed the plan, stating that if the staff "gets out of the way," it could lead to improved engagement.

The announcement has generated a considerable amount of uncertainty among stakeholders, but Parratt reassured them that the three possible positions—grant, denial, or declining to express a view—is what the staff has always done. Moreover, she believes that chart will make it easier to track the staff’s work on no-action letters.

Morrison and Foerster’s Martin Dunn concurred that in the September announcement the staff just reiterated the same three options that have always existed. He noted that if the staff decides not to state a view, it simply means that it is not getting involved and the parties are free to litigate the matter. He said that he hopes that declining to state a view does not become the norm this proxy season.

Dunn, who spent a number of years working with no-action letters at the SEC, thinks that oral advice makes sense from a time-management perspective. He cited instances in which proponents submit a lot of letters on an issue, many of which do not advance the matter. It can take up a lot of the staff’s time to maintain those files, he noted, and oral advice would eliminate that.

Concerns about the approach. Dunn does have one concern about oral no-action advice. If the staff calls the proponent, and then calls corporate counsel, how can counsel be sure that the two parties heard the conversation the same way, he said.

Elizabeth Ising, a partner at Gibson Dunn and frequent author of no-action requests, said that she is not too worried about the staff delivering decisions orally. She is concerned about the instances in which the staff issues no decision. Clients are not going to like the uncertainty, she noted, and having to decide whether or not to litigate the matter.

Glass Lewis. Dunn noted that proxy adviser Glass Lewis has decided to take a hard line with respect to the new no-action approach. It recently released its policy stating that in cases where the staff states no view, Glass Lewis will recommend against the company’s governance committee.

Glass Lewis went a step further, stating that if no-action advice is given orally, it expects to see disclosure about it in a company’s proxy. If there is no written record, Glass Lewis plans to give a negative recommendation on the company’s governance committee.

On this point, Stephen Brown, a senior adviser at the KPMG Board Leadership Center, recommended that companies disclose oral no-action advice or the staff’s decision to take no position somewhere in their proxy statements. It is a good idea to demonstrate to investors that the company has gone through the process and heard from the staff, he said.

Wednesday, November 06, 2019

Peirce favors digital assets safe harbor, suggests improvements to enforcement program

By John Filar Atwood

SEC Commissioner Hester Peirce plans to propose that the Commission create a safe harbor for entities that want to develop digital asset networks. In a keynote address at Practising Law Institute’s conference on securities regulation, Peirce said she envisions a two- to three-year period during which a token issuer would be allowed to develop a network without the force of laws bearing down on them.

Peirce lamented that there is no workable regulatory framework for crypto assets. The SEC should not be dictating whether a digital asset network will be a success because it does not have a framework in place, she said.

She acknowledged that the agency has issued crypto asset guidance, and there have been some instructive enforcement actions. The problem is that they do not offer a way forward for people that want to operate in the digital asset space, she said. An entity that has raised private funds and wants to launch a network cannot issue tokens for fear that they might be securities, she added.

Under Peirce’s proposal, entities that want to start a digital asset network would have to disclose certain basic information, such as a description of the tokens, the number of tokens they plan to issue, and whether the principals have a criminal background. After that, she believes people should be able to transfer tokens back and forth. If the network is fully functional at the end of the initial few years, she proposes that it be allowed to continue to operate without being subject to the federal securities laws.

Peirce intends to propose a non-exclusive safe harbor that network operators do not have to use it they do not want to. She said that she plans to present her proposal to the Commission "soon," but does not know whether it will get the support of the other commissioners.

Enforcement improvements. Peirce also discussed the SEC’s enforcement program and offered four suggestions for how to improve it. First, she said that to strengthen the program the Commission should look for rules that need to be written, rewritten or adjusted.

She cited the example of the advertising rule, which was adopted in 1961, but is scheduled to be updated with proposals released at today’s SEC open meeting. Under the advertising rule, the Commission brought an enforcement action against a radio show host who went off script and expressed his own positive opinion of an investment adviser. Peirce questioned whether the agency should be spending its limited enforcement resources to stop harmless testimonials.

A second recommendation to improve the enforcement program offered by Peirce was to resolve certain problems through the Office of Compliance and Inspections examination process instead of through enforcement referrals. It could assist the ultimate goal of getting better protection for investors, she noted. She admitted that one drawback of this proposal is a lack of transparency since the resolution of the matter might not become widely known.

Peirce also suggested that the SEC could improve the enforcement program by being more sensitive to the far-reaching implications of the actions it takes. Specifically, she does not believe that the consolidated audit trail (CAT) may not be good for investors.

CAT criticism. In her view, the CAT would provide too much information and data to the government. It is a privacy issue, she said, adding that too much gathered information could assist cyber criminals. She noted that in order to be effective, the SEC has to gather some data, but she would rather respect the privacy of investors.

Her final recommendation was for the Commission to acknowledge the valuable role of self-regulation. She clarified that she was not talking about SROs, which she views as quasi-governmental organizations. Peirce would like to see the industry regulate itself where individuals hold colleagues and customers accountable. The industry needs to develop an internal sense of right and wrong, she stated. This is not possible if the SEC micromanages every enforcement issue, she concluded.

Tuesday, November 05, 2019

CFTC sued for failing to provide information on its “secret settlement” in Kraft case

By Brad Rosen, J.D.

In yet another strange and bizarre development in connection with the CFTC’s ill-fated resolution of its market manipulation enforcement action against Kraft Foods Group and Mondelēz Global, New York law firm Kobre & Kim has sued the agency in the Southern District of New York. The law firm alleges that the Commission refused to respond to its Freedom of Information Act (FOIA) request seeking information with regard to the attempted settlement of that case. Kobre & Kim asserts its request will shed light on the unusual and unprecedented terms the agency agreed to in its attempted settlement of the matter, which included a “gag” provision by which the parties agreed to make no public statements about the case, other than those already in the public record (Kobre & Kim LLP v. CFTC, October 31, 2019).

Seeking to solve the mysteries around the CFTC-Kraft settlement. At the onset, Kobre & Kim raises a central question which is at the core of its FOIA complaint and quest for documents: “[W]hy did the CFTC, the nation’s principal regulator of commodities and derivatives markets, try to conceal the factual and legal bases for its litigation settlement with Kraft Foods Group Inc. and Mondelēz Global LLC … and agree never to discuss that settlement in public?” Some other public policy-oriented concerns raised by the law firm include:
  • The CFTC has left the public in the dark about how the CFTC applied its anti-manipulation authority to a fact pattern it litigated for over four years. Beyond seeding concerns across the industry over arbitrary enforcement, the CFTC’s actions threaten to chill legitimate market behavior while failing to deter potential misconduct in the future.
  • Unless and until the CFTC provides a full accounting of the attempted Kraft settlement, the public cannot have reasonable confidence that the agency is discharging its core mission of fostering open, transparent, and competitive markets.
  • The CFTC’s secret settlement in the Kraft case, like its handling of other recent market manipulation cases, is a disservice to the industry the CFTC oversees. This is the latest example of the CFTC obfuscating the law on market manipulation by pressing legal theories that are inconsistent with what the courts have articulated and using its leverage to secure private settlements purportedly validating the CFTC’s own theories. 
The CFTC’s ill-fated market manipulation enforcement efforts. The complaint provides a comprehensive survey of the CFTC’s efforts over the years to assert its anti-manipulation enforcement authority, as well as the obstacles it has encountered. It notes that the Kraft matter was the first litigated case brought by the CFTC under Section 6(c)(1) of the Commodity Exchange Act (CEA), as amended by the Dodd-Frank Act and implementing Commission Rule 180.1.  

The Kraft case took on heightened importance following the CFTC’s loss in another market manipulation case, CFTC v. DRW Investments, LLC, in November 2018. Following a bench trial in the DRW case, the judge rejected the CFTC’s theory of manipulation, stating that it was “only the CFTC’s Enforcement Division that has persisted in its cry of market manipulation, based on little more than an ‘earth is flat’-style conviction that such manipulation must have happened because the market remained illiquid.” In a stinging rebuke to the CFTC in that matter, the court also observed, “It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product.” Kobre & Kim represented the defendants in that litigation.

The central importance of the Kraft case. According Kobre & Kim’s complaint, following the court’s rejection of the CFTC’s manipulation theory in DRW, the industry was at a loss regarding what the CFTC would (or would not) deem to be manipulation in the future. Many in the industry were looking to the Kraft case for that guidance.  Kobre & Kim asserts that the CFTC responded to its defeat in DRW by further obscuring the law and abandoning its four-year litigation against Kraft in favor of a settlement in which the defendants ultimately paid $16 million to resolve the matter, but where the Commission made no public findings of fact or conclusions of law.

According to the law firm, the CFTC’s agreement not to make any public statements about the case in the future as part of its resolution ensured that large swaths of the rationale for the settlement would remain insulated from public oversight. In effect, the Kobre & Kim contends that the CFTC negotiated a private resolution that left the industry without any intelligible guidance and with a potential misimpression that the legal theories asserted against Kraft had a sound legal basis. 

Legal claims and relief requested. According to the four-count complaint, the CFTC’s violation of FOIA includes its:
  • failure to comply with statutory deadlines;
  • failure to conduct a reasonable search;
  • improper withholding of agency records; and
  • failure to produce reasonably segregable information. 
As part of its relief, Kobre & Kim is seeking: an order for the Commission to immediately process the FOIA request; an order requiring the agency to conduct searches reasonably calculated to identify all records responsive to the request; a declaration that Kobre & Kim is entitled to disclosure of the records sought by the request; and attorney fees and costs reasonably incurred in pursuing the action.

CFTC officials did not respond to a request for comment on this lawsuit. As is practice in these types of matters, the Department of Justice will respond to the complaint.

The case is No. 19-cv-10151.

Monday, November 04, 2019

Pre-suit communication was a demand letter in the guise of an informal letter

By Rodney F. Tonkovic, J.D.

A letter that a shareholder argued was simply making suggestions to a company board had enough "legal bite" to constitute pre-suit demand, the Delaware Court of Chancery found. The shareholder claimed that his letter was simply an informal suggestion that the board look into its compensation practices, but the court said that the content of the letter looked enough like a demand for it to be construed as a pre-suit litigation demand for purposes of Rule 23.1 (Solak v. Welch, October 30, 2019, McCormick, K.).

The letter. The suit was brought a shareholder of Ultragenyx Pharmaceutical Inc., a biopharmaceutical company incorporated under Delaware law. In April 2018, Ultragenyx filed an updated compensation policy within its definitive proxy statement filed with the SEC. In June 2018, the shareholder sent a letter to the Ultragenyx Board of Directors suggesting that the board take immediate action to address excessive director compensation and other compensation practices and policies. The letter referred to a recent Delaware Supreme Court case in which the court said that shareholder ratification of an equity incentive plan does not foreclose review for breach of fiduciary duty. The letter did not expressly ask the board to initiate litigation (and contained a footnote to the effect that it was not to be considered a demand) but stated that the shareholder would pursue all available remedies if there was no response within 30 days.

In October 2018, the board responded, stating at the outset that it understood the letter to be a demand pursuant to Rule 23.1. The board then explained that it conducted an investigation with the assistance of counsel and described the approach used to set Ultragenyx's compensation policies. The response also said that the board unanimously resolved that it would neither change the compensation policy nor authorize commencement of a civil action.

This derivative action commenced in November 2018, based on the board’s allegedly excessive non-employee director compensation practices. The complaint asserted three causes of action: breach of fiduciary duty, unjust enrichment, and corporate waste. Eight of the directors serving at the time of the complaint were named as defendants. Ultragenyx moved to dismiss under Rule 23.1(a).

Demand. At issue was whether the shareholder's letter constituted a pre-suit demand on the board. The shareholder argued that the letter was simply an informal attempt to educate the board and encourage it to make changes to the compensation policies. The court disagreed.

The shareholder maintained that because the letter did not expressly demand that the board commence litigation, it could not be construed as a pre-suit litigation demand. The court cited precedent holding that pre-suit communications do not have to expressly demand litigation to constitute pre-suit demand. In this case, the letter articulated the need for "immediate remedial measures," proposes remedial action, and requested that the board take such action. While the letter said that it was not a demand, the court remarked that "these strong overtures of litigation very much make it look like one."

The court went on to note other factors that led to the conclusion that the letter constituted a demand. First, the fact that the complaint in this action was a near-copy of the letter weighed heavily in favor of deeming it a pre-suit demand. The remedial measures requested in the letter also resembled action commonly achieved through derivative litigation. The court noted in addition that a very similar letter by the same plaintiff had been had been held to constitute a pre-suit demand by a New York state court.

Finally, the court found in conclusion that the complaint did not plead with the required particularity that demand was wrongfully refused. The complaint failed to allege any facts supporting an inference that the demand was wrongfully rejected and did not even acknowledge the board's response. The court accordingly granted the motion to dismiss.

The case is No. 2018-0810.

Friday, November 01, 2019

100 days at the helm—newcomer Dr. Heath Tarbert attempts to make his mark at the CFTC

By Brad Rosen, J.D.

In a TED Talk styled keynote address titled The First 100 Days and Beyond, CFTC Chairman Heath Tarbert led off the 35th Annual Futures and Options Expo in Chicago by laying out the agency’s renewed mission, vision, core values, as well as providing his road map for achieving five strategic goals for the Commission. Even though this was Tarbert’s first keynote address to an FIA Expo audience where he shared his detailed thoughts about the CFTC’s agenda and the regulatory landscape, the Chairman opted to break from the agency’s prior practice and decided not to publish these remarks. Nonetheless, a video of the presentation is available here, with the Chairman’s comments beginning at 1:08:20.

The first 100 days. Dr. Tarbert was sworn in as the agency’s 14th Chairman in mid-July 2019. He marked his 100th day as the CFTC chairman on September 22nd. Tarbert stated that he came to CFTC with an understanding of financial regulation, having served as an assistant secretary at the Treasury Department. However, he needed to take some time to better understand the industry and agency. Towards this end, Tarbert indicated that he held 26 meetings with almost all of the agency’s approximate 700 employees. Also, during his first 30 days as chairman, Tarbert noted that he tried to make no key decisions, but rather spent his time listening to staff, learning what people were working on, and the issues that mattered most to them. The agency’s renewed agenda and strategic objectives were a direct outgrowth of these early meetings with CFTC personnel.

The Chairman’s first 100 days also included a controversy over the enforcement settlement with Kraft Food Group, Inc. which went awry. A district court initially called questioned the chairman’s conduct, and called for him to come to Chicago to testify in a contempt proceeding in connection with the CFTC’s purported breach of a court entered consent order. However, a Seventh Circuit panel later ruled he was not required to do so, nor could he be held in contempt himself.

Mission, vision and core values. Chairman Tarbert discussed the following foundational statements and principles, an outgrowth of his meetings with CFTC leadership and staff and which he noted they voted to approve: 
  • The CFTC’s mission statement is “to promote the integrity, resilience, and vibrancy of the derivative markets though sound regulation”;
  • The agency’s vision statement is “to be the global standard for sound regulation”;  and
  • The CFTC’s four core values include commitment, forward thinking, teamwork, and clarity. 
Five strategic goals. Chairman Tarbert observed that the following five strategic goals for the CFTC emanate from the noted statements in connection with the agency’s mission, vision and core values. These goals are: 
  1. Strengthening the resilience and integrity of the derivative markets while fostering their vibrancy. This will include stepping up CCP supervision, and building out the Division of Clearing and Risk, increasing international cooperation, and improving regulations around margin and capital requirements;
  2. Regulating derivative markets to promote the interest of all Americans. This includes a renewed focus on various types of market participants including agricultural, end users, smaller financial institutions, as well as enhancing customer protection and educational efforts;
  3. Encourage innovation and enhance the regulatory experience for the market participants both home and abroad. This involves focusing further on principals based regulation, increasing coordination between the CFTC and SEC, eliminating red tape, reducing the number of no-action letters except in limited circumstance. With regard to digital assets, the Chairman specifically noted if the United States does not lead on this front, someone else will;
  4. Be tough on those who break the rules. This will require being fair and consistent, increasing coordination with law enforcement and other regulatory agencies, as well as increasing surveillance effectiveness; and
  5. Focusing on unique mission and improve agency’s operational effectiveness. This involves promoting efficiencies throughout the organization, and containing costs, as well as attracting and retaining a diverse workforce. 
Seventh Circuit provides relief but not vindication regarding Kraft’s contempt claim. A persistent cloud hanging over Chairman Tarbert’s first 100 days revolved around the Commission’s settlement with Kraft Foods, its purported breach of a court ordered gag provision, and subsequent contempt charges which directly implicated the Chairman’s liability. While that cloud has dissipated with the Seventh Circuit ruling the chairman cannot be deemed culpable, it has not disappeared. Unless the matter is settled, the case will proceed for trial, and the district court judge will determine if the CFTC itself is in contempt of its earlier order.

In any event, with the trials and tribulations of the first 100 days behind him, Chairman Tarbert appears to be ready to move forward with a far reaching and aggressive agenda for the agency. Whether he will make his mark, time will tell.

Thursday, October 31, 2019

Experts address cybersecurity trends, best practices at fintech webinar

By Jay Fishman, J.D.

The North American Securities Administrators Association, Inc. (NASAA) included a panel discussion on cybersecurity data breaches and the best ways to prevent them as part of its October 29, 2019 Fintech and Cybersecurity Symposium held in Washington D.C. and online. Jake van der Laan, the director and chief information officer of the Information Technology and Regulatory Informatics Division at the Financial and Consumer Services Commission in New Brunswick, Canada moderated the panel. The panelists included David Kelley, the surveillance director at FINRA’s Kansas City District Office; Assunta Vivolo, the assistant director of the Cyber Unit at the SEC’s Philadelphia Regional Office; and Charles de Simone, the vice president of Technology and Operations for the Securities Industry and Financial Markets Association (SIFMA).

Van der Laan heightened the topic’s importance by first citing the significant Equifax, Yahoo, Marriot, and Capital One data breaches of the past three years, and then adding the following statistics—that by 2020 there will be six billion Internet users who could become cyberattack victims, and that there are 250 pieces of malicious software released daily to perpetrate those attacks.

Van der Laan asked the panelists the following questions:
  1. What types of data breaches are you seeing now and predict for the future?
  2. How should firms manage their risk now and in the future?
  3. What help is there for a firm’s clients and U.S. citizens to prevent cyberattacks to their own data?
What types of data breaches are you seeing now and predict for the future? Kelley said that FINRA’s staff, when going on broker-dealer firm examinations, have asked members about the types of cyberattacks they have been subjected to. The firms replied: (1) phishing emails; (2) account compromise; (3) imposter websites; (4) ransomware; and (5) malware. Kelley and Vivolo both remarked on the rise of two types of imposter websites, one type where the firm already has a legitimate website but a copycat website suddenly appears containing the same accurate information about the firm and perfect photos of its executives.

The criminals try to lure unsuspecting clients to add their personal, confidential information onto the fake website before the firm or regulatory authorities discover the scam. The other type occurs when a firm does not have a website and then suddenly has one. The sudden website is, of course, fake.

All three panelists additionally mentioned a rise in client accounts being compromised inadvertently by third parties. De Simone said that this type of data breach begins innocently when a firm entrusts a third-party vendor to provide the technology for protecting the firm’s clients’ account data. The third party, itself, might be trustworthy but may rely on a fourth party vendor to supply the nuts and bolts of that technology, which could cause the data breach. Essentially, the firm does not become aware of the client data breach until it is too late because the firm only directly contracted with the third party so was not even aware of the fourth party’s existence.

The panelists also proclaimed a rise in cyberattacks caused by company insiders who are either malicious or unintentional insiders. The panelists mentioned the 2017 Verizon data breach caused by a "malicious insider" out for revenge against the company in order to cite the statistic that 25 percent of all data breaches are caused by insiders. The "unintentional insider" they referred to as a "weak link in the company" who may be a fine person but believes he or she is doing a good deed in relaying confidential data to someone outside the company, who then causes the attack.

How should firms manage their risk now and in the future? Regarding data breaches that occur through account compromise, Vivolo said that firms should create and require a two-tiered authentication process for accessing client account information. Concerning insiders, de Simone stated that SIFMA encourages its members to create an insider threat program to train employees on steps to take to mitigate cyberattacks. All the panelists agreed that it is much easier to proactively create cyberattack programs to test before an attack occurs rather than to wait until an attack happens.

But Kelley and Vivolo emphasized that there is not a "one size fits all" approach for all firms. Kelley said that small, medium, and large size firms each have different risks, and that the appropriate method also depends on a company’s type of business, which often prescribes the type and amount of data it maintains. Kelley said that FINRA tries to assess a member firm’s risks by raising the issue when staff performs a field examination, and then hints that the firm should implement a data breach prevention program. He stressed the importance of having these talks with firms especially in light of FINRA’s discovery that many firms do not even know where their data is stored. And Vivolo added that assessing the risks of data stored on the cloud is increasingly becoming a concern because many firms now rely on the cloud to store their data. She also declared the importance of firms’ knowing if their critical data is being stored by a fourth party because in the event of a breach, the firm itself will be liable.

But Vivolo also mentioned that SEC Regulations SCI, SID, and SP were promulgated to help issuers and firms assess their cybersecurity risks. And de Simone exclaimed that firms should hire enough people to work on cybersecurity matters behind the scenes in their offices so that the firm’s consulting cybersecurity technology experts can proactively address the problem in the field.

Concerning the future, the panelists remarked upon the increase in insurance companies selling firms cybersecurity insurance. The panelists agreed that having this insurance is a good idea in the event of a cybersecurity attack, which they declared will inevitably happen to all firms. The panelists further proclaimed that the process of applying for the insurance is a good thing if, in order to calculate the amount of insurance a firm needs, it forces the firm to assess its cybersecurity assets, its data, where the data is stored, and the risk of that data being subject to cyberattack.

What help is there for a firm’s clients and U.S. citizens to prevent cyberattacks to their own data? All the panelists emphasized that the firms alone cannot prevent cyberattacks. They said that it is up to everyone in the chain including the firms’ clients and U.S. citizens to bear some of the responsibility at the community level. The panelists said, for example, that individuals can take steps to mitigate data breaches by protecting their router, creating a two-tiered authentication process to access data, updating their devices’ virus protections, and installing patches.

When Van der Laan asked the panelists what they are doing to help citizens protect themselves from data breaches, Kelley remarked upon FINRA’s website now having a web page to provide cyber information as hot topics develop. Vivolo mentioned the SEC’s investor.gov website, together with the Commission’s Office of Investor Advocacy and Education. And de Simone said that SIFMA members routinely inform their clients about cybersecurity issues to protect them from attack.

Wednesday, October 30, 2019

Paxos greenlighted to use DLT to clear equity trades during limited production test

By Mark S. Nelson, J.D.

A no-action letter issued by the SEC’s division of Trading and Markets to Paxos Trust Company, LLC will allow Paxos to conduct a 24-month test of its Paxos Settlement Service (PSS) using distributed ledger technology (DLT). Paxos had raised the possibility that, absent no-action relief, its production test of the PSS could make it an unregistered clearing agency without a relevant registration exemption. The exact role of the SEC’s clearing agency regulations in the DLT/blockchain space was not directly addressed in the SEC’s key documents on digital asset securities, such as the DAO Report or the SEC’s "Framework," both of which focus on investment contracts, although several other divisional statements strongly hint at the requirements for clearing agencies. As a result, the Paxos no-action letter will serve as one example of how DLT/blockchain activities might be addressed in the clearing agency context, but it remains to be seen if such relief can be scaled up for a larger group of securities with much higher trading volumes on a permanent basis.

A Paxos press release emphasized that the PSS would be the first settlement system for U.S. equities that was not part of the legacy market infrastructure developed nearly 50 years ago. "The U.S. equities business continues to face unprecedented consolidation and economic pressures, requiring a comprehensive transformation of market structure," said Paxos CEO and co-founder Charles Cascarilla. "This is an important first step on our journey to reimagine the entire post-trade infrastructure, and one that creates immediate benefits for market participants." Cascarilla added that the PSS could be scaled up for other asset classes and clients.

Paxos’s website explains its business as that of attempting to "democratize access to a new, global, frictionless economy." The company also boasts several prominent directors, including former Senator and Democratic presidential candidate Bill Bradley and former FDIC Chairwoman Sheila Bair.

PSS production test. The PSS is designed to test the feasibility of using DLT to settle equity trades. Specifically, the PSS leverages multiple accounts at Paxos and The Depository Trust Co. plus wire transfers from participants to a Paxos bank account to create a "digitized security entitlement" that is credited to a participant’s account within the PSS on the Paxos ledger. However, the PSS trial, at least initially, will not attempt corporate actions processing (e.g., dividend payments), so PSS participants will have to transfer their securities from their PSS Accounts to their DTC accounts nightly. The PSS will utilize a private, permissioned DLT.

Paxos argued in its no-action request letter that its PSS would be consistent with the Congressional findings expressed in Exchange Act Section 17A(a)(1)(C): "New data processing and communications techniques create the opportunity for more efficient, effective, and safe procedures for clearance and settlement." Paxos, for example, said its PSS would bring several benefits, including faster settlement through the use of T+0 or T+1 and not just the current standard of T+2. The PSS also would facilitate enhanced intraday liquidity by employing a simultaneous delivery versus payment process that results in settlements that are irrevocable and unconditional.

According to the Division of Trading and Markets, its staff will not recommend enforcement against Paxos if Paxos conducts a test to gauge the feasibility of operating a settlement system for U.S.-listed equity securities without registering as a clearing agency. The SEC’s reply to Paxos’s request emphasized that the no-action relief would be granted for a limited time for the purpose of processing a de minimis volume of trades in a small number of equity securities, which themselves will subject to multiple selection criteria. Paxos must begin to wind up the test one month before the end of the 24-month test period.

More specifically, the PSS trial will adhere to a number of parameters, including: (1) a limit of seven participants; (2) securities will be public securities registered under Securities Act Section 6 or Exchange Act Section 12; (3) a security must satisfy six criteria, including being a component of the Dow, S&P 500, or the Russell 1000; and (4) trading must comply with volume limits. Paxos said it will monitor for compliance with the parameters of the test period.

Registration looms without no-action relief. The SEC has on at least two occasions warned securities markets participants that some entities engaged in the business of digital asset securities may have to comply with the regulations for clearing agencies. The SEC’s guidance on whether digital asset securities are investment contracts, however, is far more detailed than its several statements on market participants such as exchanges and clearing agencies operating in the same space.

In its November 2018 Statement on Digital Asset Securities Issuance and Trading, the Division of Trading and Markets along with the Division of Corporation Finance and the Division of Investment Management, expressed numerous concerns about the trading of digital asset securities. The last footnote to the statement observed that regulations applicable to clearing agencies also could be relevant in this context. In March 2018, the Division of Trading and Markets and the Division of Enforcement also had warned that some entities may need to register as clearing agencies in a Statement on Potentially Unlawful Online Platforms for Trading Digital Assets .

Exchange Act Section 17A(b)(1) mandates that clearing agencies be registered. Under Exchange Act Section 3(a)(23), a "clearing agency" is any person who, among other things, acts as an intermediary in making payments or deliveries in connection with securities transactions. The statutory definition also provides a long list of entities that are excluded from the definition, including national securities exchanges, national securities associations, or broker-dealers solely because they perform certain specified activities.

Tuesday, October 29, 2019

Enforcement Co-Director Peikin touts self-reporting, creative remedies at Securities Docket conference

By Amanda Maine, J.D.

Steve Peikin, co-director of the SEC’s Division of Enforcement, recently participated in a panel discussion at the Securities Docket 2019 Enforcement Forum. Peikin addressed recent Division initiatives, such as its Share Class Selection Disclosure Initiative, as well as the SEC’s approach to remedies and settlements.

SCSD Initiative and self-reporting. Peikin touted the Commission’s Share Class Selection Disclosure (SCSD) Initiative, which encouraged mutual funds to self-report violations of SEC disclosure rules relating to mutual fund fee structures, including 12b-1 fees, in exchange for favorable settlement terms. Nearly 100 firms have entered into settlements with the Commission, including 79 in March and 16 in September.

Bradley J. Bondi of Cahill Gordon & Reindel, who moderated the discussion, asked Peikin if the SEC would pursue similar self-reporting initiatives like the SCSD Initiative and the Municipalities Continuing Disclosure Cooperation Initiative. Peikin said that he would not rule it out but stated that the self-reporting initiatives established by the SEC in recent years involved certain criteria such as behavior that was widespread and difficult to detect.

Bondi also inquired why the SEC chose a self-reporting initiative to capture mutual fund disclosure failures as opposed to a 21A report. For example, Bondi pointed to the Commission’s 21A report from October 2018 which outlined various cybersecurity-related incidents but did not sanction the companies cited in the report. Peikin explained that the SEC had already brought several enforcement actions relating to 12b-1 fee disclosures before the SCSD Initiative, so the self-reporting initiative would be more appropriate.

Regarding self-reporting in general, former SEC Enforcement Director William McLucas, now at Wilmer Hale, said that the lack of guidance about self-reporting from the SEC can result in tough discussions with clients because there are no guarantees for self-reporting in contrast to the detailed guidelines from the Department of Justice. George S. Canellos, formerly of the SEC’s Enforcement Division and currently at Milbank, agreed, stating that without formal guidelines for cooperation credit, the SEC is “all over the map.”

Remedies. Bondi asked Peikin about the Commission’s use of non-monetary penalties. Peikin said that the SEC is taking a creative approach to remedies which may not involve financial sanctions. The SEC wants to address the cause of the problem, he said. As an example, he cited the SEC’s enforcement action against Tesla and its CEO Elon Musk, which involved a settlement requiring Musk to step down as Tesla chairman and imposed certain procedures for monitoring Musk’s public statements about the company.

Bondi cited a Cornerstone report that SEC penalties are trending downward and inquired about how the Commission assesses penalties. Peikin said that the SEC continues to evaluate the harm caused by the conduct, its egregiousness, and how widespread the conduct was in assessing penalties. Peikin also said the Commission wants companies and firms to be aware of the message it sends when imposing a penalty.

Settlements and waivers. Bondi brought up a recent change at the Commission involving the way the SEC approaches settlements and subsequent waivers. Under the new approach, instead of considering settlements and waiver requests separately, the Commission will examine them simultaneously. Peikin said that the policy is still very new and that CorpFin makes its own recommendations separate from Enforcement. He said that the Division is still studying it and to “stay tuned.”

Canellos was not as shy in expressing his opinion on the new policy. He praised the new procedure, stating that before it was enacted, he couldn’t inform his client what the consequences would be when entering a settlement with the SEC. He went on to say that most disqualifications that result from an SEC order, such as disqualification from well-known seasoned issuer (WKSI) status, are “dumb” and can occur from the “tiniest infraction.” According to Canellos, these collateral disqualifications should be a remedy that the SEC seeks, rather than something that flows automatically from the imposition of an administrative order.

Monday, October 28, 2019

SEC proposes updates to filing fees systems

By Lene Powell, J.D.

The SEC has issued proposed rule amendments designed to make filing fee systems more efficient. The amendments would automate some aspects of the currently highly manual systems for filing fee preparation and payment processing by companies and investment companies, with the aim of making processes faster, easier, and less error-prone. The proposal would make fee data machine-readable by requiring it to be presented in eXtensible Business Reporting Language (XBRL). The proposal would also allow fees to be paid via Automated Clearing House (ACH) and eliminate the option for payment via paper checks and money orders (Filing Fee Disclosure and Payment Methods Modernization, Release No. 33-10720, October 24, 2019).

Improved efficiency. Currently, filers and Commission staff must process and validate EDGAR filing fee information within the filing by highly manual and labor-intensive methods. Filing-fee related information is generally not machine-readable, and the underlying components used for the calculation are not always required to be reported, sometimes resulting in calculation and re-keying errors. In addition, complexity and number of transactions can make fee calculation difficult.

Proposed changes. The proposal would make changes to the following forms to require disclosure and structuring of all information necessary to calculate the fee in Inline XBRL format:
  • Forms S-1, S-3, S-8, S-11, S-4, F-1, F-3, F-4, and F-10 under the Securities Act;
  • Schedules 13E-3, 13E-4F, 14A, 14C, TO, and 14D-1F under the Exchange Act; and
  • Forms N-2, N-5, and N-14 under the Investment Company Act.
The proposal would also add an option for fee payment via ACH, which offers faster and more accurate fee payment processing through standardized fee payment identification fields, and eliminate the option for fee payment via paper checks and money orders.

Cost to implement. The SEC said that costs to implement the changes will vary across filers, depending how much of their data is already in structured format, but should be minimal because the information is already required to be gathered. The SEC believes that 266 filers would be newly subject to Inline XBRL requirements as a result of the proposed amendments and would therefore incur costs to develop processes and potentially license software or engage a third party to comply with the proposed requirements.

Request for comment. The SEC asked for comments on costs and benefits of the proposed rules from the point of view of filers, investors, and other market participants, as well as on reasonable alternatives. The SEC asked 47 specific questions, including whether the amendments should be phased in over time.

The release is No. 33-10720.

Friday, October 25, 2019

Judge vacates $16M Kraft-CFTC consent order and reopens manipulation case over wheat trades

By Mark S. Nelson, J.D.

U.S. District Judge John Robert Blakey vacated a consent order agreed to by the CFTC, Kraft Foods Group, Inc., and Mondelez Global LLC regarding alleged manipulation by Kraft of markets for red winter wheat, a key ingredient in Kraft’s snack foods. The district court’s latest order preserves part of the contempt proceedings that were ongoing against the CFTC before the Seventh Circuit was asked to clarify how the district court should proceed on the contempt issues. The district court also reopened the case and directed the parties to either reach a new settlement or to prepare to agree to a trial date at a hearing set for late November (CFTC v. Kraft Foods Group, Inc., October 23, 2019).

Contempt proceedings. Just days ago, the Seventh Circuit ruled on the CFTC’s petition for a writ of mandamus filed after the district judge had raised the prospect of CFTC officials being called to testify about public statements the Commission and individual commissioners made following entry of the original consent order that settled the CFTC’s case against Kraft for $16 million but without the court making any factual findings or conclusions of law. Kraft and Mondelez had asked the district court to find the CFTC and several of its commissioners in contempt of court for allegedly violating the consent order’s gag rule provision. The Commission’s public statement and a separate public statement by Commissioners Dan Berkovitz and Rostin Behnam asserted a right to speak on the matter based on a provision in the Commodity Exchange Act (CEA) and an interpretation of the consent order’s gag rule.

As the Seventh Circuit had noted, the district judge responded in the mandamus proceeding to the effect that criminal contempt was no longer a possibility for the CFTC or its individual commissioners or staff. That means the remaining contempt proceedings will focus on civil contempt issues. But Judge Blakey’s newest order makes clear that the civil contempt motion filed by Kraft is denied with respect "to any request for civil contempt personally against the CFTC Chairman, Commissioners, or staff members." The civil contempt proceeding, however, remains open to address other related issues.

Judge Blakey also clarified that CFTC commissioners and staff will no longer face the prospect of testifying in court in any further contempt proceedings. The judge will issue a separate order resolving the open contempt issues, including whether the CFTC violated the consent order and other alleged violations of prior court orders, such as one regarding the privacy of settlement conference discussions. Said the court: "Consistent with this Court's practice throughout these proceedings, no other aspect of this case has been made private, and no secret adjudication has been, or will be, authorized."

Consent order vacated. Judge Blakey also vacated the consent order previously agreed to by the CFTC, Kraft, and Mondelez, citing language in the Seventh Circuit’s opinion to the effect that the consent order’s gag rule was "ineffectual" at least regarding public statements made by individual CFTC commissioners. As a result, in combination with the view that the gag rule was material to the prior settlement, the court vacated the consent order, the court’s approval of the consent order, and the court’s judgment.

The Seventh Circuit had reasoned thus regarding the public statement by Commissioners Berkovitz and Behnam: "So if we understand the consent decree as an effort to silence individual members of the Commission, it is ineffectual, for no litigant may accomplish through a consent decree something it lacks the power to accomplish directly, unless some other statute grants that power—and no one argues that any other statute overrides §2(a)(10)(C)." The provision cited is CEA Section 2(a)(10)(C), which states: "Whenever the Commission issues for official publication any opinion, release, rule, order, interpretation, or other determination on a matter, the Commission shall provide that any dissenting, concurring, or separate opinion by any Commissioner on the matter be published in full along with the Commission opinion, release, rule, order, interpretation, or determination."

The statement issued by Commissioners Berkovitz and Behnam expressly relied upon the CEA provision as the basis for their speaking publicly on the CFTC-Kraft settlement. The Commission’s public statement on the settlement interpreted the gag rule in the consent order to apply only to a "party" (i.e., the Commission, Kraft, and Mondelez), but not to individual commissioners speaking on their own behalf.

Judge Blakey further explained the vacatur as follows: "Quite simply, the factual record undermines the notion that the parties ever agreed to the CFTC's recent legal theory that the Consent Order would somehow bind the CFTC as an entity, but not bind the very agents through which it acts, i.e., its Chairman, Commissioners or staff members."

Case reopened. Having vacated the consent order, Judge Blakey then reopened the CFTC’s case against Kraft and Mondelez and lifted the stay that had halted proceedings in the district court while the Seventh Circuit mulled the CFTC’s mandamus petition. That means numerous motions also have been reinstated and must be resolved as the case moves forward, including:
  • CFTC’s motion for summary judgment on Count III (speculative position limits) and Count IV (wash sales). The CFTC’s overall theory was that Kraft signaled the market not to store wheat such that sellers would be forced to sell wheat to Kraft at lower prices.
  • Kraft’s/Mondelez’s motion for summary judgment. The motion emphasizes the lack of evidence (while also seeking to exclude Dr. Wilson’s report on false signaling), the lack of an artificial price, the presence of a valid hedge exemption, and that wash sales claims fail as a matter of law.
  • Kraft’s/Mondelez’s motion to exclude testimony of Dr. William Wilson, the CFTC’s economics expert
  • Kraft’s/Mondelez’s motion to strike Dr. Wilson’s report of August 31, 2018.
  • CFTC’s motion to compel Kraft/Mondelez to produce deposition transcripts and exhibits from the related private civil case of Ploss v. Kraft (N.D. Ill, No. 15-cv-2937). U.S. District Court Judge Edmond E. Chang is considering several motions and the next scheduled status hearing is set for November 25, 2019.
Judge Blakey observed that CFTC, Kraft, and Mondelez can enter into a new settlement agreement and submit a new proposed consent order to the court. But if the parties cannot agree to a settlement, they should be prepared on November 20, 2019 to set a trial date.

The case is No. 15-cv-2881.

Thursday, October 24, 2019

Zuckerberg defends Facebook, Libra before FSC

By Amy Leisinger, J.D.

Facebook CEO Mark Zuckerberg spoke to members of the House Financial Services Committee regarding Facebook’s involvement with the proposed Libra payment system and the ongoing challenges facing the tech giant. According to Zuckerberg, the digital currency would serve consumers with limited access to means to transfer money, but the legislators expressed concerns about privacy and security, power concentration in the Libra Association governing the system, and the potential for systemic issues arising resulting from widespread adoption. Several of the committee members also pressed the Facebook official on the company’s approaches to discriminatory advertising and issues surrounding employee diversity.

Libra. In June 2019, the Libra Association (a consortium of organizations, including Facebook’s Calibra subsidiary) announced plans to develop Libra, a currency that would be built on a blockchain and backed by a reserve of real assets called the Libra Reserve. Calibra would develop a digital wallet for Libra that would be available both as a standalone app and through Facebook’s Messenger and WhatsApp products. Libra is designed to target more mainstream users than traditional cryptocurrencies, particularly those who do not engage with the traditional financial system but have access to a mobile phone

FSC Chairwoman Maxine Waters (D-Cal) opened the discussion by urging Facebook to address its other privacy and advertising concerns before jumping into the cryptocurrency arena. According to Zuckerberg, however, the primary purpose of Libra is not strictly to act as a cryptocurrency but to promote financial inclusion for the unbanked and underbanked with a safe, efficient means of sending and receiving payments around the world. Money should be able to move as quickly as a message, he said. In his view, the financial structure in United States is outdated, and a more modern approach could serve the financial system as a whole. In response to Rep. Carolyn Maloney (D-NY), Zuckerberg stressed that Facebook does not ultimately control the Libra Association and would not be involved the Libra project if approval from U.S. regulators cannot be obtained.

“[W]e support Libra delaying its launch until it has fully addressed U.S. regulatory concerns,” Zuckerberg stated.

Regarding risks, several committee members asked why individuals and businesses should trust Facebook given its history of failing to protect private information. Zuckerberg reiterated that compliance with U.S. regulations will be a prerequisite of Facebook’s involvement in the Libra project, and “know your customer” and anti-money laundering regulations, as well as other federal regulations, will apply. In addition, there is and will remain a clear separation between Facebook’s social data and Calibra’s financial data, he explained. Zuckerberg stressed that the goal is to create global payment system not a currency, and the United States needs to innovate to ensure that the dollar continues to lead. Representative Andy Barr (R-Ky) agreed that it is always better to be on the side of innovation, and Zuckerberg noted that there are also risks to not trying new things. Legislation and regulation could put the United States at odds with counterparts around the world, including China, which is moving forward with a system similar to Libra. Assets would be used to underpin Libra, and protections would be in place for unauthorized transactions, Zuckerberg explained. However, Rep. Juan Vargas (D-Cal) stated, “when something threatens the dollar, we get nervous.”

When asked why companies including Visa, Mastercard, PayPal, and eBay have dropped out of the Libra Association, Zuckerberg noted that the Libra project is an innovative project that comes with a certain amount of risk. Over 20 companies remain in the association, and other entities have expressed interest in getting involved, he stated. Calibra is only one member of the group, and Facebook does not expect to continue leading Libra efforts; the Libra Association now has a governance structure in place and will be driving the project going forward, according to Zuckerberg.

Chuy Garcia (D-Ill) questioned Zuckerberg on the potential for Facebook to overpower traditional financial institutions, noting his introduction of the Keep Big Tech Out of Finance Act, which is designed to prohibit large platforms from becoming financial institutions or being affiliated with financial institutions, as well as to prohibit them from establishing or operating a digital asset intended to be broadly used as medium of exchange. Garcia asked whether Libra should be regulated as a bank, and Zuckerberg stated that, although Libra is a different type of payment system, the SEC should ultimately decide. Garcia replied that blurring the lines between banking and commerce tends to cause problems.

Other concerns.
Several committee members also questioned Zuckerberg regarding potential discrimination in connection with Facebook advertisements and diversity issues in employment. He acknowledged that as part of a settlement, those who seek to advertise housing, employment, or credit opportunities are now required to go through a special advertisement purchasing process that prohibits targeting by age, gender, or zip code. Separately, he noted that Facebook has made diversity a priority in hiring and plans; within the next five years, Facebook plans to have women, people of color, and other underrepresented groups make up at least 50 percent of its workforce, Zuckerberg said. Diversity leads to “better decisions, better products, and better culture,” he concluded.

Wednesday, October 23, 2019

PCAOB officials outline inspections trends, best practices

By Amanda Maine, J.D.

Top officials in the PCAOB’s Division of Registration and Inspections recently addressed ALI-CLE’s 2019 Accountants’ Liability Conference in Washington, D.C. The officials gave advice on how to prepare for an inspection and identified the most common deficiencies the staff has encountered during recent inspections.

Areas of focus. George Botic, director of the Division of Registration and Inspections, advised that the Board’s five-year strategic plan, which was issued as a draft in August 2018, and approved by the PCAOB in November 2018, emphasized that the inspections program should seek to prevent audit failures and not just detect them. The staff has kept this is mind in its approach to quality control by taking what it has learned from the inspections of the six largest firms and applying these lessons to inspections of smaller firms, he said.

According to Botic, the staff has maintained an external focus on issues such as updating what goes into an inspection report. Inspection reports as they exist now are very long, so the staff is thinking about how to make them more user-friendly. Botic said the staff hopes to issue a draft of an improved inspection report later this year or early next year.

The staff has also taken a more proactive approach to communications with audit committee chairs, Inspections Deputy Director Christine Gunia said. Compared to previous years, the staff engaged with all audit committee chairs of audits selected for inspection in 2019, instead of just some of them, according to Gunia. She also said that the staff has been engaging in two-way dialogue with audit committee chairs rather than simply asking them questions. As of September 30, the Board’s inspection teams had dialogues with over 325 audit committee chairs, Gunia stated.

Preparing for an inspection. Gunia also gave tips on how to prepare for an inspection, the most important of which is clear and timely communication. Gunia advised that beginning in 2019, as part of responding to comment forms, firms are being asked to link the stated deficiency to their system of quality control. According to Gunia, this will help inform and possibly identify where in a system of quality control the failure occurred and detect or prevent a deficiency from occurring.

One effective way of communicating with inspections staff is through the use of visual aids, such as process flow diagrams and whiteboarding, Gunia recommended. She added that communication does not end when the inspectors leave. For example, post-inspection communication occurs in the context of written replies to the comment forms, Gunia said.

Frequent findings. Inspections Deputy Director Timothy P. Sikesoutlined several recurring findings that arise during inspections that can negatively impact audit quality. One common practice that continues to arise is the alteration of audit work papers. Sikes warned that altering work papers can result in sanctions, including the revocation of a firm’s registration and barring individuals from the industry. Firms are also failing to timely archive their audit documentation within 45 days of the inspection, he noted.

The staff has noted that some firms are not meeting their obligations under Form AP. Some Forms AP contain incomplete or inaccurate information or are not filed at all, Sikes stated. He encouraged auditors to review the Board’s guidance on Form AP, which was issued in February 2017.

Independence issues continue to be a problem, according to Sikes. The staff frequently identifies deficiencies that suggest some firms and their personnel either do not understand independence requirements or do not have controls in place to prevent independence violations. Other common inspections findings the staff has encountered include those related to internal control over financial reporting, revenue recognition, accounting estimates, and evaluating the risk of material misstatement, he added.

Good practices. Sikes also highlighted a number of good practices the staff has observed. These include extending accountability to key firm leaders, developing guidance to identify and assess risks of material misstatements, revising training programs and providing support from experienced personnel, and enhancing audit tools in areas of significant judgement.

Tuesday, October 22, 2019

SEC directors address Enforcement Division matters including cybersecurity

By Jay Fishman, J.D.

SEC Enforcement Division Co-Directors Stephanie Avakian and Steven Peikin, in an October 21, 2019, hour-long SEC Historical Society webinar moderated by Merri Jo Gillette (the deputy general counsel at Edward Jones), answered questions about the Division’s handling of cybersecurity and other enforcement matters.

Fiscal years 2019 and 2020. Gillette separated her questions into those pertaining to the Division’s handling of enforcement issues in the just-now-ending 2019 fiscal year, and those enforcement matters being addressed in the new fiscal year.

Avakian and Peikin emphasized that the Commission’s primary issue in any fiscal year is investor protection but that fiscal year 2019 saw an uptick in cybersecurity and initial coin offering cases, with the particular challenge being how to keep pace with the increasing technologies used to perpetrate these cyber and virtual currency crimes. The co-directors added that until recently, limited resources prevented them adding staff to help prosecute these frauds. Moreover, they proclaimed that the 35-day government shutdown earlier this year prevented them from even investigating these cases but that they learned during the shutdown how to expedite the handling of cases to more quickly resolve them when the shutdown ended.

When Gillette asked about fiscal year 2020, Peikin said he does not anticipate a big change because the landscape from 2019 was broad enough to extend into the new year. Peikin and Avakian both stated that the Division will always get the typical fraud cases but that 2020 will probably see escalating schemes involving cybersecurity, initial coin offerings and conflicts of interest. And they remarked that other than the challenge from having limited resources to go after these schemes, the additional challenge particularly nowadays is discovering and then educating themselves on these technologically advanced securities crimes, e.g., cybersecurity and virtual currencies, as the crimes so quickly develop electronically to victimize investors.

Cybersecurity. Regarding cybersecurity, Gillette relied on a SEC cybersecurity report to ask whether the Commission expects corporate boards to provide steps to prevent or mitigate a cyberattack. Avakian and Peikin answered that the Commission does not expect companies to have a specific approach in place but would hope that they have something to disclose to investors along with the risks of a data breach. The co-directors then went on to cite the Yahoo case as an example of a company whose lack of any cyber policy in place allowed wholesale data breaches to occur. They additionally pointed out that Yahoo was one of the only companies whose data breach warranted SEC prosecution.

When asked what factors would prompt an SEC investigation, Avakian and Peikin were quick to point out that because of having limited resources, the Enforcement Division must look at a number of factors including the size of the entity and, depending on size, what, if any, cyber policy is in place, what type and how many disclosures the entity has failed to provide investors about potential data breaches, and whether other U.S. or foreign government agencies have gotten involved. If other agencies such as the Environment Protection Agency have gotten involved because the company is, say, polluting the air, the SEC won’t join the case unless investors were involved and collectively lost a certain large amount of money from investing in the entity. Likewise, if a foreign government were prosecuting an entity domiciled in that country, even if U.S. investors were involved and lost money on U.S. bonds or stocks, the SEC would weigh a number of factors such as how many U.S. investors were involved and how much money they lost before deciding whether to enter the fray.

When Gillette asked about the Division’s prosecution of individuals such as a company’s CEO versus just the company itself, Avakian and Peikin stated that 70 percent of the Division’s cases name individuals while the other 30 percent name the company alone because the evidence does not show one or more individuals as being responsible for the crime. But they emphasized that prosecuting individuals has a deterrent effect, although sometimes it is a long process because the individual has a lot to lose, including reputation, and so spends a lot of money on litigation.

Digital coin offerings. The co-directors made a point of mentioning that they do not prosecute only fraud, but that especially in the emerging initial coin offering arena they will go after the issuers who fail to register an offering. They said that for whatever reason these issuers think that the coins are not securities and so are exempt from registration, and attempt to sell them without claiming an appropriate exemption or absent that, without registering them with the SEC. By simply selling them, they are not providing investors with the appropriate disclosures they need to make an informed decision about whether to invest and, thereby, open the investors up to experiencing significant financial losses if the investment is a bust, which it often is.

Self-reporting and tolling. Gillette spent some time asking about the issue of tolling and self-reporting. The co-directors said that this SEC self-reporting initiative incentivizes the alleged wrongdoing entities and individuals to sign tolling agreements for the possible receipt of a reduced crime and sentence down the line. They said, however, that signing a tolling agreement is not in theory supposed to equate with a defendant’s “being cooperative” to earn them reduced crime and sentencing status but that in reality a defendant’s signing the agreement can work to mitigate circumstances by, for example, permitting a settlement. Conversely, a defendant’s refusal to sign a tolling agreement often prompts Division staff to expedite the investigation to bring about a quick, harsh resolution for the defendant. And the reason for expedition is to avoid from the tolling of a fraud statute, the loss of disgorgement from the defendant’s ill-gotten gain to pay back the victimized investors.

Usefulness of white papers and Wells process. When Gillette asked about the usefulness of white papers and the Wells process for resolving cases, Peikin and Avakian answered in the affirmative. Peikin further stated that white papers have sometimes actually resulted in decisions and parts of an outcome going in a different direction from what was previously thought.