Monday, March 18, 2024

Internal auditor awarded $1.25 million for reporting misconduct

By John Filar Atwood

The CFTC has awarded $1.25 million to a whistleblower whose responsibilities included compliance or internal audit functions at the subject company. Stricter whistleblower requirements apply to employees with compliance or internal audit responsibilities, but the CFTC said that the whistleblower satisfied those requirements by first raising the matter internally and then waiting at least 120 days to contact the agency.

It is the first CFTC whistleblower award that applied the 120-day safe harbor provision to a person who served in an entity’s internal compliance or audit function. The whistleblower contacted the CFTC only after the employer took no meaningful remedial action on the issues in question.

In its order, the CFTC noted that it normally does not consider information that a whistleblower obtains from his or her role as an internal audit or compliance employee to be derived from his or her independent knowledge. However, the exclusion from independent knowledge does not apply when the employee waits at least 120 days after reporting it to his or her supervisor, or the audit committee, chief legal officer, or chief compliance officer.

In granting the award, the CFTC noted that the whistleblower’s information by itself was responsible for the agency’s enforcement staff opening an investigation and taking action against the company.

The CFTC’s director of enforcement said that the award recognizes the risks that company insiders take in coming forward with information as well as the value of the specific information provided.

Friday, March 15, 2024

Supreme Court asked to decide if seized assets can be offset against disgorgement

By John Filar Atwood

A petition for certiorari asks the Supreme Court to determine whether seized assets can be credited against disgorgement and whether the district court’s nominee analysis on three discrete relief defendant assets was legally sufficient to satisfy the requirements of the nominee doctrine. The district court and Second Circuit found that the seized assets could not be offset against disgorgement because they were not ill-gotten gains from the misconduct. The petitioner contends that the disgorgement is punitive and that the Supreme Court’s holding in SEC v. Liu demands that disgorgement remain within equitable limits (Ahmed v. SEC, March 6, 2024).

The petitioner is the wife of Iftikar Ahmed who allegedly defrauded Oak Management Corp., his employer, and investors out of $65 million over a ten-year period. The SEC ordered Ahmed to disgorge $64.2 million. In connection with the action against Ahmed, Oak seized assets belonging to Ahmed and his wife, a relief defendant, in the amount of $35 million. Ahmed sought unsuccessfully to have the seized assets credited against the disgorgement total.

Limitations on disgorgement. The petitioner is seeking review on the grounds that the Second Circuit decision conflicts with the Supreme Court’s authority on equitable limitations inherent in disgorgement. She noted that in Liu the Supreme Court invalidated punitive measures in disgorgement remedies, ruling that a remedy grounded in equity must be deemed to contain the limitations upon its availability that equity typically imposes. In her view, the Circuit Court decision punishes her by charging her twice for disgorgement and providing the victim a double recovery.

The petitioner also disagrees with the district court’s ruling that the value of shares returned to the alleged victims in two specified transactions could not be offset against the calculation of disgorgement as Ahmed’s conflict of interest in one transaction and his position on both sides of the second deal precluded the credit of the value of shares against disgorgement. The petitioner asks the Supreme Court to consider that an equitable remedy presupposes a loss to the victims, but there was no loss in the two transactions at issue.

Nominee doctrine. The petitioner also asks the Supreme Court to consider the legal requirements necessary to declare a relief defendant a nominee of a primary defendant such that her assets are deemed equitably owned by the defendant and can be used towards satisfaction of the SEC’s judgment. In her view, the Second Circuit’s affirmance of nominee status of certain relief defendant assets conflicts with the Supreme Court’s precedents that mandate reversal when decisions are made on an erroneous basis of law. It also creates a circuit split on the legal sufficiency needed to satisfy the requirements of the nominee doctrine to conclude certain assets as nominees, she contends.

The petitioner concludes that the case provides the Supreme Court with an opportunity to weigh in on the government’s ability to avoid judicial scrutiny of its disgorgement calculations and on the proper application of the nominee doctrine.

The case is No. 23-987.

Thursday, March 14, 2024

CII urges SEC to prioritize agenda items

By Rodney F. Tonkovic, J.D.

The Council of Institutional Investors has written to the SEC in response to the agency's invitation to comment on its latest semiannual regulatory agenda. CII notes its continued support of long-deferred action on "proxy plumbing" regulations as well as a proposal to address non-GAAP financial measures. Other items covered by the letter include CII's recent petition for rulemaking on the traceability of shares and proposals on Regulation Best Execution and Regulation NMS.

Regulatory Flexibility Agenda. The SEC most recently published its agenda of rulemaking actions in August 2023. The Regulatory Flexibility Act requires each federal agency to publish in the Federal Register a list of the rules it expects to consider in the following year. The Commission invites comments on the agenda and the individual entries, and comments should be received 30 days after publication.

Penned by CII's general counsel, Jeffrey P. Mahoney, the letter reflects the organization’s priorities with respect to SEC rulemaking: investor rights and protections; corporate disclosure; and market systems and structure. The letter is, accordingly, divided into these three categories and under these headings addresses five subtopics.

Investor rights. The letter first urges the SEC to add a project to its agenda to protect investor rights to recover losses under Securities Act Section 11. CII itself recently petitioned the Commission for rulemaking on traceability of shares in part as a response to the Supreme Court's Slack decision affirming that shareholders must be able to "trace" their shares to a registration statement. One approach under consideration would be to amend Rule 144 to limit sales of unregistered securities for a certain period after the effectiveness of a registration statement. CII's petition suggests requiring the use of technology to facilitate tracing. There is no shortage of options, CII says, and the issue is "not whether, but how to do so."

Corporate disclosure. Under the rubric of corporate disclosure, CII notes its continued support of a new agenda item closing the regulation loophole governing non-GAAP financial measures. To that end, the letter reiterates a 2019 request that the Commission require disclosure of: quantitative reconciliation to GAAP of non-GAAP financial measures used to determine executive compensation; and a qualitative description of why the non-GAAP financial measures are better for determining executive pay than GAAP financial measures.

CII states that the use of non-GAAP adjustments to determine incentive plan payouts is a common practice. Plus, recent research indicates that companies use non-GAAP earnings to justify higher executive compensation. The letter asks the SEC to promptly propose a rule requiring, at minimum, that companies include a hyperlink to a quantitative GAAP reconciliation for any non-GAAP financial measures contained in their CD&A.

Market systems and structure. CII also praises the Commission for its adoption of amendments updating Rule 605 disclosures. This should be followed by rules on Regulation Best Execution and Regulation NMS, the letter says. Concerning Regulation Best Execution, CII has concerns with two provisions (which it has discussed in-person with Chair Gensler): a proposed exemption for an institutional customer; and omission of a proposed requirement for order-by-order decision making.

The letter says that CII broadly supports the provisions of the Regulation NMS proposal. In particular, CII supports the proposed uniform reduction in the access fee cap set by Rule 610.

Finally, the letter expresses CII's continued disappointment that "Proxy Access Amendments" remain categorized as a long-term action on the agenda. CII believes that the SEC should prioritize improving "proxy plumbing," first by proposing the above-noted rulemaking to facilitate tracing. Secondly, the SEC should prioritize addressing end-to-end vote confirmation: this could be as simple as requiring all participants in the voting chain to provide issuers with access to voting record information for the limited purpose of confirming how a particular shareholder's shares were voted.

Wednesday, March 13, 2024

SEC ‘must’ adopt rules on crypto, Coinbase tells Third Circuit

By Lene Powell, J.D.

The SEC is “pursuing a power grab” over the crypto industry by engaging in enforcement while foregoing rulemaking, crypto giant Coinbase told the Third Circuit. In a new filing, Coinbase argues the SEC's “refusal to engage in rulemaking” is arbitrary and capricious and an abuse of discretion in violation of the Administrative Procedure Act (APA). Coinbase asked the court to vacate the SEC’s denial of petition for rulemaking and direct the SEC to commence rulemaking (Coinbase, Inc. v. SEC, March 11, 2024).

The new filing is the latest in a fierce exchange. Coinbase previously asked the Third Circuit to require the SEC to respond to its 2022 petition for rulemaking. The SEC responded by denying the rulemaking petition. The Third Circuit then dismissed the action as moot, and Coinbase filed the current challenge.

Coinbase’s lawsuit is also parallel to another action involving the parties. In an enforcement action in the Southern District of New York, the SEC has charged Coinbase with registration violations including failure to register as a national securities exchange, broker-dealer, and clearing agency. The SEC contends that the securities laws apply to Coinbase’s conduct, while Coinbase argues they do not.

“No workable framework.” Coinbase argues the SEC has performed an “about-face.” Earlier when the crypto industry was building up, the SEC indicated it had little statutory authority over digital assets and what authority it did have was unclear. Market participants responded by investing heavily in a what Coinbase says is a two-trillion-dollar industry. Then, the SEC pivoted and began a “scorched-earth, nationwide campaign” of enforcement.

Now, says Coinbase, it is caught in a catch-22: the SEC tells digital asset firms to “come in and register” under threat of enforcement suits, but registration is neither required nor possible under existing rules, which were designed decades ago for legacy financial assets and businesses.

Coinbase says it filed its petition for rulemaking because rulemaking is the only way for the agency to draw clear lines identifying them, to provide fair notice, and to create a workable regulatory framework that makes compliance with the securities laws possible.

Rulemaking needed. Coinbase is challenging the SEC’s denial of Coinbase’s petition for rulemaking. While the SEC communicated its decision in a letter, Coinbase calls the decision an “order.”

Coinbase argues:
  • The SEC must engage in rulemaking because it has adopted sweeping new views of the securities laws and existing laws do not work for digital assets;
  • The SEC cannot rationally regulate digital assets through ad hoc district court enforcement actions;
  • The SEC’s refusal to commence rulemaking should be vacated because the SEC offered no rational explanation for its inaction on Coinbase’s petition for rulemaking.
Remedies sought. Coinbase asked the court to grant the petition for review, vacate the SEC’s order, and direct the agency to begin a “long-overdue” rulemaking process.

This is case No. 23-3202.

Tuesday, March 12, 2024

Investor Advisory Committee recommends scaling down SEC’s predictive analytics proposal

By Lene Powell, J.D.

The SEC Investor Advisory Committee (IAC) adopted a recommendation for the SEC to scale back proposed rules on digital engagement practices. A majority of the committee recommended that the SEC narrow some proposed definitions and increase focus on disclosing conflicts of interest.

Some members voted against the IAC’s recommendation, believing that it unduly shifts the focus to disclosing rather than neutralizing conflicts of interest.

Proposed rules. The SEC’s predictive data analytics proposal, released last July, would require firms to identify and eliminate any conflicts of interest arising from the use of covered technologies, as well as implement policies and procedures and keep certain records.

According to the proposal, firms are increasingly using a type of artificial intelligence called predictive data analytics (PDA) to understand and direct individual investor behavior. Firms may also use digital engagement practices (DEPs) like behavioral prompts, differential marketing, game-like features, and other design features to engage retail investors when using a firm’s digital platforms for trading, roboadvice, and financial education.

These technologies can create conflicts of interest that place a firm’s interests ahead of investors’ interests, the SEC says. For example, firms could use PDA-like technologies to encourage investors to engage in activities like excessive or risky trading that are profitable for the firm but may increase investors’ costs, undermine performance, or expose investors to unnecessary risks.

The proposal has met intensely polarized feedback. Better Markets called the proposed rules “essential to protect investors,” while NASAA supported the proposal with some recommended changes. In contrast, major industry groups strongly criticized the proposal, including the U.S. Chamber of Commerce, Investment Company Institute, SIFMA, and Investment Adviser Association.

IAC recommendation. At a meeting on March 7, the IAC adopted a recommendation on the SEC’s proposal. Committee member Paul Roye, former SVP and senior counsel at Capital Research and Management Company, said the recommendation suggests these changes:
  • Narrow the scope of the definition of covered technologies to target the unique risk of predictive data analytics and artificial intelligence technologies;
  • Narrow the definition of investor interaction to include technologies that interact directly with investors or that aid in that interaction with investors;
  • Use the current definition of conflict of interest;
  • Use the existing framework to mitigate or eliminate conflicts of interest involving predictive data analytics and artificial and technology when disclosures are inadequate; and
  • Clarify the definition of what constitutes a recommendation under Regulation Best Interest.
Roye suggested the recommended changes would avoid unintended consequences and adverse effects on investors and not impede the adoption of new beneficial technologies.

Dissent. Two committee members said they could not support the IAC’s recommended changes.

SEC Investor Advocate Cristina Martin Firvida said if covered technologies were to be redefined to focus on the use of exceptionally complex and opaque technologies, then in her view firms should not be permitted to address conflicts of interest through disclosure alone. Rather, she supports requiring firms to eliminate conflicts or their effects when the conflicts are the result of covered technologies. This would build upon existing regulations and does not represent a dramatic departure from firms’ existing regulatory obligations, she said.

Leslie Van Buskirk, administrator of the Division of Securities, State of Wisconsin Department of Financial Institutions, said she “firmly opposes” elements of the recommendation. She outlined concerns including that the recommendation would undermine the primary benefit of the SEC's approach—that it would transition industry practices to addressing associated conflicts at the earliest opportunity.

Commissioner statements.
SEC Chair Gary Gensler said that while the use of AI can promote greater financial inclusion and enhanced user experience, it can also raise conflicts of interest, which the proposed rules address. Gensler has previously said that under current rules, brokers and advisers cannot address conflicts of interest through disclosure alone.

Commissioner Hester Peirce questioned why the recommendation was changed from an earlier draft, particularly regarding the earlier version’s emphasis on disclosure versus mitigation of conflicts.

Monday, March 11, 2024

SCOTUS asked to weigh in on scienter, falsity pleading requirements

By Anne Sherry, J.D.

A petition for certiorari asks the Supreme Court to resolve two circuit splits concerning pleading scienter based on internal reports. Nvidia, the petitioner, argues that the decision against it deepened a circuit split by allowing a case to proceed to discovery based on speculation about what internal reports might have said. The ruling also created a new circuit split as to whether a plaintiff’s expert opinion can alone satisfy the falsity element of a securities fraud action (NVIDIA Corp. v. E. Öhman J:or Fonder AB, March 4, 2024).

Circuit splits. Last August, a Ninth Circuit panel narrowly revived some claims alleging that Nvidia Corp. and three of its officers defrauded investors by downplaying the extent to which Nvidia’s gaming revenues relied on the demand for cryptocurrency. The district court had held that the plaintiffs failed to prove scienter, but the appeals court found the complaint pleaded that one of the individual defendants both made materially false and misleading statements and did so with scienter.

Judge Sanchez dissented from the Ninth Circuit opinion. He observed that the complaint’s central falsity allegation was based entirely on a post-hoc analysis by an outside expert (Prysm) that relied on generic market research and questionable assumptions. The complaint did not put forward any internal report or data source that would have put executives on notice that their statements were false or misleading when made, nor did it cite any internal source corroborating Prysm’s revenue estimates. On the contrary, the only specific allegation of an internal study supported the defendants’ statements.

Further, Judge Sanchez noted, “We have never allowed an outside expert to serve as the primary source of falsity allegations where the expert has no personal knowledge of the facts on which their opinion is based, for example by corroborating their conclusions with specific internal information or witness statements.”

Petition. Nvidia argues in its cert petition that for the reasons Judge Sanchez noted, the panel opinion creates one circuit split (using an expert opinion to prove falsity) and deepens another (allowing scienter to rest on speculation). It asks the Court to consider two questions:
  1. Whether plaintiffs alleging scienter under the PSLRA based on allegations about internal company documents must plead with particularity the contents of those documents, as held by the Second, Third, Fifth, Seventh, and Tenth Circuits; and
  2. Whether plaintiffs can satisfy the PSLRA’s falsity requirement by relying on an expert opinion to substitute for particularized allegations of fact. The Second and Fifth Circuits have answered this question in the negative.
Nvidia writes that the Ninth Circuit is wrong on both issues and that its decision erodes the purpose of the PSLRA to end abusive securities litigation. The divergence from the Second Circuit is especially problematic, Nvidia asserts, because together the Second and Ninth account for a significant majority of securities fraud suits.

Two aspects of the PSLRA’s heightened pleading standards show why the Ninth Circuit’s analysis of the scienter element is incorrect. Congress has required scienter to be pleaded with particularity, which demands detail—“omissions and ambiguities count against inferring scienter” (Tellabs, Inc. v. Makor Issues & Rights, Ltd. (U.S. 2007)). Second, the PSLRA imposes another, even stricter demand on scienter: the plaintiff must plead facts giving rise to a strong inference that the defendant acted with the requisite state of mind.

Nvidia argues that the Ninth Circuit’s falsity analysis is also incorrect. The falsity element requires particularized allegations of fact, but an expert opinion is not a fact at all, much less a particularized one. “Allowing plaintiffs to evade that obligation by retaining an expert—who then turns to generic market data to speculate about what might have happened—eviscerates the PSLRA,” Nvidia writes.

The case is No. 23-970.

Friday, March 08, 2024

New paper analyzes how lawyers, judges view GenAI

By Mark S. Nelson, J.D.

Senior Legal Analyst Mark S. Nelson examines how lawyers think about and use generative artificial intelligence (GenAI) in their professional work and how the use of GenAI is being perceived by the courts. Specifically, this latest paper covers:
  • The promise and risks of GenAI in law practice.
  • Recent disciplinary cases.
  • Comments on the Fifth Circuit’s proposed GenAI local rule.
  • Legal ethics rules and GenAI.
To read “We’re lawyers, not luddites: GenAI in law practice and the courts,” please click here.

Thursday, March 07, 2024

SEC expands scope of Rule 605 reporting entities

By Rodney F. Tonkovic, J.D.

By unanimous vote, the SEC has adopted amendments modernizing the disclosure requirements of Rule 605 of Regulation NMS. Significantly, the amendments expand the scope of entities subject to the rule requiring monthly execution quality reports to encompass larger broker-dealers. The amendments will also modify the categorization and content of order information reported under the rule to capture a larger range of data. Finally, market centers and broker-dealers will now be required to produce summary reports on execution quality. The amendments will be effective 60 days after publication in the Federal Register and the compliance date will be 18 months after that date (Disclosure of Order Execution Information, Release No. 34-99679, March 6, 2024).

Disclosure of order execution information. Since its adoption in 2000, Rule 605 of Regulation NMS has required market centers to disclose order execution quality statistics in national market System stocks. A ”market center” was defined in Rule 600 to include any exchange market maker, OTC market maker, alternative trading system, national securities exchange, or national securities association.

There have been no substantive changes to Rule 605 since its adoption. During the meeting, Chair Gensler observed that the Rule 605 reports resemble the numbers and symbols that make up the opening credits to "The Matrix." He quipped that there have been three sequels to "The Matrix" since 1999, so it's about time for a sequel to Rule 605.

Larger broker-dealers. The final rule amendments expand the scope of entities subject to Rule 605 to include larger broker-dealers that introduce or carry at least 100,000 customer accounts. The Commission's analysis found that approximately 85 larger broker-dealers combined handle over 98 percent of customer accounts and that this threshold will balance the benefits of having broker-dealers produce execution quality statistics with the costs of implementation and continued reporting.

Larger broker-dealers that are also market centers must produce separate reports for each function. This will allow interested parties to view the firm's execution quality from the perspective of how it operated in each role, the Commission says. The Commission also specified that NMS stock ATSs must report separately from their broker-dealer operators and adopted a separate reporting requirement for single-dealer platforms.

NMS Stock ATSs and single-dealer platforms will also be subject to reporting under the rule.

In a change from the proposal, the Commission will not require separate reports for orders that a market center receives for execution from a qualified auction. At the same time the amendments to Rule 605 were proposed, the Commission proposed an order competition rule that contemplates qualified auctions. Since the Commission is still considering this proposal, the qualified auctions do not yet exist.

Categories and content. The amendments will also change the scope and content of the execution quality reports. Rule 605's reporting is limited to "covered orders," and the definition of that term has been expanded to include certain orders submitted outside of regular trading hours (that become executable after the opening or reopening of trading during regular trading hours), certain orders submitted with stop prices, and non-exempt short sale orders, i.e., those where a short sale price test is not in effect.

The amendments change how orders are categorized both by size and type. Rule 605's existing order categories will now be based on both notional dollar value and whether an order is for a fractional share, for an odd-lot, or for a round lot or greater rather than number of shares. The Commission has also added four new order types and replaced three existing categories of non-marketable order types with four new categories. The information required to be reported under the rule has been amended to include: modified time-to-execution reporting categories; realized spread time horizons with new statistical measures of execution quality; and new statistical measures of execution quality.

Summary reports. Finally, the amendments require entities subject to the rule to make a publicly available summary report. The Commission noted that the detailed report contains a large volume of statistical data that many market participants will be unable to directly analyze. Summary reports will be more readily accessible and will provide "human-readable information" that any investor can assess without needing technical expertise or relying on an intermediary.

The release is No. 34-99679.

Wednesday, March 06, 2024

Lawyers who won case against Tesla compensation grant seek percentage of shares rescinded

By Mark S. Nelson, J.D.

Gregory V. Varallo of Bernstein Litowitz Berger & Grossman LLP, attorneys for plaintiff Richard J. Tornetta, who had sued Tesla claiming that CEO Elon Musk’s executive compensation grant of several hundred million vested options, among other things, amounted to breach of fiduciary duty, seek attorney fees and an expense reimbursement equal to 11.0145 percent of the 266,947,208 shares freed up and returned to Tesla because the Delaware Chancellor concluded, after a trial, that CEO Elon Musk’s record stock grant should be rescinded. The fee request is the result of adjustments made to an initial request of 15 percent that was based on a prior large Delaware fee award (Tornetta v. Musk, March 1, 2024).

Tornetta’s attorneys won the trial after 4.5 years of discovery and a 5-day trial that featured testimony from multiple fact and expert witnesses. According to the plaintiff’s brief in support of the fee request, only two other U.S. cases produced larger recoveries and those cases involved the additional award of punitive damages.

The fee request asserts that a large award would mirror the benefit obtained from taking the case to trial at great risk to the plaintiff. More than 303 million vested options were cancelled and can now be used by Tesla for any corporate purpose, said the plaintiff’s brief. Lawyers for Tornetta also argued that Tesla will not have to pay a large cash amount and that Tesla may even enjoy tax benefits under the proposed award scheme. The proposed fee, said the brief, was consistent with other cases where fees were paid out as a percentage of shares and that the valuation employed in crafting the fee request would avoid having to explain whether the value of winning the rescission was the same or different from the value of the shares.

According to the plaintiff’s attorneys, the proper starting point for an award is 15 percent, the amount awarded in Southern Peru Copper, after a downward adjustment for the delay brought about by plaintiffs in that case. Here, Tornetta’s attorneys purport to seek a “conservative” recovery of a “fee awarded in kind” such that they would adjust the 15 percent baseline by a liquidity adjustment of 26.57 percent, ultimately yielding and a requested recovery of 11.0145 percent of 266,947,208 Tesla shares. Footnote 82 to the plaintiff’s brief spells out the math used to arrive at the fee request. The attorneys for Tornetta noted that, unlike the plaintiff in Southern Peru Copper, Tornetta and his counsel in the Tesla case had acted with “alacrity.”

The case is No. 2018-0408-KSJM.

Tuesday, March 05, 2024

Investors group petitions Commission for new rulemaking regarding traceability of shares

By Suzanne Cosgrove

The Council of Institutional Investors (CII) has urged the SEC to initiate new rulemaking that will make it easier to trace shares sold into the marketplace through both direct listings and initial public offerings and, in the process, protect investors’ rights under Section 11 of the Securities Act of 1933.

The CII said the urgency of its petition is in part a response to the Supreme Court decision Slack Technologies, LLC v. Pirani. The Court’s ruling affirmed that shareholders must be able to “trace” their shares to the registration statement covering them.

“Until recently, traceability was not an issue, given that underwriters generally imposed a lockup period for insiders and early investors after a registration statement became effective,” the CII stated in a letter sent to the Commission on February 29. “A lockup period prevented insiders and early investors from selling unregistered shares acquired before the public offering.”

Slack case offers context. As reported by Securities Regulation Daily last June, the Supreme Court backed corporations’ growing preference for direct listings over IPOs in a ruling involving the instant-messaging company Slack, which went public in 2019 through a direct listing. By bypassing the IPO process, holders of pre-existing unregistered Slack shares were able to sell them to the public immediately. The plaintiff in the related case bought shares on the day Slack went public and later, but his complaint did not allege the purchases were traceable to the registration statement that he claimed was misleading.

The Supreme Court concluded that the statutory context of Securities Act Section 11 required the plaintiff to trace his shares to the allegedly misleading registration statement. The Court’s decision resolved a prior split ruling created by the Ninth Circuit when it held 2-to-1 that the plaintiff had standing despite not tracing the shares to the registration statement in the defendant’s direct offering.

Proposed share tracing options. The CII noted a working group of academics and former SEC officials previously recommended that the Commission amend SEC Rule 144 to limit sales of unregistered securities for a certain period after the effectiveness of a registration statement.

But in its recent letter, the CII suggested three other technology-based options that would update and enhance the protections afforded under Section 11. Those technology-based solutions included:
  • Requiring that registered and exempt shares are offered in a direct listing trade with differentiated tickers, at least until expiration of the relevant Section 11 statute of limitations.
  • Migrating the clearance and settlement system to a distributed ledger system or to other mechanisms to allow the tracing of individual shares as individual shares, and not as fractional interests in commingled electronic book entry accounts.
Lastly, the CII referenced research by Professors John C. Coffee, Jr., and Joshua Mitts that advocated using computing power to trace the purchase of shares. As the study points out, broker-dealers, exchanges and FINRA all maintain detailed, timestamped transactional records that show when securities in one account are transferred to another account. The records are kept and stored electronically and are all contained within the Consolidated Audit Trail, the authors noted.

The existence of the data makes it possible to trace transactions using either first-in-first-out (FIFO) or last-in-first-out (LIFO) accounting assumptions for determining the cost of inventory. Those accounting assumptions could be adapted to provide for tracing all shares without relying on other methodologies, such as probability analysis that some courts view as inadequate, the CII said.

Monday, March 04, 2024

House FSC advances disapproval resolution on SEC’s SAB No. 121

By Mark S. Nelson, J.D.

The House Financial Services Committee, during an abruptly abbreviated markup last week, succeeded in advancing a Congressional Review Act (CRA) resolution that, if enacted, would disapprove the SEC’s Staff Accounting Bulletin (SAB) No. 121 on custody of crypto assets. The action comes just weeks after a bipartisan and bicameral group of lawmakers announced their intention to overturn the SEC’s guidance. The House FSC vote on H. J. Res. 109 was 31-19 to approve the resolution, with three Democrats joining Republicans in support of the resolution and with one Democrat and one Republican not voting. The Senate version of the resolution has not been acted on since being introduced.

The contents of SAB No. 121 are three Q&A-style sets of guidance, although it is the first question regarding how to account for the safeguarding of crypto assets that has drawn the most attention. The SEC stated that a crypto firm should enter a liability and asset on its balance sheet for any custodied crypto and that the value of the safeguarding liability and the asset should be the fair market value of the crypto assets held for platform users. The remaining Q&As deal with disclosure and the time frame for applying the guidance to financial statements.

“After Chair Gensler tried to tuck a major policy change into so-called staff guidance, the GAO ruled SAB 121 constitutes a rule,” said House FSC Chair Patrick McHenry (R-NC) in his opening remarks at the markup. “So now, our Committee is taking action to rescind this misguided rule and ensure Americans can custody digital assets in one of the safest ways possible—through highly regulated banks.”

According to an opening statement form House FSC Ranking Member Maxine Waters (D-Calif), Republicans on the committee risked stripping away clarity on crypto accounting rules by pursuing the CRA resolution. Said Waters: “This bulletin is non-binding SEC staff guidance intended to help clarify how a company should account for its customers’ cryptocurrencies. We often hear Republicans and the crypto industry complain about a lack of clarity from the SEC, but ironically, the resolution before us effectively blocks the SEC staff from providing that clarity around crypto.”

The GAO ruling mentioned by McHenry in his opening remarks was supposed to provide clarity on the status of a document the SEC typically considers to be guidance. Although the Administrative Procedure Act and the CRA may not provide a clear answer on this topic, the GAO and other sources suggest that the definition was intended to have a broader meaning that just notice and comment rulemaking.

Stephen Hall, Legal Director and Securities Specialist at Better Markets, issued a statement in advance of the markup questioning the wisdom of Congress overturning financial accounting guidance.

“It is therefore critical to consider whether Congress has the expertise to second-guess the judgment that the SEC has made in the bulletin regarding some highly technical accounting issues,” said Hall. “And wouldn’t the CRA resolution set a dangerous precedent of nullifying accounting requirements that are designed and intended to protect investors, customers, markets, and financial stability—especially given the extraordinary and demonstrated risks that the crypto markets pose?”

The Chamber of Digital Commerce also issued a blog post in early February when the CRA resolution was first announced. “Today’s bipartisan resolution represents a decisive action to ensure the SEC operates within its designated rulemaking authority,” said the Chamber of Digital Commerce. “By failing to issue SAB 121 in adherence with the rulemaking process, the SEC bypassed established procedures, compromising the integrity of the regulatory framework, and violating principles of transparent and inclusive governance.”

Friday, March 01, 2024

Commissioners offer guidance for advisory committee’s discussion of accredited investors, IPOs

By John Filar Atwood

As the SEC’s Small Business Advisory Committee prepared to discuss the definition of “accredited investor,” Chair Gary Gensler asked the committee members to consider when it is appropriate that investors get, or not get, full and fair disclosure about a securities offering. Regarding the committee’s second agenda item, the state of the IPO market, Gensler touted the recently adopted SPAC rules noting that just because a company uses an alternative method to go public does not mean that its investors do not deserve the same protections as a traditional IPO.

Commissioner Peirce. Commissioner Hester Peirce focused her remarks on the importance of letting investors decide how to invest their money. Investor protections that come in the form of prohibitions, such as the limitations included in the accredited investor definition, run contrary to persons’ right to decide for themselves how and where to invest.

Peirce also worried about the potential negative impact that changes to the accredited investor definition could have on angel networks that help new businesses get off the ground. She acknowledged that investing in young companies is very risky but said that empowering decision making with education is better than taking away one’s right to invest.

With respect to the IPO market, Peirce asked committee members to help identify the causes for the decline in the number of listed companies in the U.S. over the past 25 years. Some of the causes are outside the Commission’s control, she noted, but added that the SEC has a role in the rising costs of being a public company. She cited reports indicating that external reporting costs for public companies have outstripped inflation since 2000, and warned that they could rise further if the Commission moves forward with the climate rule.

Peirce encouraged the committee members to consider what are the most substantial regulatory cost-drivers for public companies, and what regulations dissuade them from going public. She also asked them to help the Commission decide how to better scale regulations to encourage companies to go public earlier in their life.

Commissioner Uyeda. Commissioner Mark Uyeda spoke about the accredited investor definition, suggesting that the SEC move away from an “all or nothing” approach where an accredited investor can invest 100% of his or her assets in a single private offering, but if he or she falls a dollar short of qualifying as an accredited investor, they cannot invest at all. He suggested that the Commission consider allowing an individual to invest up to certain percentages of a personal financial metric, like the aggregate dollar value of his or her securities investments, in private offerings.

Uyeda encouraged committee members not to be restricted by the past. Some have called for the net worth and annual income thresholds to be indexed to inflation from the levels established in 1982, he noted, but pointed out that this assumes that these levels were correct to begin with. That approach also assumes that net worth and annual income are the appropriate metrics for assessing an individual’s ability to invest in private offerings, he said. He advised committee members to develop recommendations free from decisions made over 40 years ago.

Uyeda also suggested that any regulatory approach to private offerings should focus on opportunity rather than paternalism, where the ability of more individuals to participate in private offerings is seen as a benefit, not a detriment. The paternalistic approach in which the government decides who can and cannot invest may harm the exact persons who it is trying to protect, he stated.

Uyeda noted that the Commission’s rules do not limit investments in public companies to only investors who meet certain wealth or income thresholds. Investors have their own tools to protect themselves from the risks of private investments, he said, including diversifying or just walking away from an investment. He encouraged committee members to remember that these other tools exist as they develop their recommendations.

Commissioner Lizarraga. Commissioner Jaime Lizarraga discussed how venture capital’s reach into disadvantaged communities remains very limited. In 2022, he said, Latino, African American, and women-only founders each received less than two percent of venture capital dollars.

Many of the small businesses included in those statistics lack access to traditional entrepreneurial ecosystems, or to the friends-and-family networks that can provide access to needed capital, he said. Due to the essential role these small businesses play in job creation, and in the success of their communities, it is essential that they benefit from the Commission’s capital formation tools and resources, Lizarraga concluded.

Thursday, February 29, 2024

As AI usage soars, academics, legal experts look for regulation blueprints

By Suzanne Cosgrove

In As AI Usage Soars, Academics, Legal Experts Look for Regulation Blueprints, Wolters Kluwer legal analyst Suzanne Cosgrove looks at the current state of U.S. regulation—or the lack of it—that addresses the benefits and perils of artificial intelligence applications. While major industries race to implement AI and worry about being left behind, a parallel race is taking place among academics and legal experts, who are drawing up proposals that promote basic standards and principles to guard against the technology’s misuse. Legislators and regulators seem to agree that the need for an innovative set of AI rules is critical—and urgent.

To read the entire article, click here.

Wednesday, February 28, 2024

Chancery invalidates stockholder agreement that tied board’s hands

By Anne Sherry, J.D.

The Delaware Court of Chancery struck down parts of a stockholder agreement that constrained the board’s authority to act. While Delaware allows corporations to contract, stockholder agreements containing veto rights and other restrictions conflict with the state’s board-centric model of governance. Provisions that compelled the board to recommend the stockholder’s designees for election; compelled filling a vacancy created by a departing designee with another designee; and enabled the stockholder to prevent the board from increasing the number of director seats were facially invalid under the General Corporation Law (West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, February 23, 2024, Laster, J.).

New-wave agreement. The court observed that stockholders have long contracted among themselves to address how they will exercise their stockholder rights. However, a “new wave” of agreements goes beyond this practice to enshrine extensive veto rights and other restrictions on corporate action. The new-wave agreement in this case required the board to obtain the stockholder’s prior written consent before taking virtually any action; ensured that the stockholder could select a majority of directors; and forced the board to populate committees with the same proportion of the stockholder’s designees as the full board.

These contracts are in tension with DGCL Section 141(a), which states that “the business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.” Even when a corporation has a controlling stockholder, Delaware corporations are managed by the board.

Section 141(a) claims. The court undertook an exhaustive review of Delaware cases analyzing Section 141(a) claims. These cases involved challenges to stockholder or director agreements; rights plans; CEO employment agreements; improper delegations of board power; termination of merger agreements; and bylaws. Only one case, Sample v. Morgan (Del. Ch. 2007), argued for ignoring the Section 141(a) framework entirely and evaluating contractual restrictions exclusively for compliance with fiduciary duties. This case “stands alone and on dubious ground” for acknowledging the twice-tested framework of Professor Berle and then discarding the first test—compliance with the technical rules governing the dispute.

Reviewing the Section 141(a) decisions led the court to formulate a two-step inquiry. First, is the challenged provision part of an internal governance arrangement? If so, then under Abercrombie v. Davies (Del. Ch. 1956), does the provision impose a restriction that violates Section 141(a)?

Governance factors. The court gleaned several factors that indicate a contract is part of a governance arrangement. Governance agreements frequently have a statutory grounding in a section of the DGCL (for example, stockholder agreements are rooted in Section 218(c) and (d)). Unlike in a standard commercial contract, counterparties in a governance agreement are likely to be officers, directors, or stockholders. The challenged provisions may seek to specify the terms on which intracorporate actors can authorize the corporation’s exercise of its power.

A fourth factor that distinguishes a governance agreement from a commercial contract is that the former does not reveal an underlying commercial exchange. Relatedly, the governance rights are not there to protect a commercial bargain; they are the point of the contract. The presumptive remedy of a governance arrangement will be equitable relief enforcing the bargained-for control rights. Finally, a governance arrangement is more likely than a commercial agreement to have durable, indefinite duration.

The case at hand. The preapproval provisions in this case leaned more towards governance arrangements. They were obviously included to preserve the stockholder’s control even in the event that his voting power dropped below a majority. They amounted to “prototypical governance provisions in a prototypical governance agreement.”

Accordingly, applying the Abercrombie test, the court held that the provisions were facially invalid. Because they expressly required the stockholder’s prior approval before the board could act, they went even further than the voting provision in Abercrombie, which threatened directors with removal after they acted. The provisions were “so all-encompassing as to render the Board an advisory body.”

The court rejected the company’s argument that the provisions could operate legitimately. Setting aside the deterrent effect of the requirements, the provisions do not formally constrain the board as long as the stockholder and the directors agree. But there would be no need for the provisions if the parties were in agreement. “In every setting where [the stockholder] enforces one of the Pre-Approval Requirements, the provision will operate invalidly to constrain the Board.”

Similarly, several of the agreement’s provisions relating to board and committee composition were facially invalid. Others, though, such as one giving the stockholder the right to propose a specific number of director candidates, did not impose any restriction on the board in violation of Section 141(a).

The case is No. 2023-0309-JTL.

Tuesday, February 27, 2024

Beyond ChatGPT: Using generative AI in legal practice

By Lene Powell, J.D.

Generative artificial intelligence (GenAI) has enormous potential to assist attorneys in legal practice, but high-profile mistakes have raised concerns. How can attorneys safely use this new technology?

Get tips for reliably using GenAI in legal research and drafting from University of Colorado Law School Professor Harry Surden, who presented recommendations at a symposium of Northwestern University Pritzker School of Law, “AI and Law: Navigating the Legal Landscape of Artificial Intelligence.”

A new Vital Briefing by Senior Legal Analyst Lene Powell, J.D. covers:
  • What is GenAI?
  • Using GPT-4 in legal practice
  • How reliable is it?
  • Techniques to improve reliability
Click here to read Beyond ChatGPT: Using generative AI in legal practice.

Monday, February 26, 2024

SEC updates staff ethics rules

By Rodney F. Tonkovic, J.D.

The SEC has updated the ethics rules governing the securities purchases and holdings of its staff. The amendments update the SEC’s Supplemental Ethics Rules and include amendments prohibiting investments in financial industry sector funds, enhancing data collection, and optimizing the use of agency resources. The amendments were adopted jointly with the Office of Government Ethics and amend existing SEC standards while supplementing ethical standards applicable to all Executive Branch employees. The rules will be effective 30 days after publication in the Federal Register (Supplemental Standards of Ethical Conduct for Members and Employees of the Securities and Exchange Commission, Release No. 34-99582, February 22, 2024).

The updates to the SEC’s Supplemental Ethics Rules, 5 CFR Part 4401.102, Supplemental Standards of Conduct for Members and Employees Securities and Exchange Commission include:

Prohibitions Against Financial Industry Sector Funds: The SEC has long prohibited employees from purchasing or owning securities in entities directly regulated by the agency. This prohibition has been expanded to include financial industry sector funds in order to avoid conflicts of interest and to assure the public that employees are not profiting from the Commission's access to material information. This prohibition also addresses the incongruity previously resulting from an SEC employee's theoretical ability to hold unlimited shares in a financial industry sector fund that concentrates holdings in directly regulated entities.

Enhancements to Data Collection: The proposal would have required the use of an automated system to collect reportable transactions and holdings. Taking into consideration commenters' concerns about privacy and cybersecurity, the final rules instead authorize the use of either an internal or third-party automated compliance system and permit rather than require employees to use an automated compliance system to comply with the reporting requirements. The existing 5-day transaction certification requirement has also been retained. The release notes that the technical requirements of any automated compliance system have yet to be determined.

Optimizing Efficient and Effective Use of Agency Resources: Existing regulations required all securities transactions (unless specifically exempted) by employees to be pre-cleared and then reported to the SEC. In order to focus on higher-risk trading and reporting, the pre-clearance, reporting, and holding requirements for "permissible diversified investment funds" have been eliminated. These permitted funds include diversified registered investment companies, money market funds, 529 plans, and diversified pooled investment funds, all of which pose little or no risk of conflicts of interest for members and employees, the Commission says.

"I was pleased to support today's adoption of rules to strengthen the SEC’s ethics requirements," said SEC Chair Gary Gensler. "These amendments modernize our compliance program and will help ensure the SEC honors the trust the public has placed in our agency."

The release is No. 34-99582.

Friday, February 23, 2024

Crypto exchange files suit challenging SEC jurisdiction

By Anne Sherry, J.D.

A digital assets company and a trade association are challenging the SEC’s assertion of jurisdiction over crypto. In the complaint against the SEC in a Texas district court, Lejilex and Crypto Freedom Alliance of Texas ask for a declaratory judgment that Lejilex’s crypto exchange is not subject to SEC registration and that the crypto trades on the exchange are not sales of securities (Lejilex v. SEC, February 21, 2024).

Lejilex is a Texas corporation that intends to operate the Legit.Exchange platform, allowing users to trade digital assets in blind bid/ask transactions. Lejilex will not take custody of the assets but will handle administrative functions. The idea is to provide the benefits of non-custodial smart contracts while maintaining the high standards required by large financial firms. Lejilex is also a member of the trade-association plaintiff, the Crypto Freedom Alliance of Texas.

The complaint pushes back against the SEC’s assertion that digital asset transactions are investment contracts because they are expected to appreciate due to the efforts of others. Using that logic, the plaintiffs say, buying Nike sneakers to resell is a securities transaction because the flipper expects to turn a profit based on Nike’s managerial and promotional efforts.

The plaintiffs also invoke the major questions doctrine, a key issue in the SEC’s ongoing action against crypto giant Binance. Congress has not only declined to grant the SEC authority over crypto, the complaint states, but it is considering assigning at least some of that authority to the CFTC. “Given those circumstances, there is no support for the proposition that Congress back in the 1930’s conferred on the SEC regulatory authority over the entire digital asset industry—let alone over the myriad other commodities and assets that the SEC’s sweeping approach would cover.”

In a press release, the plaintiffs echoed the sentiments of other crypto industry players who wished the SEC would work with rather than against them. “We wish we were launching our business instead of filing a lawsuit, but here we are,” said Lejilex cofounder Mike Wawszczak. “Fear of rogue enforcement should not be a thing entrepreneurs are forced to experience.”

Crypto Freedom Alliance of Texas launched last September to advocate for clear and consistent crypto regulation in the state. “Amidst the failures of the federal government to pass sensible legislation regulating digital assets, there is an enormous opportunity for Texas to take a proactive stance by embracing pragmatic and forward-thinking crypto regulations,” states a press release from the launch. Kinjal Shah, Crypto Freedom Alliance of Texas Chair and General Partner at Blockchain Capital, said, “Texas should move forward and lead by example with sensible crypto policies that protect consumers and investors, and foster innovation.”

The case is No. 24-cv-00168.

Thursday, February 22, 2024

Muni regulator withdraws adjusted rate card

By Mark S. Nelson, J.D.

The Municipal Securities Rulemaking Board has withdrawn its proposed rate card that would have adjusted assessments for dealers and municipal advisors. The adjusted fees were put in place late last year and were briefly in effect, but criticism from the industry prompted the SEC to temporarily suspend the MSRB’s changes and to simultaneously institute proceedings to determine whether to approve or disapprove the MSRB’s revised fee structure.

Last summer the MSRB approved adjustments to the rate card that would allow for the MSRB to fund its operations. For FY24, the regulator sought an annual expense budget of $47.4 million, or about 4.8 percent above the FY23 amount. As a result, the underwriting fee would have increased from $0.0297 to $0.0371, and the municipal advisor professional fee would have increased from $1,060 to $1,160. The MSRB's withdrawal of the rate card means that fees will revert to the FY23 levels, at least until the MSRB submits a new funding proposal.

A public comment from a collection of industry groups said the MSRB’s budgeting process lacked transparency to a degree that it was difficult to understand if the proposed fees are reasonable under the applicable statute. The groups also expressed concern that the MSRB’s spending plans may not be sufficiently linked to its Congressional mandate.

“The MSRB's budgeting and rate-setting strategy is alarmingly opaque and troubling, particularly as it entails formulating spending plans before securing revenues to meet these financial targets,” said the groups. “Our interest in this area is great, since MSRB budget increases lead to underwriter and municipal advisor fee increases.”

The MSRB responded to industry comments shortly before the SEC temporarily suspended the rule proposal. Said the MSRB: “The MSRB understood when it first established the Rate Card Process that it would need to review its implementation to ensure that it was operating as intended and that the Rate Card Process would evolve over time. The MSRB will undertake such retrospective review of the Rate Card Process in light of the input received from commenters and the MSRB’s experience implementing the first rate adjustment to establish the 2024 Rate Card Fees.”

In a footnote to this passage, the MSRB observed that the rate card process was begun during a time when trade count was initially at record low levels (2021) but then surged to record high levels (2023).

The MSRB’s reply letter also said its retrospective review would consider public comments regarding a variety of topics, including: (1) the role of volatility and predictability with respect to rate setting and the potential that rates may have adverse effects; (2) achieving a balance between fees imposed on dealers and those imposed on municipal advisors; (3) financial transparency; and (4) outreach to the municipal securities industry. On this last point, the MSRB noted its Congressionally designated role in rate setting but suggested that it could mull a more formal process for seeking industry views on its final rate setting process.

The SEC’s suspension order acknowledged the MSRB’s attempt to provide more information about the reasonableness of the rate card process but also indicated that those efforts had come only recently. “However, due to the date of receipt of the MSRB Letter (i.e., late afternoon one business day before the suspension deadline), the Commission has not had sufficient time to evaluate the material included therein.” The temporary suspension, added the SEC’s order, will give the agency time to further assess the reasonableness of the MSRB’s rate card proposal.

Wednesday, February 21, 2024

Technology experts explore the pitfalls, promises and impact of generative AI on expert witness work

By Collin Starkweather, Izzy Nelken, and Jey Kumarasamy

Without doubt, recent rapid advances in generative AI (Gen AI) technologies have captured the attention of the legal community as a wide range of legal professionals look to adapt their practices to an ever-changing legaltech landscape. These changes are also having a profound impact on the work carried out by expert witnesses who now must navigate and address a host of complex issues as a result of the emergence of GenAI.

In an article, Dos and Don’ts for GenAI in Expert Work, the authors explore some of the significant potential pitfalls confronting expert witnesses in an environment where GenAI tools have become ubiquitous. In clear and concise fashion, the article discusses potential applications of GenAI in expert witness work based on the current state of the art and anticipated near-term development in the technology. The authors also take a hard look at some of the caveats that arise when applying GenAI in an expert witness setting. Finally, the piece provides a comprehensive set of practical recommendations for best practices when using GenAI for expert witness undertakings.

To read the entire article, click here.

Tuesday, February 20, 2024

New Hampshire lawmakers reject anti-ESG bills

By Anne Sherry, J.D.

A New Hampshire Senate committee voted last week to recommend against an anti-ESG bill. The bill would require a public retirement system fiduciary to “take into account only financial factors” and lists examples of ESG factors that would be considered non-financial. A House bill that would have made it a felony for a public pension fund to consider ESG factors was struck down by voice vote last week.

Senate bill. SB 520 would redefine the term “fiduciary” from the current definition modeled on the Internal Revenue Code. The bill would require pension fiduciaries to consider only financial factors and would define “financial” as excluding actions taken “to further social, political, or ideological interests.” It lists categories of ESG factors that could be considered furthering such interests, including considerations around greenhouse gas reductions and other environmental standards; board diversity; abortion access; access to gender-affirmation surgery; and divestment from weapons manufacturers.

In its report of “inexpedient to legislate” (ITL), the Senate Committee on Executive Departments and Administration said that it heard testimony that the New Hampshire Retirement System (NHRS) already acts solely out of fiduciary duty and that the bill could prohibit the pension system from investing in well performing companies.

House bill. Two weeks ago, HB 1267 was struck down by a voice vote of the full House adopting the committee report of ITL. The bill would have made it a felony to invest public retirement or taxpayer funds “knowingly in a manner violating fiduciary duty concerning environmental, social, and governance (ESG) criteria.” Notes on the bill’s methodology include concerns raised by some stakeholders: the state Treasury said that the bill could conflict with laws and executive orders requiring it to maximize financial benefits for the state, and NHRS said the restrictions could reduce investment returns.

Pension’s position. The NHRS board met earlier this week to discuss the Senate and House bills, among other matters. Minutes from the meeting include a draft resolution opposing the bills, noting, “Environmental, Social, and Governance (ESG) or any other non-pecuniary factor is never considered as an end unto itself but is one of many factors viewed in regard to its potential impact on our ability to obtain the highest return for New Hampshire’s active and retired public employees and their beneficiaries.”

NHRS notes that in 1987, it opposed a bill that would have required it to divest from companies doing business in Northern Ireland that failed to take affirmative action under the MacBride Principles. “At the time, external legal counsel warned NHRS that legislation adding non-fiduciary factors to the use of retirement funds would mean that these funds would be no longer used for ‘the exclusive purpose’ of providing benefits,” the resolution states.