Wednesday, March 20, 2019

Roisman ICI address takes on role of proxy advisory firms

By Rodney F. Tonkovic, J.D.

In his first formal speech as a Commissioner, Elad L. Roisman told a group of investment managers that it is a "good time" for the Commission to consider guidance to help asset managers use the services of proxy advisory firms. In a March 18, 2019 keynote address before the Investment Company Institute members at the group's Mutual Funds and Investment Management Conference, Roisman discussed the proxy process, paying particular attention to the fiduciary role of a fund adviser and the responsible use of third party proxy advisory firms in the voting process.

Roisman has been charged by Chairman Jay Clayton with taking the lead on the Commission's efforts to improve the proxy process. Roisman began his remarks by noting that his experiences before becoming a commissioner, including serving as a corporate secretary, were still fresh in his mind, inspired his interest in the proxy voting system, and informed his current role.

Roisman framed his remarks as a follow-up to questions he posed at a November 15, 2018 proxy process roundtable concerning: 1) how fund boards and advisers fulfill their fiduciary duty in the context of proxy voting; 2) how they rely on proxy advisory firms; and 3) whether the SEC should take any actions to alter the current state of affairs. He observed that the Commission's current set of rules governing the role of fund advisers in voting proxies focuses on principles and disclosure. Advisers are also explicitly required to adopt and implement policies and procedures to ensure that advisers vote clients' proxies in the clients' best interests.

Best interest? The Commission's rules leave fund advisers with a lot of flexibility, Roisman noted, and their fiduciary duty fills in the gaps. The critical question then, is: "What is in the best interest of a fund in the context of proxy voting?" The default position of many advisers, he said, seems simply to be to vote on every proxy. But, there are costs behind voting that could add up quickly, so he asked for input on whether the Commission should provide guidance on what the rules require with respect to whether an adviser must vote and on what considerations should go into that vote. Roisman personally feels that the answer should, in some cases be "No."

Roisman also asked for input as to how advisers handle conflicting interests when proxy voting functions are centralized within the fund complex, especially where asset managers aim to vote uniformly across funds. Distinct funds could have different interests or investment objectives that could lead them to desire a different outcome in the same company's proxy. Roisman inquired if advisers have found voting policies that are flexible enough to apply to all funds while accounting for their differences.

Proxy advisors. Roisman then turned to the role of third party proxy advisory firms, stating that he was interested in hearing from asset managers about how they use these firms to case votes. He said up front that these firms provide valuable services, so additional regulations should not be imposed upon them without thorough consideration. But, he stressed, asset managers must use their services responsibly. Here, he noted the practice of "robo-voting," where asset managers rely too heavily on advisory firms' recommendations. He also brought up concerns about factual errors in the advisors' reports and how asset managers react to them. A final concern is potential conflicts of interest arising when proxy advisory firms consult for public issuers on corporate governance matters and how they disclose or otherwise mitigate these conflicts.

In light of these concerns, Roisman said that "it is a good time for the Commission to consider whether guidance would be helpful to asset managers as they consider how to utilize the services of proxy advisory firms." Relatedly, he added that it may be appropriate for the Commission to reassess whether current practices fit within the intended scope and purpose of the Exchange Act's proxy solicitation exemptions relied on by proxy advisory firms.

Other reforms. Roisman closed his remarks by briefly addressing other areas of the proxy process that are less directly related to asset managers. He observed that the infrastructure, or "plumbing," underlying the proxy voting system is complex, inefficient, and sometimes unreliable in a way that might require "comprehensive solutions based on modern technology. He is also interested in the thresholds for submission and resubmission of shareholder proposals and the balance between robust shareholder engagement and the consideration of idiosyncratic views rejected by the majority of shareholders.

Tuesday, March 19, 2019

Canadian authorities roll out framework for regulation of crypto-asset trading platforms

By John Filar Atwood

The Canadian Securities Administrators (CSA) and the Investment Industry Regulatory Organization of Canada (IIROC) are seeking public input on the appropriate way to regulate Canadian platforms that trade crypto-assets. The regulators offered a proposed regulatory framework, but are seeking feedback on core issues such as how to address custody and verification of assets, price determination, market surveillance, and clearing and settlement.

The CSA and IIROC noted in a news release that crypto-asset trading platforms may be subject to securities and/or derivatives regulation depending on how they operate and the assets they make available for trading. They are concerned that the exiting regulatory system may not fully address the novel features and potential risks of crypto-assets. Where securities legislation applies to the platforms, the CSA and IIROC said that they are considering a tailored regulatory framework to address the novel features and risks.

The consultation paper seeks input on a number of areas that will assist in determining appropriate requirements for platforms. The CSA and IIROC noted that they will continue to engage with international regulators about their approaches to crypto-asset trading platforms, and will consider input on a variety of existing regulatory approaches.

The CSA, through its regulatory sandbox, is in discussions with several platforms that are seeking guidance on the requirements that apply to them. Platform operators and their advisers told the CSA that they would welcome a regulatory framework as they try to build consumer confidence and expand their businesses. At the moment, there are no platforms recognized as an exchange or otherwise authorized to operate as a marketplace or dealer in Canada.

The CSA and IIROC acknowledged that some well-established crypto assets that function as a form of payment or means of exchange on a decentralized network, such as Bitcoin, are not currently in and of themselves securities or derivatives. Rather, they have certain features that are analogous to existing commodities such as currencies and precious metals.

Application of securities laws. Securities legislation may still apply to platforms that offer trading of crypto-assets that are commodities, the CSA said, because the investor’s contractual right to the crypto-asset may constitute a security or derivative. The regulators are evaluating the specific facts of how trading occurs on platforms to assess whether or not a security or derivative may be involved.

To make this determination, they are considering, among other things: (1) whether the platform is structured so that there is intended to be and is delivery of crypto-assets to investors; (2) if there is delivery, when that occurs, and whether it is to an investor’s wallet over which the platform does not have control or custody; (3) whether investors’ crypto assets are pooled together with those of other investors and with the assets of the platform; (4) whether the platform or a related party holds or controls the investors’ assets; (5) if the platform holds or stores assets for its participants, how the platform makes use of those assets; and (6) whether the investor can trade, or rollover positions held by the platform.

Proposed framework. The proposed framework will apply to platforms that are subject to securities legislation and that may not fit within the existing regulatory framework. It will apply both to platforms that operate in Canada and to those that have Canadian participants.

The framework is based on the existing regulatory framework applicable to marketplaces and incorporates relevant requirements for dealers facilitating trading or dealing in securities. A platform that brings together orders of buyers and sellers of securities and uses non-discretionary methods for these orders to interact is a marketplace.

As a marketplace, a platform will be subject to requirements set out in NI 21-101, National Instrument 23-101 Trading Rules (together with NI 21-101, the “Marketplace Rules”), and National Instrument 23-103 Electronic Trading and Direct Access to Marketplaces.

In addition to marketplace functions, the platform may also perform dealer functions such as providing custody of crypto-assets and permitting direct access to trading by retail investors. The framework will include requirements that address the risks relating to these additional functions.

The CSA noted that some entities will not fall within the definition of a marketplace. For example, an entity that is trading crypto-assets that are securities but always trades against its participants and does not facilitate trading between buyers and sellers may be regulated as a dealer only and therefore not be subject to the Marketplace Rules and the proposed framework.

Firms that are currently registered in the category of exempt market dealer and are permitted under securities legislation to facilitate the sale of securities, including crypto-assets, in reliance on available prospectus exemptions in National Instrument 45-106 Prospectus Exemptions, can continue to offer this service as long as they do not fall within the definition of “marketplace.”

Registered firms introducing crypto-asset products and/or services are required to report changes in their business activities to their principal regulator and the proposed activities may be subject to review to assess whether there is adequate investor protection.

Investment dealers. Like the Marketplace Rules, the framework contemplates platforms both becoming registered as investment dealers and becoming IIROC dealer and marketplace members. IIROC currently oversees all investment dealers as well as trading activity on debt and equity marketplaces in Canada, and has a comprehensive body of rules governing the business, financial and trading conduct of IIROC members.

IIROC also has established programs to assess compliance with both IIROC’s rules applicable to dealers, and the universal market integrity rules that govern trading on a marketplace. IIROC also has experience with dealers and marketplaces that trade a variety of securities and has developed tailored compliance programs and applied tailored rules for marketplaces.

Derivatives. The CSA plans to consult on the appropriate regulatory framework to apply to marketplaces that trade over-the-counter derivatives, including platforms that offer derivatives with exposure to a crypto-asset. In the interim, if a platform is trading or dealing in crypto-assets that may be classified as derivatives, to the extent that the platform has similar functions to those contemplated in the consultation paper, it may be appropriate to apply requirements to those platforms that are similar to the requirements contemplated by the framework. However, the CSA expects that the requirements may need to be tailored to reflect the requirements that currently apply to derivatives or are otherwise appropriate to apply to those products and marketplaces.

Monday, March 18, 2019

Latham attorneys examine developments in SEC’s approach to cryptocurrency regulation

A public statement and five settled cease-and-desist proceedings indicate how the SEC plans to apply the federal securities laws framework to cryptocurrencies, according to attorneys at Latham & Watkins LLP. They discuss how the recent actions clarify the Commission’s approach to determining whether token transactions constitute unregistered securities offerings or unregistered broker-dealer or exchange activity and for resolving unregistered token offerings. They also look ahead to what they expect to be the next enforcement frontier for the cryptocurrency space.

To read the entire article, click here.

Friday, March 15, 2019

Senate Agriculture Committee gives warm reception to nominee for CFTC Chairman

By Lene Powell, J.D.

In a broadly positive hearing, the Senate Agriculture Committee appeared poised to approve the nomination for CFTC Chairman of Heath P. Tarbert, who currently serves as Assistant Secretary for International Markets at the Treasury Department. If confirmed, Tarbert would replace current CFTC Chairman J. Christopher Giancarlo, whose term is set to expire in mid-April.

Although the committee did not vote following the March 13 hearing, Committee Chairman Pat Roberts (R-Kan) signaled bipartisan support for the nomination.

“It is clear, at least to the Chairman, and I think the Ranking Member shares my view, that you are more than qualified to join the Administration in the role of Chairman of the CFTC,” said Chairman Roberts.

Tarbert was nominated in January 2019, following the Administration’s announcement of intention to nominate in December 2018.

Experience. Tarbert has extensive experience in both the public and private sectors. At the Treasury Department, he works to advance U.S. interests in multilateral organizations on financial stability and regulatory issues, negotiate trade agreements, and support the Committee on Foreign Investment in the United States (CFIUS), among other responsibilities. He has worked in all three branches of government, having served as Special Counsel to the Senate Banking Committee, Associate Counsel to President George W. Bush, and law clerk to Supreme Court Justice Clarence Thomas. Prior to joining Treasury, he was a partner in the global financial regulatory practice at the international law firm Allen & Overy.

Tarbert received his JD and SJD from the University of Pennsylvania, and also earned a DPhil from Oxford University, where he was a Thouron Scholar.

Positions. In Tarbert’s view, the Dodd-Frank Title VII derivatives reforms are important and need to be completed. In protecting the health of the U.S. derivatives markets, he stressed the need to strike the right balance between allowing markets to flourish and innovate, while protecting customers from harm and protecting against threats like cyberattacks.

In addition to prepared testimony, Tarbert responded confidently to scattershot questions over the nearly hour and a half hearing, addressing the following topics:
  • Cross-border regulation. In response to Robert’s statement that he and Ranking Member Debbie Stabenow (D-Mich) are concerned about E.U. regulation of U.S. derivatives clearinghouses, Tarbert said he “agrees wholeheartedly” that U.S. clearinghouses need to be regulated exclusively by U.S. regulators.
  • Position limits. Roberts said he hopes the CFTC will move on a final position limits rule later this year. Tarbert agreed that the rule needs to be finalized, and said that important considerations include exemptions for bona fide hedgers, accurate measures of deliverable supply, and parity between the three major wheat contracts.
  • CFTC enforcement. In response to a question from Stabenow, Tarbert said he would keep the CFTC’s Enforcement Division the largest agency division, and would invest resources as needed. His priorities would include protecting the markets as well as customers, holding individuals accountable as well as institutions, and coordinating with other regulators and law enforcement. Responding to Sen. Sherrod Brown’s (D-Ohio) concern that the CFTC has grown too lenient in enforcing violations, Tarbert said he does not believe in leniency, but that self-reporting can be useful, assuming it’s followed up with systematic self-correction.
  • Cybersecurity. Tarbert assured Stabenow that he would ensure the CFTC has access to the relevant information it needs, including from Treasury’s Office for Critical Infrastructure Protection, which is led by a former general from U.S. Cyber Command and NSA and looks at specific vulnerabilities in the U.S. financial system. He observed that the area of greatest concern is “where systemic risk maps onto cyber risk.” He committed to looking at a bipartisan bill by Sen. Amy Klobuchar (D-Minn) and Sen. John Thune (R-SD) that would facilitate coordination between the public and private sectors.
  • Market irregularities. Tarbert said that in general, price convergence in the derivatives markets is critically important, otherwise market participants cannot use contracts to hedge. Responding to questions from Roberts and Klobuchar about irregularities in the hard red winter wheat and cattle markets, he said he would look into this issue more.
  • Systemic risk. Responding to concerns expressed by Brown and Sen. Tina Smith (D-Minn) about systemic risk, including from a substantial concentration of swaps dealing among five large banks, Tarbert said that it is crucial that initial and variation margin be imposed on these financial institutions. Prior to the financial crisis, margin was not routinely collected and it had a daisy chain effect, as the failure of one institution led to the failure of another, and so on. Continuing to move swaps trading onto transparent markets is another important step, he said. In addition, as risk continues to be concentrated in clearinghouses, these entities must be closely supervised and have recovery and resolution plans. 
  • CFTC resources. Brown as well as Sen. Kristen Gillibrand (D-NY) expressed frustration with the CFTC’s chronically low funding and pressed Tarbert to commit to seeking self-funding for the CFTC. Tarbert responded that he would provide any technical assistance requested on this score, but that ultimately this is a question for elected officials.
  • Automated trading. Gillibrand expressed worry about the effects of unregulated automated trading and asked if Tarbert would reopen the CFTC’s Regulation Automated Trading, for which progress seems to have stopped. Tarbert said he would want to get the discussion going again, and that the CFTC needs to continue its analytical studies using current data. In addition, exchanges and clearinghouses need to put in relevant risk management, possibly including circuit breakers.
  • Volcker Rule. Sen. Debra Fischer (R-Neb) said she is concerned that community banks did not create the financial crisis, yet are being punished for it, and that she has heard that there may be further delays in the Volcker rule. Tarbert agreed that the rule should be narrowly tailored regarding community banks or that they should be exempted altogether. He promised he would work with other agencies to ensure that end users like farmers and ranchers would have access to commodities products, and that he would make every effort to ensure that the rule is finalized in a timely way so that end users can have certainty. 
Support. Chairman Giancarlo has expressed support for Tarbert.

Roberts indicated that he hopes the nomination will move swiftly.

“Your testimony today provides a solid basis to report you favorably out of committee,” Roberts told Tarbert. “Per our rules, we can’t do so today—wish we could—but we will endeavor to do so in the very near future.”

Thursday, March 14, 2019

Giancarlo reflects on tenure and looks forward in final FIA Boca appearance as agency chief

By Brad Rosen, J.D.

In remarks at 44th Annual International Futures Industry Conference held in Boca Raton, CFTC Chairman J. Christopher Giancarlo reflected on his time at the Commission and covered a vast array of topics in a speech titled Improving the Past, Tackling the Present, and Advancing to a Digital Market Future. Giancarlo took the opportunity to recall becoming a commissioner five years ago, and then being nominated by President Trump as CFTC chairman two years ago. He observed “Knowing that my time as Chairman would be short, I wanted to be bold in action.” During the course of his speech, the chairman highlighted some of the bold actions he has initiated during his term as the agency’s leader, and also underscored his efforts to put the CFTC on the path to become a 21st Century digital regulator.

Improving on past work. Noting his long public support for the G-20 swaps market reforms as adopted in Title VII of the Dodd-Frank Act, the chairman pointed to those areas of regulatory implementation where he has been critical. These include:
  • Dealer capital. The adverse impact of new bank capital requirements, particularly the supplementary leverage ratio (“SLR”), which has caused financial institutions to take capital out of trading markets in amounts out of proportion with the capital level needed support overall market health and durability. The Commission has recently submitted comments to banking regulatory to implement a new approach for calculating the exposure amount of derivatives contracts under the agencies’ regulatory capital rules.
  • SEF rules. He sees the current swap trading framework as inconsistent with the Dodd-Frank Act by being too prescriptive, too burdensome, and too modeled on futures markets. Last November, amid controversy among commissioners the Commission issued a proposed rule on Amendments to Regulations on Swap Execution Facilities and the Trade Execution Requirement and request for comment. The chairman believes the impermanence of the current SEF rule framework poses risk for market participants.
  • Swap data harmonization. Giancarlo is frustrated with the progress made on swaps data harmonization, which is one of the last unfinished elements of the G-20 swaps reforms to be completed. He warned that if changes are not forthcoming in the governance of the implementation of these data standards, the CFTC will consider working with its key international counterparts to pursue a separate and more effective course to finally complete this swaps reform. 
Addressing the present. The chairman pointed to a number of current undertakings that are front row and center for the Commission. These include:
  • Project KISS. Project KISS is the agency-wide review of CFTC rules, regulations, and practices to make them simpler, less burdensome, and less costly. It has resulted in a range of rule and process improvements that are reducing regulatory costs and burdens. The chairman noted there are still more Project KISS initiatives in the pipeline.
  • Market Intelligence Branch. In 2017, the Market Intelligence Branch (MIB) was created as part of the CFTC’s Division of Market Oversight. Its charge is to understand, analyze, and communicate current and emerging derivatives market dynamics, developments, and trends – such as the impact of new technologies and trading methodologies. In Giancarlo’s view, MIB has been a resounding success as it keeps commission leadership and staff apprised of key market developments.
  • Running a tight ship. Upon assuming the chairmanship, Giancarlo, as a former business executive, pledged that he would run a tight ship at the CFTC. That meant bringing the best operational practices from the private sector to the CFTC. Giancarlo believes progress has been made on this front, noting that staff morale is good. Importantly, the chairman points to first funding increase the agency has received in half-a-dozen years, which he asserts was based solely on the merits of the agency budget request. With the funding increase, Giancarlo stated that the Commission can now turn to many important needs of the agency, including some longer-range goals that have had too little attention. 
Preparing for the future. Echoing familiar themes, Chairman Giancarlo advanced his vision of the future where the CFTC is transformed into a 21st Century regulator. In the midst of today’s increasingly digital and algorithmic markets, Giancarlo identified several factors that are challenging the work of regulators. These include the extraordinary pace of exponential technological change, the disintermediation of traditional actors and business models, and the need for technological literacy and big data capability.

Giancarlo observed that the CFTC’s response to rapidly changing markets and technological developments, is built upon the following four cornerstones:
  • Adopting an "exponential growth mindset" that anticipates the rapid pace of technological innovation and the need for appropriate regulatory response;
  • Becoming a "quantitative regulator" able to conduct independent market data analysis across different data sources, including decentralized blockchains and networks, without being reliant on self-regulatory organizations and market intermediaries;
  • Embracing "market-based solutions" to determine the value of technological innovations, as we witnessed with the launch of crypto-asset-based futures products; and
  • Establishing an internal FinTech Stakeholder to address the opportunities and challenges that FinTech presents and manage the ever-present tension between innovation and regulation. 
According to Giancarlo, for the CFTC that stakeholder is LabCFTC, which was launched almost two years ago. In that time, it has had over 250 separate interactions with innovators big and small. According to the chairman, the unit has effectively explained technology innovation to agency staff and other regulators and has effectively advocated for technology adoption. It has also reached out and learned about technological change and market evolution, while providing a dedicated liaison to innovators.

Conclusion. In closing, the Chairman Giancarlo stated, “With the proper balance of sound policy, regulatory oversight, private sector innovation and a little bit of courage, new technologies and global trading methodologies will lead our markets to evolve in responsible ways, and continue to grow the economy and create a future of untethered aspiration, a future where creativity and economic expression is a social good in its own right, a source of human growth and advancement.”

Wednesday, March 13, 2019

Musk responds in contempt proceedings over unvetted tweet

By Anne Sherry, J.D.

Elon Musk responded to contempt proceedings initiated by the SEC by arguing that he was not required to get preapproval for an after-hours tweet because it was not material. Musk also cites his recent restraint on Twitter as reflecting his commitment to the settlement he reached with the SEC and avoiding further conflicts. Finally, Musk spins his appearance on 60 Minutes in his favor, noting that in light of his “sincerely-held criticism of the SEC” the contempt action amounts to agency overreach (SEC v. Musk, March 11, 2019).

Last October, the Southern District of New York approved a settlement requiring Tesla to implement, and Musk to comply with, procedures for the oversight of social media posts and other writings. The policy that Tesla adopted states that writings that reasonably could contain material information must be submitted to the general counsel and disclosure counsel prior to publication. On the evening of February 19, Musk tweeted that Tesla would make “around 500k” cars in 2019, but he clarified a few hours later that Tesla’s annualized rate of production would reach 500,000 by the end of the year.

Materiality. Musk now counters the SEC’s contempt motion by arguing that the tweet could not reasonably be considered material. The response puts the tweet into context with other tweets from the same evening, presenting an overall picture that “Tesla has come a long way and is now flourishing globally.” This was celebratory and forward-looking, Musk maintains, and any reasonable observer would take it as “a statement of pride and optimism, not of guidance.” Musk notes that his own tweet did not notably move the market (citing a 0.09 percent movement in after-hours trading), but the SEC’s motion seeking to hold him in contempt caused a 3.4 percent stock price decline (also in after-hours trading).

The SEC said that Musk was required to seek preapproval of the tweet because Tesla’s policy lists “projections, forecasts, or estimates” as examples of subjects that may be material. Musk notes that the policy actually says that this type of information “may, depending on its significance, be material.” Requiring Musk to obtain preapproval of every statement that arguably falls into any of the non-exhaustive categories listed in the policy would go beyond the requirements of the order, and the district court is not authorized to impose obligations beyond those mandated by the consent decree.

Finally, Musk counters the SEC’s argument that he needed to obtain preapproval even if the tweet restated previously disclosed information, because that disclosure occurred more than two days prior. In Tesla and Musk’s reading of Tesla’s policy, a preapproved communication must be released within two days of the preapproval, but this does not mean that a communication is subject to mandatory preapproval just because of a prior disclosure. “Such a requirement would make no sense, because information already known on the market is immaterial,” Musk argues (internal quotation omitted).

Attempts to comply with policy. According to the response, the court cannot hold Musk in contempt unless he did not diligently attempt to comply with the court’s order, and Musk has cut his tweets related to Tesla nearly in half since entry of the order. He also no longer tweets information that he believes is, or could be, material. Musk’s conferral with disclosure counsel after the tweet in question, and his subsequent correction, do not amount to “willful flouting” of judicial authority, he says. Finally, in the 60 Minutes interview cited by the SEC, Musk unequivocally said that he would comply with the order out of respect for the justice system, and his allowance that he may make mistakes cannot be used as evidence that he intended to violate Tesla’s policy.

First Amendment concerns. Musk asserts that the SEC’s institution of contempt proceedings was motivated by embarrassment at his criticisms of the agency, including on 60 Minutes. The “sweeping gag order” the SEC seeks amounts to a content-based prior restraint that would fail review under a strict scrutiny standard, as there are less restrictive means to achieve the government’s interest.

The case is No. 18-cv-08865.

Tuesday, March 12, 2019

SCOTUS asked to revisit ESOP duty under Fifth Third

By Anne Sherry, J.D.

In Fifth Third Bancorp v. Dudenhoeffer (U.S. 2014), the Supreme Court established pleading requirements for an investor to state a claim for breach of the duty of prudence against a fiduciary of an employee stock ownership plan. IBM ESOP defendants have petitioned the Court for a writ of certiorari to examine, in light of a circuit split, whether a plaintiff can satisfy this pleading standard by alleging generally that the harm from a fraud increases the longer it goes on (Retirement Plans Committee of IBM v. Jander, March 4, 2019).

Comparing early disclosure to later disclosure. Under a restrictive reading of Fifth Third, a plaintiff must plausibly allege an alternative action that a prudent fiduciary in the same circumstances could not have viewed as more likely to harm than to help the fund. The Second Circuit determined that the plaintiffs met this threshold. The ESOP defendants allegedly knew that IBM stock was artificially inflated due to an undisclosed fraud and were empowered to disclose the truth. The plaintiffs also alleged that the failure to make prompt disclosure hurt the long-term prospects of IBM as an investment because reputational damage increases the longer a fraud occurs. The complaint also alleged that IBM stock traded in an efficient market, so that a prudent fiduciary need not fear an overcorrection—the market would devalue the stock only by the amount its price was artificially inflated.

The court gave particular weight to the allegation that the defendants knew that disclosure was inevitable because IBM was likely to sell its business. In this scenario, the fiduciary is not comparing disclosure to the status quo of nondisclosure, but comparing “the benefits and costs of earlier disclosure to those of later disclosure—non-disclosure is no longer a realistic point of comparison.”

Petition. The ESOP petitioners argue that the Second Circuit’s reliance on “generalized allegations” subverts Fifth Third and creates a circuit split that, considering New York’s significance to the financial markets and ERISA’s liberal venue provision, will make the Second Circuit the forum of choice for duty-of-prudence claims.

The ESOP petitioners note that the decision directly conflicts with decisions of the Fifth and Sixth Circuits. In a case involving a Whole Foods retirement plan, the Fifth Circuit rejected allegations derived from “general economic principles” that longer frauds mean harsher corrections. The Sixth Circuit also rejected the argument in a case involving Eaton Corporation’s plan. All three cases—IBM, Whole Foods, and Eaton—were filed by the same counsel and advanced very similar arguments, the petitioners observe, noting that the Fifth Circuit opinion remarked on the ease with which the generic allegation could be made in multiple cases. The fact that the courts ruled differently on essentially the same arguments reveals the starkness of the circuit split, according to the petition.

As to the generic nature of the allegation that disclosure is inevitable, this allegation is always available and the respondents concede as much in their complaint, the petitioners argue, with such statements as “no corporate fraud lasts forever; there is always a day of reckoning” and “the federal securities laws, if nothing else, would eventually have forced IBM to come clean.” By placing so much weight on allegations that are present in any Fifth Third claim, the Second Circuit upended the pleading requirement of that decision, which was carefully struck to “weed out meritless lawsuits.”

The circuit court dismissed this concern, reasoning that the fact that similar allegations can be made in other ERISA cases did not make them less plausible in the instant case. Referencing the Court’s statement in Fifth Third that it is important to “divide the plausible sheep from the meritless goats,” the petitioners argue that under the Second Circuit’s approach “every goat becomes a sheep” as long as the allegations of worsening fraud and inevitable disclosure are included.

Finally, the petitioners maintain that the Second Circuit’s decision will permit an end-run around the federal securities laws, allowing plaintiffs who cannot meet the pleading requirements of a fraud claim under the PSLRA to package the same allegations as Fifth Third claims. They observe that separate IBM plaintiffs brought a companion case under the federal securities laws resting on the same allegations underlying the ERISA claim.

The case is No. 18-1165.

Monday, March 11, 2019

House passes government ethics/elections bill with Shareholders United Act amendment

By Mark S. Nelson, J.D.

The House passed the Democratic majority’s signature government ethics and election reform legislation with two securities law provisions in tow. While prospects for enactment of the For the People Act of 2019 (H.R. 1) are uncertain, the bill, which passed by a vote of 234-193, would lift the ban on SEC rulemaking regarding public company disclosures of political spending activities. The bill also would require public companies to adopt procedures to assess their shareholders’ preferences regarding corporate political spending. The latter provision was introduced as stand-alone legislation earlier this year and was added to the For the People Act via an amendment.

The For the People Act is primarily a wide-ranging government ethics and election reform bill. The Congressional Budget Office's first evaluation of the bill attempted to put a price tag on some of its components, including the Freedom From Influence Fund, which would, among other things, provide matching funds for smaller donations to House campaigns; the CBO estimated that the Fund's costs could exceed $1 billion, but that funding would come from future legislation. A second CBO estimate addressed potential assessments on civil and criminal fines.

The White House issued a veto threat in response to the For the People Act, citing separation of powers, federalism, and First Amendment concerns about the election reform provisions of the bill. The Administration's statement also characterized the government ethics provisions as “well-intentioned but misguided” because they could limit executive branch functionality.

Shareholder preferences. Representative Jamie Raskin (D-Md) previously introduced the Shareholders United Act of 2019 (H.R. 936), a play on words invoking the Supreme Court's landmark opinion Citizens United, that would allow public company political donations only if a company has in place a procedure to assess the preferences of its shareholders. However, this requirement would not be met if a majority of the company’s shares are held by investors who are barred by law, contract, or fiduciary duty from expressing political views. The text of the Raskin bill was added via an amendment to the For the People Act by a vote of 219-215.

On the House floor, Rep. Raskin said that while a Constitutional amendment to reverse Citizens United is a long-term goal, Congress should now invoke Justice Kennedy’s admonition in Citizens United that the methods of “corporate democracy” can mitigate abuses by executives regarding corporate political spending. As a result, Rep. Raskin’s amendment to the For the People Act would require public companies “to get shareholder buy-in on the front end” in order for a public company to make political expenditures.

Friday, March 08, 2019

FASB clarifies aspects of new leases standard

By Amy Leisinger, J.D.

The Financial Accounting Standards Board has issued an Accounting Standards Update to address concerns raised by stakeholders in the transitional period leading up to implementation of FASB’s new leases standard. The ASU aligns the guidance for fair value of an underlying asset by a lessor that is not a manufacturer or dealer with that of existing guidance and requires lessors within the scope of Topic 942, Financial Services—Depository and Lending, to present all “principal payments received under leases” within investing activities. The ASU also exempts both lessees and lessors from having to provide certain disclosures in the fiscal year when the new leases standard is adopted.

“The changes will help ensure a smoother transition to the standard without affecting the quality of information provided to investors and other financial statement users,” FASB Chairman Russell G. Golden said.

Fair value. FASB notes that there is an exception for lessors who are not manufacturers or dealers for determining fair value of leased property (the underlying asset in connection with leases standard) as the asset’s cost, reflecting any volume or trade discounts that may apply. Topic 842, Leases, did not carry forward this exception, and lessors previously qualifying for the exception are now required to apply the Topic 820 fair value standard, the exit price. The ASU reinstates the exception in Topic 842 for lessors that are not manufacturers or dealers and allows lessors to use cost for fair value. The ASU provides, however, that if too much time has passed between acquisition and lease commencement, lessors will be required to use exit price instead.

Cash flow statements. According to FASB, Topic 840 does not provide guidance on how cash received from sales-type and direct financing leases should be presented in cash flow statements. Stakeholders told FASB that lessors within the scope of Topic 942, Financial Services—Depository and Lending, have presented “principal payments received under leases” within investing activities and hoped to continue this practice. However, Topic 842 introduced guidance requiring all lessors to present all cash receipts from leases within operating activities, creating a conflict on the presentation of “principal payments received from leases” under certain leases. The ASU clarifies that depository and lending institutions that are lessors within the scope of Topic 942 will present all “principal payments received under leases” within investing activities under current practice.

Transition disclosures. Topic 842 requires lessees and lessors to provide transition disclosures upon adoption of the new leases standard and did not explicitly exempt entities from applying a requirement to provide identical disclosures for interim periods after the date of adoption. The ASU clarifies FASB’s original intent to exempt both lessees and lessors from having to provide certain interim disclosures in the fiscal year in which the new leases standard is adopted.

Thursday, March 07, 2019

Peirce warns of unintended consequences to new disclosure types

By Rodney F. Tonkovic, J.D.

SEC Commissioner Hester M. Peirce's remarks before the Council of Institutional Investors included both praise for the role institutional investors play in the market and criticism of some of CII's positions. While she supported the perspective of institutional investors and their participation market reforms, she warned that some reforms could go too far and cause a loss of focus on how effectively companies put their money to work.

Praise for CII. Peirce began her remarks at CII's 2019 Spring Conference in Washington, D.C. by noting CII represents an important group of sophisticated, long-term, and bulk players in the market. Therefore, the group's views on how to improve the functioning and structure of the capital markets are of real interest, Peirce said. She also praised CII's advocacy for systemic change in the proxy system, such as its support for universal proxy cards and suggestions on tracking proxy voting using blockchain technology.

Peirce also expressed her appreciation of CII's active participation in the Commission's disclosure reform efforts. Here, she noted that CII had provided helpful feedback in a comment letter on the value of modernizing EDGAR and improving data tagging. The Commissioner observed that she has concerns about the costs and drawbacks of embedding specific technology in rules, so CII's views on the matter were especially valuable. Peirce also pointed to CII's participation in other areas of debate, such as its objection to the use of dual-class shares and its views on stock buybacks.

Airing of grievances. Shifting tone slightly, Pierce quoted from the Seinfeld "Festivus" episode: "I got a lot of problems with you people, and now you're gonna hear about it." She emphasized, of course, that she was grateful for CII's views on financial regulation and corporate governance and affirmed that she would continue to look to CII for advice.

Peirce's chief criticism concerns the focus of many investors "on non-investment matters at the expense of concentration on a sound allocation of resources to their highest and best use." She is concerned with a broad trend of securities disclosures focusing more on "an amorphous and shifting set of virtue markers," or "matters that do not go to an assessment of how effectively companies are putting investor money to work."

Mandatory arbitration. To this point, she specifically referenced CII’s position with respect to a recent Johnson & Johnson shareholder proposal concerning mandatory arbitration. The Division of Corporation Finance, relying heavily on an opinion by the New Jersey attorney general, said that the proposal could be excluded under Exchange Act Rule 14a-8(i)(2). While this decision concerned the interpretation of state law, Peirce noted, that it was not much help in confronting how such a bylaw provision would interact with federal law, and that would be a matter for the courts. However judges may decide the issue, CII's stance is that such clauses threaten the principles of sound corporate governance due to, among other concerns, the non-public nature of arbitration. Peirce countered that, while she would not insist on mandatory arbitration for all companies, the alternative of class action litigation and its accompanying costs can be harmful to shareholders.

14a-8 reform. Turing to shareholder proposals more broadly, Peirce sees a clear need for fundamental reform of the shareholder proposal process, where CII does not. The current thresholds encourage small handfuls of shareholders, Peirce argued, to repeatedly put forward losing proposals reflecting "idiosyncratic preferences" that incur costs that are borne by all of the shareholders. And, when companies such as Johnson and Johnson come to the SEC, the 14a-8 process foists staff into what Peirce sees as an inappropriate policymaking role.

Disclosure. Another area in which Peirce and CII do not see eye to eye is the push for new types of disclosure. Peirce favors the current disclosure-based regime for capital markets regulation over other potential models, while CII has, for example, supported efforts to require companies to disclose information about board members’ personal characteristics. While new Compliance and Disclosure Interpretations have also emphasized such self-identification, Peirce is wary that board members will see pressure to divulge personal details that they would rather keep private, among other unintended consequences.

In conclusion, Peirce cautioned that asking the SEC to concentrate on issues other than protecting investors, facilitating capital formation, and fostering fair, orderly, and efficient markets, shifts its focus away from its primary mission. She noted that the Commission is engaged in rulemaking that requires considerable effort, such as proxy reform, Dodd-Frank rulemaking, and market structure reforms. "I do not believe that investors are best-served when our staff is distracted by matters unrelated to our core mission," she said.

Wednesday, March 06, 2019

IAA and SIFMA oppose Nevada’s proposed fiduciary rule

By Jay Fishman, J.D.

The Investment Adviser Association (IAA) and the Securities Industry and Financial Markets Association (SIFMA) have each sent the Nevada Securities Division (the Division) a comment letter opposing the Division’s proposed fiduciary rule for broker-dealers and investment advisers. Both IAA and SIFMA remarked that the proposal would violate certain provisions of the National Securities Markets Improvement Act of 1996 (NSMIA).

IAA. The IAA complained that the proposed rule would violate NSMIA’s Title III on investment advisers by not clarifying that the rule applies only to Nevada investment advisers. Specifically, the rule’s initial reference to “investment advisers” incorrectly implies that it also covers SEC investment advisers, which NSMIA forbids. IAA emphasized that NSMIA allows the states only limited authority over SEC investment advisers: (1) to require SEC advisers’ investment adviser representatives with a place of business in the state to register and pay a filing fee; (2) to require SEC advisers to file a notice consisting of their SEC-filed documents and a notice filing fee; and (3) to investigate and bring enforcement actions against SEC advisers for fraud.

The IAA suggested the following replacement language be made to the draft to eliminate the suggestion that the rule regulates SEC advisers in violation of NSMIA:
  1. The term “investment adviser” in these regulations does not include any “federal covered adviser,” as defined in NAC 90.042; or
  2. The term “investment adviser” in these regulations refers to an investment adviser required to be licensed pursuant to NRS 90.330. 
SIFMA. SIFMA strongly advised the Division to shelve the proposal until the SEC develops and finalizes Congress-mandated federal regulations to meaningfully raise the bar for broker-dealers providing personalized investment advice to retail customers about securities. SIFMA acknowledged that promulgating standard of conduct laws and rules at the state level is well intentioned but would ultimately result in conflicting standards and less investor access to information and choice of products. Specifically, states attempting to create their own fiduciary rules would introduce a new level of investor confusion, which would undercut not only the SEC’s promulgation of a uniform, nationwide, heightened best interest standard of conduct for broker-dealers but would also undercut investor protection generally. Moreover, exclaimed SIFMA, Nevada’s proposed rule would significantly run the risk of driving the movement for a fee-based business model, which small investors particularly would not be qualified for, and many Nevada investors would likely suffer the inability to access brokerage accounts, as well as a broker-dealer’s financial advice.

Tuesday, March 05, 2019

SCOTUS asked to reject CFTC’s proximate cause theory and authority to impose lifetime industry bans

By Brad Rosen, J.D.

Precious metals dealer Southern Trust Metals, Loreley Overseas Corporation, an overseas affiliate, and its principal Robert Escobio, in a petition for writ of certiorari, are asking the United States Supreme Court to overturn an Eleventh Circuit ruling that adopted the CFTC’s position with regard to its fraud determination and sanctions. In particular, the petitioners contend that the appellate court erred by deciding that foreseeability and reliance alone, absent any finding of loss causation are sufficient to establish proximate cause. Additionally, the petitioners are asking the high court to overturn lifetime industry bans, arguing that such injunctions constitute penalties which are unconstitutional in violation of separation-of-powers principles (Southern Trust Metals, Inc. v. CFTC, February 15, 2019).

District court ruling. The federal court for the Southern District of Florida found in favor of the CFTC that the corporate defendants and its principal Robert Escobio had defrauded its customers under the Commodity Exchange Act (CEA). Specifically, the court found that the defendants engaged in margined derivatives transactions while purporting to actually purchase precious metals on behalf of customers. The court enjoined the defendants from further violations and ordered payment of a $357,032 civil monetary penalty and $2,103,617 in customer restitution. As a controlling person, Escobio was found jointly and severally liable for Southern Trust’s violations of the antifraud provisions of the CEA and CFTC regulations.

Eleventh Circuit proceedings. In an initial ruling, an Eleventh Circuit panel upheld a district court judgment in favor the CFTC finding that defendants Southern Trust Metals, Inc., Loreley Overseas Corporation, and Robert Escobio violated the Commodities Exchange Act. That judgment was based on CFTC claims that the defendants failed to register as futures commission merchants, transacted the purchase and sale of contracts for the future delivery of a commodity future outside of a registered exchange, and promised to invest customers’ money in precious metals but instead invested the funds in futures. Notwithstanding, the appellate court rejected and vacated the portion of the judgment relating a restitution award for a group of investors whose losses were associated solely with the registration violations. That portion of the judgement was remanded to the district court.

A subsequent judgement of the appellate court was entered on July 12, 2018. That pleading is contained in Appendix A of the petition. The petitioners then sought a rehearing en banc which was denied by a ruling dated October 18, 2018 as set forth in Appendix D of the petition.

Petition for writ of certiorari. The petition, filed on February 15, 2019, asks the Court to consider the two following questions:
  1. Whether foreseeability and reliance alone, without any proof of loss causation, satisfy Section 13a-1(d)(3)(A) of the Commodity Exchange Act’s proximate cause requirement, in contravention of the Supreme Court’s decisions in Bank of America Corp. v. City of Miami and Dura Pharmaceuticals, Inc, v. Broudo; and
  2. Whether a lifetime industry ban is a penalty and therefore beyond a district court’s statutory and equity power to issue without violating separation-of-powers principles.
In their filing to the Supreme Court, the petitioners assert that the CEA limits restitution in enforcement actions to “losses proximately caused” by a violation of Section 13a-1(d)(3)(A) of the CEA. They contend that the Court’s 2017 decision in Bank of America Corp. v. City of Miami, Florida holds foreseeability is not enough to satisfy proximate cause. Moreover, they argue that establishing proximate cause under the Court’s 2005 decision, Dura Pharmaceuticals, Inc. v. Broudo requires a plaintiff to show loss causation, meaning “not only that had he known the truth he would not have acted but also that he suffered actual economic loss.” The petitioners contended that the Eleventh Circuit erred by ruling that foreseeability and reliance are all Section 13a-1(d)(3)(A) of the CEA requires to satisfy proximate cause and specifically held loss causation is not required.

The petitioners also contend that the Eleventh Circuit also erred by affirming a lifetime industry ban against them. They assert that the injunctive relief provisions of CEA Section 13a-1(a) authorize no such relief, and further note that the circuits are split on whether an injunction may be deemed to be a permissible penalty.

The case is No. 18-1123.

Monday, March 04, 2019

SEC staff agrees to waive in-person voting requirements for fund boards in some instances

By John Filar Atwood

In certain circumstances, investment company board members no longer have to meet in person to vote on matters before the board, according to the staff of the SEC’s Division of Investment Management. In a no-action letter issued to the Independent Directors Council (IDC), the staff said that voting by telephone, video conference, or other means would not diminish the board’s ability to carry out its oversight role or other specific duties. The position extends to business development companies as well as investment companies and series thereof.

In the letter, the staff stated that in light of market, regulatory, and technological developments, it has continued to review existing director responsibilities to determine whether they are appropriate and are carried out in a manner that serves the shareholders’ best interests. The staff believes that the relief requested by IDC will remove significant or unnecessary burdens for funds and their boards.

The staff indicated that it will not recommend enforcement action for violations of Investment Company Act Sections 12(b), 15(c) or 32(a), or Rules 12b-1 or 15a-4(b)(2) thereunder if fund boards do not adhere to in-person voting requirements in certain cases.

Applicable situations. The relief applies in situations where the directors needed for the required approval cannot meet in person due to unforeseen or emergency circumstances, provided that no material changes to the relevant contract, plan and/or arrangement are proposed to be approved at the meeting and the directors ratify the applicable approval at the next in-person board meeting (“Scenario 1”). It also applies where the directors needed for the required approval previously fully considered all material aspects of the proposed matter at an in-person meeting but did not vote on the matter at that time, provided that no director requests another in-person meeting (“Scenario 2”).

IDC requested no-action relief with respect to the following actions: 1) renewal (or approval or renewal in the case of Scenario 2) of an investment advisory contract or principal underwriting contract pursuant to Section 15(c); 2) approval of an interim advisory contract pursuant to Rule 15a-4(b)(2) with respect to Scenario 2 only; 3) selection of the fund’s independent public accountant pursuant to Section 32(a) (with respect to Scenario 1, the accountant must be the same accountant as selected in the immediately preceding fiscal year); and 4) renewal (or approval or renewal in the case of Scenario 2) of the fund’s 12b-1 plan.

In its letter, IDC described unforeseen or emergency circumstances as those that could not have been reasonably foreseen or prevented and that make it impossible or impracticable for directors to attend a meeting in-person. Such circumstances could include, but not be limited to, illness or death, including of family members, weather events or natural disasters, acts of terrorism, and disruptions in travel that prevent some or all directors from attending the meeting in person.

Consistent with prior relief. IDC argued that relief in this area would be consistent with prior positions taken by the staff in exemptive orders and no-action letters. IDC cited relief granted by the staff in the wake of the September 11, 2001 attacks and during the 2008 financial crisis.

In addition to the arguments put forth by IDC, the staff said that in reaching its decision it also considered the views expressed by the Mutual Directors Forum in a June 2017 letter to Chairman Jay Clayton.

Friday, March 01, 2019

Report from the 2019 Global Legal Hackathon front: Innovators' work on enhancing contract life-cycle management takes first place in Riverwoods

By Brad Rosen, J.D.

A group of technology savvy innovators recently came together as part of the Global Legal Hackathon (GLH) in Riverwoods, Illinois the last weekend in February to create a new legal technology application called ICAIR (Contract Alert Intelligent Result) designed to further protect companies and help them manage their legal, financial, and reputational risks. In the process, the eight-member WeCAIR team became one of the event’s first round winners, earning the right to proceed to the semifinals in March, and potentially on to the finals scheduled in New York City in May.

In Riverwoods, 26 participants were spread over four teams, and including staff, volunteers, and judges. There were 48 attendees during the course of the weekend. Aside from the first-place finisher, a number of other interesting legal problems were tackled by the other three teams. These included:
  • An application called Required Event Disclosure which would assist corporate counsel to determine whether a particular event, such as a data breach or an oil spill, required disclosure to shareholders under securities law by utilizing artificial intelligence and data enrichment techniques;
  • The Cover Your Case application which allows a busy litigation attorney to find available counsel to cover routine court calls and proceedings in short order; and
  • A tool named Legal Hub which facilitated matching clients to attorneys with specialized expertise in a given practice area. 
While the prevailing WeCAIR team was battling it out in Riverwoods over an intense 52-hour timespan, more than 6,000 participants were similarly competing at Global Legal Hackathon events across six continents, 46 cities, and 24 countries, making it the largest legal technology innovation event in history. Wolters Kluwer played a leading role as a GLH global sponsor, hosting or sponsoring nine venues which included Amsterdam, Frankfurt, Madrid, Milan, Bucharest, Budapest, Warsaw, New York, as well as Riverwoods, which is just north of Chicago.

What is the GLH? Simply, the GLH provides a platform for legal innovators to come together to build and launch technology-based solutions aimed at a solving a particular problem connected with the practice of law or access to legal services. Many GLH participants focused their efforts on some of the most significant challenges as identified by Wolters Kluwer customers from around the world. The top five issues included the following: 
  • Tracking legal changes affecting the industry and the impact on the firm and customers;
  • Providing relevant legal information connecting external and internal knowledge;
  • Better understanding the impact of regulatory changes/events, particularly across multiple jurisdictions;
  • Enabling small legal practices to compete with bigger players; and 
  • Crafting a winning litigation strategy. 
The Riverwoods judges weigh in. In Riverwoods, an esteemed panel of judges was assembled to consider the various projects. They included Kingsley Martin, President of KMStandards, Laura Kopen, Research Analyst at Neal Gerber and Eisenberg LLP, Noel Elefant, Founding Member and Principal Attorney at General Counsel Practice, LLC, and Kristofer Swanson, Vice President and Forensic Services Practice Leader at Charles Rivers and Associates.

In evaluating the projects, the panel peppered the GLH participants with penetrating questions and focused on following three criteria: 
  • User validation. Does the developed solution have a good understanding of the users and their needs?
  • Design and implementation. How good is the solutions design? How well is it executed
  • Business Model. How feasible is the business model? 
While the panel seemed impressed with the eventual ICAIR application winner, that did not stop them from asking tough and scrutinizing questions. The team’s lead spokesperson described the application as being able to review of portfolio of contracts in light of some exogenous event, such as a tsunami or terrorist attack, and advise management of emergent risks.

Judges probed team members with respect how an “event” is defined under the system, how to train the system, customization, and how to price and market the application. The team leader noted that the system was based on a fully automated approach, but it could also accommodate specific human intervention.

Why legal hackathons matter and are needed. There aren’t many opportunities for people who work in law firms, corporate legal departments, and other institutions to connect and work on innovation together according to Dean Sonderegger, Vice President & General Manager, Legal Markets and Innovation at Wolters Kluwer Legal & Regulatory U.S. He believes that the hackathon platform provides a space for various legal industry players to express their needs and collaborate on solutions. Specifically, Sonderegger has articulated some key reasons why legal hackathon events are of crucial importance to the industry including: 
  • Connectivity among participants: A hackathon provides a forum for networking and collaboration that is rare to encounter in our industry. Connections made at industry events or conferences certainly have their value, but participating in an iterative process with industry peers presents a different kind of opportunity to connect with people whom you may not otherwise encounter.
  • Exposure for great ideas: Hackathons have the potential to shine the light on people with great ideas. This presents a very different format from many other legal market events, where start-ups may not have as much of a presence as other companies. Events of this kind allow truly innovative thinking to take center stage.
  • Identification of common issues: It’s normal for professionals in certain functions to have similar sets of challenges—and chances are there’s someone halfway across the world with the same challenges as you, and perhaps that person has an idea about how to solve them. Collaborative events give professionals the chance to connect and dive into solving for specific use cases that impact their work and their clients. 
  • Getting away from the day-to-day grind. When you’re focused on operating your business, it’s not easy to innovate within your own environment. According to legal technology leader David Fisher, “Hackathons can create a unique laboratory for professionals to invent, build, and innovate around common challenges that practitioners encounter every day.” Fisher is the founder and CEO of Integra Ledger and one of the founders of the Global Legal Blockchain Consortium, a legal industry group focused on standards and governance for the use of blockchain technology in the industry. 
A future of innovation has arrived. At the commencement of proceedings in Riverwoods, Stacey Caywood, CEO, Wolters Kluwer Legal & Regulatory, told GLH participants that “something incredible is waiting to be discovered” and “we look forward ground breaking solutions to improve legal practice.” As the recent weekend demonstrates, the legal hackathon platform will surely continue to be a key driver in the creation of solutions that have real impact for professionals.

Thursday, February 28, 2019

CFTC Chairman Giancarlo provides insights into priority undertakings at the agency

By Brad Rosen, J.D.

SIFMA President and CEO Kenneth E. Bentsen, Jr. sat down with CFTC Chairman J. Christopher Giancarlo to explore a number of top matters under consideration at the Commission in the premier episode of its new video series titled A View from Washington.

In this first edition, Chairman Giancarlo provided insight into five timely CFTC undertakings, including an update on last year’s CFTC cross-border white paper, next steps on the proposed SEF trading rule, the final phase of implementation of initial margin, progress on inter-agency harmonization, and the chairman’s priorities in the remaining months of his tenure.

An update on the CFTC cross-border white paper. Giancarlo provided an update on the CFTC’s 2018 white paper, Cross-Border Swaps Regulation Version 2.0: A Risk-Based Approach with Deference to Comparable Non-U.S. Regulation. He noted that, based on feedback and discussions with fellow regulators and market participants, if a jurisdiction has adopted the G-20 accords it should be afforded deference, provided there is a rough degree of regulatory equivalence. The chairman further observed if the U.S. is going to regulate the rest of the world, then non-U.S. regulators will likely look to do the same.

Next steps in connection with the proposed SEF trading rule. Chairman Giancarlo indicated that the Commission is in the process of responding to feedback and concerns from market participants on the proposed SEF trading rule where the comment period was recently extended. Acknowledging the proposed rule received its share of constructive criticism, the chairman urged that the CFTC’s approach to swaps execution should encourage greater flexibility and innovation. He asserted that the CFTC should not dictate how swaps execution should occur as it currently does by virtue of its RFQ (request for quote) or order book requirement.

Giancarlo also identified three major concerns articulated by a broad cross section of market participants. First, there are concerns about how additional markets will be brought under the scope of the rule. Second, many believe that pre-trade communications should be permitted in the SEF execution environment. Third, many are concerned about issues surrounding impartial access, especially when a SEF can determine the eligibility of market participants. Giancarlo noted that the CFTC is committed to establishing the best regulatory framework with regard to SEF execution.

Final phase implementation for initial margin. Giancarlo also shared his view regarding the final phase of initial margin implementation, which is set for 2020, and the potential challenges market participants could have in preparing for this final phase. The chairman observed that around 1,000 new market participants may be brought into the new initial margin regime and that the Commission is very sensitive to issues around systematic risk. Giancarlo also indicated that the CFTC is working closely with other regulators in connection with issues concerning documentation and margin threshold amounts. He indicated that many of these matters remain on the table and may well be subject to further study.

A progress update on inter-agency harmonization. The chairman also provided his views on the progress of efforts for inter-agency harmonization between the SEC and CFTC, particularly given the joint jurisdiction over the swaps market. Giancarlo reiterated his commitment to this undertaking and noted that progress has been made on a number of fronts, although the government shutdown slowed up the process. The chairman also asserted that getting the pending SEF rules right is particularly crucial in light of these discussions and the potential impact on security swaps. In conclusion, Chairman Giancarlo is excited about the progress that has been made in this area and expects good things to emerge from this process.

CFTC priorities and the year ahead. Chairman Giancarlo explained that he has adopted both a backward looking and forward-looking focus as he looks at the year ahead and the completion of his tenure as CFTC chairman. As for looking to the past, the chairman noted significant progress being made on matters that have long been on the agency’s plate, such as updating SEF rules, cross-border matters, and reforms that have emerged as a result of the CFTC’s Project Kiss initiative that seeks to clean up 40 years of accumulated rules and regulations.

As for looking forward, Chairman Giancarlo unscored the importance of the agency continuing to modernize and become a quantitative regulator and to make greater use of data in all of the CFTC’s operations. The chairman pointed to the relatively recent establishment of LabCFTC, the Market Intelligence Branch, and the creation of the Chief Market Intelligence Officer position. In Chairman Giancarlo’s view, these and other measures will lead to better analysis across the board, and will spur the agency’s continued evolution to meet whatever challenges lie ahead.

Wednesday, February 27, 2019

SEC says Musk’s unvetted tweet is in contempt of court

By Anne Sherry, J.D.

The SEC began proceedings that could end with a contempt order against Tesla CEO Elon Musk for tweeting false information that had not been preapproved. Last October, the Southern District of New York approved a settlement requiring Tesla to implement, and Musk to comply with, procedures for the oversight of social media posts and other writings. The Commission is now asking the court to order Musk to explain how a February 19 tweet that mischaracterized Tesla’s projected production numbers does not constitute contempt of court (SEC v. Musk, February 25, 2019).

Settlement terms. The settlement came about after Musk tweeted last August that he had secured funding to take Tesla private at a substantial premium to its then-trading price. Later in the month Tesla walked back these statements and eventually clarified that it was not pursuing a going-private transaction. The SEC charged Musk with fraud based on the tweets, and the parties reached a settlement that, among other things, required Tesla to implement procedures to preapprove “any written communications that contain, or reasonably could contain, information material to the Company or its shareholders.” Tesla also undertook to designate an experienced securities lawyer charged with reviewing those communications. The court approved the settlement after requiring the parties to submit a joint letter in support.

Another false tweet. On the evening of February 19, Musk tweeted that Tesla would make “around 500k” cars in 2019. Later that night, after intervention by the designated securities counsel, Musk corrected this tweet to say that Tesla’s annualized rate of production would reach 500,000 by the end of the year. The SEC now seeks a contempt order against Musk (but not Tesla) for violating the court’s order “by engaging in the very conduct that the pre-approval provision … was designed to prevent.”

Tesla directors, including Musk, are defending a private class-action lawsuit over the failure to implement internal controls and procedures to ensure that Musk’s tweets were truthful. This action, which concerns conduct prior to Tesla’s adoption of the preapproval requirement, had been pending for about a week when Musk made the “500k” tweet.

Musk failed to abide by order. The SEC notes that Tesla did adopt a “senior executives communications policy” as required by the final judgment. The policy states that writings that reasonably could contain material information must be submitted to the general counsel and disclosure counsel prior to publication. “Projections, forecasts, or estimates regarding Tesla’s business” are specifically listed as examples of information that may be material. Under the policy, preapproval essentially expires after two days—if the executive waits longer than that to publish the approved post, he must re-confirm the preapproval.

After a communication from SEC staff, counsel confirmed on behalf of Musk and Tesla that the initial February 19 tweet had not been preapproved and that as soon as Tesla’s designated counsel saw it, that attorney arranged to meet with Musk and they drafted the corrective tweet. Musk claimed that he did not believe that he needed to seek preapproval because the tweet was recapitulating information that had been preapproved 20 days prior. The SEC counters that a violation need not be willful in order to find contempt and that Musk’s claim is undermined by the two-day expiration date on preapprovals.

A defensive approach. The SEC’s settlement was generally perceived as a slap on the wrist, and the agency kept quiet when Musk subsequently tweeted that “the Shortseller Enrichment Commission is doing incredible work.” With the February 19 tweet, however, Musk gave the Commission an opening. In its motion, the SEC quotes from a transcript of Musk’s appearance on 60 Minutes, emphasizing his assertions that “we might make some mistakes” (by releasing some material information without preapproval) and that “nobody’s perfect.” The excerpt continues with Musk’s statement, “I want to be clear. I do not respect the SEC.”

The case is No. 18-cv-8865.

Tuesday, February 26, 2019

Corp Fin director says staff will not reconsider its position on J&J arbitration proposal

By John Filar Atwood

In a letter signed by Division of Corporation Finance Director William Hinman, the staff of the SEC declined to reconsider its position that Johnson & Johnson may omit from the proxy materials for its upcoming annual meeting a proposal asking the company to adopt a mandatory arbitration bylaw provision for disputes between the company and its shareholders. The staff opted not to present the request for reconsideration for full Commission review, finding that the matter did not present a novel or highly complex issue that needed to be resolved by the Commission.

The proposal was submitted to Johnson & Johnson by the Doris Behr 2012 Irrevocable Trust. The company sought to omit the proposal on the grounds that it would require Johnson & Johnson to violate the laws of New Jersey where the company is incorporated.

In a carefully-worded response on February 11, the staff agreed with Johnson & Johnson, noting that the New Jersey Attorney General’s ruling that implementation of the proposal would violate state law was a legally authoritative statement that the staff was not in a position to question (see our previous coverage). Chairman Jay Clayton issued a statement in support of the staff’s position on the proposal.

On February 18, the staff received a letter from the trustee of the proponent asking the staff to submit the matter to the Commission for review. In support of his request, the trustee argued that when validity under state law is at issue, a company should not be treated as having met its persuasion burden based on an opinion of counsel acknowledging the absence of settled law.

Rationale for reconsideration. The trustee claimed that the staff treated the New Jersey Attorney General’s letter as authoritative even though letter itself acknowledged the absence of any relevant case law in New Jersey. The trustee acknowledged that New Jersey would likely look to Delaware law in this circumstance, but pointed out the New Jersey Attorney General has no special expertise in interpreting Delaware law. Moreover, the trustee believes that the New Jersey Attorney General’s role as the state’s chief legal officer does not empower him or her to make authoritative interpretations of New Jersey law.

The trustee also reiterated the point it made in an earlier letter that there is substantial U.S. Supreme Court authority for the conclusion that any New Jersey law that prohibits arbitration in this context would be preempted by federal law. The trustee argued that the staff should have addressed that basis in federal law for rejecting the company’s no-action request. In the trustee’s view, the failure to address this is alone a sufficient basis for appeal since if New Jersey law actually did bar arbitration in these circumstances, it would be preempted by federal law.

J&J rebuttal. Counsel for Johnson & Johnson urged the staff not to reconsider its position on the matter because the trustee had presented no new information in its request. Counsel cited several prior instances where the staff declined to reconsider where the proponent did nothing more than reiterate arguments made in previous letters to the staff.

Hinman noted in his reply to the trustee that staff is allowed to present a request for Commission review of a no-action response relating to Rule 14a-8 if it determines that the request involves “matters of substantial importance and where the issues are novel or highly complex.” The staff applied this standard and concluded that in light of the New Jersey Attorney General’s opinion that implementing the proposal would cause the company to violate state law, the matter does not present a novel or highly complex issue.

Monday, February 25, 2019

Advocacy group criticizes the role of private equity investment in manufactured home communities

By Amanda Maine, J.D.

Americans for Financial Reform (AFR) recently published a report decrying the increasing influence of private equity in manufactured housing. The report finds that private equity firms investing in manufactured home communities threaten low-income families and other vulnerable groups due to little incentive to invest capital into these communities and taking advantage of residents’ limited mobility to increase rents and lot fees.

Manufactured housing.
Manufactured homes (sometimes called “mobile homes” or “trailers”) are factory-built houses, many of which resemble single-family residences and are secured to concrete foundations. An important source of affordable housing, approximately 2.9 million manufactured homes in the U.S. are in communities in which the residents own or rent their homes and rent the land under their homes through the payment of lot fees. Residents also pay additional fees for shared amenities, services, and utilities.

Private equity in manufactured housing. According to AFR, private equity firms are buying up mobile home communities and raising rents and fees, exploiting the fact that many residents cannot move their homes because they are attached to a foundation or due to prohibitive moving costs. Even homeowners who are able to move their homes to escape these higher costs are constrained through zoning and regulations as to where they can go.

Another consequence of this immobility is that private equity investors have few incentives to invest in these properties, AFR stated. Residents often complain that the investors make only cosmetic changes and do not maintain roads, trees, and other common areas. “Private equity investments striving for short-term gains and a quick exit are not intended to create a sustainable housing system of community,” the report warns.

AFR also observed that private equity firms and institutional investors obtain billions of dollars from Fannie Mae to acquire manufactured home companies. In particular, the report notes that a $1 billion loan was obtained from Fannie Mae to purchase Yes! Communities, with the majority stake being held by a sovereign wealth fund and an institutional investor. The loan was characterized by Fannie Mae as “supporting affordable housing” even though it was not clear whether the mortgage terms included requirements to limit rent increases, according to the report.

Residents harmed. The report contains several anecdotes from residents who have been harmed by the actions of private equity owners. One resident noted that after the Carlyle Group purchased her community, the first rent increase was 7 to 8 percent, where previous increases had been 3 to 4 percent. She noted that Carlyle had promised to their investors a return of 7 to 8 percent. It also began charging new homeowners $2,250 a month in lot fees compared to $800 to $1,200 in nearby communities, she said.

Another resident said that after her community was sold, her rent went up from $250 for the space and $400 for the house payments to $1,330 a month just to rent the space. She added that many Spanish speakers live in her community, some of whom are undocumented, which makes them an easy target for harassment by management.

Action needed. AFR senior policy counsel Linda Jun said, “The growing reach and impact of private equity in many parts of the housing market….calls out for attention from lawmakers and regulators.” The report makes several recommendations, including calling on local and state governments to establish rent regulations to allow for reasonable and gradual rent increases; enacting good cause eviction laws to prohibit “eviction mills”; ensuring safe and healthy community maintenance through local, state, and federal government regulation; and instituting transparent, meaningful complaint procedures that residents can follow to report problems.

Local, state, and federal governments should also ensure that residents are protected from retaliation, discrimination by corporate investors, fraudulent or exploitative lease terms, and corporate community owners serving as exclusive real estate agents controlling a homeowner’s right to sell his or her home, the report advised. In addition, the report urges Fannie Mae and Freddie Mac to take steps to prevent their investments from undermining their duty to serve the manufactured housing market by requiring all purchasers, as a condition of financing, to commit to preserving affordability, prohibit unfair lease terms like rent-to-own contracts and excessive fees, and undertake regular property maintenance.

Friday, February 22, 2019

Emulex brief argues for reversal of Ninth Circuit's ruling on Section 14(e) standard

By Rodney F. Tonkovic, J.D.

Emulex Corporation's petitioner brief before the Supreme Court argues that the Ninth Circuit wrongly expanded the inferred private remedy under Section 14(e) to reach conduct taken without scienter. According to Emulex, the Ninth Circuit expressly split from five other circuits by declaring that Section 14(e), which prohibits fraud in tender offers, supplies an inferred private cause of action based on mere negligence, not scienter. This stance is incorrect, the brief argues, because even if one accepts the existence of an inferred private right of action under Section 14(e), there is no basis for expanding that cause of action to reach negligent conduct (Emulex Corporation v. Varjabedian, February 19, 2019).

Only negligence? The case arose from the 2015 merger of Emulex with another technology company. The respondent shareholders alleged that a recommendation statement that Emulex filed with the SEC left out a "premium analysis" and thus created a materially misleading impression in violation of Section 14(e). The district court dismissed the complaint with prejudice, holding that Section 14(e) requires showing a strong inference of scienter and rejecting the shareholder's argument that only proof that the defendants were negligent was required. The Ninth Circuit reversed and required the district court to reconsider under a negligence standard.

Emulex then filed a petition for certiorari asking whether the Ninth Circuit correctly held that Section 14(e) supports an inferred private right of action based on a negligent misstatement or omission made in connection with a tender offer. The Second, Third, Fifth, Sixth, and Eleventh Circuits all require proof of scienter. The court granted certiorari on January 4, 2019, and the case is set for oral argument on Monday, April 15, 2019.

Petitioner brief. Emulex's brief argues that the Ninth Circuit's error demands reversal. First, private rights of action must be created by Congress, and, in recent years, the Court has consistently refused to create new inferred private rights of action or to extend the scope of private rights that had been previously inferred. Even if there is an inferred private right of action under Section 14(e), the brief argues further, that inferred remedy should not be extended to mere negligence.

In its brief, Emulex notes that Section 14(e) was modeled in Rule 10b-5, which requires a showing of scienter. The brief points out that Congress wrote robust procedural protections when it authorized private negligence actions under the securities laws, and Section 14(e), which says nothing about negligence in the first place, has none of these protections against abuse. The language of Section 14(e) (e.g., "fraudulent," "deceptive," and "manipulative") is "unmistakably linked with intentional conduct," the brief contends, in contrast to concepts linked with a negligence regime, such as "reasonable care." The brief argues that the Ninth Circuit erred in looking at clauses of Section 14(e) in isolation instead of as a whole.

Moreover, allowing recovery based on negligence under Section 14(e) would circumvent Section 18's express cause of action authorizing suit against makers of false statements in SEC filings. The brief observes that the respondents could have sued under Section 18, but opted instead to sue under the inferred cause of action that the Ninth Circuit had derived from Section 14(e). Emulex notes that Section 18 claims are subject to procedural protections not found in Section 14(e) and, importantly, that Section 18 expressly forecloses liability based on negligence.

Emulex also takes issue with the Ninth Circuit's reliance on the Court's decision in Aaron v. SEC (1980) in finding an inferred private right. Aaron, the brief explains, concluded that scienter was not required under all subparagraphs of Securities Act Section 17(a). Emulex asserts that the language and historical context of Section 17(a) and Section 14(e) differ in ways that suggest that scienter is required under Section 14(e). The brief also suggests that Aaron is inapposite because Section 14(e) was modeled on Rule 10b-5, not Section 17(a).

Finally, the brief maintains that even if Section 14(e) proscribed negligent conduct, it would not be privately enforceable. First, if Aaron's treatment of Section 17(a) is used as a model, most appellate courts have held that there is no inferred right of action under Section 17(a) at all. In addition, Section 14(e) does not meet the requirements the Court has looked to in deciding whether Congress intended to create a private right of action. First, the Court looks for "rights creating" language, but Section 14(e) is a general prohibition and lacks language focusing on a particular class. And, Section 14(e) explicitly gives the SEC and enforcement role and nowhere alludes to a private remedy.

The petition is No. 18-459.

Thursday, February 21, 2019

Industry groups weigh in on SEC’s variable annuity disclosure proposal

By Amy Leisinger, J.D.

Several industry groups have voiced support for the SEC’s proposal to permit issuers of variable annuity contracts and variable life insurance contracts (together, VIPs) to use a summary prospectus to satisfy their statutory prospectus delivery obligations. According to the Investment Company Institute (ICI), the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness (CCMC), and the Independent Directors Council (IDC), the simplified disclosure and delivery requirements would benefit investors by allowing them to receive information in a clearer, more easily understood manner and would reduce costs for VIPs and underlying portfolio companies, namely registered investment companies. The organizations, however, recommended certain changes regarding permitted disclosures to prospective and existing VIP owners to ensure they have the information necessary to make informed decisions.

Disclosure proposal. In October 2018, the SEC proposed new Securities Act Rule 498A, which would permit the satisfaction of prospectus delivery obligations for VIPs by sending a summary prospectus to investors and making the statutory prospectus available online. The proposed rule contemplates an “initial summary prospectus” for new investors and an “updating summary prospectus” for existing investors. The initial summary prospectus would include: an overview of the contract; a table summarizing certain key information about the contract, and more detailed disclosures relating to fees, purchases, withdrawals, and other contract benefits. The updating summary prospectus would include a brief description of certain changes that occurred during the previous year, plus the key information table from the initial summary prospectus.

The proposed rule would also require that the statutory prospectus and the contract's Statement of Additional Information (SAI), to be accessible, for free, online at a website specified in the summary prospectus. Prospectuses for underlying mutual fund investment options may also be available online; this option would only be available for portfolio companies available as investment options through variable contracts that use contract summary prospectuses. An investor may choose to have information delivered in print or electronically at no charge.

ICI. ICI voiced strong support for the proposal, noting that requiring VIP issuers to include certain key information about portfolio companies in an appendix to the summary prospectus and providing an optional online delivery method for portfolio company prospectuses would benefit both customers and firms. The organization did, however, recommend certain enhancements to increase the usefulness of the summary prospectus:
  • VIP issuers should be allowed to include a statement informing investors how to obtain more current portfolio company performance information.
  • VIP issuers should be permitted to provide performance information for the life of the portfolio company beyond the timeframes provided in the proposal to align portfolio company disclosure requirements with the requirements for mutual funds.
  • VIP issuers should be allowed to include a portfolio company’s net expense ratio after any waivers and/or reimbursements and be required to make disclosures regarding only those portfolio company sub-advisers that manage a significant portion of the portfolio instead of all sub-advisers. 
ICI also encouraged the SEC to provide flexibility regarding the website address on which portfolio-company materials may appear and descriptions of the terms of any expense-limitation arrangements and confirm that an updating summary prospectus is only required to highlight changes that have affected the availability of portfolio companies.

CCMC. The CCMC expressed its support for the proposal’s efforts to make prospectuses more transparent for, and easily understood by, customers. A layered approach to disclosures allows for providing key information up front, with additional details available online or in paper format, the organization explained. However, the CCMC noted, the SEC should ensure that disclosure requirements are principles-based and allow for the flexibility necessary to effectively communicate with investors. Further, according to the CCMC, the proposal creates an opportunity to overall improve the language of annuities, and the SEC should take steps to avoid codifying old and confusing annuity language in within the new rule and amendments.

“[M]andating the use of confusing terminology runs counter to the stated goal of helping investors better understand these products,” the organization opined.

To counteract potential issues, the CCMC recommended that the SEC avoid prescriptive wording choices and, instead, outline more general requirements for underlying content so that disclosures can be adjusted to provide consumers with more accurate information regarding VIPs.

IDC. The IDC noted that fund directors are strongly in favor of providing investors with clear and useful information in an accessible format and that a layered approach that allows investors to individually choose the amount of information they receive and how they receive is beneficial for all. A more “user-friendly” approach better reflects the way that consumers make financial decisions in modern times, the organization explained. Further, the IDC applauded the proposal to make funds’ summary and statutory prospectuses available online, noting that this option will produce cost savings for funds and their shareholders. However, the IDC suggested providing flexibility regarding the website on which fund materials will appear and urged the SEC not to require that they be made available at the same website as the VIP materials.