Friday, January 18, 2019

Tax-withholding transactions were not short-swing profits

By Rodney F. Tonkovic, J.D.

A Tenth Circuit panel affirmed a district court judgment that alleged short-swing profits were exempt from disgorgement. Because the tax-withholding transactions at issue were both non-discretionary and approved in advance, they satisfied an exemption from Section 16(b)'s general requirement that short-swing profits be disgorged. The decision was made on the briefs, without oral argument, and is not binding precedent (Olagues v. Muncrief, January 16, 2019, per curiam).

This derivative action was brought by a shareholder of WPX Energy, Inc. against the company and two of its officers. As part of a compensation plan, WPX executed restricted stock unit (RSU) agreements with the officers, with the right to receive the shares on predetermined vesting dates. When the shares vested, they triggered certain tax-withholding requirements outlined in the RSU agreements, and WPX withheld a portion of the officers' shares to pay the tax obligations associated with the awards.

Short-swing allegations. After discovering the tax-withholding transactions, the shareholder accused the officers of engaging in improper short-swing sales and demanded recovery of $384,924 in alleged short-swing profits under Section 16(b). The shareholder rejected WPX's explanation that the transactions were exempt. Instead, he offered the choice of resolving the matter by paying him a "consulting fee" or going to court. In a footnote, the court noted that the shareholder has filed similar lawsuits in California, Colorado, Delaware, Florida, Massachusetts, North Carolina, Ohio, Texas, and Washington.

The district court in Oklahoma agreed that the transactions were exempt from disgorgement under Rule 16b-3. The rule provides an exemption from disgorgement for, as relevant here, non-discretionary transactions that are "approved in advance" by the issuer's board or an independent committee. The shareholder argued that the payment of tax liability was discretionary because payment of the taxes was deferred under IRS rules. The court concluded, however, the dispositions of stock were non-discretionary tax withholding transactions that were specifically contemplated in the RSU agreements.

Exempt from disgorgement. On appeal, the shareholder again argued that the tax-withholding dispositions were purely discretionary. He also maintained that even if the dispositions were non-discretionary, they were not "approved in advance" because the board's compensation committee did not specifically approve each individual transaction. The panel disagreed on both points.

In arguing that the dispositions were discretionary transactions, the shareholder pointed to language in the RSU agreements that, he claimed, gave WPX unfettered discretion to refuse to hold the shares. This, the panel said, was a selective reading of the provision that omitted important qualifying language pertaining to taxes becoming due prior to a vesting date, which was not the case here. The applicable portion of the withholding provision made it clear that the tax-withholding transactions at issue (after vesting) were mandatory and thus non-discretionary under Section 16b-3(e).

Finally, the panel determined that the tax-withholding transactions were also "approved in advance" by the compensation committee. The panel explained that the withholding provision adequately identified a fixed time, manner, and amount of the withholdings. Since these terms and conditions were sufficient, the subsequent exercise of the withholding required no further approval. The panel accordingly affirmed the district court's grant of summary judgment in favor of WPX and the officers.

The case is No. 18-5018.

Thursday, January 17, 2019

Webinar explores the evolving SEC whistleblower minefield

By Brad Rosen, J.D.

Since the establishment of SEC’s whistleblower program in 2012, which was part of the 2010 Dodd-Frank market reform legislation, more than $326 million has been awarded to 59 whistleblowers. Enforcement actions resulting from whistleblower tips have resulted in more than $1.7 billion in remedies, with approximately $900 million of that amount being returned to victimized investors as the disgorgement of ill-gotten gains.

In FY 2018, the SEC’s Office of the Whistleblower (OWB) received 5,282 whistleblower tips from all 50 states, the District of Columbia, and 72 foreign nations. Notably, more money was awarded to whistleblowers in FY 2018 than all prior years combined, including three of the program’s largest awards – a $49 million joint award to two individuals, as well as individual awards of $39 million and $33 million.

With these developments as a backdrop, a panel of experts came to together to discuss a multitude of legal and regulatory issues in a Securities Docket webinar titled Navigating the Minefield of Dodd-Frank’s Whistleblower Provisions (2018 Update). The conversation focused on developments within SEC’s OWB, the recent Supreme Court decision in Digital Realty Trust, Inc. v. Somer, the SEC’s resulting implementing regulations, as well as some key takeaways for compliance professionals. Panelists included Gibson Dunn attorneys Joseph Warin, John Chesley, Amanda Machin, Nicole Lee, as well as Sean McKessy from Phillips and Cohen LLP, a former SEC OWB chief, and Jim Barratt, a managing director from Ankura Consulting Group.

Digital Realty Trust, Inc. v. Somer revisited. The Supreme Court’s decision in early 2018 in Digital Realty Trust was front row and center in the panel’s discussion. In that case, the Court held that the whistleblower provisions of the Securities Exchange Act require that a person report a possible securities law violation to the SEC in order to qualify as a whistleblower protected against employment retaliation under Section 21F(h) of the Dodd-Frank legislation, and thereby invalidated the Commission’s rule interpreting that provision’s anti-retaliation protections to apply regardless of whether a report of possible securities law violations was made to the Commission, to a different government agency, or internally to an employer.

Proposed amendments to SEC Rule 21F being considered. The panel also noted that following the Digital Realty ruling, the Commission proposed amendments to bring the whistleblower rules in line with the holding of the Supreme Court. These proposed amendments would:
  • Incorporate a uniform definition of “whistleblower” covering only those who report to the SEC in accord with the statutory definition per Digital Realty Trust;
  • Permit the SEC to include amounts collected in connection with deferred prosecution agreements, non-prosecution agreements, and other alternative settlement vehicles in the calculation of “related action” awards;
  • Permit the SEC to consider the size of small (greater than $2 million) and large (less than $30 million) awards in setting the appropriate percentage of awards;
  • Permit the SEC to bar permanently applicants who submit multiple frivolous applications;
  • Create summary disposition procedures for non-conforming applications; eliminate potential duplicative recoveries for “related actions” subject to separate whistleblower award schemes; and
  • Clarify and enhance certain other policies and procedures. 
The public comment period for the proposed amendments ended in September 2018, with the SEC currently considering 100 unique comment submissions.

Some key takeaways for compliance personnel. Jim Barratt from Ankura Consulting Group had some suggestions for compliance personnel in light of recent developments in the whistleblowing space. His observations include the following:
  • Internal compliance processes are even more important in post-Dodd-Frank world. The Digital Realty Trust decision may encourage employees to bypass internal reporting processes and go directly to the SEC with complaints. Accordingly, companies should review compliance & HR policies and procedures to ensure that internal reporting is easy, accessible, and perceived as corporate priority.
  • 120 Days is the new standard for corporate internal investigations. In two separate rules passed as part of Dodd-Frank regulations, the SEC chose 120 days as key milestone for investigations. Moreover, internal investigations that place a company in position to make disclosure decision within 120 days should be deemed presumptively reasonable.
  • There is a need to adjust the voluntary disclosure calculus. Now, with the clear requirement that an individual report to the SEC to be protected against retaliation under the Dodd-Frank Act, together with growing whistleblower awards and plaintiffs’ bar, expect more external reporting overall. Highly publicized anti-retaliation enforcement actions are likely to encourage external reporting of not only securities fraud, but also of related misconduct.
Lastly, the panelists were in general agreement that the Dodd-Frank whistleblower provisions are likely here to stay. Notwithstanding campaign promises by President Trump of “dismantling” Dodd-Frank, the whistleblower program is somewhat an exception in that it has enjoyed broad bipartisan support.

The webinar can viewed in its entirely on replay by clicking here.

Wednesday, January 16, 2019

IAA voices concerns about proposal for portable retirement investment accounts

By Amanda Maine, J.D.

The Investment Adviser Association (IAA) weighed in on a proposal from Sen. Mark Warner (D-Va) and Rep. Jim Himes (D-Conn) for a new approach on a universal and portable retirement savings account for Americans that have frequent job turnover and those who use alternative work as their primary jobs. IAA warned of possible unintended consequences of the proposal and stressed the importance of investor choice and access to different investment strategies.

PRIA proposal. The legislators’ proposal, which was published in the form of a white paper and not actual legislation, discusses the establishment of Portable Retirement and Investment Accounts (PRIAs). According to Warner and Hines, fewer workers are staying at a single employer for decades as they have in the past. The white paper also discusses “alternative work arrangements” that play an increasingly significant role in the economy, such as independent contractors, part-time workers, and gig workers.

The white paper emphasizes that PRIAs are not meant to replace 401(k)s, IRAs, and other existing retirement accounts. Instead, the PRIA plan should fill gaps in the retirement savings market that hurt workers who change jobs often or are employed in alternative work arrangements.

The white paper outlines four principles for the proposed PRIA: that it is universal, portable, simple, and smart. On the universal principle, the white paper states that every American will get a PRIA, which is created when a person is provided a social security number.

Regarding the portable principle, the white paper stresses that many Americans do not have the benefits of a workplace plan, and that a PRIA plan would follow an account that travels from job to job. Employers that do not offer a workplace retirement plan would be required to provide direct deposit of employee elective contributions to the PRIA for every worker on their payroll. “Gig economy” employers would also have to offer direct deposit to the PRIA. “As workers move among these jobs, the PRIA travels with them,” the white paper states. It would also make rolling over accounts easier, and it would not disrupt the existing retirement system.

Regarding simplicity, the white paper asserts that a new federal entity called the PRIA Board would be a “one-stop shop” for helping Americans save in a PRIA. The PRIA Board would also help savers reclaim funds from accounts they lost, such as through a company that has gone bankrupt or where the employee left sponsoring business years ago which lost track of the employee’s retirement fund.

The white paper also says the PRIA would be “smart” in that it offers two types of accounts: PRIA Basic and PRIA Choice. PRIA Basic would be the default account for every American; the PRIA Board would oversee this plan by hiring a private sector firm to develop investments and administer accounts. PRIA Choice, to which a saver can convert their PRIA Basic, would be fully administered and managed by a private financial institution.

IAA concerns. IAA’s letter advises that while it appreciates the proposal for its attempt to fill a gap in the retirement system, it implores that its authors be cognizant of possible unintended consequences of such a proposal should it be enacted into law.

IAA is concerned about the proposal would make financial institutions compete with one another not only on the basis of their fees, but also on the “desirability” of investment choices. According to IAA, this might mean that only passively-managed investment strategies would be considered for either PRIA plan. Government policies should not explicitly or implicitly favor one type of investment management over another, IAA stressed.

In the same vein, IAA urged policymakers not to assume that passive investment strategies are inherently less risky than active investment strategies, especially because risk management is a key component of many active retirement investment strategies. “Retirement policies should recognize the importance of preserving investor choice and access to a range of investments and investment strategies,” IAA concluded.

Tuesday, January 15, 2019

3M may exclude proposal to impose holding periods on stock and options

By Amy Leisinger, J.D.

The Division of Corporation Finance would not recommend enforcement action if 3M excludes a proposal directing its compensation committee to ensure that stock and option awards to “corporate officers” are subject to a holding period of at least five years. According to the staff’s letter, 3M demonstrated a basis for its view that it may exclude the proposal under Rule 14a-8(i)(7) as relating to the company’s ordinary business operations.

Bases for exclusion. In its request, 3M argued that the proposal to implement a restricted period for officers’ stock and stock options is not a proper subject for action under Delaware law (its state of incorporation) and also would require the company to violate Delaware law. The state’s General Corporation Law provides that the affairs of a Delaware corporation are to be managed by the board of directors except as otherwise provided in the law or in the company’s certificate of incorporation, and 3M’s bylaws specifically provide that the company’s business and compensation of officers is to be managed by the board of directors, the company explained. According to 3M, the proposal also would interfere with the board’s authority to issue stock and options upon the terms that it deems advisable and cause the company to breach existing contractual obligations by imposing a transfer restriction on outstanding shares in violation of Delaware law. As such, 3M also lacks the power or authority to implement the proposal, the company noted.

The company also contended that the proposal is vague and indefinite in violation of Rule 14a-9 in that it fails to define certain terms and to provide guidance on how the proposal would be implemented. Specifically, according to 3M, the proposal does not define the word “redeemed” in its proposal to prevent stock options to be redeemed with a five-year period. In addition, the company noted, the proposal does not define its use of the terms “restricted stock” or “restricted period.” The possibility of multiple, conflicting interpretations would prevent stockholders and the company from determining with certainty exactly what measures the proposal requires, 3M argued.

The proposal also deals with matters relating to the company’s ordinary business operations, 3M noted, and the staff has permitted other companies’ exclusion of proposals seeking to regulate the compensation of a broader class of employees than the company’s senior executives under Rule 14a-8(i)(7). The staff also has previously noted that a compensation proposal may be excludable as relating to ordinary business if it applies to any person not a senior executive officer or a director, and the proposal’s use of the term “corporate officers” covers employees who would not be considered senior executives, 3M stated.

The staff agreed with 3M’s position that the company may exclude the proposal as relating to its ordinary business operations and found it unnecessary to address the alternative bases for exclusion. The staff also noted that the proposal relates to compensation generally and is not limited to that to be paid to senior executive officers and directors.

Related legislation. The issue of restricted periods applicable to stock and stock options could, however, become a consideration for companies in the future, as both the House and Senate introduced legislation last year containing provisions to impose a holding period on equity securities held by an officer or director of a corporation. Under the Accountable Capitalism Act, these individuals would be prevented from selling, transferring, or assigning a security owned with respect to that corporation in exchange for value for five years, other than in connection with the sale of the corporation or through a will or the laws of descent.

Monday, January 14, 2019

ISS predicts California law will drive nationwide upswing of female board directors

By Lene Powell, J.D.

A new study by ISS finds that California’s new law requiring public companies to include female directors on their boards could have “significant reverberations” for the entire U.S. market, potentially increasing the number of women on U.S. boards by 22 percent. The law begins to kick in this year and ISS says that many companies have a long way to go, with 89 percent of California-based companies needing to make changes to their boards` in the next three years to meet requirements. ISS believes the law will contribute to gender diversity despite potential legal challenges that could derail implementation.

The study’s findings were detailed in a post by ISS staff Mikayla Kuhns, Rudy Kwack, and Kosmas Papadopoulos.

California follows Europe. As the first legislation in the country to address gender in board composition, S.B. 826 was signed into law on September 30, 2018. The law applies to publicly held domestic general corporations or foreign corporations whose principal executive offices are located in California, as stated on the corporation’s SEC 10-K form.

According to the phased-in implementation, the law will first require company boards to have at least one woman by the end of 2019. By the end of 2021, companies with boards of five directors must have at least two women on their boards, and companies with six or more directors on their boards must have at least three women directors. Penalties for violations are stiff, with fines of $100,000 for an initial violation and $300,000 for a second or subsequent violation.

The law follows the example of legislation in this area in other countries. Norway led the trend in 2007 by requiring all public company boards to have a gender balance of at least 40/60. Many European countries have followed suit, with specific requirements varying by country. The European Commission has proposed to require a minimum 40-percent gender balance for non-executive directors.

By the numbers. Applying certain filters to ISS Analytics data, the study found the following statistics:
  • About one-third of California-based companies (217) lack any female director, so will need to appoint at least one female director by the end of 2019.
  • Of the 689 companies with executive offices in California, only 78 companies (11 percent) fully comply with the 2021 requirements. Nearly two-thirds of the companies with market capitalization greater than $10 billion do not have enough women on their boards to meet the 2021 mandate.
  • California lags in board gender diversity, particularly in the information technology and health care sectors. California ranks 37th among U.S. states in percentage of large-cap companies (market capitalization greater than $1 billion) with at least two women on the board.
ISS believes that compliance with the new law will result in women occupying 1,159 new public company board seats. This could lead to an approximately 22 percent increase of female directorships nationwide.

However, ISS’s conclusions were met with skepticism by Allen Matkins partner Keith Paul Bishop, who noted that the study authors did not explain how they determined director gender or clarify whether companies excluded by the law were included in the statistics.

Potential legal snags. The new law faces possible legal opposition. A coalition of business groups led by the California Chamber of Commerce argued three objections in a letter to the state senate prior to the bill’s passage:
  • Focus on gender potentially elevates it as a priority over other aspects of diversity. The group believes that a comprehensive approach covering all classifications is more productive.
  • The law violates the U.S. Constitution, California Constitution, and California civil rights law. Displacing male directors would illegally discriminate against them, said the group.
  • The law conflicts with the Internal Affairs Doctrine of Corporations Code Section 2116, because it applies to publicly traded corporations that have principal executive offices in California but are incorporated in another state. Under the internal affairs doctrine, the laws of the state where the company is incorporated apply, not the law of where the principal executive offices are located.
Former governor Jerry Brown noted possible legal issues upon signing the bill, saying he “did not minimize the potential flaws that indeed may prove fatal to [the law’s] ultimate implementation.” But whatever the outcome, ISS expects the law to enhance the existing momentum towards greater gender diversity at U.S. boards.

Friday, January 11, 2019

Questions are raised about investors' profit expectations

By Rodney F. Tonkovic, J.D.

A Fifth Circuit panel remanded a civil enforcement action after finding that there was an issue of fact as to whether partnership interests were really securities. The panel concluded that there were issues of material fact as to whether the investors had any real power over their investments, if they had relevant business experience, or if the managers were effectively irreplaceable (SEC v. Arcturus Corporation, January 7, 2019, Stewart, C.).

In this case, a group of promoters, including Arcturus Corporation, sold interests in oil gas projects to investors. The interests were not registered as securities, and the SEC filed this action in December 2013, alleging violations of the antifraud and registration provisions of the securities laws.

Joint ventures were securities? After about a year and a half of discovery, both parties filed for summary judgment. The district court ruled in favor of the Commission, finding that the interests qualified as securities. The court rejected the promoters' argument that the investments were joint ventures, and thus not securities, because the investors lacked any real power, were inexperienced, and were dependent on the promoters to control the ventures.

Joint ventures were not securities. On appeal, the circuit court reversed and remanded the district court's decision due to significant issues of material fact. Before the district court, the parties agreed that only one Howey factor was at issue: whether the investors expected to profit solely from the efforts of the defendants. In the Fifth Circuit, analysis of this factor is governed by Williamson v. Tucker (5th Cir. 1981), and, as noted, the district court concluded that the drilling interests qualified as securities under the three Williamson factors; a party needs to satisfy only one factor.

The first Williamson factor examines whether the investors had any real power to control the drilling projects. Here, the panel examined the documents setting up the arrangement and how that arrangement functioned in practice. The court concluded that the record showed: (1) the investors had formal powers, (2) they used these powers, (3) the voting structure was not necessarily coercive, (4) the investors received information, (5) they communicated with each other, and (6) the number of investors was not so high that it eliminated all of their power.

The second factor looks at whether the investors were so inexperienced that they could not intelligently exercise their powers. The Commission pointed to the defendants' cold-calling campaign that did not specifically seek experienced investors and to statements by four investors that they lacked experience in drilling investments. The record showed, however, that the investors not only had experience in oil and gas drilling, but that the promoters made it clear that only qualified investors were eligible. Taken together, these facts raised an issue about the investors' knowledge and experience, the court said.

Finally, the third Williamson factor concerns how dependent the investors are on any unique capabilities that the managers possess. Despite the SEC's arguments to the contrary, the panel was not convinced by the record that the managers were contractually irremovable. And, while the managers controlled the investors' funds, with no ability to recoup, this did not make them irreplaceable because the investors knew they would not get their money back unless the wells were productive. In addition, the investors were plausibly able to cut management out of contracts for operations subsequent to the exploratory phase of operations.

In sum, the panel concluded that the promoters raised issues of material fact that the district court failed to consider. The judgment was accordingly reversed and remanded.

The case is No. 17-10503.

Thursday, January 10, 2019

Constitutional challenge lodged against SEC gag regulation

By Rebecca Kahn, J.D.

Non-profit think-tank and publisher The Cato Institute has brought an action against the SEC seeking declaratory judgment that the 1972 “Gag Regulation” is unconstitutional under the First Amendment. Cato claims injury because a specific gag order prevents it from publishing an entrepreneur’s account that he was the victim of an overzealous SEC investigation (Cato Institute v. SEC, January 9, 2019).

Settlement terms. An American entrepreneur contracted with Cato to write a book about his experience at the center of an SEC investigation. Although the SEC agreed to settle his case with no admission of wrongdoing, no details could be revealed because, as part of the settlement, the SEC demanded that he agree to a gag order under Gag Regulation 17 C.F.R. Section 202.5(e), prohibiting him from ever discussing his case or even criticizing the agency’s handling of it.

Banned book. The entrepreneur wrote and sent a manuscript to Cato, telling the story of how he believes he was the victim of egregious government overreach at the hands of overzealous officials: how he had personally done nothing wrong, yet the government leveraged the threat of crippling fines and the prospect of years of costly litigation to extract a settlement from him when he ultimately admitted no wrongdoing. In 2018, Cato signed an agreement to publish the manuscript. But publishing the book is actually illegal. Moreover, Cato claims that the Gag Regulation prevents Cato from presenting panel discussions or other forms of public dialogue featuring individuals who have been subject to SEC enforcement actions.

Legal action. Represented by the Institute of Justice (IJ), Cato challenges the SEC’s use of gag orders to prevent parties to settlements from questioning or criticizing the agency. The complaint argues that doing so presents an unconstitutional, content-based restriction on the freedom of the press in violation of the First Amendment. The civil rights complaint “seeks to end the federal government’s decades-long use of gag orders in violation of the First Amendment . . . and to vindicate the Cato Institute’s basic First Amendment right to publish a book critical of official government conduct.”

Gag regulation. Since 1972 when the SEC first adopted the gag order policy, it has been a non-negotiable term of settlement in hundreds of cases, including, most recently, Elon Musk’s settlement. To justify the policy, the SEC explained that “it is important to avoid creating, or permitting to be created, an impression that a decree is being entered or a sanction imposed, when the conduct alleged did not, in fact, occur.” In other words, the IJ press release states, the SEC demands gag orders in order to prevent bad publicity about its enforcement activities.

The SEC is not alone in its use of non-negotiable gag orders. Following the SEC’s lead, the Consumer Financial Protection Bureau, the Commodity Futures Trading Commission, and numerous state agencies have adopted similar policies.

“The government cannot strip Americans of their First Amendment rights and impose a gag order, just because it wants to evade public oversight or criticism,” said IJ Senior Attorney Robert McNamara. “The best way to determine if government agencies are overstepping their bounds is to have a public debate about it, which is exactly what the SEC is suppressing by unconstitutionally imposing gag orders.”

As Cato and others have argued, the Commission’s use of “neither admit nor deny” settlements allows the government to impose punishment without actually establishing that any law was broken. The result is a system where the press and the public hear only one side of the story: The SEC issues press releases detailing its allegations at the beginning of an enforcement action, and then it enters into settlements in which the accused is forced to promise never to dispute any of those allegations in public.

In a December 11, 2018 hearing on SEC oversight by the Senate Committee on Banking and Urban Affairs, Sen. Tom Cotton (R-Ark) quizzed SEC Chairman Jay Clayton on the SEC’s policy. Clayton defended the no-admit-no-deny policy, stating that it has been an effective means to reach settlements and is in the interest of the public. “If we can settle matters quickly, we can move on to other matters. The no-admit-no-deny approach has enabled us to get to settlements, to get people their money back, [and] get bad actors out of the marketplace,” Clayton said. Cotton questioned whether the policy amounts to a prior restraint on speech which is content-based and therefore a violation of the First Amendment. Clayton replied that “the First Amendment does not permit all speech without sanction: you can't commit fraud.” Clayton added that the SEC’s policy is meant to “restrict people who have done prior wrong from telling people, ‘pay no attention to that.’”

“It is vital for citizens of a democracy to know how their government operates, particularly when it accuses fellow citizens of wrongdoing,” said Cato Institute Vice President for Criminal Justice Clark Neily. “The SEC’s policy of demanding lifetime gag orders as a condition of settlement flouts the First Amendment and prevents publishers like the Cato Institute from educating the public about the true nature and behavior of government.”

“Nothing is more fundamental to the First Amendment than an American’s right to publish a book critical of the government,” said IJ Attorney Jaimie Cavanaugh. “The SEC shouldn’t be in charge of deciding who is allowed to criticize the SEC. The government cannot use the threat of ruinous prosecution to ward off criticism of its actions.”

Wednesday, January 09, 2019

2018 finishes with 234 IPOs, a 24 percent increase from 2017

By John Filar Atwood

The IPO market limped to the finish line in 2018 with the holidays and substantial unrest in the broader markets keeping new issues on the sidelines for the last few weeks. Even so, the year tallied 234 deals, a 24 percent increase over 2017’s 189 IPOs. The aggregate offering proceeds for the year were $56.3 billion, a significant improvement over the $44 billion raised by 2017’s IPOs. Last week, no new issues were completed for a third straight week, and December finished with nine completed deals. That was one fewer than in November, and two fewer IPOs than last December.

New registrants. The week’s activity included three new registrations, including China-based software provider Powerbridge Technologies. The company is hoping to raise $15 million for its business of providing software and solutions to government and corporate organizations engaged in global trade. Powerbridge will continue to be controlled by its CEO following the offering. Genetic engineering company Poseida Therapeutics also registered. The company develops T-cell treatments for hematological malignancies and solid tumors. Super League Gaming, a California-based e-sports company, is planning a $25 million IPO. Super League offers a cloud-based amateur e-sports content platform to serve gamers around the world. The company enlisted Northland Securities as first lead manager. Northland last served as lead underwriter on a completed IPO in June 2017. The pace of new registrations slowed to 14 in December from 16 in November, and 19 in December 2017. The year ended with 268 preliminary IPO registrations, 45 more than were filed in 2017.

Withdrawals. October 2017 registrant WatchGuard was the lone company to withdraw last week. The provider of mobile video solutions for law enforcement has decided not to pursue an IPO at this time. The company never amended its initial public registration. Four Forms RW were filed in December, which is one more than in November and three more than last December. The final tally for 2018 was 38 withdrawals, up from 31 in 2017.

The information reported here is gathered using IPO Vital Signs, a Wolters Kluwer Regulatory U.S. database that includes all SEC registered IPOs, including REITs and those non-U.S. IPO filers seeking to list in the U.S. markets. IPO Vital Signs does not track closed-end funds, best efforts or non-underwritten deals, or IPO offerings for amounts less than $5 million.

Tuesday, January 08, 2019

Investment adviser group opposes more regulation of proxy advisory firms

By Amanda Maine, J.D.

In a follow-up comment letter to the SEC’s November proxy roundtable, the Investment Adviser Association (IAA) implored the Commission to tackle issues relating to the proxy infrastructure weaknesses that were highlighted at the roundtable. Nevertheless, IAA recognized that the issue of proxy advisory firms is “politically heated” and reiterated its opposition to further regulation of proxy advisory firms, citing the importance of such firms in providing administrative and research services and the increased costs that would result from increased regulation of the firms.

Proxy advisory firm services. IAA’s letter emphasized the services that proxy advisory firms provide are valuable to investment advisers, including voting mechanics, data tracking and aggregation, and workflow management.

IAA also addressed criticism that investment advisors engage in “robo-voting” in lockstep with proxy advisory firm recommendations. Certain investment advisers provide their own proxy voting guidelines to proxy advisory firms, which customize the recommendations and execute the proxy votes accordingly. Still others receive information based on benchmark policies or other policies such as socially responsible investing, IAA explained. Investment advisers use this information to make their own recommendations on voting proxies and do not necessarily use the recommendations of the proxy advisory firm, according to IAA.

Current rules adequate to protect shareholders. IAA cited current SEC regulations and guidance in favor of its position that additional regulation of proxy advisory firms is unnecessary. Advisers Act Rule 206(4)-6 (the Proxy Voting Rule) requires investment advisers to implement policies and procedures addressing material conflicts of interest that may arise between an adviser and its clients, an issue that was brought up at the SEC’s proxy roundtable. In addition, under the Compliance Program Rule (Advisers Act Rule 206(4)-7), advisers must disclose to clients how they obtain information about how the advisers voted client proxies.

IAA also cited Staff Legal Bulletin No. 20, which outlines issues for investment advisers to consider when evaluating whether to retain a proxy advisory firms and addresses due diligence and oversight questions relating to the proxy advisory firm’s staffing and personnel, the robustness of its policies, and how it addresses conflicts of interest. In addition to the statutory fiduciary requirement of investment advisors, IAA stated, the Proxy Voting Rule, the Compliance Program Rule, and SLB No. 20 provide a “robust regulatory framework” that does not warrant further regulation of the proxy advisory voting process.

Costs. IAA also raised concerns about the potential costs of any new regulation of proxy advisory firms. It rejected the notion that conflicts of interest are grounds for more proxy advisory firm regulation. IAA emphasized again that firms currently disclose these conflicts of interest in a manner sufficient for investment advisers to review and evaluate them, which should negate the need for new regulations in this area.

IAA also opposes a requirement that proxy advisory firms distribute their reports to issuers for review and comment prior to distributing the reports to those that use and pay for the reports. Not only could such a requirement interfere with the independence and analyses of the reports, it is also unworkable due to the timeline which would be required to distribute reports to issuers, receive their feedback, and then distribute the reports to investment advisers and other clients.

Pass-through vote. IAA expressed its opposition to the suggestion that funds obtain feedback directly from shareholders regarding proxies for fund portfolio securities, or “pass-through” votes. IAA points out that a primary reason that investors purchase fund shares is to benefit from professional management of the fund and expert analysis, which includes the manager making the voting decision.

In addition, IAA noted that a shareholder has access to information which allows him or her to determine in which funds to invest consistent with the shareholder’s philosophy. IAA also advised that a fund’s portfolio securities are legally owned by the fund, and possess legal shareholder rights, including voting rights.

Finally, IAA noted the practical issues related to pass-through voting. A fund may hold hundreds of thousands of securities, and distributing information to each and every shareholder for proxy purposes would be not only logistically difficult, but also extremely costly. Such a requirement would overwhelm shareholders with paperwork. Shareholders who have made an affirmative decision to invest in a fund managed by professionals expect their investments to be handled by fund management, IAA explained.

Monday, January 07, 2019

Receiver’s claims did not exceed statutory authority

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

A receiver appointed under the New Jersey Securities Act did not exceed his statutory authority in bringing arbitration claims on behalf of a failed hedge fund. An intermediate New Jersey appellate court held that a receiver acting on behalf of a defrauded entity may initiate arbitration even if the entity’s investors will ultimately benefit from any assets recouped in arbitration. Accordingly, the ruling of the lower court was affirmed (Interactive Brokers, LLC v. Barry, December 31, 2018, Currier, H.).

FINRA arbitration claims. A New Jersey chancery judge appointed a receiver for Osiris Fund Limited Partnership after the New Jersey Attorney General discovered the fund had operated as a Ponzi scheme, defrauding its investors of more than $6.5 million. The chancery court granted the receiver full statutory powers to perform his duties, including the powers set forth in the New Jersey Securities Act.

Acting as the sole claimant on behalf of Osiris, the receiver then initiated FINRA arbitration proceedings against Osiris’s trading platform, Interactive Brokers, LLC. The receiver alleged, among other things, that Interactive Brokers and one of its employees had aided and abetted the fraud. Interactive Brokers then moved to enjoin the arbitration proceeding, arguing that it was beyond the scope of the receiver’s authority, but the chancery court denied the motion.

Appeal. On appeal, Interactive Brokers reiterated its argument that the FINRA arbitration exceeded the receiver's authority because the receiver had grounded his claims on damages incurred by Osiris's investors, rather than Osiris itself. The appellate court disagreed, citing federal court precedent holding that a receiver can bring a suit to redress injuries suffered by a legal entity even though the entity’s investors will ultimately benefit from the asset recovery.

Here, the statement of claim filed in the arbitration listed Osiris as the sole claimant. The statement of claim charged Interactive Brokers and the employee with aiding and abetting the fraudulent conduct while detailing their substantial participation in the wrongdoing. These were claims that belonged to Osiris, which was harmed when its funds were removed for unauthorized purposes. Accordingly, Osiris was entitled to the return of the unlawfully transferred monies, and the receiver properly wielded his authority under the New Jersey Securities Act.

The case is No. A-4197-17T4.

Friday, January 04, 2019

Company cannot wield its failure to provide notice as sword against stockholders

By Anne Sherry, J.D.

The Delaware Court of Chancery ruled that while an action to determine board composition under Section 225 is narrow in scope, the court may consider allegations of inequitable conduct to the extent germane. The dispute, between a stockholder of SPAR Group, Inc., and its board, is still in discovery, and the court will permit the directors to advance their defense that the plaintiff acted inequitably. Ruling against the directors, however, the court held that the company’s failure to provide prompt notice of director consents to shareholders did not preclude the consents’ effectiveness (Brown v. Kellar, December 21, 2018, Zurn, M.).

The plaintiff’s action under Section 225 of the Delaware General Corporation Law sought a determination that written consents he and another stockholder delivered to the board in July 2018 removed and replaced an incumbent director. The director defendants opposed the plaintiff’s motion for summary judgment and sought to advance a defense based on inequitable conduct by the two shareholders. They also argued that the written consents were not yet effective because the corporation did not send the required prompt notice to stockholders.

Directors may supplement the record. Section 225 proceedings are summary in rem actions with a limited scope: determining issues that pertain to the validity of actions to elect or remove a director or officer. Although the scope of Section 225 is narrow, the plaintiff was incorrect in saying that allegations of inequitable conduct cannot be considered. An issue can be litigated in a Section 225 proceeding if it is necessary to decide in order to determine the validity of the election or designation by which the director or officer claims to hold office.

In light of precedent, the court concluded that it could adjudicate the question of inequitable conduct to the extent germane to determining the board’s composition. Furthermore, the directors’ defense could be cognizable under Section 225 because it alleged inequitable conduct that could, when developed, affect the director consents and the plaintiff’s requested board composition. The court denied the plaintiff’s motion for summary judgment, allowing the director defendants to develop and test the defense’s allegations at trial.

Consents were effective despite lack of notice. Turning to a “more classic” Section 225 dispute, the court determined that the director consents were effective under Section 228 upon delivery of the July 5 consent. The consents complied with all the provisions of Section 228 except for the prompt notice requirement, but the court concluded that this notice requirement is not a prerequisite to a corporate action by written consent, but rather an additional obligation resulting from the action.

Although written notice is critical, and a Delaware case under specific facts found an exception to the general rule that notice is not a prerequisite to effectiveness, the instant case was governed by the rule rather than the exception. “Where the parties acting by written consent clash with the companies that must deliver the notice, as here, applying Di Loreto’s exception would grant the companies a sword with which to delay or thwart written consents by slow-rolling notice to the stockholders,” the court reasoned.

Neither did the Securities Exchange Act provide an independent notice requirement that precluded the consents’ effectiveness: even if Rule 14c-2 imposed a notice requirement beyond that of Section 228, corporations cannot avoid their obligations under Delaware law by resorting to purportedly conflicting obligations under Rule 14. Furthermore, permitting the directors to delay notice by playing Rule 14c-2 and Section 228 against each other, when each independently encourages that notice, “would pervert the incentives of both the SEC regulations and Delaware law.”

The case is No. 2018-0687-MTZ.

Thursday, January 03, 2019

Volcker Rule proposal would exclude community banks

By Rodney F. Tonkovic, J.D.

Five federal regulatory agencies are seeking public comment on proposed amendments to exclude certain community banks from the Volcker Rule. The proposal would reflect statutory amendments to section 13 of the BHC Act modifying the definition of "banking entity." The joint proposal would exclude community banks with $10 billion or less in total consolidated assets and total trading assets and liabilities of five percent or less of total consolidated assets from the Volcker Rule's restrictions (Proposed Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, Release No. BHCA-5, December 21, 2018).

The Securities and Exchange Commission, Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Commodity Futures Trading Commission have proposed to amend section 13 (the "Volcker Rule") to reflect statutory amendments made by the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA). The EGRRCPA modified the definition of "banking entity" to exclude certain small firms from section 13's restrictions and by permitting a banking entity to share a name with a hedge fund or private equity fund that it organizes and offers under certain circumstances.

Community bank exclusion. Specifically, the proposed amendments would exclude community banks with $10 billion or less in total consolidated assets and total trading assets and liabilities of five percent or less of total consolidated assets from the Volcker Rule's restrictions. Prior to the EGRRCPA, "banking entity" encompassed any insured depository institution, or any company controlling one, among other entities. The Act modified the scope of "banking entity" to exclude certain community banks and their affiliates. Foreign banking organizations with a U.S. branch or agency, however, continue to be subject to the Volcker Rule's prohibitions.

The agencies propose to modify the definition of "insured depository institution" in the 2013 final rule to conform to the EGRRCPA amendments. Accordingly, under the proposal an insured depository institution must satisfy two conditions to qualify for exclusion from the definition of "banking entity": the institution, and every entity controlling it, must have (1) total consolidated assets equal to or less than $10 billion and (2) total trading assets and liabilities equal to or less than five percent of total consolidated assets. Because insured depository institutions already monitor their total consolidated assets and total trading assets and liabilities for other purposes, the agencies believe that this test would impose no new burdens.

Name sharing. The proposal would also amend the restrictions applicable to the naming of a hedge fund or private equity fund to permit an investment adviser that is a banking entity to share a name with the fund under certain circumstances. Name sharing in this manner would be subject to the conditions that the investment adviser is not an insured depository institution, a company that controls an insured depository institution, or a company that is treated as a bank holding company under the International Banking Act, and that it does not share the same name or a variation of the same name as one of these entities.

Comments are due within 30 days after publication in the Federal Register.

The release is No. BHCA-5.

Wednesday, January 02, 2019

CFTC staff grants relief for Eurex to clear swaps

By Amy Leisinger, J.D.

On December 20, the CFTC staff issued three letters granting permission to Eurex Clearing AG to begin clearing swap transactions on behalf of U.S. futures commission merchant (FCM) customers. In the series of letters, the staff confirms Eurex’s compliance with applicable requirements, provides relief from certain CFTC regulations, and provides no-action relief allowing modifications to an acknowledgment letter necessary to deposit customer margin (CFTC Letter Nos. 18-30, 18-31, and 18-32).

FCM clearing. In the first letter, the CFTC’s Division of Clearing and Risk noted that the February 2016 order granting registration to Eurex as a derivatives clearing organization (DCO) required the organization to comply the Commission’s straight-through-processing requirements in Regulation 39.12(b)(7) before clearing certain swap transactions. The staff confirmed that Eurex has adequately demonstrated its ability to comply with the straight-through-processing requirements. Prior to this relief, Eurex could clear swap transactions for U.S. persons but not for customers of FCMs. The staff also approved certain rules submitted by Eurex.

Depositing margin collateral. The second letter, issued jointly by the Division of Clearing and Risk and the Division of Swap Dealer and Intermediary Oversight, permits FCMs that are Eurex clearing members to deposit customer-owned securities as margin collateral for swap transactions with Clearstream Banking AG, a German central securities depository (CSD). CFTC regulations permit an FCM or DCO to hold customer funds deposited to margin with a foreign bank if the bank maintains capital in excess of $1 billion and the FCM or DCO holds U.S. dollars in the United States in segregated accounts on behalf of customers in an amount sufficient to meet all U.S. dollar obligations.

In its request for relief, Eurex explained that Clearstream does not maintain regulatory capital in excess of $1 billion as required and that an FCM holding customer securities denominated in U.S. dollars at Clearstream (outside the U.S.) does not constitute the FCM holding U.S. dollar denominated assets in the U.S. to meet its U.S. dollar obligations. However, Eurex noted, Clearstream operates and is regulated as a CSD and its banking activities are “purely ancillary” to its CSD operations. In the event of insolvency, any U.S. dollar-denominated securities deposited at Clearstream would be protected from the third-party creditor claims under German and Luxembourg law as they move through the custody chain back to the U.S., Eurex stated.

The staff highlighted Eurex’s representations that each of its FCM clearing members will establish segregated accounts at Clearstream to hold securities deposited by customers and that Clearstream would provide daily account balance information for each FCM customer account it maintains to the relevant self-regulatory organizations or the National Futures Association to qualify as a depository for customer funds. The staff granted the requested relief from the CFTC’s regulations subject to the certain conditions, including:
  • The relief is limited to customer-owned securities as margin and does not extend to the holding of customer margin for futures contracts by Clearstream.
  • Each Eurex FCM clearing member must provide each prospective Eurex clearing customer with a written disclosure statement describing the Eurex clearing process and associated risks.
  • If an FCM clearing member of Eurex Clearing carries for another non-clearing FCM an account that includes swap positions cleared through Eurex, the clearing member must take steps to ensure that the non-clearing FCM has provided the disclosure statement to its customers.
  • Eurex and its FCM clearing members may only accept customer-owned securities that are issued in, or by the governments of, Germany, France, United States, Canada, United Kingdom, and Japan.
  • Eurex must at least annually conduct due diligence to determine that each entity in the custody chain for each of the relevant jurisdictions continues to be a bank with at least $1 billion in capital, a CSD, or a central bank in good regulatory standing. 
Acknowledgment modification. The third letter, the Division of Clearing and Risk, provides no-action relief permitting modifications to the acknowledgment letter that Eurex is required to obtain pursuant to previous no-action relief from the Deutsche Bundesbank in order to deposit customer margin in the form of cash at the Bundesbank. Eurex had requested that the Bundesbank provide an acknowledgment letter for customer funds that Eurex will deposit, but the Bundesbank, as the central bank of Germany, proposed to execute the letter modified with respect to the operations of a central bank. The division agreed that the proposed new language is sufficiently broad to take into account the information originally contemplated and stated that it would not recommend enforcement action against for executing the modified acknowledgment letter.

Commissioner statements. CFTC Chairman J. Christopher Giancarlo noted that the Commission is committed to ensuring that the staff takes a “considered, yet flexible approach” to applying the agency’s rules in cross-border circumstances and stated that he hopes regulators in other jurisdictions will take similar steps in appropriate circumstances. “Such shared efforts are essential to address harmful market fragmentation and to foster efficient financial markets to support global economic growth,” he said.

Commissioner Brian Quintenz, however, objected to the no-action relief, noting that, in 2017, the European Commission introduced legislation that did not acknowledge the commitment made to the CFTC with the cross-border CCP agreement the year before. Since then, he said, the EC has not provided any assurances on the status of the 2016 agreement so that the treatment of U.S. CCPs will not materially change. The commissioner did, however, commend the conditioning of the relief on the absence of any material increase in EU obligations imposed on U.S. DCOs.

The letters are CFTC Letter Nos. 18-30, 18-31, and 18-32.

Friday, December 28, 2018

PCAOB approves new standards on accounting estimates, work of specialists

By Amanda Maine, J.D.

The PCAOB has unanimously adopted standards on auditing accounting estimates and the auditor’s use of the work of specialists. The new standards, which were adopted in tandem, were a priority of the new Board and are the first substantive auditing standards finalized since the full Board was seated in April 2018. According to Chairman William Duhnke, the staff engaged in “thoughtful analysis and extensive external engagement” in recognition of these challenging areas of the audit that needed to be addressed.

Estimates. The new standard on the auditing of accounting estimates, including fair value measurements, emphasizes the need to apply professional skepticism when auditing accounting estimates, especially when it comes to potential management bias. Acting Chief Auditor Barbara Vanich noted that by their nature, accounting estimates involve complex judgments that make them susceptible to management bias.

Assistant Chief Auditor Dominika Taraszkiewicz noted that the new estimates standard replaces the existing three overlapping standards relating to accounting estimates with a new streamlined standard. The new standard and related amendments focus on the risk of material misstatement and emphasize professional skepticism. The new standard includes an appendix that provides specific direction to address auditing the fair value of instruments, particularly when the information is provided from third parties such as pricing services and brokers and dealers, Taraszkiewicz explained.

According to Taraszkiewicz, the final standard was modified in several respects from the initial proposal, including clarifying the auditor’s responsibility for identifying significant assumptions and providing additional directions on the auditor’s ability to group financial instruments with similar characteristics when applying substantive procedures to pricing information obtained from third parties.

PCAOB Chairman William Duhnke noted that currently the auditing of accounting estimates relies on three different standards adopted between 1988 and 2003. The result is an inconsistency in the accounting of estimates. He also advised that this approach pre-dates the Board’s priority for risk assessment analysis. The new standard, Duhnke said, is clearer, more consistent, and risk-based.

Board Member Jay Brown commented that determining estimates has been deemed “both an art and a science.” In the past decade, there has been a steep increase in accounting estimates, he noted. In addition, Brown observed that in developing the standard for estimates, the staff, for the first time, considered behavioral economics in rulemaking, which “incorporates a more realistic analysis of how people think and behave when making economic decisions.”

Board Member Duane DesParte said that while the new standard on estimates requires the auditor to consider both corroborating and contradictory audit evidence, auditors do not have to “scour the universe to uncover and consider any and all possible contradictory evidence.”

Work of specialists. The new standard on the auditor’s use of the work of specialists strengthens and clarifies requirements in two areas: (1) the use of the work of a company’s specialists; and (2) the use of the work of an auditor’s specialist. Regarding company specialists, the new standard is aligned with the new accounting estimates standard by incorporating risk assessment. It also sets forth factors for determining the necessary evidence for to support the auditor’s conclusion regarding an assertion when using the work of the company’s specialist.

The standard on the auditor’s use of the work of a specialist adds requirements that the specialist be informed of the work to be performed and amends requirements for assessing the knowledge, skill, and ability of the auditor’s specialist. It also amends the requirements for “objectivity” of an auditor-engaged specialist.

Associate Chief Auditor Lisa Calandriello advised that the final standard included revisions from the proposal that had been seen as unnecessarily complex or burdensome. With respect to the use of company specialists, the final standard removed the word “test” except in relation to company-produced data. For auditor specialists, the final amendments were revised to allow auditors to assess the specialists along a spectrum of objectivity, which would allow them to use the work of a less-objective specialist if the auditor performs additional procedures to evaluate that specialist’s work.

Board Member Kathleen Hamm noted both the accounting estimates standard and the work of specialists’ standards work hand in hand. She praised the staff for its work in making sure any revised standards remain “evergreen” as the use of emerging technology and data analytics evolve for financial reporting and auditing. The new standards are sufficiently principles-based and flexible to appropriately accommodate these new innovations, Hamm added.

Implementation. Board Member Jim Kaiser said he strongly supports the new standards. He noted that the new standards, if approved by the SEC, will become effective for audits of financial statements for fiscal years ending on or after December 15, 2020. While he supports this effective date, he noted that the new standards will increase demands on the financial reporting ecosystem. As such, the Board must be receptive to feedback on the implementation of the new standards and should be open to making changes if necessary, including to the effective date.

Board Member DesParte agreed, advising that while it will improve audit quality if the standards are implemented as expeditiously as possible, he also acknowledged that firms need time to update methodologies, develop tools, provide staff training, and prepare audit committees and management for these changes. In supporting the 2020 effective date, DesParte noted that the PCAOB will be establishing an implementation support program to assist firms of all sizes and other impacted stakeholders in implementing the new standards.

The new standards are subject to the approval of the Securities and Exchange Commission.

Thursday, December 27, 2018

2019 examination priorities announced by SEC Office of Compliance Inspections and Examinations

By R. Jason Howard, J.D.

In order to promote transparency of its examination program and provide insights into the areas it believes present potentially heightened risk to investors or the integrity of the U.S. capital markets, the SEC’s Office of Compliance Inspections and Examinations (OCIE) has announced its 2019 examination priorities.

The examination priorities are broken down into six categories: (1) compliance and risk at registrants responsible for critical market infrastructure; (2) matters of importance to retail investors, including seniors and those saving for retirement; (3) FINRA and MSRB; (4) digital assets; (5) cybersecurity; and (6) anti-money laundering programs.

SEC Chairman Jay Clayton said, “OCIE continues to thoughtfully approach its examination program, leveraging technology and the SEC staff's industry expertise. As these examination priorities show, OCIE will maintain its focus on critical market infrastructure and Main Street investors in 2019.”

OCIE Director Pete Driscoll said, “OCIE is steadfast in its commitment to protect investors, ensure market integrity and support responsible capital formation through risk-focused strategies that improve compliance, prevent fraud, monitor risk, and inform policy. We believe our ongoing efforts to improve risk assessment and maintain an open dialogue with market participants advance these goals to the benefit of investors and the U.S. capital markets.”

OCIE’s examination results are used by the SEC to inform rule-making initiatives, identify and monitor risks, improve industry practices, and pursue misconduct.

Wednesday, December 26, 2018

Reps. Davidson and Soto would redefine ‘security,’ clarify use of Howey test and tax treatment in new blockchain bill

By Mark S. Nelson, J.D.

A bill introduced by Reps. Warren Davidson (R-Ohio) and Darren Soto (D-Fla) would attempt to add clarity to the securities and tax treatment of digital tokens. Under the Token Taxonomy Act (H.R. 7356), a “digital token” would be excluded from the definition of security and an exemption from the Securities Act registration requirement would apply when a developer or seller of a digital token that has been notified by the SEC that it has run afoul of federal securities rules stops sales and returns sale proceeds. The bill also would clarify broker-dealer custodial rules and the tax treatment of digital tokens. The following analysis is based on a version of the bill text posted on SCRIBD and linked to from a press release issued by Reps. Davidson and Soto.

Clarify use of Howey test. Representatives Davidson and Soto said in a press release that the genesis for the bill was a desire to clarify the use of the Howey test for when an offering is an investment contract and, thus, a security. Under Howey, an offering is an investment contract if it involves the investment of money in a common enterprise with the expectation that others will generate profits. The SEC has leaned heavily on Howey in policing initial coin offerings, although other tests for whether an investment is a security exist, such as the Reves family resemblance test for whether notes are securities, something the Davidson-Soto bill appears not to address. The representatives also cited concern among the blockchain industry at what the bill’s authors believe may be conflicting statements from SEC Chairman Jay Clayton and William Hinman, Director of the SEC's Division of Corporation Finance, whom they say have “alarmed” and “encouraged” the blockchain industry.

“This bipartisan legislation draws a bright line for businesses and regulators by defining a ‘digital token’ and clarifies that securities laws do not apply to companies that use blockchain once they reach their goal of becoming a functional network,” said Reps. Davidson and Soto. “Implementing this fix will stop fraud from spreading and provide the certainty innovation needs to flourish.” Still, the representatives suggested that more regulatory initiatives will follow, while also questioning the extent to which the Federal Trade Commission has authority over digital tokens and whether legislation is needed to address the FTC.

Digital tokens would not be securities. The bill would add two definitions to the Securities Act and make conforming amendments to both the Securities Act and the Exchange Act to ensure that a “digital token” is not a “security.” As a result, “digital token” would be defined based on four features of a “digital unit” (which would be separately defined); thus, a “digital token” is a “digital unit” that: (1) is created pursuant to a verification process with rules to govern its creation and supply or as an initial allocation of digital units to be created; (2) has a transaction history recorded in a distributed, digital ledger subject to mathematical consensus verification, which cannot be changed by persons acting in common control; (3) is capable of be traded without an “intermediate custodian;” and (4) does not represent a financial interest in a company (e.g., ownership, debt interest, or revenue share). The emphasis on lack of common control appears to invoke the notion of decentralization, which has been the key to how some SEC officials think about virtual currencies (See, e.g., a June 2018 speech by CorpFin Director Hinman). Under the bill, “digital unit” would be defined as “a representation of economic, proprietary, or access rights that is stored in a computer-readable format.”

The bill also would amend the Securities Act to exempt certain transactions from the registration requirement. Specifically, the exemption would apply if a person who develops, offers, or sells a digital token with the reasonable and good faith belief it is a digital token, within 90 days after being notified by the SEC that the digital unit is a security, publishes notice of the SEC’s notification and takes reasonable efforts to stop sales and return sales proceeds (the return of proceeds provision would exclude funds for technological development).

This aspect of the bill would appear to invoke the SEC’s enforcement actions in the matters of Munchee, Inc. and, more recently, CarrierEQ Inc. (Airfox) and Paragon Coin Inc. Munchee stopped sales and returned proceeds and was not penalized or subjected to undertakings by the SEC. By contrast, the SEC penalized AirFox and Paragon Coin and subjected both entities to extensive undertakings, including an investor claims process and registration of their tokens as securities under the Exchange Act. In a press release accompanying the AirFox and Paragon Coin matters, SEC Co-Director of Enforcement Steven Peikin said the matters could serve as a “model” for ICO compliance with federal securities laws.

Moreover, the bill would make nearly identical amendments to the definition of “bank” contained in the Exchange Act, the Investment Company Act, and the Advisers Act to include other banking institutions or trust companies for which a substantial part of their business is providing custodial services. Lastly, the bill would direct the SEC to amend Exchange Act Rule 15c3-3 to provide that the “satisfactory control location” requirement can be met by public key cryptography via commercially reasonable cybersecurity practices.

Tax treatment of virtual currency. The Davidson-Soto bill also would clarify the tax treatment of virtual currencies. For one, Internal Revenue Code Section 408(m) regarding the treatment of collectibles by individual retirement accounts or individually-directed accounts per Code Section 401(a) would be amended to provide an exception for virtual currencies from the general rule that an IRA’s acquisition of any collectible is, for certain purposes, treated as a distribution equal to the cost of the collectible to the IRA. That is, IRA’s generally cannot invest in collectibles. “Collectible” generally means “tangible personal property,” such as art, antiques, metals, gems, stamps, coins, or alcoholic beverages. The bill would create an exception from the definition of “collectible” for virtual currency, in addition to existing exceptions for U.S. minted coins (See, 31 U.S.C. §5112) and for bullion of a stated fineness for contract markets under the Commodity Exchange Act (See, 7 U.S.C. §7).

The proposed amendment to Code Section 408(m) also would define “virtual currency” as “a digital representation of value that is used as a medium of exchange and is not currency (within the meaning of section 988) [i.e., certain foreign currency transactions].” This definition varies in some respects from the definition of “virtual currency” contained the IRS’s 2014 guidance. The amendment to Code Section 408(m) would apply to sales or exchanges on or after January 1, 2017.

The bill would further amend Code Section 1031 on like kind exchanges to provide that an exchange of virtual currency under Code Section 408(m) is to be treated as a like kind exchange as if the exchange involves real property. This distinction is important because the Tax Cuts and Jobs Act enacted a year ago narrowed the scope of Code Section 1031 to real property. The amendment to Code Section 1031 would apply to exchanges made on or after January 1, 2017.

Finally, the bill would add Code Section 139G to provide that gain from the sale or exchange of virtual currency (per Code Section 408(m)) can be excluded from gross income up to $600, subject to inflation adjustments in taxable years after 2018. Sales or exchanges that are part of the same transaction (or series) would be treated as one sale or exchange. Treasury would be directed to issue regulations for reporting gains or losses. Proposed Code Section 139G would apply to transactions entered into on or after January 1, 2017.

Monday, December 24, 2018

Contentious SEC-Timbervest battle comes to a relatively peaceful resolution

By Brad Rosen, J.D.

The SEC and Timbervest LLC have come to terms ending their acrimonious and high-stakes litigation dating back to September 2013. According to the Commission order in this matter, the SEC found that Timbervest violated Section 204 of the Advisers Act, which generally requires an investment adviser to make and keep accurate books and records as required by the Commission. Timbervest, while neither admitting nor denying the Commission’s findings, agreed to cease and desist from committing or causing any violations and any future violations of the applicable provision of the Advisor Act (In the Matter of Timbervest, LLC, December 21, 2018).

All further appellate and agency litigation put to rest. The resolution of this matter puts an end to ongoing appellate litigation between the parties. In September of this year, Timbervest, LLC took a step towards restarting its battle against the SEC by asking the D.C. Circuit to move forward with oral arguments on a statute of limitations argument. On November 19, 2018, the D.C. Circuit issued a decision remanding this matter back to the Commission for a new hearing before a new ALJ, or the Commission itself, in accordance with the Supreme Court’s decision in Lucia v. SEC.

In light of the D.C, Circuit’s November 19, 2018 opinion setting aside the SEC’s September 17, 2015 opinion and order, the order resolving this matter provides that the SEC’s opinions and orders dated August 22, 2016, September 17, 2015, and all prior orders of the SEC and its Administrative Law Judges in this matter will no longer have any force or effect.

SEC’s underlying claim. The SEC’s order also summarizes the agency’s underlying claim. It notes that in September 2006, Timbervest entered into a contract to sell to a third party an Alabama timberland property held by New Forestry, LLC, a fund managed by Timbervest that held pension assets of a large, publicly held company. That deal closed in October 2006, and in December 2006, Timbervest Partners, LP (“TVP”), another Timbervest managed fund, offered to repurchase the Alabama timberland from the same third party for approximately 8% more than the price for which New Forestry had sold it. That transaction closed in February 2007.

The Commission found that Timbervest failed to maintain books and records regarding the disclosure of the sale of the Alabama property and its repurchase by another fund to New Forestry or to TVP. The SEC also found that Timbervest failed to maintain sufficient books and records regarding the disclosure to New Forestry of two brokerage fees that it paid in connection with the sale of the Alabama property and another property. Timbervest’ operations have ceased. Timbervest is a Georgia limited liability company with its principal place of business in Atlanta, Georgia. The company was established in 1995, and during the period relevant to its litigation with the SEC, managed approximately $1.2 billion in timber-related investments. Timbervest registered as an investment adviser with the SEC on October 5, 1995. According to the order, Timbervest ceased its operations in May 2017.

Friday, December 21, 2018

SEC adopts rules for Reg. A reporting and Reg. NMS fee pilot

By Rodney F. Tonkovic, J.D.

Capping off a busy day of rulemaking, the SEC adopted final rules allowing reporting companies to rely on the Regulation A exemption from registration and to conduct a Transaction Fee Pilot in NMS stocks. The amendments to Regulation A will enable companies subject to the reporting requirements of Exchange Act Section 13 or 15(d) to use Regulation A. The Regulation NMS pilot will generate data to help the Commission analyze the effects of exchange transaction fee and rebate pricing models and to determine whether there is a need for regulation in that area (Amendments to Regulation A, Release No. 33-10591 and Transaction Fee Pilot for NMS Stocks, Release No. 34-84875, December 19, 2018).

Regulation A. The amendments to Regulation A were required by the Economic Growth, Regulatory Relief, and Consumer Protection Act, enacted in May 2018. Prior to the amendments, which will be effective upon publication in the Federal Register, Regulation A was not available to companies that are Exchange Act reporting companies. Revisions to Rule 251(b) permit companies subject to the reporting requirements of Exchange Act Section 13 or 15(d) to use Regulation A. Conforming changes have also been made to Form 1-A. And, revisions to Rule 257(b) provide that entities meeting the reporting requirements of the Exchange Act will be deemed to have met the reporting requirements of Regulation A.

"Regulation A provides an exemption from registration under the Securities Act for offerings of securities up to $50 million in a 12-month period," said Chairman Jay Clayton. "The amended rules will provide reporting companies additional flexibility when raising capital."

NMS Fee Pilot. The Commission also adopted new Rule 610T of Regulation NMS to conduct a Transaction Fee Pilot in NMS stocks. The pilot is designed to study NMS stocks and the effects of exchange transaction fee and rebate pricing models may have on order routing behavior, execution quality, and general market quality. The data obtained will be used to evaluate whether the transaction-based fee and rebate structure is meeting statutory goals and whether any regulatory action is needed.

The pilot includes all equities exchanges, including "maker-taker" and "taker-maker" exchanges. In addition to a control group, there will be two test groups with new restrictions: one test group will prohibit exchanges from offering rebates and linked pricing and the other will test a fee cap of $0.0010. The pilot will last for a maximum of two years. Specifically, the rule features an automatic sunset at the end of one year unless the Commission publishes a notice that it will continue for up to one additional year. The rule will be effective 60 days after publication.

Chairman Clayton said: "I expect the data provided by the pilot will help us make effective policy assessments that will benefit our markets and our investors." He also thanked former Commissioner Mike Piwowar for his contribution to this proposal.

The releases are No. 33-10591 (Reg. A) and No. 34-84875 (NMS pilot).

Thursday, December 20, 2018

New rules will require disclosure of policies for hedging company equity securities

By Rodney F. Tonkovic, J.D.

The SEC has approved rules requiring that companies disclose hedging policies in proxy or information statements for the election of directors. New Item 407(i) of Regulation S-K will require companies to disclose practices or policies with respect to hedging transactions in the companies' equity securities granted as compensation. The new disclosure requirements will be effective for proxy and information statements for the election of directors during fiscal years beginning on or after July 1, 2019. Smaller reporting or emerging growth companies, however, must comply with the new requirements on or after July 1, 2020.

Disclosure required. Proposed in 2015, the final rules implement a mandate from Section 955 of the Dodd-Frank Act, enacting Exchange Act Section 14(j) and requiring rulemaking to require disclosure of employee and director hedging. To that end, new Item 407(i) of Regulation S-K requires companies to describe any practices or policies regarding the ability of employees (included officers) or directors to engage in hedging transactions with respect to any decrease in the market value of equity securities granted as compensation or held directly or indirectly by the employee or director. Under the rule, "equity securities" includes equity securities of the company, any parent of the company, any subsidiary, or any subsidiary of any parent.

Summary or full disclosure. The requirement can be satisfied by providing a fair and accurate summary of the practices or policies that apply or by disclosing the practices or policies in full. The summary would include the categories of persons affected by the practices or policies and any categories of hedging transactions that are specifically permitted or disallowed. If the company has no applicable practices or policies, it will be required to either disclose that fact or state that hedging transactions are generally permitted.

Chairman Jay Clayton said: "The new rules will provide for clear and straightforward disclosure of company policies regarding hedging." He added that the “disclosures in themselves, and in combination with our officer and director purchase and sale disclosure requirements, should bring increased clarity to share ownership and incentives that will benefit our investors, registrants, and our markets."

Wednesday, December 19, 2018

SEC seeks comment on quarterly reports, relationship to earnings releases and guidance

By Mark S. Nelson, J.D.

The Commission, perhaps stealing a bit of its own thunder, jumpstarted by one day the busy open meeting agenda set for this week by issuing a request for public comment on quarterly reporting under the federal securities laws and on the relationship, if any, between such reports and earnings releases and earnings guidance issued by public companies. The request for comment follows an earlier public remark by President Trump about whether securities regulations should move to a semi-annual reporting framework. The commissioners had planned to mull issuing the request for comment on quarterly reporting at tomorrow’s open meeting, at which they will still address a diverse set of matters, including the PCAOB’s budget and accounting support fee, several items dealing with security-based swaps, hedging disclosures by company executives and directors, and fund of funds arrangements (Request for Comment on Earnings Releases and Quarterly Reports, Release No. 33-10588, December 18, 2018).

A history of short-termism and quarterly reporting. The immediate spark prompting the Commission’s request for comment on quarterly reporting may have been President Trump’s tweet on the topic. SEC Chairman Jay Clayton later issued a statement acknowledging the president’s remark and noting that the SEC considers the nature of its reporting requirements on an ongoing basis, including the implementation of “a variety of regulatory changes that encourage long-term capital formation while preserving and, in many instances, enhancing key investor protections.” Chairman Clayton again acknowledged the “ongoing debate” in a brief statement accompanying a press release and Fact Sheet on the request for comment. However, the underlying question of whether reporting frequency puts too much focus on public companies’ short-term financials has existed since the early years of the Exchange Act and has its roots in a much longer debate over quarterly versus semi-annual reporting.

In the 1940s, the SEC adopted quarterly reporting for some financial items only to abandon that framework for a semi-annual reporting regime in the 1950s. It was not until the 1970s, following publication of the Wheat Report (See SEC Historical Society website), and with some exceptions for real estate investment trusts, that the SEC once again adopted a quarterly reporting regime (Form 10-Q) which, over time, has evolved to include the disclosure of additional information about companies. During the current quarterly reporting regime, Form 8-K has provided an outlet for certain company disclosures needed to be made more frequently than quarterly (i.e., four business days after an event), while voluntary quarterly earnings guidance has achieved increasing prominence. (See, e.g., the Wolters Kluwer publication Loss, Seligman, and Paredes, Securities Regulation, Section 6.B.1., n. 29.) (observing that quarterly reports were not required until 1946, twelve years after enactment of the Exchange Act, despite being mentioned in Exchange Act Section 13(a)(2)).

Moreover, as the request for comment notes, the European Union has vacillated between quarterly and semi-annual reporting, adopting a semi-annual approach in its latest directive. The request for comment further observed that the EU has acknowledged the appeal of quarterly reports to market participants, while also noting the burden of such reports on smaller companies and the possibility that they may encourage a short-term focus by companies. In the U.K., which also eliminated quarterly reporting, the request for comment said one study showed that corporate investment was unchanged by whether a company issued quarterly or semi-annual reports, but analysts sometimes curbed coverage of companies that issued less frequent reports. By contrast, the request for comment said that other countries, such as Canada, Hong Kong, and Japan, still have quarterly reporting regimes.