Thursday, May 23, 2019

NASAA adopts investment adviser information security model rule package

By Jay Fishman, J.D.

The North American Securities Administrators Association, Inc. (NASAA) has adopted an information security model rule package to enhance state-registered investment advisers’ cybersecurity and privacy practices.  The package consists of:
  1. A model rule requiring investment advisers to adopt policies and procedures regarding information security (both physical security and cybersecurity) and to deliver its privacy policy annually to clients;
  2. An amendment to the existing investment adviser NASAA model recordkeeping requirements rule mandating that investment advisers maintain records of their cybersecurity and privacy policies and procedures; and 
  3. Amendments to the existing investment adviser NASAA Unethical Business Practices of Investment Advisers, Investment Adviser Representatives, and Federal Covered Advisers and NASAA Prohibited Conduct of Investment Advisers, Investment Adviser Representatives and Federal Covered Investment Advisers Model Rule USA 2002 502(b) model rules, to include failing to create, maintain, and enforce the cybersecurity and privacy policies and procedures.   
Model rule package. The package was prompted by the current potential for information security breaches at investment adviser firms that could devastate the bottom line of any business, particularly a small business, as well as damage a firm’s reputation and a client’s trust in the investment adviser.

The Ohio securities commissioner and chair of NASAA’s Investment Adviser Section, added, “This is significantly important considering that 80 percent of the 17,500 state-registered investment advisers are one-to-two-person shops.”

Regarding the overall package’s importance, NASAA’s current President and Vermont Securities Commissioner Michael Pieciak, declared that “NASAA seeks to highlight the importance of data privacy and security in our financial markets along with the related need for investment advisers to have information security policies and procedures. The package does this by providing a basic structure for how state-registered investment advisers may design their information security policies and procedures, which we expect to create uniformity in both state regulation and state-registered investment adviser practices.”

Investment adviser section annual report. NASAA also issued its 2019 Investment Adviser Section Annual Report highlighting the many activities the organization undertook in 2018 to help small- and mid-size investment adviser firms continue to succeed and to understand and comply with state securities laws. The report provides information about investment advisers across the United States, including the demographics of the 17,543 state-registered investment advisers and 10,480 SEC-registered investment advisers; their business and fee structure; their clients; and the top advisory services they provide. The report also provides NASAA project group reports, outreach efforts, and the results of a continuing education survey.

Wednesday, May 22, 2019

Chamber of Commerce criticizes recent state fiduciary proposals, urges SEC to declare federal preemption

By Amanda Maine, J.D.

The U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness (CCMC) has written to the SEC calling on the Commission to reiterate that the federal securities laws would preempt recent state proposals seeking to establish fiduciary or best interest standards. A federal standard such as the SEC’s proposed Regulation Best Interest would better serve and protect investors compared to standards that differ on a state-by-state basis, according to CCMC.

State proposals. CCMC took aim at proposals in Nevada and New Jersey that would implement new uniform fiduciary standards of conduct for broker-dealers and registered investment advisers. According to CCMC, these proposals, should they become law, would be preempted by the National Securities Markets Improvement Act of 1996 (NSMIA).
Under NSMIA, regulatory requirements imposed by state law on SEC-registered advisers are preempted, except those that relate to fraud, notice filings, and Investment Advisers Act fees. In particular, CCMC highlighted text from NSMIA that prohibits states from establishing certain requirements “that differ from, or are in addition to” those enshrined in federal law.

The Nevada Securities Division proposed new regulations establishing fiduciary duties for broker-dealers and investment advisers in January 2019. CCMC noted that the proposal states that it is meant to be “interpreted and apply in harmony” with NSMIA but added that this statement alone would not prevent federal preemption in light of the requirements of the proposal. Because the Nevada proposal would result in new financial responsibility and record-keeping requirements for broker-dealers, they would have to endure the added expense of obtaining more insurance coverage, according to CCMC.

In addition, the proposal would require that broker-dealers make and keep records beyond those required by federal law, CCMC advised. “Virtually all recommendations would result in an ongoing obligation to monitor and advise clients,” even for a one-time fiduciary recommendation, CCMC said. This would require the collection and documentation of all relevant information about the client.

CCMC also criticized the Nevada proposal for deeming as fiduciary advice certain acts not related to the recommendation of securities, such as recommending other advisors. In addition, CCMC noted that the Nevada proposal would put the burden on the broker-dealer to prove that an exemption to the fiduciary exists, another burden that NSMIA preempts states from imposing, according to CCMC.

Similarly, the proposal put forth by the New Jersey Securities Bureau last month would impose a uniform fiduciary duty for broker-dealers, investment advisers, and investment adviser representatives, CCMC observed. In fact, the proposed standard explicitly states that it would go beyond the scope of the SEC’s proposed Regulation Best Interest: “Should the SEC adopt Regulation Best Interest, the Bureau’s proposed new rule will exceed this standard,” CCMC quoted from the proposal. State laws that exceed the SEC standard must trip NSMIA preemption, CCMC implored.

Regulation Best Interest. The Commission’s proposed Regulation Best Interest, which the SEC approved for comment in April 2018 and is expected to be put to a final vote in the near future, represents an effort to provide comprehensive regulation of investment advice that will preserve retail consumer choice, including for the brokerage “pay-as-you-go” model widely used by small-money investors, CCMC asserted. Fiduciary and best interest standards adopted state-by-state will likely materially conflict with each other and with federal standards, resulting in increased compliance burdens, risks, and costs, CCMC warned. Therefore, the SEC should reiterate that state fiduciary proposals such as those put forth by Nevada and New Jersey would be preempted by federal law under NSMIA, CCMC concluded.

Tuesday, May 21, 2019

Class action alleges Lyft misled investors in IPO

By Lene Powell, J.D.

In a new lawsuit in California’s Northern District, a family trust is alleging that Lyft Inc. misled investors in documents supporting its recent IPO regarding the company's national market share, safety issues regarding its bike sharing business, and labor issues, causing the share price to be artificially inflated and resulting in investor losses when the truth came out (Malig v. Lyft Inc., May 17, 2019).

IPO. Headquartered in San Francisco, Lyft operates a peer-to-peer marketplace for on-demand ridesharing, including access to motor vehicles, shared bikes, and shared scooters. According to the suit brought by Block & Leviton, Lyft offered 32.5 million shares via its March 28 IPO at a price of $72.00 per share, for total proceeds of $2.34 billion.

Misrepresentations. The action claims violations of Section 11 of the Securities Act for misrepresentations in the registration statement and prospectus. According to the complaint, Lyft’s statements about company’s business metrics, growth potential, and financial prospects were not as strong as presented in the offering materials.

This financial weakness was allegedly due to several reasons. First, to increase the Company's reported revenues and profits in the lead-up to the IPO, Lyft began charging higher "surge pricing" more often than it had previously been doing, but keeping a higher portion of the additional revenue without sharing a proportionate share with drivers. This led to decreased payment to drivers, disincentivizing them to drive for Lyft, and potentially damaging the business on a long-term basis. Lyft drivers in Los Angeles went on strike for 25 hours on March 25, 2019, just three days before the IPO.

In addition, Lyft allegedly failed to disclose that more than 1,000 of its rideshare bicycles had safety issues, which led to thousands of bicycles being taken out of service in New York, San Francisco, and Washington, D.C. following dozens of reported injuries and safety concerns.

Damages. According to the complaint, these misrepresentations and omissions materially and artificially inflated the share price at the time of the offering. As investors learned additional information after the IPO, the company's shares fell sharply from $72.00 to under $57.00 on April 15, 2019.

The complaint states that the claims are purely strict liability and negligence claims, and that the plaintiff expressly eschews any allegation sounding in fraud.

The case is No. 3:19-cv-02690.

Monday, May 20, 2019

CFTC Chairman Giancarlo lets his hair down in first installment of FIA Speaks podcast

By Brad Rosen, J.D.

CFTC Chairman J. Christopher Giancarlo recently sat down with FIA President and CEO Walt Lukken for the association’s newly launched podcast, FIA speaks. In a candid and engaging interview, the two industry leaders looked back at the chairman’s tenure at the agency, including his many accomplishments, as well as ongoing challenges for the agency and the industry. The chairman also shared some personal insights including how he acquired the “Crypto Dad” moniker, and the role music has played in his personal and professional life.

Becoming a commissioner and embracing Dodd-Frank. At the onset of the interview, Giancarlo shared his backstory and his unlikely path to becoming the Chairman of the world’s preeminent derivatives regulatory agency. “I never aspired to a Washington career” he recollected. After practicing law for 16 years, in 2000 Giancarlo went into business and was a key player in a company that built one of the world’s largest hybrid trading platforms for OTC derivatives, and then helped take that company public.

Then came 2008, and Giancarlo found himself at the center of the financial crisis. He noted, the response was passing and implementing the Dodd-Frank Act. Giancarlo was supportive of all elements of Title VII of the act which centered around the clearing mandate, data reporting mandate, and trading on licensed platforms. Despite his support for the reforms, Giancarlo still had differences with how the CFTC was implementing Dodd-Frank. As a result, Giancarlo reconsidered an opportunity to serve in government and was delighted when he was nominated to serve as a minority commissioner by President Obama in 2014, and then renominated to serve as CFTC Chairman by President Trump in 2017.

It’s all about the calibration. Responding to Luken’s surprise that as a Republican, Giancarlo supported all aspects of the G-20 reforms set forth in Pittsburg in 2009, the chairman noted that Congress had gotten it right with respect to Dodd–Frank. He indicated that that he has been working with these reforms from a commercial point of view, and looking to take the politics out of it. “It’s about calibrating – how do you get these rules to work that is suitable for market activity, he observed. The chairman continued, “ We operate in a global marketplace. We want to have the most optimal regulatory system in world.” Giancarlo, agreed that the KISS initiative is geared to assure that Dodd-Franks elements work practically and efficiently.

An agency that punches above its weight. When asked what makes the CFTC special in its role as one of the world's leading derivatives regulators, Giancarlo responded with the following: 
  • The agency reports to the Congressional Agriculture Committees. Ag folks have a long tradition of working together on a bipartisan basis. As a result, the CFTC is much less of a political agency; that flows down from the top.
  • The staff is sophisticated and highly expert in their areas of specialization.
  • The CFTC is the world’s only exclusive regulator of derivative markets. That may be a reason why U.S. has the largest.
  • Internationally, the CFTC is regarded as a premier regulatory agency. It trains other global regulators and it has a reputation as an extraordinary and leading governmental.
Some highs and some lows. Giancarlo said he wants to be remembered for making the case for having robust well-regulated derivative market at every opportunity. He noted well-functioning derivative markets are vital and essential for enabling stable interest rates as well as stable energy and food prices.

On the downside, Giancarlo pointed to the flat funding he has seen for the agency during his years as a commissioner. “Flat funding means you are a victim of attrition – when people leave you can’t fill that spot”, he observed. The Chairman noted that this cycle may have been broken, as agency funding has increased, although not everything the agency asked for was granted in the most recent round of appropriations.

The legacy of “Crypto Dad.” Giancarlo will certainly be remembered for his opening remarks before the Senate Banking Committee, when he abandoned his prepared statement, and instead shared experieces a recent family gathering, when the younger generation expressed their enthusiasm for virtual currencies. He shared that experience with the legislators and urged them to take cryptocurrencies seriously and not dismiss them out of hand. As a result, the Chairman gained some 46,000 twitter followers, as well as the nickname “Crypto Dad”.

Giancarlo also expressed his long-term bullishness for blockchain technologies. “It here to stay” he told Lukken. Specifically, he thinks blockchain innovations have greater potential in the developing world where payment systems and currencies remain problematic.

Getting the band back together. Giancarlo and Lukken concluded their discussion by talking about how music has shaped there lives, personally and professionally. Both are accomplished musicians. Giancarlo plays banjo and guitar and performs regularly. Once leaving the CFTC, the Chairman indicated he intends to play a lot more music and get the band back together. In fact, Giancarlo indicated that he is booked later in the summer to appear at the Stone Pony, a legendary venue on the Jersey shore where Bruce Springsteen played back in the day.

Chairman Giancarlo will be leaving the CFTC later this year. For him, the beat will go on.

Friday, May 17, 2019

OCIE head highlights key compliance considerations, potential internal controls enhancements

By Amy Leisinger, J.D.

In recent remarks, the SEC’s Office of Compliance Inspections and Examinations Director Peter Driscoll urged chief compliance officers and firms on the whole to remain vigilant in their efforts to protect investors. According to the director, to effectively protect retail investors, these individuals and entities should consider the effectiveness of their anti-money laundering programs and efforts to keep pace with technological changes and attendant cybersecurity concerns. He also identified issues surrounding microcap securities and safeguarding of client assets as potential compliance concerns that could also directly affect investors.

AML. Certain financial institutions are required to maintain AML programs and report suspicious activity to the Financial Crimes Enforcement Network, which helps authorities to pursue misconduct that could threaten investors and market integrity, Driscoll noted. Broker-dealers and mutual funds should take care to ensure that their programs are tailored to address the risks specifically associated with their respective businesses and consider their size and activities and the types of transactions in which their customers engage when determining whether their programs are reasonably designed to mitigate risks, according to the director. Firms also need to take reasonable steps to address red flags identified through AML monitoring and should periodically reassess their AML programs to address emerging risks and evolving business practices, he said.

“Unfortunately, OCIE examiners continue to identify firms that are not conducting independent tests, are not conducting tests on a timely basis, or conduct ineffective tests that cannot identify failures in the firm’s AML program,” Driscoll noted.

Cybersecurity. Ensuring that firms have effective cybersecurity and technology controls has been and remains an OCIE priority, according to Driscoll. OCIE has recently identified risks associated with storage of customer information in connection with certain network solutions, including those using cloud technologies, he explained. Driscoll also stated that examination teams also have observed that some firms’ policies and procedures did not cover standard security features such as encryption and password protection. In addition, the director noted, some firms’ policies and procedures did not sufficiently address requirements for implementing secure configurations and/or engage in comprehensive vendor management.

“Strong and effective cybersecurity is critical to protecting clients’ and consumers’ privacy,” he stressed.

Microcap securities. OCIE continues to prioritize elimination of microcap fraud and remains vigilant in monitoring for manipulative market schemes that threaten to harm investors, Driscoll stated. OCIE plans to examine the role of transfer agents in the issuance of microcap securities and the removal of restricted-stock legends and will also examine firms’ adherence to quotation requirements under the SEC’s rules, he noted. The director urged firms to scrutinize red flags of fraud and manipulation when publishing quotations of over-the-counter securities.

Safeguarding assets. “Safeguarding of client funds is at the bedrock of investor protection,” Driscoll explained, and firms should never become complacent in efforts to ensure that safeguarding frameworks are effective. OCIE examines broker-dealers for compliance with customer protection rules, but technological developments have changed the landscape since rules were first adopted and firms must adapt, he noted. As such, the director encouraged firms to consider new and emerging risks when evaluating processes for safeguarding customer funds in their possession.

“Strong safeguards protect investors, firms and the marketplace—and are in everyone’s interest,” Driscoll concluded.

Thursday, May 16, 2019

Government enforcement officials highlight priorities, recent developments at PLI conference  

By Amanda Maine, J.D.

At a recent panel discussion hosted by the Practising Law Institute, government enforcement officials discussed their agencies’ priorities including cyber issues, cooperation strategies, and recent court setbacks.  

Cyber issues. Marc P. Berger, director of the SEC’s New York Regional Office, said that the Enforcement Division’s activity relating to cyber concerns generally falls into three buckets. The first bucket involves enforcement actions relating to cryptocurrency and digital assets. This area has been very active because the ICO market area has been so active, Berger advised. Even within the ICO space, cases involve two categories. One category is fraud that looks like traditional offering fraud, just with a word like “crypto,” “digital,” or “bit” in the name. The other category involves the failure to register digital tokens as securities or when they are being sold by unregistered broker-dealers, Berger explained. 

The second bucket of enforcement actions are those in which hackers gain access to systems to obtain material nonpublic information. As an example, Berger pointed to charges brought by the SEC and the DOJ against individuals in Ukraine who hacked into newswire services to gain information about corporate earnings releases and then traded on that information, reaping $100 million in illegal profits.  

The third cyber bucket involves cyber security controls, Berger said. Enforcement actions in this bucket include charges relating to policies and procedures that are necessary to protect customer records and information (Regulation S-P) and for identification theft (Regulation S-ID). Last September, the SEC for the first time brought charges for violations of Regulation S-ID, also known as the Identity Theft Red Flags Rule, Berger explained. Voya Financial Advisers agreed to pay $1 million to settle the SEC’s charges relating to weaknesses in their cybersecurity policies that resulted in the failure to detect and protect against a cyber intrusion that allowed access to the personal information of thousands of customers. Also included in this third bucket are matters relating to inadequate disclosure, such as the SEC’s $35 million enforcement action against Yahoo for failure to disclose a massive data breach.  

Regarding the self-reporting of cyberattacks, Berger said in general, the SEC will want to know how the information was accessed, whether there were sufficient walls in place, when the company knew about the intrusion, what the company did in response to the intrusion, and when the company came forward. Berger emphasized that the SEC does not want to second-guess reasonable judgment calls. He added that just because there has been a hack, it does not necessarily mean that the company’s policies and procedures were not robust or rigorous. 

Cooperation and remedies. When asked how the Commission determines to give credit for cooperating with the staff, Berger said the SEC still looks at the Seaboard factors first articulated in 2001. More recently, however, the Commission has been trying to better communicate what factors were considered in awarding cooperation credit, he said. Some of the SEC’s more recent orders have more detailed language on how cooperation credit was determined, including prompt-self reporting, document production, and fast remedial efforts, he advised. While the standards are still the same, the SEC is trying to be transparent on what actions will be useful to the staff.  

Berger also stressed that the SEC will tailor remedies to meet the Commission’s goals, citing specifically the Elon Musk/Tesla and Elizabeth Holmes/Theranos cases. In the Tesla case, one of the targeted remedies involved controls over Musk’s use of social media to communicate company matters (although Berger noted that the SEC recently found itself back in court on this matter). In the Theranos case, founder and CEO Holmes’s settlement with the SEC involved not only a penalty, but being stripped of control of the company. Using creative targeted remedies such as specific undertakings, conduct-based injunctions, and the use of cooperation credit to enhance or reduce penalty amounts are tailored to the harm the SEC is trying to address, Berger explained. He added that the SEC’s actions can have a more deterrent impact when they are brought closer in time to the alleged misconduct.  

FCPA. Christopher Cestaro of the DOJ’s FCPA Unit also weighed in on receiving cooperation credit. The DOJ’s pilot program on cooperation in FCPA cases, launched in 2016, is now a formal corporate enforcement policy, he advised. The policy outlines how the DOJ intends to resolve FCPA matters with companies and gives significant credit to companies who voluntarily and promptly self-disclose misconduct, offer full cooperation, and engage in remediation of FCPA matters. A company can also receive a declination as long as it agrees to disgorge illicit proceeds. The DOJ is very transparent about what it expects regarding cooperation, he stated.   

CFTC issues. Neel Chopra, special counsel to the CFTC’s Director of Enforcement, was asked about the government’s recent setbacks in court, such as the Flotron spoofing case and the DRW manipulation case. Regarding the Flotron case, Chopra pointed out that while the former precious metals trader was acquitted on criminal charges, the CFTC did obtain a $100,000 penalty against him. Chopra also noted that the charge of which Flotron was acquitted was conspiracy, so the courts did not disagree with the spoofing theory specifically. Chopra added that the CFTC has reached settlements and the DOJ has obtained guilty pleas in spoofing cases.   

In the DRW case, the Southern District of New York ruled against the CFTC in a bench trial involving charges of commodities manipulation, which the CFTC decided not to appeal. Chopra said that he does not think that the DRW case set a new standard for CFTC manipulation cases. He noted that the judge had dismissed some of the CFTC’s evidence such as expert testimony that the traders had intended to create an artificial price. He also believes that the opinion was particularly facts-bound and the case itself was factually anomalous due to a highly illiquid market where settlement was based on unconsummated bids, which is different from the CFTC’s traditional cases on market power. In addition, he observed that because the conduct in the DRW case ended prior to Dodd-Frank, it was not charged using the CFTC’s 180.1(c) authority, and under that regime, the case could potentially look different.  

Wednesday, May 15, 2019

SEC proposes amendments, guidance for cross-border security-based swaps

By Lene Powell, J.D.

The SEC has proposed rule amendments and interpretive guidance to adjust the regulatory framework for cross-border security-based swaps transactions and market participants. The proposals would create exceptions for certain transactions from being counted toward the de minimis threshold for registration, business conduct, and reporting requirements; limit the requirement for non-resident entities to provide opinion of counsel letters regarding books and records access; and harmonize SEC rules with the CFTC’s approach to the statutory disqualification of non-domestic associated persons of CFTC-registered swap entities (Proposed Rule Amendments and Guidance Addressing Cross-Border Application of Certain Security-Based Swap Requirements, Release No. 34-85823, May 10, 2019).

“These proposals preserve important investor and market protections, while at the same time addressing several of the practical implementation challenges that have been identified,” said SEC Chairman Jay Clayton.

De minimis threshold. Regulation SBSR implements provides a de minimis threshold for swap dealer activity that triggers the need to register as a security-based swap dealer and comply with certain business conduct and regulatory reporting and public dissemination requirements.

The SEC has proposed interpretive guidance regarding the definition of “arranged” or “negotiated” in the context of what transactions count toward the threshold for non-U.S. persons. Title VII requirements would not be triggered merely because U.S. personnel provide “market color”, i.e. certain background information regarding pricing and market conditions and trends, as long as those U.S. personnel do not receive transaction-based compensation or exercise client responsibility in connection with those transactions.

Also, the SEC is requesting comment on two proposed alternative exceptions from the requirement in Exchange Act Rule 3a71-3(b)(1)(iii)(C) to count transactions toward the de minimis threshold:
  • The first alternative proposal (Alternative 1) conditionally would permit a non-U.S. person not to count security-based swap dealing transactions at issue against the de minimis thresholds so long as all arranging, negotiating or executing activity within the United States is performed by personnel associated with an affiliated entity that is registered with the Commission as a security-based swap dealer.
  • The second alternative proposal (Alternative 2) would also allow for activity in the United States to be performed by personnel associated with an affiliate that is registered with the Commission as a broker (or, as with the first alternative, that is registered as a security-based swap dealer). 
Under either alternative, the non-U.S. person and the affiliated registered entity would have to comply with certain conditions related to business conduct, trade acknowledgments, portfolio reconciliation, disclosure, records, and financial responsibility.

Opinion of counsel letters. Under Exchange Act Rule 15Fb2-4(c)(1), nonresident SBS Entities must certify and provide an opinion of counsel that the Commission can access their books and records and conduct onsite inspections and examinations.

According to firms, this requirement can conflict with various foreign blocking laws, privacy laws, secrecy laws and other legal requirements. In response, the SEC has proposed guidance to limit the requirement for nonresident SBS Entities to obtain certification and opinion of counsel, and to narrow what the opinion must address. Proposed rule amendments would also provide additional time for nonresident SBS entities to submit certifications and opinions of counsel, allowing for conditional registration of up to 24 months before being required to submit such certification and opinion of counsel.

Statutory disqualification. Under Exchange Act Section 15F(b)(6), SBS Entity must not allow an associated person subject to a statutory disqualification to effect or be involved in effecting security-based swaps on behalf of the SBS Entity. Commission Rule of Practice 194 provides a process by which an SBS Entity may apply to the Commission for relief from the statutory disqualification prohibition on a case-by-case basis.

As detailed in the release, the SEC has proposed to amend Rule of Practice 194 to more closely harmonize the Commission’s rules with the CFTC’s approach to the statutory disqualification of non-domestic associated persons of CFTC registered swap entities.

Employee questionnaires. Previously proposed Exchange Act Rule 18a-5 would establish recordkeeping standards for stand-alone and bank SBS Entities, which would require each SBS Entity to make and keep current a questionnaire or application for employment for each associated person who is a natural person.

The SEC has proposed to add exceptions to the rule if the entity is excluded from the statutory disqualification prohibition with respect to the associated person, or the information would violate applicable law in the jurisdiction where the associated person is employed or located.

Next steps. The Commission will seek public comment on the proposed rule amendments and interpretive guidance for 60 days following publication of the proposing release in the Federal Register.

Tuesday, May 14, 2019

AmEx had no duty to update investors about contract negotiations

By Anne Sherry, J.D.

The Second Circuit agreed with a district court that American Express did not violate the securities laws by making—or failing to update—certain statements about its relationship with Costco. After AmEx ended its co-branding agreement with Costco Canada, AmEx’s CFO spoke about the company’s relationship in the United States, which the plaintiffs took as reassurance with a “forward intent.” The court found that the statements were not forward-looking and were strictly true, so there was no duty to update when the U.S. renewal negotiations deteriorated (Pipefitters Union Local 537 Pension Fund v. American Express Company, May 8, 2019, per curiam).

AmEx had separate co-branding agreements with Costco Canada and Costco United States. The company announced in September 2014 that it would not renew its agreement with Costco Canada. At the time of the announcement, an AmEx representative told a news outlet that the decision “is very specific and exclusive to Canada” and that there were separate contracts for the United States. In October 2014 AmEx CFO Jeffrey Campbell reiterated that the contracts were separate and said AmEx had “a longer and more significant relationship with Costco in the U.S., dating back over 15 years.”

In February 2015, AmEx announced that its agreement with Costco U.S. would expire in 2016. Plaintiffs sued Costco, Campbell, and then-CEO Kenneth Chenault for violations of the federal securities laws, specifically for making false and misleading statements about the renewal of the Costco U.S. agreement and for falsely contrasting the Canadian agreement with that in the United States. The plaintiffs argued that AmEx had a duty to update those statements. The district court dismissed the claims, and one plaintiff appealed.

No duty to update. Reviewing the dismissal de novo, the Second Circuit agreed with the district court that AmEx had no duty to update Campbell’s statements because they concerned only existing facts that were not forward-looking. Furthermore, those statements remained precisely correct: the Canada agreement was specific to Canada, there were separate contracts for the two Costco entities, and the relationship in the U.S. was older than that in Canada. Another of Campbell’s statements, that AmEx “works with Costco on an ongoing basis to find ways to drive value for both parties going forward,” was at most an expression of corporate optimism.

No other misleading statements. The plaintiffs also pointed to an earnings call that took place a few weeks before AmEx announced the termination of its agreement with Costco U.S. Responding to a question about when investors might hear about the Costco U.S. negotiations, Campbell spoke about the companies’ relationship, stressed that “I don’t think we’ve said anything about any ongoing discussions we’re having with Costco,” and then said that AmEx works with its partners generally every day to “evolve the relationship to make it better.” According to the plaintiffs, these statements amounted to a denial that AmEx was making any special efforts with respect to Costco U.S., which was not the case.

The appeals court disagreed. Campbell did not state that the companies were not negotiating; instead, his comment affirmed that AmEx would not comment on negotiations while they were underway. No reasonable investor could interpret the statements as denying the existence of renewal negotiations.

The case is No. 17-4142-cv.

Monday, May 13, 2019

SEC kicks off Small Business Week with roundtable examining geographical challenges to raising capital

By Amanda Maine, J.D. 

SEC Advocate for Small Business Capital Formation Martha Miller celebrated the one hundredth-day anniversary of the office’s creation with a roundtable addressing issues facing small businesses when it comes to raising capital, focusing in particular on businesses seeking their mark away from the coasts. The panelists included representatives from three startup companies, one of which has gone public, and two representatives from funding organizations.

Geographical limitations. Miller noted that the vast majority of capital is raised in the coastal regions. For venture capital, most funds are raised in four cities: San Francisco, San Jose, Boston, and New York. Only 13 percent of 2019’s first quarter dealflow had gone to companies in the mountain, midwestern, and southern regions of the country, she said. This flow of funding does not reflect the great companies in those areas, Miller observed. 

Several panelists could relate to having problems raising capitals in non-coastal areas. Nic Wilson, co-founder and CEO of Anglr, said the idea for his company started around a campfire among friends about how to develop a concept that would be interesting to other fishermen, resulting in the ANGLR fishing app. Based in Pittsburgh, Anglr was able to raise around $2 million form local angel investing groups, he said.  However, for the next stage of financing, Anglr had to travel to meet prospective investors.  Wilson said that in Chicago, Anglr met a sports tech investor, which led to a Series A round of financing last summer.

SEC Chairman Jay Clayton noted that in certain regions, the network is so vibrant that one can make a few phone calls and be made aware of the array of investor types, legal and financial services, and people who can point you in the right direction.  Bob Crutchfield, managing director of BrightEdge Fund, observed that density is a big component of the advantage that the coasts have over the rest of the country, so the challenge is to create density in communities like Nashville, Birmingham, Atlanta, and Jackson by combining resources or combining networking opportunities between the capital that resides in those communities. 

Harold Hughes, founder and CEO of fan analytics company BandwagonFanClub.com, which is based in Greenville, S.C., said that in some cases, we might be overthinking how much density is needed to get companies off the ground in smaller communities.  Sometimes the resources available in these communities can be enough to get initial funding, he said. However, the harder part is the next round of funding. He highlighted Charlotte, Raleigh-Durham, and Atlanta as a cohort of cities in which to seek funding. 

Funders weigh in.  Cathy Connett, CEO and managing partner of Sofia Fund, based in Minneapolis, said that there is a lack of funding for smaller companies that move beyond angel investing. For companies seeking to raise $3 million to $20 million, there is a lack of funding, particularly in the Midwest, she said. She also highlighted the reality of what it takes to operate a fund.  While Sofia fund essentially operates for free, most funds take a 4 percent fee. A venture capitalist might say why spend time on a $5 million deal when you can do a $100 million deal; investors look at it the same way, she advised. If I can diversify with a very large fund, why would I invest in five different funds, she observed.

Test the waters and going public. Brian Hahn, CFO and senior vice president of GlycoMimetics, brought the perspective of a recently public biotech company to the roundtable.  He praised the SEC’s “test the waters” provision, which, as part of the JOBS Act’s mandate, permitted emerging growth companies to engage in oral or written communications with certain potential qualified investors before or after filing a registration statement to gauge their interest in a contemplated securities offering. He called the provision instrumental in GlycoMimetics’ IPO. However, he noted that biotech firms face challenges that other startups do not face.  For example, compared to a tech startup, you can’t start a biotech company in your garage, he quipped.

Hahn also raised concerns about compliance with the auditor attestation requirement of Section 402(b) under Sarbanes-Oxley. GlycoMimetics went public in 2014, so the company will be going off the 404(b) onramp this year. As a result, it will be spending hundreds of thousands of dollars on 404(b) compliance when it doesn’t even have revenues yet, Hahn lamented. These represent funds that should be going to the work of the company, he said. In addition, Hahn recommended that the SEC focus more on revenue than market cap. Especially in the biotech industry, he said, you can have billions in market cap with no revenue. 

Diversity. Hughes mentioned that he was proud that his company has found ways to diversify his capitalization table, which is more than 40 percent people of color, 22 percent women, and 17 percent LGBTQ investors. He said his company will continue to push diversity in the equity crowdfunding campaign. 

Connett recalled that in the 1990s, the angel network consisted of deep-pocketed former executives who were usually men.  One of the reasons Sofia was formed, she explained, was that she never had a woman knock on her door and say they wanted to invest. There are millions of women meeting the accredited investor threshold, but not that many actually end up writing a check, she said. She also expressed concern about raising the threshold for accredited investors could result in the loss of angel investing opportunities. 

Friday, May 10, 2019

Antitrust chief discusses antitrust issues related to financial sector at Fordham conference

By E. Darius Sturmer, J.D.

Makan Delrahim, Assistant Attorney General in charge of the Department of Justice Antitrust Division, delivered a speech at the Fordham University School of Law in New York City discussing the application of the antitrust laws to the financial sector. The speech, entitled "Don’t ‘Take the Money and Run’: Antitrust in the Financial Sector", focused on three current "hot issues" in the area: the limits of fund and exchange collaboration, syndicate coordination, and ensuring antitrust compliance.

Delrahim first addressed the antitrust issues posed by common ownership and institutional investors. Noting recent debate "around the role of institutional investors in today’s economy, and whether or not their common ownership of competing firms has an effect on competition," the Assistant Attorney General mentioned a lack of agreement in current literature over which approaches to use to evaluate these effects and what the appropriate remedies should be to address potential adverse competitive effects. The Antitrust Division aims "to ensure any fix doesn’t chill innovation or harm investors," he explained.

A related area drawing the agency’s attention right now, Delrahim continued, is whether and how to bring the law governing interlocking directorates, Section 8 of the Clayton Act, forward to account for modern corporate structures. He reported that his agency is wrestling with whether to interpret the statute to apply to limited liability companies and other organizational structures as it does to corporations. While the statute itself uses only the term "corporation," it "pre-dates the use of LLCs, and certainly predates the widespread acceptance of structures like [LLCs] as an alternative corporate form to a traditional corporation," he remarked. He added that while courts have not yet directly addressed the question, and the legislative history leaves Congressional intent as to that issue unclear, the competition analysis is the same from an agency review perspective.

The Antitrust Division chief next spoke about unlawful collusion, offering highlights of the agency’s criminal enforcement efforts in the financial sector. Delrahim noted that the Antitrust Division’s investigations and prosecutions touching the industry have ranged from international cartels to more local bid rigging. He pointed to its involvement in numerous investigations relating to collusion among real estate investors and bidders at foreclosure and tax lien auctions, as well as prosecutions in the markets for municipal bond derivatives, interest rate benchmarks, and foreign currency exchange that have resulted in 39 convictions and criminal corporate fines of over $3.9 billion.

He acknowledged that not all of the agency’s prosecutions were successful, citing last year’s acquittal of several U.K.-based traders who were indicted for conspiring to manipulate the Eurodollar foreign exchange market and the appellate reversal of the trial convictions of two traders found guilty of manipulating their LIBOR submissions. Nevertheless, Delrahim said, the Justice Department remains willing to pursue "lengthy, difficult investigations from start to finish with dogged persistence and professionalism," and will continue to devote the necessary resources to prosecute challenging cases in the financial services industry. Delrahim pointed out the successful working relationship the Antitrust Division has with numerous other components and agencies both domestically and abroad, and hinted at several upcoming announcements by the agency, including one in an investigation involving the financial sector.

Lastly, Delrahim offered thoughts on the financial sector’s antitrust compliance. "For some firms, the commitment to a culture of compliance as a result of our investigations is readily apparent," he remarked. "Investment in compliance should have benefits," he added. "If violations do occur, robust compliance programs should lead to prompt detection, which not only nips the conduct in the bud, minimizing the harm to consumers, but also gives companies the greatest chance of winning the race for leniency." Delrahim cited plea agreements with Barclay’s and BNP Paribas following investigations into their participation in price fixing conspiracies to show that "extraordinary prospective compliance has tangible benefits," such as reduced criminal fines.

Thursday, May 09, 2019

SEC and PCAOB actions against accountants dropped significantly in 2018

By John Filar Atwood

The PCAOB finalized only 13 enforcement actions against accountants in 2018 representing a 63 percent decline from the 35 actions in 2017, according to a new report from Cornerstone Research. The number of SEC enforcement actions against accountants in 2018 was 32, down 20 percent from the 40 in 2017.

Cornerstone noted in a news release that 2017 was the PCAOB’s most active year of enforcement against accountants, which the report defines as certified public accountants employed by SEC registrants, auditors, and audit firms in the U.S. Conversely, 2018’s tally was the lowest since 2013 and only about 40 percent of the 2015-2017 average of 32 actions.

The head of Cornerstone’s accounting practice said that the decline in enforcement actions against accountants at the PCAOB corresponded to significant changes in leadership at the board.

PCAOB actions. The report states that audits of brokers and dealers continued to represent a large percentage of PCAOB actions, accounting for 46 percent of the 2018 final actions. In 2018, 70 percent of final PCAOB actions involved both an audit firm and one or more auditors, up from the 2013–2017 average of 54 percent. The number of respondents in 2018 final PCAOB actions fell nearly 65 percent from its 2017 all-time high, according to Cornerstone.

The most common allegation in final PCAOB enforcement actions in 2018 involved engagement quality reviews. Specifically, more than two-thirds of the 2018 final actions involved this area. The report notes that nearly one in three final actions involved auditing of related party transactions, while only one action finalized in 2018 involved a financial statement restatement.

Cornerstone found that in addition to bars, suspensions, and other nonmonetary sanctions, the PCAOB imposed monetary penalties against over half of respondents in 2018. Total monetary settlements against individual accountants were $25,000, and monetary settlements against audit firms totaled $660,000.

SEC actions. The report states that final SEC enforcement actions involving accountants have declined in each of the past three years. Cornerstone attributed the 2018 decline to a significant decrease in final actions involving CPAs employed by SEC registrants. In 2018, only 16 final actions involved CPAs employed by SEC registrants, the lowest level in the past six years, according to the report.

In 2018, three out of four final SEC actions involved only individuals, consistent with the 2013–2017 average, Cornerstone found. The total number of respondents (both individuals and firms) in SEC actions finalized in 2018 was 44, well below the 2013–2017 average of 57 respondents.

Cornerstone found that common allegations in final SEC enforcement actions involving accountants included insider trading and engagement quality reviews. The report states that about one-third of the SEC actions were connected to a financial restatement in 2018, and about 10 percent of the actions involving individuals included insider trading allegations. Nearly half of the actions involving auditors or audit firms in 2018 were related to engagement quality reviews, while more than one-third of the actions alleged violations related to auditing of related party transactions.

In addition to bars, suspensions, and other nonmonetary sanctions, the SEC imposed monetary penalties against nearly half of respondents in 2018. The report states that total monetary settlements against individual accountants were less than $600,000, and total monetary settlements against audit firms were approximately $2 million.

State follow-on actions. The report also states that the majority of SEC and PCAOB actions finalized in the 2013-2017 timeframe resulted in a state follow-on action against at least one individual or firm respondent. While the majority of state follow-on actions are completed within two years of a final SEC or PCAOB action, according to Cornerstone, one in four takes longer than two years to complete.

Wednesday, May 08, 2019

Witnesses make the business case for diversity at congressional hearing

By Amanda Maine, J.D.

The House Subcommittee on Diversity and Inclusion held a hearing to examine the economic benefits that result from the implementation of robust implementation of diversity and inclusion (D&I) strategies at corporations and firms. The hearing was bipartisan in nature, with both Democrats and Republicans praising efforts to improve diversity in the corporate landscape and in the financial services industry in particular.

Why diversity matters. Several of the witnesses and committee members drew attention to a study from McKinsey & Company entitled "Why Diversity Matters." According to the study, companies in the top quartile for gender or racial and ethnic diversity are more likely to have financial returns above their national industry medians, with the opposite being true for those in the bottom quartile for diversity.

Victoria Budson, co-founder and Executive Director of the Women and Public Policy Program of Harvard Kennedy School, testified that while women are more highly educated than men across many levels of the education spectrum, the financial services industry has not made full use of this talent. Women may be more equally represented in entry-level roles, but as one looks up the organization, far fewer are in senior leadership positions, and hardly any women of color are found in the c-suite in the financial services industry, despite numerous studies showing that diversity in teams leads to better performance, she said. Gender and racial diversity are correlated to novel solutions, greater innovation, and higher collective intelligence, Budson explained.

Adrienne Trimble, president of the National Minority Supplier Development Council (NMSDC), emphasized that a commitment to diversity is not a social program or a handout. D&I strategies have clear, measurable impact to a corporation’s bottom line. It is especially important to consider diversity due to the country’s changing ethnic demographics, noting that by 2045, it is expected that the U.S. will be majority-minority and all Americans should have a stake in the economy, she said, adding that D&I strategies can help develop products to meet market demand.

William Von Hoene, Jr., Chief Strategy Officer at energy giant Exelon Corporation, touted his company’s D&I program, stating, "our success would be impossible without our commitment to diversity" driven by a wide range of backgrounds, ideas, and perspectives. Exelon’s diversity strategy includes tracking its progress as it does with other key metrics such as safety and financial performance, he said. He also noted that Exelon has seen an improvement in diversity of its senior leadership since it launched efforts to improve diversity six years ago. Five of its six utility businesses have CEOs that are either Hispanic or African-American, and the CEO of Exelon Utilities is a woman. In addition, Exelon also pursues a D&I strategy when it comes to contracting with suppliers, banks, and money managers. The result, according to Hoene: "our supply chain had never operated more efficiently than it does today, nor have our banks, outside law firms, money managers or other professional service providers."

Rory Verrett, founder and managing partner of recruiting firm Protege Search, said that there are five core guiding principles for implementing a D&I strategy. First, it must have the support of the CEO and the board of directors. Second, it must be linked to performance standards and tied to executive compensation. Third, there must be diversity on interview teams, and not just on candidate slates. Fourth, companies must be transparent about issues such as hiring and promotion rates of minorities and women as well as compensation. Finally, companies should be able to unleash the entrepreneurial potential of their diverse employees, he said.

Rick Guzzo, senior leader of Workforce Strategy at Mercer, said that his company has worked with hundreds of companies on their diversity strategies. Diversity is important in driving business value for many reasons, including reputation, investors, and results. Reputation matters because companies that have reputations for inclusion will be favored when competing for top talent and for consumers. It matters to investors who are increasingly interested in ESG (environmental, social, and governance) investing, he said. As for business results, there is plenty of evidence that a well-managed diversity strategy contributes to business success, Guzzo added.

Members’ questions. Subcommittee Chairwoman Joyce Beatty (D-Ohio) inquired how minorities can get fair access to federal contracting opportunities. Trimble observed that her organization, NMSDC, is in a good position to help the federal government reach out to capable minority suppliers. She asked Verrett what the best way would be to help the retention of minorities in firms. Verrett explained that women and minorities are the least likely to be mentored, sponsored, and promoted, so having reliable data on these metrics is important. It is also important to have brand recognition in the market by encouraging clients to engage in a narrative that is specific to candidates of color.

Replying to subcommittee Ranking Member Ann Wagner (R-Mo) on how to improve recruiting minorities and women, Verrett advocated extensive mentorship and sponsorship opportunities, programs for lifestyle challenges (such as paid family leave), training to rotate through all areas of the company, and holding leaders accountable.

Representative Maxine Waters (D-Calif), chairwoman of the full Committee on Financial Services, said a common complaint is from African-Americans, and African-American women in particular, who have worked at a company for years only to get passed up by newer hires for promotions, and asked what can be done to help companies to stop this from happening. Budson said that rather than have an evidence-based framework for promotion, the conversation is about "who’s ready?" Companies should define characteristics for upward mobility and be transparent and specific about these characteristics, she advised.

In response to Rep. Trey Hollingsworth’s (R-Ind) question on how Exelon started its diversity initiative, Von Hoene noted that his industry touches on large urban populations, so the company was mindful that its customers are a very diverse group. He added that the realization that it is not simply the right thing to do, it is the right business thing to do creates momentum to embrace diversity strategies. Hollingsworth asked Budson what is happening that holds women back, to which Budson replied that it is sometimes characterized that women opt-out, when it is more accurate to say that they get fed up and want to go to environments where they feel valued with respect to pay, status, flexibility, and what work is assigned.

Representative Anthony Gonzalez (R-Ohio) said that there is a strong interest in diversity from business leaders in his district and asked Von Hoene how to tailor what Exelon has done for small businesses. Von Hoene acknowledged that one size does not fit all, but the same general principles apply. He noted that a smaller company devoted to diversity could actually have some advantages over a larger company due to more personal relationships with employees. Representative Brian Steil (R-Wis) also asked about small business implementing diversity strategies, to which Verrett recommended starting out a business with a diverse workforce. He observed that millennials are choosing to work for diverse companies.

Trimble added that smaller businesses sometimes have the opportunity to be more flexible, criteria favored by Generation X and millennials. Budson recommended that small companies build partnerships with local student organizations as part of a diversity strategy. She also advised "de-biasing" the hiring process, such as hiding an applicant’s name or where they went to school.

Tuesday, May 07, 2019

CFTC chairman asks FRB to issue guidance on implementation of impending Phase Five margin requirements

By Brad Rosen, J.D.

In a letter to Federal Reserve Board Vice Chairman Randal Quarles dated April 29, 2019, CFTC Chairman J. Christopher Giancarlo laid out a number of significant issues concerning the “Phase Five” implementation requirements for initial margin on uncleared swaps which are scheduled to take effect in September 2020.

New requirements will impose significant costs on smaller firms. Giancarlo explained in the letter that, “As market participants prepare for Phase Five, many of the smaller entities are realizing that, while their notional amounts exceed $8 billion, their calculated margin amounts are less than $50 million.” Identifying the central problem, Giancarlo noted these firms “will soon be required to incur the time and expense of preparing to exchange initial margin even though they will not be required to exchange margin.”

Under the current uncleared margin rules, swap market participants do not have to exchange initial margin unless the calculated amount of margin exceeds $50 million. Additionally, entities with a notional amount of swaps of less than $8 billion are out of scope of the rules. As a consequence, they do not have to establish custodial services, document margin relationships, or operationalize margin exchange.

Chairman’s recommendations. Giancarlo noted the agency’s Office of Chief Economist (OCE) and Division of Swap Dealer and Intermediary Oversight (DSIO) had analyzed market data in response to domestic and international concerns that many small market participants will be brought into scope in the Phase Five implementation. Based on this analysis, Giancarlo made the following specific recommendations:
  • U.S. regulators issue regulatory guidance clarifying that a U.S. regulated entity need not have in place systems and documentation to exchange initial margin on uncleared swaps with a given counterparty if its calculated bilateral initial margin amount with that counterparty is less than $50 million; and,
  • Global regulators further engage with the Basel Committee on Banking Supervision (BCBS) and International Organization of Securities Commissions (IOSCO) to reflect in global principles its recent confirmation that the implementation framework does not specify documentation, custodial, or operational requirements if the bilateral initial margin amount does not exceed the framework's €50 million initial margin threshold.
Consternation over Phase Five abounds. At a recent meeting of the CFTC’s Global Risk Advisory Committee (GMAC), regulators and industry participants alike expressed their consternation and concerns over potential negative consequences associated with implementing the Phase Five requirements during a panel dedicated to the topic. During the meeting, it was noted that:
  • The International Swaps and Derivatives Association (ISDA) estimates Phase Five will bring 1100 entities into the scope, compared to only 34 for Phases One through Three;
  • Entities impacted by Phase Five are concentrated around the low end of the threshold, especially entities involved in non-financial activities; and,
  • Concerns abound around administrative congestion, as each new swap relationship will require investment manager documentation, custodial relationships, and the demand for high quality collateral. 
In his letter, Chairman Giancarlo concluded that uncleared margin rules in the U.S. clearly recognize that small market participants should be granted some form of relief from initial margin requirements. He noted, “This is because small entities contribute little to systemic risk, and would, in any case, exchange only small amounts of initial margin.”

Monday, May 06, 2019

SEC proposes to amend Reg S-X disclosures on acquisitions and disposition of businesses

By Lene Powell, J.D.

The SEC has proposed amendments to rules and forms to improve disclosure requirements for financial statements relating to acquisitions and dispositions of businesses, including real estate operations and investment companies. The goal is to give investors better financial information about acquired and disposed businesses and give companies more timely access to capital, as well as reduce the complexity and cost of preparing disclosures (Amendments to Financial Disclosures about Acquired and Disposed Businesses, Release No. 33-10635, May 3, 2019).

“The proposed rules are, first and foremost, intended to ensure that investors receive the financial information necessary to understand the potential effects of significant acquisitions or dispositions,” said Chairman Jay Clayton.

In a statement, Commissioner Robert Jackson said the rules do need to be updated, but he is concerned that the proposal treats mergers as an “unalloyed good,” even though mergers come with both benefits and costs. Jackson urged commenters to weigh in with detailed ideas on how to improve the proposal and allow investors to hold executives accountable, especially for mergers that harm investors over the long run.

“Some acquisitions create important efficiencies; others allow managers to build empires and extract value from investors. Our disclosure rules should give investors the tools to tell the difference,” said Jackson.

Existing requirements. As explained in a fact sheet, under Rule 3-05 of Regulation S-X, a registrant that acquires a significant business other than a real estate operation must provide separate audited annual and unaudited interim pre-acquisition financial statements of that business. Rule 3-14 of Regulation S-X addresses disclosures related to acquisition of a significant real estate operation. In addition, Article 11 of Regulation S-X requires registrants to file unaudited pro forma financial information relating to the acquisition or disposition.

Rule 3-05 applies to registrants that are registered investment companies and business development companies. However, investment company registrants differ from non-investment company registrants in significant ways, including that they mainly invest for returns from capital appreciation and/or investment income, are required to recognize changes in value to their portfolio investments each reporting period, and generally do not consolidate entities they control or use equity method accounting. As a result, it is often unclear how to apply reporting requirements to acquired funds.

Proposed changes. The proposed amendments would:
  • Revise the investment test and the income test regarding significance, expand the use of pro forma financial information in measuring significance, and conform the significance threshold and tests for a disposed business;
  • Reduce the time period that financial statements of the acquired business must cover from the three most recent fiscal years to two; 
  • Allow the omission of certain expenses for certain acquisitions of a component of an entity;
  • Clarify when financial statements and pro forma financial information are required; 
  • Allow the use in certain circumstances of, or reconciliation to, International Financial Reporting Standards; 
  • No longer require separate acquired business financial statements once the business has been included in the registrant’s post-acquisition financial statements for a complete fiscal year;
  • Align Rule 3-14 with Rule 3-05 where no unique industry considerations exist; 
  • Clarify the application of Rule 3-14 regarding the determination of significance, the need for interim income statements, special provisions for blind pool offerings, and the scope of the rule’s requirements;
  • Amend pro forma financial information requirements to improve content and relevance, specifically, disclosure of “Transaction Accounting Adjustments,” reflecting the accounting for the transaction; and “Management’s Adjustments,” reflecting reasonably estimable synergies and transaction effects;
  • Make corresponding changes to the smaller reporting company requirements in Article 8 of Regulation S-X; 
  • Add a definition of significant subsidiary that is tailored for investment companies; and
  • Add a new Rule 6-11 and amend Form N-14 to cover financial reporting for fund acquisitions by investment companies and business development companies. 
The comment period will run for 60 days after publication in the Federal Register.

Friday, May 03, 2019

Chief Accountant Bricker discusses past and future of financial reporting

By Amy Leisinger, J.D.

In recent remarks, SEC Chief Accountant Wesley Bricker spoke about financial reporting evolution over the last four years and suggested several concepts to incorporate in looking toward the future of financial reporting. According to the official, the quality and reliability of financial reporting has increased over time due to the collective efforts of regulators, auditors, and other market participants, but there has been a long-term trend of less trust in corporations and audit firms. “Confidence in financial reporting is essential to a healthy economy,” Bricker stated.

Recent work. High-quality financial statements help investors to make well-informed decisions, Bricker noted, and regulators and industry participants have been working to advance financial reporting. Accountants should act with the highest level of integrity and accountability, and the Commission continues to work to protect investors from those that fail to meet their professional obligations, he said. FASB has issued new standards for revenue recognition, leases, and targeted improvements to hedging activities, among other things, and Bricker opined that these updates will continue to enhance financial reporting.

In addition, the official explained that non-GAAP reporting designed to supplement comparable GAAP numbers can add insight for investors concerning business performance from various perspectives, but that integrity and consistency in these figures is essential. Bricker also noted that auditor independence is fundamental to the credibility of audit reports and that independence standards must be reviewed over time to ensure that they continue to be effective in relation to evolution in financial industry.

“Preserving and enhancing confidence in the quality of audit services is essential to the public interest and all Americans,” he stated.

To aid in audit firm governance, many large audit firms have appointed independent directors or independent council members to strengthen monitoring and to foster audit quality, Bricker said. These individuals should be independent of mind and willing to challenge others in a constructive manner and contribute to firms’ annual transparency or audit quality reports, according to the official. With regard to audit committees, he said that an audit committee should incorporate the audit firm’s understanding of a company’s business and should take steps to familiarize itself with relevant research evidence. Bricker encouraged voluntary audit committee disclosures and urged committee members to continue to consider ways to improve communication with investors.

Moving forward. While noting that instances of ineffective disclosure controls have decreased for the second year in a row and that auditor inspection findings are on the decline, Bricker suggested that technological advancements could create new risks and complexities in connection with financial reporting. In addition, increasing investor reliance on financial intermediaries could affect how accounting and audit information serves investors, he explained; informed decision-making relies on high-quality, comparable financial information and other metrics, according to Bricker. Additional consideration must be given to the unique audit issues faced by small businesses and the corresponding costs, the official noted. On a broader scale, regulators and industry participants must continue international cooperative efforts to ensure that high-quality financial information is available regardless of the jurisdiction from which it comes, he explained.

“Even as we advance high-quality information in the capital markets, it is critically important to understand and maintain focus on the core principles that will move us forward and to continue to act by them,” Bricker concluded.

Thursday, May 02, 2019

MFA recommends expansion of ‘fund of funds’ proposal to include private funds

By Rodney F. Tonkovic, J.D.

A comment letter by the Managed Funds Association asks the SEC to include private funds in the scope of its proposed "fund of funds" rules. While the MFA supports the updating of the regulation of fund of fund arrangements, it believes that the proposed rule should also include private funds in the scope of Investment Company Act rule 12d1-4 so they may invest in the same manner and subject to the same conditions as registered funds.

Funds of funds. On December 19, 2018, the Commission proposed a new rule and related amendments designed to streamline and enhance the regulatory framework for fund of funds arrangements. "Funds of funds" are created when a mutual fund or other type of fund invests in shares of another fund. The proposal, which would rescind Investment Company Act Rule 12d1-2 as well as a series of exemptive orders issued since the 1990s, would allow, under proposed Rule 12d1-4, a fund to acquire the shares of another fund in excess of the limits of the Investment Company Act without obtaining an individual exemptive order from the Commission, subject to certain conditions.

In its proposal, the Commission acknowledged that expanding the scope of the proposed rule to private funds would level the playing field for those funds. But, the proposal continues, there are risks associated with expanding the scope to private funds including that private funds are not registered with the SEC and are not subject to the same reporting and recordkeeping requirements as registered entities. Accordingly, the Commission did not propose to include private funds as acquiring funds under the scope of the rule.

Market benefits. In its letter, the MFA argued that including private funds would benefit investors and capital markets. With more options, private funds could incorporate ETFs into their investment strategies for the benefit of their investors. ETFs offer an attractive range of opportunities across sectors, the letter says, and restricting private funds from the full range of investments would tilt the playing field in favor of investors in registered funds. Plus, the current restrictions limit hedging through ETFs and could distort price discovery.

Policy concerns. Next, if the proposal is expanded to include private funds, those funds would be required to comply with the investor protection conditions in a substantially similar manner as registered funds. These conditions, the letter adds, would mitigate policy concerns of undue influence and control of acquired funds, layering of fees, and the formation of overly complex structures that could confuse investors.

Along these lines, the MFA recommends amendments to the rule that would provide additional flexibility for private funds to benefit their investors while continuing to protect investors generally. For example, the proposal contains a prohibition against an acquiring fund from controlling the acquired fund. The MFA recommends that the Commission apply the existing requirement in Section 12(d)(1)(A), which prohibits an acquiring fund and companies it controls from acquiring in the aggregate more than 3 percent of an acquired fund’s shares, to Rule 12d1-4.

Compliance. Next, responding to the Commission's explanation that private funds are not subject to the same reporting and recordkeeping requirements as registered funds, the MFA suggested that the extensive regulatory and reporting requirements already applicable to registered private fund managers would provide the sufficient oversight to ensure compliance with the rule. Forms ADV and PF, for example require advisers to private funds to provide extensive information.

Investments in ETFs. Finally, if the Commission declines to include private funds from Rule 12d1-4, the MFA recommends that it allow additional investments by private funds in ETFs, subject to appropriate conditions. The Commission could also opt to treat ETFs separately from other registered funds based on their different characteristics, the letter suggests.

Wednesday, May 01, 2019

House passes bill to create senior investor taskforce at SEC

By Mark S. Nelson, J.D.

The House passed legislation that would establish a taskforce within the SEC to address a range of issues that can impact older investors. The National Senior Investor Initiative Act of 2019 (also called the Senior Security Act) (H.R. 1876), co-sponsored by Rep. Josh Gottheimer (D-NJ) and Rep. Trey Hollingsworth (R-Ind), would require the taskforce and the GAO to report to Congress on the financial abuse of senior investors. The bill passed by a vote of 392-20

Taskforce to make recommendations. If enacted, the bill would create the Senior Investor Taskforce within the Commission to consider issues unique to senior investors. The taskforce’s director would be appointed by, and report to, the Chairman. The taskforce would have a lifespan of 10 years, although the Chairman could reestablish the taskforce.

The functions of the taskforce would emphasize four topics: (1) financial exploitation and cognitive decline; (2) possible changes to SEC regulations and to the rulebooks of self-regulatory organizations; (3) coordination within and without the SEC, including with the Elder Justice Coordinating Council; and (4) coordination with state securities regulators and state law enforcement authorities and with other federal regulators.

The Senior Investor Taskforce would have to report to Congress every two years, but not until the GAO submits a report to Congress and to the taskforce on financial issues affecting senior citizens. The taskforce’s reports would focus on eight topics, including the “most serious issues” for senior investors regarding financial products and services and the existing policies and procedures of market participants such as broker-dealers and investment advisers. The bill would define the persons to be studied as those who are over age 65, although the SEC portion of the bill uses the term “senior investor” to describe these persons and the GAO portion of the bill uses the term “senior citizen.”

Bipartisan support. On the House floor, Rep. Gottheimer, citing a report published by the Senate Special Committee on Aging, told members that seniors are the victims of nearly $3 billion in scams each year. The bill’s co-sponsor, Rep. Hollingsworth, added that the problem will continue to grow while also describing two common scams where fraudsters seek to persuade seniors to pay money to help foreign princes or other supposed dignitaries come to the U.S. or to pay money to get family members out of foreign prisons where they are supposedly being held.

Democratic floor manager Rep. Bill Foster (D-Ill) noted that seniors’ memory and judgment issues can make them vulnerable to exploitation. In July 2014, a meeting of the SEC's Investor Advisory Committee explored this aspect of elder abuse. Kathy Greenlee, then-Administrator of the Administration for Community Living and Assistant Secretary for Aging, U.S. Department of Health & Human Services, made the case (see video beginning at 2:03:14) for the SEC and other federal regulators to become more involved in protecting elderly investors. Greenlee said that elder financial abuse is about old age, not just money. She also cited two risk factors that may account for the growth of elder financial abuse: loss of cognitive function and social isolation.

Republican manager French Hill (R-Ark) remarked that preventing fraud against seniors is important because seniors hold much of the U.S.’s investment assets. He also observed that fraud problems extend beyond seniors’ financial relationships to seniors’ interactions with other trusted individuals such as accountants and lawyers.

State regulators also have given their support for provisions in the bill that would promote consultation between federal and state authorities. Michael S. Pieciak, President of the North American Securities Administrators Association and commissioner on the Vermont Department of Financial Regulation, said in a letter to Rep. Gottheimer that, should the bill become law, it will help inform regulators about the problem of elder financial exploitation.

Financial literacy. The House also passed by a vote of 411-6 the related H. Res. 328, which would promote financial literacy for seniors (a separate resolution that would target financial literacy for young adults passed by voice vote). Although the resolution for seniors would not alter securities laws as would the National Senior Investor Initiative Act, its recitations nevertheless demonstrate the scope of elder financial abuse: (1) just one in 44 cases is reported; (2) 10,000 baby boomers turn 65 every day; (3) one in five citizens over age 65 are victims of financial, property, or identity offenses; and (4) annual losses due to elder financial abuse total $36.5 billion. The statistics cited by the resolution come from the National Adult Protective Services Association, the Investor Protection Trust, and the National Center on Aging.

The one bill and two resolutions passed by the House would complement other recently-enacted legislation aimed at protecting seniors. For example, the Senior$afe Act of 2017 (S. 223; H.R. 3758), sponsored by Sen. Susan Collins (R-Maine) and then-Rep. Kyrsten Sinema (D-Ariz) (Sinema is now a U.S. Senator), eventually became law in 2018 as Section 303 of the Economic Growth, Regulatory Relief, and Consumer Protection Act (S. 2155). The Senior$afe Act provides immunity from suit to individuals and financial institutions that report suspected financial abuse of seniors, provided that those who make such reports have received mandated training.

Tuesday, April 30, 2019

New SEC/Musk settlement spells out which Tesla tweets require preapproval

By Anne Sherry, J.D.

Tesla CEO Elon Musk once again agreed to oversight of his social media posts after SEC contempt proceedings revealed that he had not sought preapproval of any tweets. This version 2.0 of the parties’ settlement, if approved by the Southern District of New York, would substitute a list of categories of written communication requiring preapproval by a designated in-house attorney. Version 1.0 simply stated that preapproval was required for posts that could contain material information (SEC v. Musk, April 26, 2019).

The catalyst for Settlement 1.0 was a series of tweets in which Musk said that he had secured funding to take Tesla private; this turned out not to be the case. The SEC charged Musk with fraud 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.

Five months later, Musk tweeted that Tesla would make “around 500k” cars in 2019. The Tesla attorney saw the tweet and met with Musk, who clarified in another tweet a few hours later that Tesla’s annualized rate of production would reach 500,000 by the end of the year. The SEC brought proceedings to hold Musk in contempt of the court’s order approving Settlement 1.0, noting that Musk had admitted that he had not sought approval for the misleading tweet. In fact, as the SEC argued, Musk had not sought preapproval for a single tweet since the October 2018 settlement.

Musk’s response to the contempt proceedings argued that the “500k” tweet could not reasonably be considered material. Settlement 2.0 attempts to clear up any ambiguity by substituting a more specific list of topics for 1.0’s materiality standard. Pointedly, the list includes “potential or proposed mergers, acquisitions, dispositions, tender offers, or joint ventures” and “production numbers or sales or delivery numbers” that are new or deviate from previously published guidance.

It also includes information about earnings and guidance, projections and forecasts, new or proposed business lines unrelated to existing ones, events regarding Tesla securities or financing, nonpublic legal or regulatory findings, changes in control, and a catch-all: other topics that the company or a majority of independent board members request, if “they believe pre-approval of communications regarding such additional topics would protect the interests of the Company’s shareholders.”

The case is No. 18-cv-8865.

Monday, April 29, 2019

CFTC proposes first rules on the road to achieving high quality swaps data

By Brad Rosen, J.D.

The CFTC has approved a proposed rule geared to improve the quality of swap data and to update and streamline regulations related to swap data repository (SDR) operations and governance. The proposed rule is the first rulemaking to come out of the agency’s report, Roadmap to Achieve High Quality Swaps Data (the “Roadmap”), a comprehensive review of swap reporting regulations issued by the CFTC’s Division of Market Oversight (DMO) in July 2017.

Key elements of the rulemaking. The main elements of the proposed rule update various requirements and include:
  • SDRs verifying swap data with reporting counterparties;
  • correcting swap data errors and omissions for SDRs, reporting counterparties, and other market participants;
  • SDR governance regulations; and
  • SDR operational requirements to ensure that data is available to the CFTC and the public as required by the CEA.
CFTC commissioners weigh in on the proposed rule. Four of the five commissioners provided prepared statements setting forth their respective views on the proposed rule. Two commissioners, Dawn Stump and Rostin Behnam, concurred with the rulemaking, each expressing concerns and reservations, although for diametrically opposed reasons. As of press time, Commissioner Brian Quintenz had not issued a statement addressing the proposed rule.

Chairman Giancarlo provides historical context. Chairman Giancarlo noted that the proposed rule changes, and the other changes described in the Roadmap, will result in more complete, more accurate, and higher-quality data available to the CFTC and to the public, will streamline data reporting, and will help the CFTC perform its regulatory responsibilities.

Giancarlo also provided some historical context, observing that a critical component of the 2008 financial crisis was the inability of regulators to assess and quantify the counterparty credit risk of large banks and swaps dealers. To address this shortcoming, the Dodd-Frank Act gave the CFTC broad responsibility to enhance regulatory transparency and price discovery for market participants through trade reporting to SDRs.

In 2011 and 2012, the CFTC adopted rules for swap data reporting, recordkeeping, and SDRs. In the chairman’s view, however, these initial rules lacked technological detail and specification. As a consequence, he directed the DMO to outline a series of steps to improve data reporting requirements. Some of these are contained in the Roadmap and serve as a foundation for the current proposed rulemaking.

Berkovitz notes improvements in the verification process are called for. Commissioner Berkovitz, while recognizing some of the successes existing reporting rules have achieved, notes that proposed rule amendments identify other areas where the CFTC’s existing swap data reporting rules are not working as effectively as they could. Specifically, the commissioner pointed to the proposed rule’s treatment of swap data verification and the need to promptly correct errors or omissions contained in previously reported data. He observed that the proposed rule would clarify and strengthen the obligations of SDRs and reporting counterparties by requiring SDRs to provide reporting counterparties with regular reports on open swaps to “verify the accuracy and completeness of swap data reported to SDRs.” In turn, reporting counterparties will be required to respond affirmatively by indicating that the records in the reports they receive are accurate, or otherwise correct any errors or omissions.

Stump expresses concerns about the imposition of immense additional burdens on SDRs. Commissioner Stump stated her disagreement with some of the policy and procedural choices in proposed rulemaking and questioned certain underlying assumptions driving the policy changes. She expressed her discomfort with the lack of details and nebulous description of certain obligations in many parts of the proposal, which in her view will make informed public comment difficult. In particular, Commissioner Stump disagrees “with imposing immense additional burdens on swap data repositories and all types of reporting counterparties” without commensurate streamlining of regulatory obligations in the rest of the CFTC’s swap data reporting rule set.

Behnam seeks flexibility but opposes any rollback of Dodd-Frank initiatives. Conceptually, Commissioner Behnam prefers viewing the proposed rule as a part of the Commission’s ongoing duties to regularly review its regulations to increase efficiencies and avoid unintended consequences, rather than as a first step in implementing the roadmap. Behnam further noted that even as the Commission endeavors to provide surgical flexibility and a more principles-based approach with regard to regulating swaps activities, he will continue to oppose any roll backs of Dodd-Frank initiatives.

The CFTC is seeking comments on the proposal. The comment period will end 75 days after the proposal’s publication in the Federal Register. All comments will be posted on CFTC’s website.

Friday, April 26, 2019

FINRA details use of fines collected in 2018

By Mark S. Nelson, J.D.

According to a report issued by the Financial Industry Regulatory Authority, Inc., the U.S.’s self-regulatory organization responsible for broker-dealer oversight spent $81.1 million on a variety of capital and strategic initiatives and on investor education and efforts to promote compliance by broker-dealers. The bulk of these funds came from fines imposed by FINRA. Of these funds, just over 81 percent were allocated for capital and strategic purposes, while just under 19 percent were allocated for educational and compliance purposes. FINRA’s first full report on fines was issued pursuant to its Financial Guiding Principles, which it published in January 2018 as part of an effort to improve the transparency of its operations. Previously, FINRA had issued an interim report on fine monies roughly in the time frame that it adopted its Financial Guiding Principles.

FINRA’s 2018 report indicates that it made fines-eligible expenditures based on $61.0 million in fines issued, which it then combined with $20.1 million in reserves to arrive at a total expenditure of $81.1 million. Although FINRA’s Financial Guiding Principles document lists four purposes for which its board or finance committee may use these funds, the report divided expenditures across just two more generalized categories: capital/strategic initiatives and educational/compliance initiatives.

FINRA spent $65.7 million (81 percent of its total expenditures) on capital/strategic initiatives. Expenditures in this category included migrating applications to cloud-based platforms, machine learning tools to better detect suspicious market behavior, and improvements to FINRA’s examination program. These expenditures, however, did not include the costs of FINRA’s participation in the consolidated audit trail (CAT) consortium and the related costs of FINRA having been selected to be the CAT’s plan processor.

With respect to educational/compliance initiatives, FINRA spent a total of $15.4 million or nearly 19 percent of its total expenditures. These funds were allocated across three areas: (1) compliance resources ($7.3 million); (2) FINRA staff training ($4.6 million); and (3) investor education ($3.5 million).

A comparison of the 2018 report to the 2017 interim report, at least on the surface, implies significant differences regarding how FINRA funded its capital/strategic and educational/compliance initiatives (more use of reserves in 2018 than 2017), and how it allocated funds between capital/strategic and educational/compliance initiatives (more funds for capital/strategic initiatives than for educational/compliance goals in 2018 versus 2017). However, as FINRA’s interim report cautioned, the numbers for 2017 may not reflect “full implementation” of the requirements for fines contained in its Financial Guiding Principles. The 2018 report is the first full report on FINRA’s use of fine monies.

More generally, FINRA explained that it collects funds from two revenue streams. One stream focuses on providing restitution to harmed investors (FINRA said this is its “highest priority”), while the other stream, fines, focuses on deterring misconduct. Funds collected through the imposition of fines are accounted for separately and do not appear in FINRA’s operating budget, nor are fines used to set FINRA employees’ pay. FINRA said it follows a set of guidelines for imposing fines in specific cases and that it does not seek a minimum amount of fines.