Wednesday, September 18, 2019

Clayton stresses importance of market price transparency, fostering small business growth

By Amanda Maine, J.D.

In an address at Central Michigan University, SEC Chairman Jay Clayton praised the role of the market on ensuring confidence in market prices. He also heralded the role of small business innovation and assured that the SEC is examining how to foster more entrepreneurial ecosystems beyond the traditional hot spots of the east and west coasts.

Market prices. Prices for stocks, bonds, and other assets should be generated by markets that are “transparent, information-rich, and fair,” Clayton said. Comparing prices to light houses, Clayton observed that they are non-excludable and non-rivalrous—he cannot keep others from using price information, and his use of price information does not affect others’ ability to use that information.

To give a more concrete example, Clayton cited mortgages. Two people with the same credit seeking a 30-year mortgage should pay the same amount, which should fairly reflect their credit relative to others with better or worse credit, Clayton explained. Investors, particularly Main Street investors, should be confident that that public company stock prices reflect the views of all investors, including “professional investors.” All investors benefit from the work of professional investors, which “economists adore,” Clayton quipped.

The availability of market prices is also important from the perspective of public company managers, Clayton said. When managers make decisions impacting the long-term outlook of the company, such as human capital, equipment, and research, they rely on metrics derived from public market-generated pricing information, according to Clayton. “Prices matter,” he said, including earnings multiples and cost of capital estimates. He emphasized that today’s prices impact long-term decisions.

Small business. Clayton then turned to what he called one of his favorite topics: small business capital formation. Clayton noted that 25 years ago, public markets dominated private markets. Today, he observed, private markets are outpacing the public markets. The SEC has an important role to play in the “creation and incubation” of small businesses, Clayton advised.

Clayton touted the establishment of the SEC’s Office of the Advocate for Small Business Capital Formation as an element of the Commission’s dedication to fostering small business growth. He also cited some geographically small but highly functioning networks and ecosystems for small business growth, including Silicon Valley, New York, the Route 128 Corridor, and Austin. These networks or “ecosystems” are vital to reducing the costs of information access, verification, contracting, the protection of rights, and the pursuit of remedies, Clayton said.

The SEC wants to expand the number of these ecosystems beyond the east and west coasts, Clayton stated. Currently 85 percent of venture capital is concentrated in Silicon Valley, Boston, and New York. However, Clayton noted that the Mississippi River Valley has hundreds of large public companies and prominent universities but only a handful of established capital firms. To address this, the SEC is examining how to foster more entrepreneurial ecosystems in non-coastal areas, Clayton said. He said he hoped that people will share their experiences and challenges regarding raising money for small businesses. “Let us know,” Clayton urged.

Tuesday, September 17, 2019

Controversial Volcker Rule amendments adopted prior to CFTC Sunshine Act meeting without public discussion

By Brad Rosen, J.D.

In his first open meeting as the 14th chairman of the CFTC, Heath Tarbert trumpeted the virtues of running the agency guided by the principles of unity, collegiality, and transparency. Towards that end, the Commission unanimously approved two final rules—one addressing position limits for security futures products (SFPs), and the other dealing public rulemaking procedures under Part 13 of the CFTC Regulations. The adoption of these rules was described as “housekeeping” undertakings during the course of the meeting.

Final rules on Volcker Rule amendments were dropped from the agenda. Despite talk of greater transparency and improving public visibility with regard to the CFTC’s rulemaking process, consideration of the highly controversial final rule on revisions to the Volcker Rule was removed from the agenda prior to the meeting. Notwithstanding a 3-2 split vote among the commissioners on the measure, the final rule was handled as a seriatim matter, and public comments were confined to prepared statements by the commissioners issued after the completion of the meeting. The original Volcker Rule is premised on the notion that banks should be barred from proprietary trading and from running hedge funds.

In support of the final revisions to the Volcker Rule, Chairman Tarbert stated that the initial regulations “have metastasized from Mr. Volcker’s original, simple vision to the degree where his distinction between proprietary and non-proprietary trading is hardly recognizable.” He also voiced concerns that the Volcker Rule may affect liquidity in the derivatives markets. Commissioner Brian Quintenz further noted that the final rule tailors and simplifies the Volcker Rule so as to enable banking entities to effectively provide traditional banking services to their clients in a manner that is consistent with the statute. Tarbert and Quintenz also issued a joint statement in support of interagency cooperation where they expressed their hope and expectation that banking regulators will work with the CFTC to address issues surrounding the supplementary leverage ratio (SLR) calculation, a matter that has impacted market liquidity.

In opposition to the final rule, Commissioner Rostin Behnam reiterated his concerns that the action would “encourage a return to the risky activities that led to the financial crisis, and perhaps further consolidate trading activity into a few institutions.” He added that while the proposed rule “merely threatened to kill Volcker through a thousand little cuts, the final rule goes for the throat.” He noted that the final rule significantly weakens the prohibition on proprietary trading by narrowing the scope of financial instruments subject to the Volcker Rule.

These concerns are echoed by Commissioner Dan Berkovitz as he stated, “The revised Volcker Rule will render enforcement of the rule difficult if not impossible by leaving implementation of significant requirements to the discretion of the banking entities, creating presumptions of compliance that would be nearly impossible to overcome, and eliminating numerous reporting requirements.”

Security futures position limit increase endorsed. All five commissioners enthusiastically supported the final rule addressing position limits and position accountability levels for security futures products. Those rules had not been substantively amended to account for market developments since they were first adopted in 2001. During that time period position limits on equity options had increased while the CFTC’s SFP position limits have remained unchanged. These updates to SFP position limits aim to provide regulatory comparability with equity options and minimize competitive disparity between the two markets. Commissioners Stump and Quintenz each issued statements on this final rule as well as the final rule addressing Part 13 amendments. Commissioner Berkovitz issued a separate statement on positions limits for SFPs.

Consensus on Part 13 amendments. All commissioners also supported amending the Part 13 regulations on public rulemaking by withdrawing the Part 13 rules, other than rule 13.2 which allows for or petitions for rulemaking. As the Administrative Procedures Act (APA) governs the Commission’s rulemaking process, most of the Part 13 rules were viewed as unnecessary and defunct. Moreover, the rules, which were adopted in 1976 shortly after the birth of the CFTC have not been touched in the 43 years since then. It was also noted that this rulemaking would not repeal or limit in any way the rights that the public has today in CFTC rulemakings under the APA. Commissioners Behnam and Berkovitz each issued separate statements on this final rule.

CFTC monitoring ongoing developments in the Middle East. Towards the conclusion of the meeting, Chairman Tarbert acknowledged the drone strikes over the weekend on a Saudi Arabian oil processing facility which accounts for one half of Saudi oil production and five percent of the world’s crude oil supply. He noted that as with any major market moving event, the CFTC immediately commenced monitoring impacted markets and will continue to do so as events unfold.

Monday, September 16, 2019

Panelists reflect on NASAA’s role in taking on Prudential at annual conference

By Jay Fishman, J.D.

The North American Securities Administrators Association, Inc. (NASAA) celebrated its 100th year as the states’ investor protecting umbrella organization by, among other things, relaying an egregious case of fraud from the late 1980s/early 1990s involving Prudential that ultimately propelled NASAA into becoming the most prominent “local cop on the beat” for protecting investors. The story serves as a reminder of NASAA’s role in combatting fraud, as it has more recently through a coordinated cryptocurrency crackdown.

New Jersey’s Securities Bureau Chief, Christopher Gerold, became NASAA’s new President for 2019-2020, and NASAA revamped its website to make it more investor-friendly.

Aside from the conference. Important NASAA events surrounding the conference that occurred in August/September 2019 included the following:
  • On August 7, NASAA updated its implementation of a coordinated cryptocurrency crackdown; 
  • On September 8, NASAA’s state investment adviser examinations uncovered rising cryptocurrency deficiencies; and
  • On September 11, the last day of the conference NASAA’s 2018-2019 President and Vermont’s Financial Regulation Commissioner Michael Pieciak testified before Congress’s House Subcommittee on Capital Markets, Securities, and Investment, urging that no further action be taken to expand the nation’s private securities markets until a more careful study of the impact on public markets and investor protection can be conducted. Pieciak stated that “NASAA is concerned that our current regulatory regime has gone too far in favoring private capital raising over public markets.” 
It therefore appears that new President Gerold’s concerns for 2019-2020 will involve, among other matters, cryptocurrency, the need to not expand U.S. private securities markets, and the impact that Regulation Best Interest will have on state securities regulation once the SEC rule takes effect in June 2020.

Regarding cryptocurrency and fintech, on October 29, 2019, NASAA will hold a fintech and cybersecurity symposium at the Spire Event Center in Washington, D.C., or virtually in your home or office. Find more details on NASAA’s website.

David and Goliath story. NASAA’s panel celebrating its 100-year anniversary, entitled “True David and Goliath Story: How State Securities Regulators Tackled a Wall Street Giant,” involved how NASAA brought down Prudential Securities Inc., forcing it to initially pay $330 million in a 1994 settlement and then much more money following a late 1980s scheme to swindle nearly 340,000 investors nationwide. The four panelists who were the most active advocates for the investors at the time opined that from its New York headquarters on Wall Street, Prudential was positively evil because it sent many brokers across the country with marketing materials falsely promoting Prudential’s limited partnership investments as “guaranteed” and “safe.” Many of the brokers were new to the job and had no idea they were selling the investors totally fraudulent products. Furthermore, throughout the time period NASAA was investigating the case, Prudential’s executives continuously denied any wrong doing and continued the scheme to wipe out investors’ entire life savings. Moreover, Prudential threatened and carried out the threat to destroy the working lives of those brokers who said they were going to report the fraud to the SEC and NASAA. Panelist Kurt Eichenwald, a journalist for the New York Times, who tenaciously worked around the clock to uncover the scheme, rose to prominence as a writer of corporate financial fraud books, including “The Informant” which became a 2009 motion picture.

He and the other three panelists—Matthew Neubert, the Arizona Corporate Commission’s Executive Director, and Nancy Smith and Wayne Klein who were New Mexico’s and Idaho’s Securities Directors at the time of the crime—all stated that this case made NASAA the prominent state investor protector because in the late 1980s, the SEC was only investigating matters where the victims were corporations, not individual retail investors, and did not, therefore, take a proactive role in this investigation.

When the story began, various state securities commissioners started getting complaints from a handful of their respective resident investors about the worthlessness of purchased Prudential limited partnership products. But later, when the commissioners realized this was a nationwide fraud, and that they individually were not equipped financially or staff-wise to go after Prudential, and that the SEC was not sufficiently addressing the issue, they reached out to NASAA to form a collective task force. In 1994, Prudential continued to deny any wrongdoing but agreed to a $330 million settlement which was immediately used to begin compensating the unfortunate investors. But NASAA said $330 million was not enough money to financially restore all of the 340,000 victims. As a result, for the first time ever, a company—Prudential—agreed to pay an open-ended amount of money which ultimately became the largest-ever settlement paid out at the time, $1.4 billion.

Friday, September 13, 2019

Financial planners join battle over SEC’s Regulation BI

By Mark S. Nelson, J.D.

XY Planning Network, LLC (XYPN) and Ford Financial Solutions, LLC have sued the SEC alleging that the recently effective Regulation Best Interest (Regulation BI) is legally infirm because it exceeded the SEC’s statutory authority, its adoption failed to comply with the law, and that the resulting final rule is arbitrary or capricious. XYPN is a financial planning firm that focuses on advising Generation X and Y clients. Regulation BI was adopted in June 2019, became effective September 10, 2019, and firms will be required to begin complying with the rule by June 30, 2020 (XY Planning Network, LLC v. SEC, September 10, 2019).

Same story as states. XYPN’s complaint, filed in the federal court in the Southern District of New York, tells a remarkably similar story to the complaint by eight state attorneys general filed days earlier. Both complaints lament that the distinctions between investment advisers and broker-dealers have become increasingly blurred and that Regulation BI does little to clarify those differences. Both complaints note that a majority of the Commission, in adopting Regulation BI, disregarded the recommendation of SEC staff who conducted the Dodd-Frank Act-mandated study that the Commission impose a uniform fiduciary duty without regard to the financial interests of a broker-dealer. And both complaints find fault in the Commission majority’s reliance on Dodd-Frank Act Section 913(f) (authority to "commence rulemaking") and other Exchange Act provisions to justify the adoption of Regulation BI rather than citing Dodd-Frank Act Section 913(g), which provides more specific rulemaking authority regarding the type of standard to be adopted.

Moreover, both XYPN’s and the states’ complaints recite that Dodd-Frank Act Section 913 was the result of compromise between the House and Senate versions of the legislation that was intended to give the SEC authority to increase the standard of conduct applicable to broker-dealers. XYPN said that historically broker-dealers were considered "intermediaries" rather than fiduciaries, while the states’ complaint explained that broker-dealers make "arms-length sales recommendations." That means broker-dealers generally must provide "suitable" recommendations under the Financial Industry Regulatory Authority’s Rule 2111. By contrast, XYPN said investment advisers historically have been fiduciaries, which the states’ complaint elaborated upon by saying investment advisers adhere to fiduciary principles of "trust and confidence," which the states’ complaint said embraces two components—a duty of care (including the suitability standard) plus a duty of loyalty (avoid or disclose conflicts).

Although XYPN’s complaint did not mention the now-defunct Department of Labor (DOL) best interest contract standard, the states’ complaint did note that the Fifth Circuit had credited Dodd-Frank Act Section 913(g)(2) as the basis for the SEC’s authority to regulate in the investment adviser space, as opposed to the DOL’s lack of such authority, in vacating and setting aside the DOL’s fiduciary rule.

The Fifth Circuit opinion explained further that the blurring of the distinction between investment advisers and broker-dealers, as noted by a "major securities law treatise," had been observed as early as 2006 in a study conducted by LNR-Rand which provided some of the impetus for the Dodd-Frank Act provisions on broker-dealers, including Section 913(g). With respect to the Section 913 study mandated by the Dodd-Frank Act, the treatise further noted that two SEC commissioners raised concerns about the recommendation in a public statement because, in part, the study lacked sufficient analysis. (See Loss, Seligman & Paredes, Securities Regulation, a Wolters Kluwer Legal & Regulatory U.S. publication, at Chapter 8.A.1.).

"Solely incidental." The Commission, in the context of Regulation BI, also addressed via an interpretive release several potentially confusing issues regarding Regulation BI and the Investment Advisers Act’s exclusion of certain broker-dealer activities. Advisers Act Section 202(a)(11) defines "investment adviser" to mean, among other things, any person who is compensated for engaging in the business of advising others about the value of securities. Advisers Act Section 202(a)(11)(C) excludes from this definition any broker-dealer who performs these services in a manner that is "solely incidental" to the conduct of the broker-dealer business and who does not receive "special compensation" for those services; this exclusion is known as the broker-dealer exclusion.

The Commission’s new interpretive release, issued the same day it adopted Regulation BI, states in relevant part: "We interpret the statutory language to mean that a broker-dealer’s provision of advice as to the value and characteristics of securities or as to the advisability of transacting in securities is consistent with the solely incidental prong if the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions."

XYPN’s complaint, but not the states’ complaint, further observed that the "harmful consequences" of Regulation BI could be "exacerbated" due to the interpretive release. Specifically, the complaint posits that the Commission’s interpretive release seeks to revive an expansive view of the Advisers Act’s catch-all provision allowing the Commission to exempt "such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order" (See Investment Advisers Act Section 202(a)(11)(H)). According to XYPN, the interpretive release, thus, runs afoul of a 2-1 decision by the D.C. Circuit in 2007 invalidating the Commission’s attempt to create an exemption for another set of broker-dealers beyond those mentioned in Advisers Act Section 202(a)(11)(C). The majority in that case consisted of Judge Judith Rogers (author of the opinion) and now-Supreme Court Justice Brett Kavanaugh; Chief Judge Merrick Garland dissented because he believed that Chevron required deference to the Commission's interpretation.

XYPN’s co-founder, Michael Kitces, had commented on proposed Regulation BI noting both that the proposed standard for broker-dealers would perpetuate the confusion that already existed among retail investors about what standards apply to investment advisers and to broker-dealers. The comment also posited that the SEC had elided the fact that, absent a narrow exception for "solely incidental" services, broker-dealers are required to register as investment advisers if they want to give investment advice to customers.

Standing. It is axiomatic that in order to bring suit in federal court a party must have standing to do so. XYPN asserted that its members could be harmed by the anti-competitive effects of Regulation BI. Put another way, XYPN claims its members, who take a "fiduciary oath" and are registered investment advisers, could, among other things, lose business if broker-dealers are able to market themselves as pursuing their customer’s best interest all the while adhering to a lower legal standard than is applicable to investment advisers.

The states’ complaint, by contrast, asserts that they could lose tax revenue from the taxable portions of their residents’ retirement accounts if broker-dealers are able to give conflicted investment advice under Regulation BI. The states also assert that they may incur "a greater financial burden" if they must assist retirees who have reduced financial means. Moreover, the states posit that they have a "quasi-sovereign" obligation to look out for their resident’s economic well-being.

The case is No. 19-cv-08415.

Thursday, September 12, 2019

House subcommittee examines whether private offering exemptions are barrier to IPOs and retail investment

By John Filar Atwood 

The rapid growth of private markets and the decline in IPOs over the past few decades have given rise to a number of legislative proposals aimed at improving investment opportunities for retail investors. The House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets met today to discuss some of those bills and whether private offering exemptions create a barrier to IPOs and retail investment.

Subcommittee Chair Carolyn Maloney (D-NY) noted that private markets are now more than twice the size of public markets—in 2018 issuers raised $2.9 trillion in exempt offerings compared to $1.4 billion through public offerings. This raises questions such as whether Congress should permit retail investors to participate in private markets, and whether private offerings are actually better investment opportunities or not, she said. The SEC has relaxed the rules around private markets for decades, and it is time to ask whether it has gone too far in deregulating, Maloney added.

Mike Pieciak, Vermont commissioner of Financial Regulation and past president of the North American Securities Administrators Association, testified that NASAA is concerned that the current regulatory regime has gone too far in favoring private capital raising over public markets. However, he does not believe the solution is to encourage retail investors to get into the private markets.

Definition of accredited investor. Pieciak is not in favor of the proposals in the Fair Investment Opportunities for Professional Experts Act that would expand the definition of “accredited investor,” allowing more investors to access exempt offerings. NASAA is deeply concerned over the lack of information about private markets, he said. Public information is essential to the proper functioning of the markets, so Congress should work to reinvigorate and grow the public markets rather than encourage retail investors to enter the private markets, he added. 

Elisabeth de Fontenay, a law professor at Duke University, said that research suggests that retail investors would do worse if they were allowed into private markets. In the private markets, there are unregistered, unregulated investments with poor return prospects, she noted. In response to questions from Alexandria Ocasio-Cortez (D-NY), she acknowledged that retail investors would not have access to a reasonable valuation in private market, would have no audited financial statements, and would not be notified if a private company is under investigation.
In de Fontenay’s view, legislative proposals should encourage more companies to go public. This may require reversing the provisions of the JOBS Act that allow companies to stay private indefinitely, she advised.

JOBS Act changes. Renee Jones, a law professor at Boston College, agreed with de Fontenay, stating that the most effective way for Congress to shore up shrinking public equity markets is to reverse the JOBS Act amendments to Section 12(g). Section 12(g) allows unicorns (private companies with greater than $1 billion in market capitalization) to delay an IPO indefinitely, allowing important companies to operate in secrecy, she stated.

Congress should at least impose minimum disclosure obligations for companies of a certain size with dispersed ownership patterns, Jones testified. This reform would increase pressure for an IPO or sale, and provide needed information for investors considering purchasing shares, she said.

Doug Ellenoff, a partner at Ellenoff Grossman & Schole LLP, said the he favors the proposal to broaden the definition of “accredited investor” but would not support any changes to the JOBS Act. Private markets and public markets exist for very different reasons and constituents, he noted, and regulators should ensure that both are operating well with minimum regulation. In his view, companies should be allowed to remain private if they so choose, regardless of their size.

Cost of being public. Ellenoff emphasized that the cost of being public is burdensome. A meaningful percentage of a company’s profits go to preparing initial disclosures, he noted, and that money is out of pocket before a company knows whether its offering will be successful.

Subcommittee member Trey Hollingsworth (R-Ind) related a story about the CEO of a newly-public Indiana company who told him that it is very costly to be a public company. The CEO estimated that his company was spending $12.5 million per year to be public. Hollingsworth said that newly public companies need a runway where costs increase as a company grows rather than being hit with the high costs immediately.

Report to Congress. Witnesses also discussed the merits of a bill that would require the SEC to submit a report to Congress about private securities offerings. Among other things, it would require the Commission to conduct an impact study before proposing or adopting any change to a rule regarding either exempt offerings or reporting requirements for public companies.

While several panelists supported the legislation, Ellenoff does not. He noted that the SEC has already begun an effort to harmonize the offering framework by issuing a concept release in June. Any legislation in this area might get in the way of the SEC’s efforts, he said, and encouraged Congress to just let the Commission do its job.

Wednesday, September 11, 2019

SEC proposes accountability requirements to speed CAT NMS Plan implementation

By Rodney F. Tonkovic, J.D.

The SEC has proposed amendments intended in part to facilitate the implementation of the national market system plan governing the Consolidated Audit Trail. Participating self-regulatory organizations would be required to file and publish complete implementation plans and progress reports. The proposed amendments also include financial accountability provisions establishing deadlines for four implementation milestones; if these deadlines are missed the amount of fee recovery available to the participants is reduced (Proposed Amendments to the National Market System Plan Governing the Consolidated Audit Trail, Release No. 34-86901, September 9, 2019).

The plan. On November 15, 2016, the SEC voted unanimously to approve a proposed national market system plan to create, implement, and maintain a consolidated audit trail that will allow regulators to track all activity throughout the U.S. markets in NMS securities. The plan was submitted by participating self-regulatory organizations in response to a requirement in Rule 613 of Regulation NMS.

Implementation status. Under the original deadlines in the CAT Plan, participants would begin recording and reporting data to the Central Repository by November 15, 2017. This and multiple other deadlines were not met, however, and the participants sought an extension, but the request was rejected by the Commission. According to a statement by Chairman Clayton on the CAT's status however, some progress has been made: the SROs began reporting certain data to the CAT; the SROs have published final specifications for the initial reporting of equities and options to facilitate broker-dealer reporting; and the SROs and the broker-dealer industry are working together to develop ways to conduct Large Trader Reporting.

"CAT needs to be implemented without further delays," said Chairman Jay Clayton. "The proposed amendments are designed to bring greater transparency and accountability to the implementation of the CAT." In the status report, Clayton also expressed his belief that "next six to twelve months will be critical for moving the CAT from concept to reality."

Proposed amendments. The proposed amendments are intended to ensure that the plan participants fulfill their obligations to deliver a functional CAT in a reasonable time frame, the proposal states. Participants would be required to develop a complete implementation plan (plus quarterly progress reports) with a detailed timeline and objective milestones. Each plan and progress report must be approved by the operating committee established by the CAT Plan and submitted to the participant's CEO, President, or equivalently situated senior officer. The formal and publicly-available progress reports are meant to increase accountability, and there would also be financial accountability if implementation milestone dates are not met.

Operational transparency. The CAT Plan does not currently have provisions requiring participants to provide public updates on implementation progress. To address this concern, the Commission proposes to amend Section 6.6 of the Plan by adding a new Section 6.6(c) requiring that:
  • Participants with the Commission, and make publicly available, a detailed implementation plan and ongoing quarterly progress reports. 
  • Each document must be submitted to the CEO, President, or an equivalently situated senior officer at each Participant and then approved by a supermajority vote of the Operating Committee. 
  • To the extent that any document is not approved by a unanimous vote of the Operating Committee, each Participant whose Operating Committee member did not vote to approve the document must separately file with the Commission, and make publicly available, a statement identifying itself and explaining why it did not vote to approve the document in question.
Financial accountability. To prevent additional delays, the Commission proposes to establish target deadlines for four critical implementation milestones. When the CAT Plan was approved, it provided for participants to recover implementation fees, costs, and expenses from their industry members. If participants miss the implementation milestones, the amount of CAT funding that they can recover from Industry Members will be reduced at regular intervals. The target dates and milestones, which are discussed in detail in the proposal are: 
  • April 30, 2020: Initial Industry Member Core Equity Reporting;
  • December 31, 2020: Full Implementation of Core Equity Reporting Requirements;
  • December 31, 2021: Full Availability and Regulatory Utilization of Transactional Database Functionality; and
  • December 31, 2022: Full Implementation of CAT NMS Plan Requirements. 
Comments should be received within 45 days following publication of this proposal in the Federal Register.

The release is No. 34-86901.

Tuesday, September 10, 2019

SEC advisory committee recommends ‘proxy plumbing’ changes

By Amanda Maine, J.D.

The SEC’s Investor Advisory Committee recently voted to approve a series of recommendations regarding the Commission’s rules on “proxy plumbing,” or the mechanics of communication and voting under the proxy rules. While the recommendation was approved by a distinct majority of the IAC, some members dissented due to some specific language used in the text and the recommendation to adopt with some changes the 2016 proposal on universal proxy.

Recommendation. The approved recommendation consists of four parts: (1) requiring end-to-end vote confirmations; (2) reconciliation of vote-related information; (3) conducting studies on investor views on anonymity and share lending; and (4) adopting the SEC’s proposed universal proxy rule with certain changes.

Regarding end-to-end vote confirmations, the recommendation notes that investors are currently unable to determine whether their voting instructions for shares they own are carried out and counted in votes. In implementing the confirmation requirement for end-users, the SEC should require that confirmations indicate that proxies and/or voting instructions were received and implemented, or if not, give a reason as to why not. Confirmations could take any reasonable form, including electronic delivery or delivery through the system already developed by proxy servicing firm Broadridge Financial Solutions.

A duty to cooperate in regular reconciliations is driven by routine errors and mismatches in the system in place today, according to the recommendation. The SEC should therefore require every participant in the proxy system to cooperate with the others to reconcile ownership and voting information on a regular basis. The recommendation advised that costs associated with this requirement would fall over time as the process becomes more routine.

The staff should study the reasons for and the extent to which customers of intermediaries actually want to remain anonymous (that is, to not be “non-objecting beneficial owners” or “NOBOs”) to the companies in which they own stock, the committee recommended. A second study should examine the extent to which share lending contributes to errors, over-votes, or under-votes, as well as whether the effect of share lending on voting entitlements is effectively disclosed to investors. Both studies would inform further monitoring or rulemaking by the Commission.

Finally, the IAC recommended that the SEC move forward on implementing a universal proxy to allow shareholders to vote for the combination of nominees they wish to represent them. The committee offered suggestions to revise certain aspects of the Commission’s 2016 proposal, including revisiting what percentage of shareholders dissidents should be required to solicit to be able to use universal proxy and addressing the issue of incumbents that may refuse to serve if elected to a split slate.

Objections. While most committee members approved of the recommendation, some members dissented. Professor J.W. Verret of Antonin Scalia Law School at George Mason University expressed his dissatisfaction that the recommendation did not address the role of proxy advisory firms. According to Verret, the proxy system is so interrelated that the issue of proxy advisors should have been considered as part of the recommendation. He also was disappointed that the recommendation did not consider revising the rules on shareholder proposals, some of which are “conflicted and politically motivated,” Verret lamented.

Verret and Lydia Mashburn of the Cato Institute also expressed concern about the universal proxy recommendation. Verret said that what the committee is recommending goes further than the IAC’s previous recommendation, which encouraged the SEC to remove barriers to universal proxy, not mandate them.

Mashburn also took issue with some of the language included in the recommendation: “We do not believe private actors will improve the system without SEC intervention.” Mashburn disagreed with this characterization and said she could not put her name on it. However, she indicated that she was in favor of the recommendations regarding confirmations and reconciliation.

Professor John Coates of Harvard Law School, who chaired the Investor-as-Owner subcommittee that developed the recommendation, agreed that there is work yet to be done regarding shareholder proposals and proxy advisory firms to improve the proxy system. However, he added that wanted to recognize that those issues may involve some tricky policy issues and political tradeoffs that may make it hard to progress in those areas and may need to be worked through in the form of a comment process.

Monday, September 09, 2019

FASB proposes guidance to ease transition in benchmark reforms

By Lene Powell, J.D.

With trillions of dollars in loans, derivatives, and other contracts expected to move away from LIBOR and other benchmarks toward alternative reference rates, the Financial Accounting Standards Board (FASB) has issued a proposed Accounting Standards Update (ASU) that would provide temporary optional guidance to ease the potential burden in accounting for, or recognizing the effects of, reference rate reform on financial reporting.

“The FASB is committed to providing stakeholders with the guidance they need to ease the process of migrating away from LIBOR and other interbank offered rates to new reference rates,” said FASB Chairman Russell G. Golden. “The Board’s proposal will address operational challenges they have raised and ultimately help simplify the process while reducing related costs.”

Migration from LIBOR. Responding to concerns about structural risks of LIBOR and other interbank offered rates, regulators around the world have been working on reform initiatives to identify alternative reference rates that are more observable or transaction-based and less susceptible to manipulation. In late July, IOSCO issued a statement emphasizing the need to move away from LIBOR and identifying specific topics for LIBOR users to consider, including risk-free rates (RFRs), infrastructure, conventions, fallbacks, term rates, regulatory dependencies, communication, and international engagement. The SEC and CFTC have also stressed the need to switch to alternative reference rates.

Proposed FASB guidance. Given the significant volume of contracts and other arrangements like debt agreements, lease agreements, and derivative instruments that reference LIBOR and other interbank offered rates, benchmark reform poses significant operational challenges in terms of the need to modify existing contracts. As FASB explained in a fact sheet, certain accounting issues may arise. For example, changes in a reference rate could disallow the application of certain hedge accounting guidance, and certain hedge relationships may not qualify as highly effective during the period of the market-wide transition to a replacement rate.

The proposed guidance, “Facilitation of the Effects of Reference Rate Reform on Financial Reporting,” would:
  • Simplify accounting analyses under current GAAP for contract modifications if qualifying criteria are met;
  • Allow hedging relationships to continue without dedesignation upon specified changes in the critical terms of an existing hedging relationship due to reference rate reform;
  • Provide optional expedients for existing fair value hedging relationships for which the derivative designated as the hedging instrument is affected by reference rate reform;
  • Provide temporary optional expedients for cash flow hedging relationships affected by reference rate reform. 
The proposed amendments would be:
  • Applicable to all entities, subject to meeting certain qualifying criteria;
  • Limited to contracts and hedging relationships that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform;
  • Elective, not required;
  • Temporary; the amendments would not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022. 
Next steps. FASB encouraged stakeholders to review and comment on the proposed ASU by October 7, 2019.

Friday, September 06, 2019

IAA recommends tweaks to FINRA proposals to amend IPO rules

By Amy Leisinger, J.D.

The Investment Adviser Association has submitted comments to the SEC on the Financial Industry Regulatory Authority’s proposal to amend FINRA Rules 5130 and 5131 governing purchases and sales of initial public offerings. According to IAA, the proposed changes would remove certain barriers to capital formation and increase the availability of new issues. However, the organization contends, certain conditions in the proposed changes to exemptions are overly narrow, and FINRA should modify them to remove quantitative thresholds.

In its comments, IAA notes that FINRA’s IPO rules are designed to ensure that broker-dealers make fair offerings of securities and that they and other insiders do not take advantage of their positions for their own benefit. However, the organization explains, IAA members’ clients may not currently meet the requirements of foreign investment company exemption from prohibitions on investment and are sometimes restricted in their ability to invest in new issues on behalf of foreign plan clients. The proposed changes would address these concerns, IAA states.

Quantitative thresholds. IAA takes issue, however, with the quantitative thresholds in the proposed foreign plan exemption, specifically the requirement that a foreign plan have at least $10 billion in assets and 10,000 participants to qualify. According to IAA, some of its members come close to, but do not meet, these thresholds, and prohibiting these entities from investing in new issues on behalf of foreign plan clients would not serve the policies underlying the rule. Further, the organization contends, a specific minimum of assets and clients is not necessary to show that a foreign plan lacks a concentration of interest, and the other conditions of the proposed exemption are sufficient to prevent manipulation or abuse.

IAA also urges FINRA to remove the quantitative thresholds from the foreign investment company exemption. The proposal would create alternatives to the current requirement that no person owning more than 5 percent of a foreign investment company’s shares be a restricted person—that the company has 100 or more direct owners or 1,000 or more indirect owners. However, according to IAA, none of these three quantitative tests is necessary to demonstrate that a foreign investment company is widely held. Quantitative tests are not used to ensure that a U.S. investment company is widely held, and they should not be deemed necessary for a foreign public fund, the organization states. The conditions that the fund is listed for sale to the public and was not formed for the purpose of investing in new issues are sufficient to achieve the objectives of the rule, IAA concludes.

Thursday, September 05, 2019

Hearing to determine CFTC’s contempt in Kraft Foods matter continued until October

By Brad Rosen, J.D.

In this closely watched case, Judge Sharon Johnson Coleman of Northern District of Illinois granted the CFTC’s emergency motion filed on August 28, 2019, under seal, to continue a previously scheduled hearing for September 12, 2019 to October 2, 2019. The deadline for submitting for prehearing briefs was also extended. As the agency’s motion was filed under seal, it is not publicly available and the basis for the CFTC requesting the continuance is unknown. On August 30, 2019, the defendants Kraft Foods Group, Inc., Mondelez Global LLC filed responses to the CFTC’s filing, which similarly were under seal and unavailable to the public (CFTC v. Kraft Foods Group, Inc., August 30, 2019, Coleman, J.).

Judge Blakey, the presiding judge in the case, is scheduled to conduct the evidentiary hearing on October 2nd where CFTC Chairman Heath Tarbert, Commissioners Rostin Behnam and Dan Berkovitz, and Division of Enforcement Director James McDonald will be required to appear, testify, and be subject to cross examination.

Relief granted to the CFTC and recent developments. In addition to continuing the evidentiary hearing to October 2, 2019, Judge Coleman also granted the additional relief requested in CFTC’s emergency motion:
  • Leave to file an oversized brief;
  • The briefing deadline for the motion for contempt, sanctions, and other relief has been extended to September 23, 2019; and
  • The court entered the CFTC’s emergency motion to vacate the minute order dated August 19, 2019 entered by the court.
In other developments, on September 30, 2019, CFTC General Counsel Daniel J. Davis, and Deputy General Counsel also filed appearances in the case on behalf of the Commodity Futures Trading Commission.

A strange trip its been. The genesis of the current dispute goes back to August 14, 2019, when Kraft, Mondelez, and the CFTC entered into a consent order whereby it was agreed that the defendants would pay $16 million to resolve CFTC claims they manipulated wheat futures prices. That consent order was unusual in two respects. First, Kraft, Mondelez, and the CFTC (as a full Commission) were limited in their ability to speak publicly about the case. Moreover, the order was void of any factual findings or conclusions of law, which is out of the ordinary in these types of regulatory settlements.

What happened next was even more unusual. On August 15, 2019, the CFTC issued a press release, a statement about the case where the agency boasted that the penalty was valued at three times the defendants’ gain from the alleged wrongdoing, among other things. Additionally, CFTC Commissioners Behnam and Berkovitz issued a joint statement freely sharing their thoughts about the settlement and its policy implications. They claimed the gag provision did not apply to them.

Not surprisingly, Kraft and Mondelez took issue with the CFTC and commissioner public statements. On August 16, 2019, they filed an emergency motion for contempt and sanctions charging the CFTC with deliberately violating the consent order. In an initial hearing on August 19, 2019, Judge Blakey ordered key CFTC officials to appear at the evidentiary hearing (now set for October 2, 2019) to provide further explanation with regard to the various public statements made.

Developments in this highly unusual case will remain closely watched by regulatory and criminal attorneys across the country.

The case is No. 15-cv-02881.

Wednesday, September 04, 2019

Kokesh casts no doubt on prior rulings on disgorgement in SEC enforcement proceedings

By Rodney F. Tonkovic, J.D. 

A Second Circuit panel has affirmed a district court judgment ordering the payment of disgorgement. The court rejected the appellant's argument that the district court lacked the authority to impose disgorgement after Kokesh v. SEC and denied challenges to the remedies calculations (SEC v. de Maison, August 30, 2019, per curiam).

Pump-and-dump scheme. Angelique de Maison was part of a ring of individuals charged taking part in a pump-and-dump scheme involving a microcap company. According to the Commission, de Maison's husband, Izak Zirk de Maison F/K/A/ Izak Zirk Engelbrecht, orchestrated a scheme starting with the installation of associates as officers and directors of Gepco Ltd., a publicly traded microcap issuer, while he secretly ran the company and illegally transferred shares to the associates. The de Maisons then manipulated the market for Gepco's stock, with Angelique seeking out investors to purchase unregistered securities in two fraudulent issuers.

The Commission first brought this action in 2014. After an amended complaint was filed in July 2015, settlements were reached late that year with several of the defendants, including de Maison. Under the terms of the judgment and consent, de Maison agreed to pay disgorgement and a civil penalty, and the Commission moved for relief in January 2018. In July 2018, the district court ordered de Maison to disgorge $4,240,049.30, plus prejudgment interest, and to pay a third‐tier civil penalty of $4,240,049.30.

Kokesh argument rejected. On appeal, de Maison's principal argument was that, after Kokesh v. SEC, the district court lacked the authority to impose disgorgement. She asserted that disgorgement is historically rooted in equity and that equitable relief does not include penalties. Kokesh, de Maison said, held that disgorgement in the securities context is always a penalty and is thus no longer an authorized remedy.

The panel rejected this argument. While a panel is not bound by the decision of a prior panel where an intervening Supreme Court decision casts doubt on the earlier ruling, that was not the case here. The panel noted that the Supreme Court in Kokesh explicitly said that was not opining on whether courts have authority to order disgorgement in SEC enforcement proceedings. Concluding that Kokesh did not disturb Second Circuit precedent on disgorgement in SEC enforcement proceedings, the panel stated that de Maison's argument must await consideration by an en banc court or by the Supreme Court.

Disgorgement affirmed. De Maison then challenged the district court's calculation of the disgorgement amount. Here, de Maison made several arguments regarding where the proceeds of the illegal sales went, but the court said that all this was a "collective distraction." De Maison, the court said, confused what made the gains "ill-gotten" in the first place: the fact that she was selling unregistered securities and was not a registered broker‐dealer.

The judgment of the district court was accordingly affirmed. The ruling is by summary order and is without precedential effect.

The case is No. 18-2534.

Tuesday, September 03, 2019

Public interest group contends Volcker Rule changes will endanger financial markets

By Brad Rosen, J.D.

Better Markets, a non-profit organization that promotes the public interest in the financial markets, has issued a fact sheet on the new Volcker Rule in an effort to correct what is seen as misimpressions and misstatements that the new rule has changed little if anything. "It is simply incorrect that the recent changes are ‘tweaks,’ ‘nips,’ ‘symbolic,’ or otherwise insubstantial. It is also incorrect that these changes merely ‘clarify,’ ‘simplify,’ or ‘streamline’ the prior rule," stated Dennis M. Kelleher, Better Markets’ President and Chief Executive Officer.

Kelleher added, "The new Volcker Rule changes are substantial, material, and consequential. They will enable and almost certainly result in significantly increased speculative trading by Wall Street’s biggest taxpayer-backed banks."

Fact Sheet details dangerous loopholes created by the new Volcker Rule. The Better Markets Fact Sheet details three specific loopholes created by the new Volcker Rule. According to the organization, these will enable Wall Street to again engage in socially useless and dangerous financial activities that do not support the productive economy or provide credit to create businesses, jobs, and economic growth. Better Markets further contends these changes are short-sighted and will once again privatize gains while socializing losses while encouraging the very high-risk behavior that ignited the 2008 crash. The loopholes identified by Better Markets include:

The "Scope Loophole." The new Volcker Rule substantially narrows the scope of financial instruments covered by the Volcker Rule. Specifically, the new rule does not include proposed definitional changes to the term "Trading Account" that would better ensure that Wall Street’s banks are prohibited from engaging in statutorily covered proprietary trading positions. Additionally, the new Volcker Rule changes the Trading Account definition so as to create a new presumption that financial instruments held more than 60 days are not speculative trades in violation of the Volcker Rule. Lastly, the new rule also effectively deletes the short-term trading intent prong of the Trading Account definition for banks subject to the market risk capital regulations.

The "Presumption Loophole." The new Volcker Rule also establishes a so-called "presumption of compliance" for certain market-making and underwriting activities. According to Better Markets, those "presumptions" are a truly radical departure from longstanding supervisory practices and represent a return to the same failed industry self-policing policies and philosophies that prevailed before the 2008 financial crisis. The presumptions will now permit Wall Street’s largest banks to avoid or evade prop trading limits, because they permit, in effect, all trading activities conducted within risk limits established by the banks themselves. Accordingly, banks will set their own limits and then determine that they are in compliance with their own limits, which they are allowed to increase without reporting that change to bank supervisors.

The "Hedging Loophole." The new Volcker Rule will permit hedging that does not actually accomplish a hedged position. Under the new rule a hedge is whatever the bank says it is (which the new Volcker Rule will not then apply to). The new Volcker Rule, like the 2018 proposal, appears to eliminate the requirement that hedging activities demonstrably hedge anything. Specifically, under the new Volcker Rule, banks will not need correlation analyses or any other specific analyses to show that hedging activities demonstrably reduce or significantly mitigate any actual risk. Banks merely need internal processes and procedures supposedly designed to reduce risks, even if they do not do so in reality.

Final thoughts. The Fact Sheet concludes that there is no genuine dispute that the new Volcker Rule will enable substantially more speculative proprietary trading. In final analysis, Better Markets observes that while the new Volcker Rule is a tremendous victory for Wall Street, it irresponsibly permits taxpayer-backed banks to engage in more socially useless and dangerous financial activities that do not support the productive economy or provide credit to create businesses, jobs and economic growth. In the organization’s view, "These changes are short-sighted and once again privatize gains while socializing losses whereby the American people will again be forced to pay the bill for bailing out Wall Street’s reckless activities."

A word about Better Markets. Better Markets bills itself as a non-profit, non-partisan, and independent organization founded in the wake of the 2008 financial crisis to promote the public interest in the financial markets, support the financial reform of Wall Street and make the financial system work for all Americans again. Better Markets works seeks to promote pro-market, pro-business and pro-growth policies that help build a stronger, safer financial system that protects and promotes Americans’ jobs, savings, and retirements.

Friday, August 30, 2019

Sidley Austin attorneys examine elements of SEC’s securities offering exemption concept release

By Sidley Austin LLP

In June, the SEC issued a concept release to solicit public input on ways to simplify, harmonize, and improve the 1933 Act exempt offering framework. The current framework is complex, having evolved over time through legislative developments, Commission rulemaking and guidance, court cases and industry practices, according to a team of Sidley Austin attorneys. In this article, they review the many elements of the concept release, and encourage interested parties to provide comments that could form the basis for future sweeping changes in this area.

To read the entire article, click here.

Thursday, August 29, 2019

Market sees no IPOs for first time since 4th of July holiday week

By John Filar Atwood

No companies completed their IPOs last week, which was the first time the market has been quiet since the 4th of July holiday week. August is following a familiar IPO market script in which activity slows dramatically during the final month of the summer. With a few days left, only seven deals have been completed this month, a far cry from July’s 29 new issues, and the 24 IPOs in June.

New registrants. The week’s activity included eight new registrations, two of which were filed by prepackaged software companies Datadog and Ping Identity Holding. Ten SIC 7372 companies have registered so far this year. Venture capital-backed Datadog provides a monitoring and analytics platform for developers, IT teams and business users. Ping Identity, which is controlled by Vista Equity Partners, provides application access security management products and services. IGM Biosciences and TFF Pharmaceuticals were the latest pharmaceutical companies to publicly register. IGM uses immunoglobulin M antibodies to treat cancer. The company’s investors include Danish investment firm Haldor Topsoe Holding. TFF, which raised $8.2 million in a May private placement, makes inhalable pulmonary disease treatments. Exagen joined 2019’s list of California-based health care industry preliminary filers. The company provides diagnostics for rheumatoid arthritis, as well as chronic autoimmune diseases. Blank checks companies Experience Investment and New Providence Acquisition also filed their IPO plans last week. Experience Investment is seeking a target in the travel and leisure industry, and New Providence intends to acquire a business in the consumer products industry. The week’s other new registrant was medical research instrument maker and software developer 10x Genomics. The company, which will be controlled by existing shareholders after the IPO, is reworking its microfluidic chips and associated products because its original versions were found to have infringed patents of Bio-Rad Laboratories.

Withdrawals. Market conditions prompted G Medical Innovations to withdraw its preliminary registration last week. The developer of health monitoring solutions amended its May 17th initial public registration only once, in early June.

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

Wednesday, August 28, 2019

Cert petition seeks uniform application of definition of reasonable attorney's fees

By Rodney F. Tonkovic, J.D.

A petition for certiorari asks the Supreme Court to examine constraints on awarding "reasonable attorneys' fee" from a common-fund settlement. After the settlement in this case, the lead counsel was granted a larger-than-lodestar fee award. The petitioner, an objecting class member, asserts that awarding more-generous fees to counsel who settle than they would receive for winning the case produces perverse incentives. The Second Circuit held, in accord with several other circuits, that the presumption that an unenhanced lodestar is sufficient does not apply to the award of fees case from a common fund created after a settlement (Isaacson/Weaver Family Trust v. Fresno County Employees' Retirement Association, August 23, 2019).

BioScrip action. This action goes back to 2013, when respondent Fresno County Employees' Retirement Association was appointed as lead plaintiff. The complaint alleged that share prices for BioScrip, Inc., a home infusion and pharmacy provider, declined after it failed to disclose possible violations of the Anti-Kickback Statute (AKS) and False Claims Act (FCA) and that one of its most profitable business segments was collapsing. A motion to dismiss the action was denied in 2015.

The parties entered into a preliminary settlement agreement in 2016 under which BioScrip agreed to pay $10.9 million into a common fund. The lead counsel then applied for a fee award under FRCP 23(h), asking for 25 percent of the fund ($2,725,000, plus interest). The counsel acknowledged that this amount was a 1.39 multiplier of the lodestar, or nearly 40 percent more than the lawyers' regular hourly rates.

Fee objection. The Isaacson/Weaver Family Trust, a class member and petitioner here, filed an objection to the fee application. According to the Trust, the meaning of a "reasonable attorney's fee" had been addressed by the Supreme Court in Perdue v. Kenny A. ex rel. Winn, 559 U.S. 542, 546 (2010). This case held that the lodestar fee is presumptively sufficient and fees exceeding an unenhanced lodestar are permitted only in exceptional circumstances. The objection noted further that the federal securities' regime of fee shifting provisions authorizes courts to award "reasonable attorney's fees" and argued that class counsel should not be able to obtain a larger-than-lodestar fee award by settling claims and seeking fees from the common-fund settlement. The proposed settlement was approved in June 2016.

In July 2017, the district court overruled the Trust's objections and granted the challenged attorney's fees. According to the court, Perdue's presumption against a lodestar enhancement does not apply to a fee award from a common fund created after a settlement because no claim settled in this case contains a fee-shifting provision. The court then approved a fee award amounting to a 39 percent enhancement of the lodestar. The Second Circuit affirmed, stating that "regardless of whether a case is brought pursuant to a statute with a fee-shifting provision, if the parties settle the case by creating a common fund, common-fund principles control class counsel's fee recovery." Common fund awards, the court said, are not constrained by Supreme Court precedents defining "a reasonable attorney's fee."

Petition. The petition asks whether Supreme Court precedent in fee-shifting cases also constrains the award of "reasonable attorneys' fees" under FRCP 23(h) from a common-fund settlement. And, the petition asks if the relevant securities law provisions subject to Perdue's rule that a reasonable attorney's fee ordinarily will be limited to the lawyers' unenhanced lodestar.

The petitioner maintains that the Court's decisions defining reasonable attorney's fees in fee-shifting cases should also apply in common-fund settlements. The Second Circuit in this case, however, joined with several others (e.g., the Seventh, Ninth, and Eleventh Circuits) in holding that fee-shifting principles and the common-fund doctrine occupy separate realms. This, the petition argues, leads to a situation where lawyers winning a case under a fee-shifting statute can expect to receive only their unenhanced lodestar. But, if they settle, they can expect significant enhancements to their lodestar. Examining Supreme Court precedent, the petition stresses that the Court has never held that counsel seeking a common-fund award are entitled to a fee that is more than sufficient to induce a capable attorney to take a meritorious case. In other words, the Court's precedent limits attorney's fees to what is reasonably necessary to compensate the lawyers.

Lastly, the petition argues that the securities laws provide for a regime of statutory fee shifting governed by the Court's decisions defining "a reasonable attorney's fee." The Second Circuit offered no comment on this issue, but if the Court takes it up, the petitioner asserts that there is no basis to conclude either that the fee-shifting provisions did not apply in this case or that they would be exempt from the Court's precedent defining reasonable fees.

The petition is No. 19-244.

Tuesday, August 27, 2019

New York legislature restores 6-year Martin Act statute of limitations

By Anne Sherry, J.D.

New York has legislatively expanded the timeline for prosecuting financial fraud after a 2018 high court ruling shrank the Martin Act’s statute of limitations from six to three years. In part because the state’s past prosecutorial victories were enabled by a limitations period that allowed sufficient time to investigate, and to bring New York’s Office of the Attorney General back in line with its counterparts at the state and federal levels, S.6536/A.8318 expressly provides for a six-year limitations period for financial fraud enforcement actions.

The Martin Act bestows broad authority on the attorney general to investigate and enforce antifraud violations. In 2018, however, the state’s Court of Appeals limited the temporal scope of that authority by holding that Martin Act claims are governed by the three-year statute of limitations applicable to liabilities imposed by statute, rather than the six-year limitations period for fraud claims. The high court also remitted to the trial court a question regarding the limitations period for claims under Executive Law Section 63(12). The new legislation explicitly sets a six-year limitations period for actions by the attorney general under both the Martin Act and Section 63(12).

The state assembly’s memorandum in support of the legislation says that the Court of Appeals decision “turned on its head literally decades of case law” by installing a limitations period that is significantly shorter than many comparable state statutes. According to the memorandum, many states have no statute of limitations for attorney general actions involving customer frauds, some states have at least six-year limitations periods, and the SEC itself has no statute of limitations for equitable remedies and a five-year statute for civil penalties. Restoring a six-year limitations period allows the New York attorney general “to operate on equal footing with other agencies, which is of paramount importance given the reduced enforcement activity that has taken place during the Trump Administration. Correcting this is critical to maintaining OAG’s status as a preeminent enforcer of consumer protection and securities law in New York State.”

Governor Andrew Cuomo and Attorney General Letitia James also called out the current Administration to varying degrees. Governor Cuomo said, “At a time when the Trump administration is hell-bent on rolling back consumer financial protections, New York remains dedicated to preventing and prosecuting fraudulent financial activity.” Attorney General James said, “As the federal government continues to abdicate its role of protecting investors and consumers, this law is particularly important. New York remains committed to finding and prosecuting the bad actors that rob victims and destabilize markets.”

The attorney general and the prime sponsor of the bill in the Assembly, Robert Carrol, highlighted that the law will allow the Office of the Attorney General a reasonable time to investigate cases of fraud. The assembly memorandum specifies that electronic discovery often leads to delays, as do roadblocks put up by targets of an investigation, which requires the OAG to file motions to compel compliance. The six-year timeline enabled the OAG to pursue financial fraud, including in the area of mortgage-backed securities following the 2008 financial crisis, which resulted in over a billion dollars in settlements.

Monday, August 26, 2019

Personal and subject matter jurisdiction issues moot during cryptocurrency cover-up investigation

By Jay Fishman, J.D.

A New York trial court denied two virtual currency entities’ motion to dismiss the New York Attorney General’s (AG) fraud claim against them under New York’s state securities law (the Martin Act) because the entities’ argument that the AG lacked personal and subject matter jurisdiction over them did not apply during the AG’s ongoing investigation and could be decided only at the time the civil action went to trial (In the Matter of the Inquiry of Letitia James, August 19, 2019, Cohen J.).

Previously, the court issued the AG’s requested order demanding that the entities, an asset trading platform operator (Bitfinex) and a virtual currency issuer (Tether), cease their ongoing activities and produce specified documents while the AG’s office investigated whether they had defrauded New York investors in violation of the Martin Act. The AG’s investigation intended to prove that Bitfinex had drained $700 million from Tether’s cash reserves while covering up the $850 million loss by repeatedly telling investors for years that their funds were intact in those reserves and backed up one-to-one by Tether’s virtual currency.

Contentions. Bitfinex and Tether contended that they were not required to produce any documents since their businesses comprised an off-shore cryptocurrency exchange without sufficient connection to New York to trigger personal jurisdiction. They additionally argued that the AG’s “extraterritorial” investigation into their business activities lacked subject matter jurisdiction because cryptocurrency is neither a “security” nor a “commodity” under the Martin Act. They further stated that the AG’s primary investigation pertains to their recent issuances of lines of credit which have no New York connection from 2017 to the present because they changed their written policies to bar all U.S. residents from opening accounts on their sites, and since that time have neither advertised nor marketed to New York or other U.S. individuals or entities.

The AG countered that her ongoing investigation revealed that Bitfinex and Tether: (1) allowed some customers located in New York to transact on the Bitfinex trading platform after January 2017; (2) knowingly permitted New York-based traders to use Bitfinex; (3) agreed to loan Tether to a New York-based virtual currency trading firm as late at 2019; (4) opened accounts and used services at New York-based banks; and (5) had a physical presence in New York until at least 2018 through an executive who resided in and conducted work from the state.

Personal jurisdiction. The court began by proclaiming that the Martin Act does not prohibit Bitfinex or Tether from challenging personal jurisdiction during a pending investigation. It also does not prohibit the court from deciding the personal jurisdiction issue while an investigation is ongoing. But the court said that to decide the personal jurisdiction question, it must look to Section 354 of New York’s General Business Law, which provides that once the AG presents an application for an order allowing an investigation under the Martin Act, a New York supreme court judge has a duty to grant the application. The court supported the statute by reciting part of the decision in the 1961 New York La Belle Creole Intl. S.A. v. Attorney General case which explained that “a foreign corporation’s immunity from civil suit in New York, on the ground that it is not doing business there, does not mean that it is immune from investigation by the Attorney General in an inquiry to determine whether it is violating the laws of this State. As long as that official has a reasonable basis for believing that the corporation violated a New York statute, the official is not prevented by the due process class of the Federal Constitution from exercising his or her power of subpoena and initiating an investigation to ascertain the facts.”

In this case, the court concluded that: (1) the La Belle court’s rationale supported the exercise of personal jurisdiction to facilitate the AG’s gathering of information, even if Bitfinex’s and Tether’s contacts fell short of what would be required to bring a civil action under the Martin Act; and (2) as set forth in the May 16, 2019 order, the AG established a reasonable basis for proceeding with her investigation and is entitled to gather information from Bitfinex and Tether to determine whether they have violated the Martin Act. On this matter of personal jurisdiction, however, the court continuously distinguished between the investigation phase of a case and that case once it is brought to trial, declaring that at trial Bitfinex and Tether might successfully argue a lack of personal jurisdiction over them.

Subject matter jurisdiction. On the subject matter jurisdiction question, the court addressed Bitfinex’s and Tether’s contention that as extraterritorial entities, they fell outside the scope of the Martin Act. But the court debunked this argument, remarking that “arguments about extraterritorial reach are unavailing where, as here, the statute is being utilized to investigate domestic conduct.” The court further stated that the Martin Act “should be liberally construed to give effect to its remedial purpose of protecting the public from fraudulent exploitation in the offer and sale of securities.” The court advised that the decision granting the AG’s order is the law of the case while her investigation is ongoing, so this court will not truncate the investigation at this stage.

The court also addressed the reasonableness of the AG’s investigation, pointing out that it could still determine a lack of subject matter jurisdiction at this investigation stage if the investigation has, in fact, uncovered bits of totally far afield material not relevant to the case. However, the court noted that the AG has not only found at least five personal jurisdiction connections between Bitfinex/Tether and New York, but on the subject matter jurisdiction question has also uncovered facts strongly suggesting that Tether’s cryptocurrency transactions have characteristics common to securities and commodities. These AG factual findings, said the court, give weight to her argument that she needs more time to uncover additional facts showing security/commodity characteristics before a final determination can be made about whether Bitfinex’s and Tether’s business activities are covered by the Martin Act. For the above reasons, the court found a prevalence of subject matter jurisdiction during this investigation phase of the case, but again stated that when the case become a civil action for trial, Bitfinex and Tether might very well show that the Martin Act lacks subject matter jurisdiction over them.

The case is No. 450545/2019.

Friday, August 23, 2019

Corporate finance expert Jeff Dodd discusses how contract-drafting principles endure amid rapid change

By Diana von Glahn

A well-drafted contract accurately translates and achieves the client’s objectives, holds up over time, and is understandable to audiences that are far removed from the transaction. So advises Jeff Dodd, co-author of Drafting Effective Contracts: A Practitioner's Guide. A partner at Hunton Andrews Kurth LLP, Dodd has extensive corporate, securities, and corporate finance experience, including public and private securities offerings, M&A transactions, joint ventures, private debt and equity financing transactions, and regulatory, governance, and compliance matters.

Dodd spoke with Wolters Kluwer about trends and challenges in negotiating and drafting commercial agreements.

You are currently working on a new edition of Drafting Effective Contracts, due out in December. How has drafting contracts changed over the course of your career? How will this edition address new problems emerging in the world of contracts?

These are great questions. When I first started practicing 40 years ago we did not need to wrestle with the issues posed by electronic contracting and the explosion of information tools. (This sounds very grandfatherly, I know.) Interestingly, however, core contract principles and doctrines remain vital and certainly the task of the good commercial lawyer, exercising prudent practical judgment, remains the same—even as the tools change and techniques are adapted.

The new edition will address electronic contracting and negotiating by electronic distance, as well as information and e-commerce contracts, in greater depth, especially as I roll out new chapters over time. However, much of the foundational, exceptional work that Bob Feldman and Ray Nimmer did will remain, as well it should, even as it gets a face lift here and there.

Can you give an example in your experience where a well-drafted contract avoided a serious problem and, conversely, where a flawed contract created a problem?

Wow! So many examples come to mind. Let me distill one instance of each.

As to the problematic contractual provision, I remember how a provision relating to adjustments to purchase price in an acquisition contract left out some key provisions concerning the accounting for accounts receivable. The amount in controversy was quite substantial. This example reminds us that we, as lawyers, cannot know everything, but we must push our clients, their accounting advisers, and others on their team to make sure the "mundane" mechanics work and that they (and we) work through concrete examples and unmercifully test language against application.

I remember a highly complex license agreement that, at first, appeared to require a difficult and commercially peculiar result, especially from our client’s point of view, of course. However, a more exacting reading and tying together the provisions made it abundantly clear that, in fact, the contract quite properly and carefully led to precisely the right and commercially harmonious result. The drafting was not faulty at all. However, this example reminds all of us that we need to be aware that, especially with complex contracts, third parties at far remove from the drafters may be reading and applying the contract in the future and could use guideposts sometimes. For an example of a bad interpretation of a complex contract that might have come out the right way with a little help of signals in the contract, take a look at Astex Therapeutics Limited and AstraZeneca AB, [2018] EWCA Civ. 2444, Case No. A3 2017 2134 (Court of Appeal).

What do you enjoy most about your work?

Wow again! How much space do I have?

Let me focus on one thing: I really enjoy working with and learning from clients as I negotiate and draft their contracts. The challenge and responsibility of translating important client objectives into a contract that fits within the tight confines of all the legal and commercial demands that may apply and is durable enough to work over time and in front of various audiences—under time pressure and certainly monetary constraints—really focuses the mind. There has not been one day of my practice that I can think of where I have not learned something. I get to learn something every day. What a great job!

What do you find most frustrating or tedious?

One word: billing.

What is the best advice you can give a new attorney given the task of drafting a contract?

Spend the time to understand—even on your "own" time (if it exits)—(a) what your client does and what really is important for it to accomplish with the contract, and (b) what those provisions from the precedents or forms you are pointed to really mean and do. Learn and be curious.

What mistakes do you see often repeated in drafting contracts?

Blindly taking a provision from one precedent or form and inserting it into the next deal. There is no Platonic Ideal Form Contract.

What would you do if you weren’t practicing law?

I have quite a few interests, but I think that I would spend more time working with, learning from, and counseling young entrepreneurs. I am an angel investor (very small), a co-founder of an angel group and participant in judging business plan competitions. I also have worked for quite some time on venture capital transactions and with emerging companies. The energy, enthusiasm, openness, and focus of young entrepreneurs is infectious and refreshing—and often humbling. If you ever worry about the future of the species, spend some time with them.

Thursday, August 22, 2019

PCAOB found audit and attestation deficiencies in more than half of 2018 audit inspections

By John Filar Atwood

The PCAOB released its annual report on the interim inspection program related to audits of brokers and dealers in which it revealed that in 105 of the audit engagements it inspected it found 55 with audit and attestation deficiencies. An additional 25 engagements had audit deficiencies but no attestation deficiencies. The PCAOB acknowledged that the percentage of deficiencies remains high, and hopes the issues identified in the report will help drive future improvements.

The report states that the PCAOB inspected 67 firms in 2018 and found only three with no deficiencies. In addition to the 105 audit engagements, the board inspected 24 examination engagements and 79 review engagements. It found deficiencies in 18 of the examination engagements and in 43 of the review engagements.

The report states that in selecting the firms to inspect and the engagements for review, the PCAOB used both risk-based and random selection methods. Moreover, the staff did not review every aspect of the selected engagements, but focused on the more complex, challenging, or subjective areas, or other areas that presented greater risk. The PCAOB noted that its observations are specific to the particular portions of the engagements reviewed and are not representative of the entirety of the specific engagements.

Quality control observations. The PCAOB requires firms to have a system of quality control that provides reasonable assurance that their personnel comply with applicable professional standards and a firm’s standards of quality. During the 2018 inspections, the PCAOB identified defects and potential defects related to engagement performance and monitoring, which are two required elements of a system of quality control.

With regard to the engagement performance and monitoring aspects of the system of quality control for certain firms, the PCAOB found that some firms’ audit methodology was not effective. Specifically, engagement teams established materiality levels that were too high to plan and perform audit procedures to detect misstatements that could be material to the financial statements because the firm’s audit methodology did not require appropriate consideration of certain relevant factors. The methodology also did not sufficiently instruct engagement teams to evaluate whether a lower materiality level was needed for particular accounts, according to the report.

In some cases, engagement teams determined sample sizes that were too small to provide sufficient, appropriate audit evidence. The firm’s audit methodology allowed engagement teams to determine samples for substantive tests of details that did not take into consideration tolerable misstatement and the allowable risk of incorrect acceptance.

Engagement quality. The PCAOB also found problems with the engagement quality review, including instances where reviews were not performed. In other instances, reviewers had served as the engagement partner for the audit of the broker-dealer’s financial statements for one or more of the previous two years and, therefore, did not meet the objectivity qualifications of an engagement quality reviewer. Further, some reviews did not include an evaluation of the engagement team’s significant judgments and the related conclusions reached that formed the overall conclusion in the engagement report.

The PCAOB reported the following numbers with respect to audit and attestation engagements with deficiencies in the engagement quality review: 83 audit engagements reviewed, and 54 with deficiencies; 19 examination engagements reviewed, and 5 with deficiencies; and 51 review engagements inspected, and 22 with deficiencies.

Auditor’s report and documentation. The 2018 inspections found that in some instances audit reports were not prepared under the applicable auditing standard. Others did not accurately describe the financial reporting framework under which the broker-dealer’s financial statements were prepared.

In other cases, a complete and final set of audit documentation was not assembled for retention as of the documentation completion date. Documentation added to the audit work papers subsequent to the report release date did not indicate the date the information was added, the name of the person who prepared the additional documentation, and the reasons for adding it, according to the report.

Examination engagements. An auditor is expected to perform an examination of statements made by the broker-dealer in its compliance report, which should include obtaining evidence about whether one or more material weaknesses existed in the broker-dealer’s internal control over compliance (ICOC) with the broker-dealer financial responsibility rules. The examination also includes performing tests of the broker-dealer’s compliance with the net capital rule and paragraph (e) of the customer protection rule (the reserve requirements rule) as of the end of the broker-dealer’s fiscal year.

In the 2018 examination engagements, the PCAOB found that in some cases planning was not sufficient because the firms did not obtain a sufficient understanding of certain of the financial responsibility rules or of the broker-dealer’s processes, including relevant controls, regarding compliance with the financial responsibility rules. In other engagements, testing of ICOC with the financial responsibility rules was not performed, or was not sufficient, including examinations in which no testing was performed of any ICOC related to one or more of the financial responsibility rules.

Other deficiencies. The report discusses numerous other areas where deficiencies were identified, including performing compliance tests, evaluating the results of examination procedures, performing review procedures, evaluating the results of the review procedures, reporting on the review engagement, auditing financial statements, the auditor’s report, auditor communications, and auditor independence.

The report also provides multiple examples of effective procedures employed by various firms. The PCAOB said that its goal in identifying both deficiencies and effective practices is to assist audit firms as they assess and refine their audit practices to prevent the deficiencies from occurring in the future.

Wednesday, August 21, 2019

Texas amends its securities act

By R. Jason Howard, J.D.

Texas H.B. 1535, enacted June 10, 2019 and effective September 1, 2019, amends several sections relating to the continuation and functions of the State Securities Board.

Subsection (J) of Section 581-2 has been amended to add language criminal prosecutions of cases under subsection B of Section 3 of the Act. With respect to cases referred during the preceding year by the Board under subsection A of Section 3 of the Act, a breakdown by county and district attorney of the number of cases where:
  • criminal charges were filed;
  • prosecution is ongoing; or
  • prosecution was completed. 
Subsection (O) of Section 581-2 has been amended to reflect a new expiration of the Act on September 1, 2031.

Section 581-2-3, subsection (B) has been amended and relates to the training program and information that must be provided to the person being trained. New subsection (D) has been added and states that the Commissioner “shall create a training manual that includes the information required by subsection B of this section. The Commissioner shall distribute a copy of the training manual annually to each member of the Board. Each member of the Board shall sign and submit to the Commissioner a statement acknowledging that the member received and has reviewed the training manual.”

Section 581-2-6 has been amended by adding and striking language relating to the maintenance of information so the Commissioner or the Commissioner’s designee can act promptly and efficiently on complaints filed with the Commissioner or Board.

New Section 581-2-8 has been added to allow for alternative rulemaking and dispute resolution. Under this section, the Board shall develop a policy to encourage the use of:
  1. negotiated rulemaking procedures under Chapter 2008, Government Code, for the adoption of Board rules; and
  2. appropriate alternative dispute resolution procedures under Chapter 2009, Government Code, to assist in the resolution of internal and external disputes under the Board's jurisdiction. 
The procedures relating to alternative dispute resolution “must conform, to the extent possible, to any model guidelines issued by the State Office of Administrative Hearings for the use of alternative dispute resolution by state agencies.”

Section 581-3 has been amended and adds new subsections (B) through (F) allowing that the Board “may provide assistance to a county or district attorney who requests assistance in a criminal prosecution involving an alleged violation” of the Act that is referred by the Board to the attorney under subsection A of the section.

New Section 581-32 has been added and related to refunds. The Commissioner “may order a dealer, agent, investment adviser, or investment adviser representative” regulated under the Act to “pay a refund to a client or a purchaser of securities or services from the person or company as provided in an agreed order or an enforcement order instead of or in addition to imposing an administrative penalty or other sanctions.” The amount of the refund may not “exceed the amount the client or purchaser paid to the dealer, agent, investment adviser, or investment adviser representative for a service or transaction regulated by the Board. The Commissioner may not require payment of other damages or estimate harm in a refund order.”

Section 581-35 has been amended and strikes the language “or register a branch office” from subsection (B)(1).