Monday, January 20, 2020

Keeping the dream alive

[In commemoration of Martin Luther King, Jr. Day, we republish a post by the late Jim Hamilton from August 28, 2010, celebrating the anniversary of Dr. King's "I Have a Dream" speech.]

By Jim Hamilton, J.D., LL.M.

I once heard Alabama federal district judge (later named to the 11th Circuit Court of Appeals) Frank Johnson Jr. caution people not to think that federal judges decide momentous civil rights cases every day. Most of the work of federal judges, he said, consists of interpreting arcane federal regulations and U.S. code provisions. Frank Johnson Jr. was the federal judge in the Rosa Parks case, which changed the history of the South and the entire U.S. So, every once in a while, I have to leave the arcane world of securities regulation to mention something more momentous.

Today is the anniversary of Dr. Martin Luther King Jr.’s "I have a dream" speech. It envisions a world and a South where, in Dr. King’s words, "one day on the red hills of Georgia the sons of former slaves and the sons of former slave owners will be able to sit down together at the table of brotherhood.’’

There is a New South today, and there are many to thank for it: President Jimmy Carter, Senator Claude Pepper of Florida - and dare I mention Governor and later Senator Terry Sanford of North Carolina? Yes, I do dare because he was a great man also.

But if the New South has a father, it has to be Dr. King. When I drive past the new gleaming auto plants and Siemens plants in South Carolina and Georgia and see the sign announcing a new $1 billion VW plant in Tennessee, I think how Dr. King made it all possible. Yes, he did. Because no global company, not Nissan, not BMW not Seimens, would ever have come and built large new plants in a segregated South. That would never have happened, and that is the God’s truth.

So, on the anniversary of "I have a dream," let us pause to honor Dr. King. Tomorrow, we return to the arcane world of securities regulation.

Friday, January 17, 2020

Court forces merger between Boston Scientific and Channel Medsystems

By Anne Sherry, J.D.

The Delaware Court of Chancery ordered specific performance of a merger between Boston Scientific and Channel Medsystems. Boston Scientific had terminated the agreement based on the intervening discovery of a Channel officer’s fraud, but the court found that the fraud did not constitute a material adverse effect given the FDA’s acceptance of Channel’s remediation plan. Furthermore, Boston Scientific’s termination constituted a breach of its contractual obligation to use commercially reasonable efforts to consummate the merger (Channel Medsystems, Inc. v. Boston Scientific Corporation, December 18, 2019, Bouchard, A.).

In December 2017, about two months after Boston Scientific and Channel entered into the merger agreement, Channel discovered that its vice president of quality had engaged in a scheme to defraud the company. The officer used shell companies and falsified invoices to steal $2.6 million over about five years. He also falsified other documents, some of which were contained in Channel’s submissions to the FDA seeking approval of its sole product, a gynecological device called Cerene. The FDA accepted Channel’s remediation plan in April 2018, a strong indicator that the fraud would not impede FDA approval. However, Boston Scientific terminated the merger agreement in May 2018. The FDA approved Cerene in March 2019, and Channel sued for specific performance of the merger.

The court concluded that although the officer’s fraud caused a number of representations in the agreement to be inaccurate, Boston Scientific failed to prove that those inaccuracies would reasonably be expected to have a material adverse effect. As is typically the case, the agreement did not define what is "material" for purposes of a material adverse effect, so the court turned to Delaware cases holding that the effect should "substantially threaten the overall earnings potential of the target in a durationally significant manner" (Akorn, Inc. v. Fresenius Kabi AG (Del. Ch. 2018)). Furthermore, it held that the relevant date for assessing whether there was a reasonable expectation of a future material adverse effect is the date on which Boston Scientific provided its notice of termination, and the relevant date on which that material adverse effect would be expected to occur is the date the parties expected to close.

Boston Scientific’s evidence of a material adverse effect fell short from both a qualitative and quantitative standpoint. The company’s main qualitative argument was that even if Cerene received FDA approval, Boston Scientific would need to remediate and retest Cerene before putting it on the market. This argument was not credible given the circumstances surrounding the decision to terminate the agreement in reliance solely on a consultant’s report without speaking with the consultant or Channel, retaining an outside consultant, quantifying the costs of remediation, or looking into Channel’s remediation efforts to date. The executive who made that decision also did not confer with a number of executives whose perspectives would have been relevant. Boston Scientific kept no written record of the meeting at which the decision was made to terminate, or any documentation at all assessing the impact of the fraud at Channel after it received the consultant’s report, and its quality expert could not identify any instance where any company, including Boston Scientific, voluntarily rebuilt a quality system and retested a device after receiving FDA approval. Furthermore, Boston Scientific’s concerns about potential products liability litigation, competitive harm, and future regulatory action were based on unsubstantiated speculation.

Boston Scientific also failed to make the quantitative case for the existence of a material adverse effect. The court did not credit its expert’s analysis because it was premised on an assumption that Boston Scientific would shelve Cerene for two to four years while it rebuilt and retested the device, a position that the court explained was not objectively reasonable. The expert also analyzed a putative change in Channel’s value that incorporated merger synergies. The chancery court consistently holds that a target should be valued as a standalone entity when determining whether a material adverse event has occurred.

Having determined that Boston Scientific’s termination of the agreement was not justified by the existence of a material adverse effect, the court held that the company breached its obligation to use commercially reasonable efforts to consummate the merger. As for the remedy, the parties expressly agreed that a failure to perform would warrant specific performance, and the equities weighed in Channel’s favor so as to make that remedy appropriate.

The case is No. 2018-0673-AGB.

Thursday, January 16, 2020

Federal prosecutors argue against former Theranos head's motion to dismiss indictment

By Rodney F. Tonkovic, J.D.

Federal prosecutors have filed motions in opposition to former Theranos CEO Elizabeth Holmes's motion to dismiss several counts of the indictment against her and the company's COO. Holmes argued that parts of the indictment failed to allege falsity and a duty disclose and also moved to dismiss portions of the indictment relating to defrauding patients who used Theranos's blood tests. The government asks the court to deny the motion in its entirety (U.S. v. Holmes, January 13, 2020).

The action was brought against Theranos founder Elizabeth Holmes and the company's president and COO, Ramesh "Sunny" Balwani. The indictment alleges that Theranos, a blood-testing company, misled the public regarding the capabilities of its technology. Holmes and Balwani represented that the technology yielded accurate results while knowing that the tests were unreliable. Holmes and Balwani were charged with two counts of conspiracy to commit wire fraud and nine counts of wire fraud stemming from two schemes: a multi-million dollar scheme to defraud investors and another scheme to defraud patients and doctors.

Falsity and duty to disclose. Holmes and Balwani ("Theranos") have asked the court to dismiss certain clauses from the superseding indictment, asserting that it fails to allege falsity and a duty to disclose. The government's motion in opposition argues that Theranos articulated the wrong standards. First, Theranos asserts that specific falsehoods are required to allege wire fraud. But, the government says, Ninth Circuit precedent says that all that must be pleaded is a fraudulent scheme or artifice, and any deceptive statements or half-truths are considered material evidence of the fraud. The court can deny the motion to dismiss based on this standard, the government argues, and does not need to consider whether the challenged clauses allege actual falsity. The government says that it only needs to properly allege wire fraud and has done so.

Even if the court considers the allegations, the government continues, they clearly allege falsity. Theranos made misrepresentations in furtherance of the scheme, including lies to doctors and patients concerning the consistency of the company's test devices when the devices' unreliability was known. Further, the statements at issue were also fraudulent as "half-truths" due to critical omissions meant to deceive, the government contends.

The superseding indictment also alleges a duty to disclose. In the Ninth Circuit, a duty to disclose arises from affirmatively telling a half-truth about a material fact, whether or not there is a relationship of trust. Even so, the government asserts that a duty of trust existed because Theranos induced investors to relax their ordinary care and vigilance through deceptive demonstrations designed to show that the technology worked.

Doctors and patients. Not only did investors lose hundreds of millions when the misrepresentations came to light, but thousands of patients received unreliable blood tests which, in many cases, caused actual harm. In their motion, the defendants asked the court to limit the case to fraud targeting investors.

The government says that this motion should be denied for three reasons. First, the indictment meets constitutional standards for pleading fraud against doctors and patients. A charging document alleging every detail that will be presented at trial is not required. Next, the alleged fraud goes to the core of the bargain between Theranos and its customers – the decision to market unreliable tests is the definition of intent to defraud, the government says. Finally, the indictment alleges that Theranos intended to deprive its victims of the money paid for testing services, and the fact that not every victim paid Theranos directly does not affect this charge's viability.

The case is No. 18-CR-00258.

Wednesday, January 15, 2020

Inaugural Asset Management Advisory Committee meeting focuses on industry transformation

By Amy Leisinger, J.D.

In the first meeting of the Asset Management Advisory Committee, panelists discussed recent developments in fund investing and the evolution of the asset management industry. Separately, panelists emphasized the importance of investor choice, particularly regarding private equity and other investments. According to Committee Chairman Edward Bernard of T. Rowe Price, informed debate leads to better ideas and solutions; even with varying perspectives, the ultimate goals of market success and proper investor protection remain the same, he explained.

"I believe the AMAC will help ensure that our regulatory approach to asset management meets the needs of retail investors and market participants at a time when the asset management industry and our markets more generally are rapidly evolving," SEC Chairman Jay Clayton said.

Industry changes. Michael Goldstein of Empirical Research Partners highlighted several aspects of transformation in asset management. The U.S. money management industry is approximately $45 trillion in size and has a substantial retail component, he said. New capital raised by private equity and venture capital has increased though some inertia remains among holdings in general. Interest rates and pricing have a lot to do with investor behaviors, Goldstein noted, but a growing preference for machines over people has changed the industry landscape, as has the trend of companies staying private for longer periods. In addition, mutual funds are getting more involved in the venture capital space, and financial professionals are moving toward describing themselves as "wealth managers" and "financial planners," as opposed to the more common "brokers." This could indicate a shift in the roles in which these professionals see themselves, he opined.

In addition, Goldstein noted that the dominance of "baby boomers" as asset holders has created some inertia and limited disruptions to a certain extent. However, at the same time, the nature of investment advice has shifted toward indexing, he said. According to Goldstein, the more the industry automates, the more decisions and returns are standardized. Technology is increasingly defining outcomes, and automated advice is becoming the norm. Ultimately, this is a reflection of what is happening in the economy and in terms of globalization, he explained.

Deloitte Consulting Principal Ben Phillips agreed that automation and data accumulation are increasing in popularity but also noted a shift from products to services; changing needs are changing consumer demand, he explained. Investors are becoming more outcome-oriented and focused on low fees, and shifts in supply and demand, particularly in connection with the decline in listed companies, are reshaping the U.S. asset management industry, according to Phillips. In addition, there is an enhanced focus on performance fees over asset-under-management fees and mass customization in efforts to align with what customers seek. Asset managers will need to increasingly rely on private markets to achieve client goals, he opined.

Private investments. In a separate panel, Stephanie Drescher of Apollo Global Management noted that credit markets are shifting private, as alternative credit and equity continue to outperform traditional asset classes. This has resulted in a substantial flow to alternative managers, with pensions even seeing increased allocations to private investments, she noted. Blackstone Group’s John Finley opined that volatility is lower in private markets and that adjustments can be made as necessary to ensure growth. We should look at democratizing access to private markets, he said.

Colby Penzone of Fidelity Investments agreed, suggesting that broadening access to private markets beyond qualified institutional buyers and accredited investors could be beneficial. Many investors already have indirect exposure to private investments through funds and other proprietary vehicles or third parties. While investor and intermediary education will be critical in the event of allowing access to private markets, the ultimate benefits could outweigh the costs.

"The SEC is in the protection business and the choice business," Finley noted. The primary focus should be on how to do both with respect to private markets, he concluded.

Tuesday, January 14, 2020

2019 year in review: Blog Tracker hot topics

By Lene Powell, J.D.

In Securities hot topics in 2019: A whirlwind expert review, we look back at blog posts by securities practitioners and other experts for insights on trends and developments in 2019, including:
  • continued dramatic growth of securities litigation and calls for reform;
  • the SEC’s adoption of Regulation Best Interest and related Form CRS and interpretations regarding the duties broker-dealers and advisers owe to customers;
  • corporate governance hot spots, including controversial proposed SEC rules on proxy advice and shareholder proposals, as well as continued debate on the role of ESG (environmental-social-governance) in corporate social responsibility; and
  • an emerging legal framework for digital assets and cryptocurrencies.

Monday, January 13, 2020

FIA and ISDA provide ESMA with their view of position limits under MiFID II

By Brad Rosen, J.D.

The Futures Industry Association (FIA), together with the International Swap Dealer Association (ISDA) responded jointly to the European Securities Markets Authority’s (ESMA) consultation referred to as the MiFID II review report on position limits and position management and draft technical advice on weekly position reports. ESMA issued its call for evidence in May 2019 inviting stakeholders to share their views with regard to the position limit regime. In their response, FIA and ISDA noted that MiFID II position limits had only been in place for approximately two years, were previously unprecedented in the European Union (EU), and were without any equivalent regime in other jurisdictions. The associations indicated that their memberships did not view the position limit regime as having caused significant negative consequences, with the exception of its impact on new and illiquid contracts. Notwithstanding, FIA and ISDA identified several areas for improvement in the position limit regime, and included the following key messages in its response letter to ESMA:
  • Refocus the scope of position limits. The associations recommended refocusing the scope of the position limits regime to include only the most important benchmark contracts with a particular focus on food commodity contracts. FIA and ISDA asserted that this would help solve the problems associated with the application of limits to new and illiquid contracts, where exchanges, dealers, and end-users have raised concerns that the existing limits are a hurdle to the development of markets for new contracts.
  • Limiting the scope of covered contracts. The associations also call for limiting the scope of contracts covered by position limits. FIA and ISDA noted that the definition of financial instruments—and of commodity derivatives—has led to extensive discussions as to whether some securities or some derivatives with no underlying physical commodity should be subject to position limits. They further noted their present inclusion in the regime is a result of their cross references between MiFID and MiFIR which suggest that they are commodity derivatives. Additionally, the associations asserted that their members support the objectives of the legislation, and particularly, the prevention of excessive speculation for underlying commodities such as food. However, they are in support of ESMA’s proposal limiting the position limit regime to a set of important, critical derivatives contracts. Further, FIA and ISDA support ESMA’s suggestion to disapply position limits applicable to securitized commodity contracts.
  • Expanding the scope of the hedging exemption. While the associations recognize that the current position limits regime includes exemptions for market participants pursuing hedging activity, they also noted that the MiFID II definition of "hedging" is clear that only non-financial entities can engage in such activity. As a result, they note that the exemption is unavailable to investment banks or commodity trading houses that are MiFID II-authorized, which both play a vital role in providing smaller commercial players with access to commodity derivatives markets.
  • Retaining carve-outs. FIA and ISDA strongly recommended retaining carve-outs from position limits for physically settled power and gas contracts asserting they are sufficiently regulated under the Regulation on Wholesale Energy Market Integrity and Transparency (REMIT) and otherwise supervised. The associations contend that the linkage between wholesale gas and power markets in the EU remains unique in commodity markets. They noted that REMIT was designed in 2011 based on the advice from the Committee of European Securities Regulators (CESR) before the creation of ESMA and from the European regulators Group for Electricity and Gas to combat insider trading and market manipulation in that sector.
As for next steps, ESMA will consider the feedback it receives to its consultation paper. Thereafter, it is expected to deliver a final report to the European Commission by end of March 2020.

Friday, January 10, 2020

BSA enforcement authority lies with FinCEN, not the SEC, Alpine Securities argues

By Rodney F. Tonkovic, J.D.

A broker-dealer hit with a $12 million civil penalty for filing deficient Suspicious Activity Reports has brought an appeal to the Second Circuit. Alpine Securities Corporation argues that the SEC was enforcing provisions of the Bank Secrecy Act that have been expressly delegated to another agency. The Commission's asserted toehold in doing so lies in the books-and-records provisions of the Exchange Act, but to claim that these provisions incorporated parts of the BSA enacted years later violates the notice and comment requirements of the Administrative Procedure Act, Alpine maintains. Finally, Alpine maintains that the district court abused its discretion through the sheer size of the penalty (SEC v. Alpine Securities Corporation, January 6, 2020).

Suspicious money laundering reporting requirements. The Bank Secrecy Act (BSA) requires broker-dealers to file a Suspicious Activity Report (SAR) with the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) to report certain transactions that the broker-dealer has reason to suspect involve funds from an illegal activity, are designed to evade BSA requirements, have no business or lawful purpose, or involve the use of the broker-dealer to facilitate illegal activity.

Alpine's SARs. Alpine Securities Corporation, a broker-dealer providing clearing services for microcap securities, had been charged by the SEC with violating Exchange Act Rule 17a-8 by filing fatally deficient SARs or by failing to file any SAR when it had a duty to do so. A strict-liability provision, Rule 17a-8 requires compliance with BSA regulations that govern the filing of SARs by broker-dealers. According to the complaint, Alpine routinely failed to identify and report suspicious activity of which it was aware. Among other deficiencies, the SARs lacked required information such as why underlying transactions were suspicious, the relevant criminal or regulatory history of the customers, the involvement of shell companies, and certain red flags for "pump and dump" schemes.

In September 2019, the Southern District of New York imposed a permanent injunction and $12 million civil penalty against Alpine. The court found that the Commission met its burden of showing over 2,700 separate violations and that a request for a penalty of over $22 million was not disproportionate. A lower, first-tier, civil penalty was imposed in light of Alpine's financial condition. The court noted that the scale and duration of the violations undermined Alpine’s assertion that its conduct was merely negligent.

Can the SEC enforce BSA? On appeal, Alpine argues that the SEC does not have the authority to enforce the SAR provisions of the BSA via Rule 17a-8. According to Alpine, Congress expressly delegated the power to administer and enforce the BSA to the Department of the Treasury as delegated to FinCEN. While this case was nominally brought under Rule 17a-8, the claims were predicated solely on violations of the BSA, the brief posits. While the district court found authority in the Exchange Act, Alpine counters that Section 17(a)'s authority over reporting does not even mention the BSA, and finding otherwise would permit the Commission to invade an authority specifically given to another agency in another statute. Courts, including the Second Circuit, have consistently rejected attempts by agencies to expand their own jurisdiction, the brief says.

The brief also takes issue with the district court's acceptance of the Commission's position that Rule 17a-8 evolved over time to incorporate the SAR provisions of the BSA, despite the rule having been adopted a decade earlier. This assertion, Alpine says, amounts to the incorporation of future legislation without notice, publication, or comment, in violation of the Administrative Procedure Act and Federal Register Act. Incorporating future statutes promulgated by a different agency also raises a delegation issue: if the requirements of Rule 17a-8 change every time FinCen amends the BSA regulations, FinCen, not the SEC, is engaging in rulemaking under Exchange Act Section 17(a). Moreover, the rules of the Office of the Federal Register state that formal approval is required to incorporate materials by reference.

Alpine notes here that the district court also failed to consider and apply Kisor v. Wilkie. The Supreme Court issued Kisor while remedies briefing was taking place, but the district court denied Alpine's motion for reconsideration. The court applied Auer deference, but Alpine contends that it committed errors discussed in Kisor, namely, not exhausting the statutory construction analysis and by giving controlling weight to an agency position that did not deserve it.

Other arguments. Next, Alpine argues that the district court adopted "novel" theories that "snippets" culled from industry guidance created automatic requirements for the filing of SARs. This approach, the brief argues, is at odds with FinCEN's approach to BSA enforcement. In short, the court's acceptance of the SEC's emphasis on "red flags" has created a new filing trigger where no such mandatory narrative requirement had been previously imposed. In arriving at this conclusion, the district court erroneously deferred to the SEC's interpretation of FinCEN's guidance, the brief says. And, there were material issues of fact with respect to whether Alpine's SARs were deficient at all; the brief claims that the court disregarded significant evidence from Alpine's fact and expert witnesses on this point.

Finally, the brief argues that the $12 million penalty is "unprecedented" and that the district court relied on impermissible factors while disregarding evidence in imposing it. Here, Alpine asserts that the penalty is "exponentially" greater than the maximum that would be imposed under the comparable BSA provisions (which would amount to $1.36 million in this case). It is not logical to increase a maximum penalty from $500 to $80,000 for the same violation simply because the SEC is the plaintiff, Alpine says. Plus, there was no evidence of illicit gain, fraud, or losses to victims. Alpine pointed out in closing that the penalty is so far in excess of its ability to pay that it would force closure of the firm.

The case is No. 19-3272-cv.

Thursday, January 09, 2020

SEC proposal would require SROs to submit new NMS plan for market data dissemination

By John Filar Atwood

In a three-to-two vote, the SEC agreed to publish for comment a proposal to direct the equities exchanges and FINRA to file with the SEC a new national market system (NMS) equity data plan to increase transparency and address conflicts of interest presented by the existing governance structure of NMS plans. The Commission also will publish for public comment notices of proposed amendments to the existing plans filed by the plan participants that are intended to address conflicts of interest and the protection of confidential information.

The proposal seeks to address the gap that has developed between the public consolidated market data feeds provided by three equity data plans and the private, proprietary data feeds sold by the exchanges. Industry stakeholders have expressed concern that the gap adversely affects those who do not access the proprietary data products, or who may not have the processing capacity to trade competitively.

Equity markets and the corporate structure of exchanges have changed dramatically since the adoption of Regulation NMS in 2005. Exchanges have converted to for-profit entities that sell their own market data products. In addition, "exchange groups" (multiple exchanges operating under common ownership) have emerged through which much of the voting power and control of the equity data plans has been consolidated.

The Commission believes that these developments have heightened conflicts of interest between the exchanges’ commercial interests and their regulatory obligations to provide consolidated market data. In particular, the SEC noted that the operation of the equity data plans has not kept pace with the efforts of the exchanges to expand the content of, and to use technology to increase the speed of, certain proprietary data products.

Governance provisions. In addition, in drafting the proposal the SEC noted that the current governance structure of the data dissemination plans perpetuates disincentives to enhance consolidated equity market data feeds, which are often slower the SROs’ proprietary feeds. Accordingly, the proposed order attempts to modernize the governance of securities information processors (SIPs) by mandating governance provisions for the new consolidated data plan. Among other things, the new plan would have an operating committee that provides votes to individuals representing non-SROs, with non-SROs having one-third of the combined voting power.

Commissioner Allison Herren Lee does not believe that adding non-SRO voting members to the governance structure and giving them one-third of the vote will ensure robust and useful SIPs. "These members would have neither the voting power, nor necessarily the market incentives, to affirmatively usher in the larger reforms required for the SIPs to provide adequate market data to investors on a fair and reasonable basis," she said. Lee, who voted against the proposal, worries that the Commission will preserve for years to come an insufficient governance structure just because it has been somewhat improved.

Commissioner Robert Jackson, who also dissented, said that rather than giving investors a say on how public data feeds are run, the proposal invites for-profit exchanges to draft their own rules. He does not blame stock exchanges for seeking to maximize their opportunities. Rather, he thinks lawmakers should change the law to address the incentives that are created by giving exchanges both control over public feeds and the opportunity to profit by selling private ones. "Without changing those incentives, we cannot and should not expect the market to fix the market," he concluded.

No perfect solution. Commissioner Elad Roisman noted that the NMS has been a hot topic for a long time, and that there is no perfect solution to NMS issues. "If there were a silver bullet, we would have thought of it. We need to move forward, and this proposal is an important first step," he said.

Chairman Jay Clayton emphasized that modernization of the markets is necessary, but acknowledged that there are very different opinions on how to go about it. In his view, the proposal "looks past the noise and moves the issue forward in a thoughtful, sensible way."

It is worth evaluating the extent to which the structure of the three existing equity data plans is in need of modernization, Clayton said. "The current structure has redundancies, inefficiencies, and inconsistencies that it may be possible to eliminate for the benefit of all market participants without any meaningful adverse effects," he noted.

Clayton concluded by inviting commenters to suggest additional or alternative measures to those in the proposal. However, he asked that any such suggestions include a comprehensive explanation as to why the alternative would be effective in addressing the significant issues set forth in the proposal.

Wednesday, January 08, 2020

OCIE announces 2020 examination priorities

By Amy Leisinger, J.D.

The SEC’s Office of Compliance Inspections and Examinations has published its annual examination priorities to enhance the transparency of its examination program and provide insight into potential risks to investors and market integrity. According to OCIE, examiners will focus heavily on issues directly affecting retail investor protection, entities providing critical services to capital markets, operations of SEC-regulated entities, and information security and fintech approaches. The office noted that many of these themes involve perennial risks and that examiners must remain vigilant in these significant areas.

"As markets evolve, so do risks and potential harm to investors. OCIE continually works to adjust its examination focus areas to target these risks and publishes its annual priorities to communicate where we see the potential for increased risk and related harm," said OCIE Director Pete Driscoll.

By the numbers. While explaining that numbers do not the complete story of effectiveness, OCIE’s report noted that the office completed 3,089 examinations in FY 2019. Examinations of registered investment advisers covered 15 percent of the population, and examinations of investment companies increased to over 15. OCIE also completed over 350 examinations of broker-dealers, 110 examinations of national securities exchanges, and over 90 examinations of municipal advisors and transfer agents. In addition, the report stated that OCIE verified over 3.1 million investor accounts involving assets totaling over $1.5 trillion.

2020 priorities. OCIE stated that, in 2020, it will continue to focus on the protection of retail investors, particularly regarding various intermediaries interacting with investors and the investment products marketed to them. Specifically, OCIE explained, examinations will include reviews of disclosures relating to fees, discounts, expenses, and conflicts of interest, as well as recommendations and advice given to retail investors. Examinations of registered investment advisers will focus on those that have never been examined, including advisers advising retail investors and private funds. Examiners will also continue to assess whether, as fiduciaries, investment advisers have fulfilled their duties of care and loyalty. After the compliance dates, OCIE also will assess the implementation of Regulation Best Interest requirements by both broker-dealers and investment advisers, as well as the content and delivery of Form CRS.

In addition, OCIE will focus on entities that provide services to the functioning of the capital markets, including clearing agencies, national securities exchanges, alternative trading systems, and transfer agents. As part of its examinations, OCIE will consider registered clearing agencies’ governance, legal, compliance and risk management frameworks by reviewing efforts to escalate identified deficiencies and evaluate the operations of national securities exchanges and how they react to market disruptions. Transfer agents’ core functions also will be a key focus, including the timing of transfers, recordkeeping and record retention, and safeguarding of securities, the report noted.

OCIE also is focused on working with firms to identify and address information security risks, the report explained. Examinations will focus on, among other things, proper storage configuration, access controls, data loss prevention, vendor management and training, and incident response and resiliency. OCIE also will evaluate oversight of service providers and network solutions and any safeguards in place to ensure proper disposal of hardware that may contain vulnerable information. The report also recognized that advancements in financial technologies warrant ongoing attention and stated that OCIE will continue to examine registered entities engaged in the digital asset space, as well as advisers that provide services to clients through automated tools and platforms.

Finally, OCIE explained that it will continue to prioritize examinations for compliance with anti-money laundering obligations and assessments of whether firms have established appropriate customer identification programs, conducted due diligence, and complied with beneficial ownership requirements. The office will also continue its oversight of FINRA and the MSRB to evaluate the operational effectiveness and policies, procedures, and controls, the report concluded.

Tuesday, January 07, 2020

Massachusetts proposes fiduciary duty rule

By Jay Fishman, J.D.

The Massachusetts Securities Division has proposed a fiduciary duty for broker-dealers, agents, investment advisers, and investment adviser representatives when they provide investment advice; recommend an investment strategy; open or transfer assets to any account type; or buy, sell or exchange any security, commodity or insurance product. Specifically, the above-mentioned industry persons are deemed to act unethically and dishonestly when they fail to act as fiduciaries for their customers or clients (as defined in the rule) during any period they:
  • have or exercise discretion over a customer’s or client’s account (unless the discretion relates solely to the time and/or price of the order’s execution);
  • have a contractual fiduciary duty;
  • have a contractual obligation to regularly or periodically monitor a customer’s or client’s account;
  • receive ongoing compensation or charge ongoing fees for advising a customer or client about the value of securities or the value of investing in, buying, or selling securities; or
  • engage in an act, practice or business resulting in a customer or client having a reasonable expectation that the respective broker-dealer, agent, investment adviser, or investment adviser representative will regularly or periodically monitor the customer’s or client’s account(s) or portfolio.
Two fiduciary duties. Broker-dealers, agents, investment advisers, and investment adviser representatives have both a fiduciary duty of care and a fiduciary duty of loyalty, as described in the rule.

Customer and client exclusions. A "customer" or "client" includes current and prospective customers and clients but does not include:
  1. financial institutions such as banks, savings and loans, insurance companies, trust companies, or registered investment companies;
  2. broker-dealers registered with a state securities commission;
  3. investment advisers registered with the SEC or with a state securities commission; or
  4. other institutional buyers.
When not a fiduciary duty. The fiduciary duty does not apply to persons acting as Employment Retirement Income Security Act (ERISA)-defined fiduciaries for an employee benefit plan, its participants, or its beneficiaries. Also, the fiduciary duty does not mandate any capital, custody, margin, financial responsibility, recordkeeping, bonding, financial, or operational reporting for broker-dealers or agents that differ from, or are in addition to, 15 U.S.C. §78o(i) requirements.

Monday, January 06, 2020

Rule 506 disqualifications waived for unregistered—but cooperating—blockchain company

By Jay Fishman, J.D.

The SEC, as part of a settlement agreement with a New York based start-up blockchain company (BC), waived the federal Regulation D, Rule 506(d)(2)(ii) disqualification provisions, thereby allowing BC to sell its digital tokens in the future by either publicly registering them with the Commission or by claiming an applicable registration exemption such as the exemption under Rule 506 (In the Matter of Blockchain of Things, Inc., December 18, 2019, Release No. 10737).

The Commission agreed to the waiver and to also not sue BC’s directors and officers partly because BC’s misconduct occurred over a relatively short six-month period, after which BC immediately ceased digital coin sales. But the SEC primarily agreed to the waiver because BC submitted a waiver request letter to the SEC imploring the Commission to not apply the disqualifications because doing so would put the start-up out of business, as well as promising to consult with the SEC staff before ever again distributing digital coins. The waiver, while granted, was made contingent on BC’s "request letter promise" to consult with Commission staff before distributing digital assets except in accordance with a qualified registration or exemption.

BC’s violations. From December 2017 to July 2018, BC raised more than $12 million from digital token sales made to U.S. investors and resales made to investors in four Asian countries. BC began its New York operation in 2015 to develop blockchain technology integration solutions and sell digital tokens on its website, but violated Securities Act Sections 5(a) and 5(b) by not registering itself and the tokens with the SEC or, respecting the tokens, alternatively claiming a registration exemption for them. Moreover, declared the Commission, BC’s digital tokens were "securities" under the test in the 1946 U.S. Supreme Court SEC v. W.J. Howey case because a BC digital token purchaser would have a reasonable expectation of obtaining a future profit based on BC’s start-up efforts to spur development of an ecosystem on its platform, including BC’s use of its offering proceeds and steps to control and increase the value of BC’s tokens (In the Matter of Blockchain of Things, December 18, 2019, Release No. 10736).

Regarding the four Asian resellers, they were to serve as the exclusive sellers of BC’s digital tokens in their respective countries but were free to resell the tokens to U.S. investors, which violated federal securities laws. And regarding the information that U.S. investors received prior to the sales, a BC white paper and its website information told them that as purchasers they would be able to convert their tokens into certain credits, allowing them to access and use the credits platform and its services, but neither the white paper nor any other documentation available to the prospective purchasers provided information on the quantity of credit services they could use upon exchanging their token for credit. And other required important information surrounding their token purchases was not disclosed to them.

Settlement stipulations. The Commission’s settlement agreement mandated BC to: (1) cease and desist from violating the above-mentioned Securities Act registration provisions; (2) pay a $250,000 penalty; (3) undertake to return funds to the investors who bought tokens in the initial coin offering (ICO) and request a return of the funds; (4) register its tokens as securities under the Exchange Act; and (5) file required periodic reports with the SEC.

The SEC’s Enforcement Division’s Associate Director, Carolyn Welshhans, proclaimed that BC "did not provide ICO investors with the information they were entitled to receive in connection with a securities offering. We will continue to consider appropriate remedies, such as those in today’s order, to provide investors with compensation and required information and to provide companies who conducted unregistered offerings with an opportunity to move forward in compliance with the federal securities laws."

These Releases are Nos. 10736 and 10737.

Friday, January 03, 2020

CFTC issues no-action relief for transition away from LIBOR

By Mark S. Nelson, J.D.

The CFTC’s Division of Swap Dealer and Intermediary Oversight (DSIO), Division of Market Oversight (DMO), and Division of Clearing and Risk (DCR) will refrain from recommending enforcement actions to the Commission if firms with swaps transitioning away from LIBOR fail to comply with a wide swath of Commodity Exchange Act (CEA) provisions and CFTC regulations governing swaps. The relief was provided in response to a request from the Alternative Reference Rates Committee (ARRC) and in response to the U.K. Financial Conduct Authority’s announcement that it will not require LIBOR panel banks to contribute to LIBOR after 2021 (CFTC Letter No. 19-26, December 17, 2019; CFTC Letter No. 19-27, December 17, 2019; CFTC Letter No. 19-28, December 17, 2019).

The three no-action letters address different aspects of the swaps market, but despite this fact, the main text and footnotes explaining the varied requirements under each no-action letter suggest a few similarities. For example, the letters discourage alteration of the economic terms of swaps and other price-forming activity. Similarly, the DSIO and DCR letters caution against extending maximum maturities or increasing total effective notional amounts.

According to the letter issued by the DSIO, the necessary relief will encompass a number of swaps regulations. For example, relief will be extended regarding the swap dealer de minimis registration threshold, uncleared swap margin rules pertaining to legacy swaps, and the basis swaps method. Additional relief applies to the swap dealer conduct requirements, rules applicable to swap documentation and swaps processing (e.g., confirmation, swap trading relationship, and reconciliation), and end users (e.g., margin rules, eligible contract participants, and documentation).

The DMO likewise issued a letter granting ARRC-related no-action relief. Specifically, the DMO said it would not recommend the Commission bring an enforcement action if, until December 31, 2021, any person fails to comply with the trade execution requirement in CEA Section 2(h)(8) regarding an IBOR-linked swap that is amended or created by an IBOR transition mechanism, solely to accommodate replacement of an applicable IBOR with reference risk-free rates (RFR).

The DCR letter addresses uncleared legacy interest rate swaps (IRS), including legacy status (although the relief would not apply to voluntarily cleared swaps), and IBOR rates and permissible fallback amendments. The DCR said the latter item is limited to uncleared legacy IRS referencing USD LIBOR, JPY LIBOR, GBP LIBOR, CHF LIBOR, and SGD SOR. Moreover, with respect to the latter item, the DCR said additional relief is possible. With respect to the amendment process, the DCR noted that fallback amendments are not required and that a swap instead could be cleared or terminated. The DCR said the no-action relief would not apply to the trade execution requirement.

"Next year is going to be crucial for the transition away from LIBOR. Firms that fail to do so will put themselves and the global financial system at risk," said CFTC Chairman Heath Tarbert in a press release. "The CFTC remains committed to working with market participants and our fellow regulators on this critical issue."

The releases are Nos. 19-26, 19-27, and 19-28.

Thursday, January 02, 2020

Audit committee chairs weigh in on audit quality, standards


In an effort to increase transparency and engage with audit committees, the Public Company Accounting Oversight Board had conversations with the audit committee chairs of almost all of the U.S. issuers inspected in 2019 (nearly 400). Engagement with audit committees helps the PCAOB to advance its mission and may assist audit committees in fulfilling their duties, the Board noted. The Board shared the executives’ comments and provided perspectives from them on measures that have been taken to improve audit quality. In response to requests from audit committee chairs, the PCAOB also provided an overview of its inspections process and responded to frequently asked questions.

Audit quality. According to the PCAOB report, most audit committee chairs evaluated audit quality by heavily focusing on their engagement teams and less so on the characteristics of the audit firm. If the engagement teams were performing well, firm-wide metrics regarding audit quality or transparency were less relevant, they explained. Some executives also noted that audit quality centers on the exercise of judgment, which can be a challenge to measure. The PCAOB also found varying levels of familiarity with "audit quality indicators" but explained some audit committee chairs were familiar with metrics such as diversity, experience, issuer knowledge, quality and continuity, professional skepticism and judgment, and responsiveness.

Many of the executives also stated that, with proper oversight and controls, shared service centers were a good way to leverage expertise while providing quality and reduced costs. Most audit committee chairs also were satisfied with their relationships with their auditors and the information they received regarding auditor independence. The executives also generally deemed communications with auditors "very good and thorough," the PCAOB noted.

New standards. In conversations with the PCAOB, the audit committee chairs also addressed new accounting and auditing standards, and some expressed concern regarding the effects that the overlapping implementation of several standards could have on resources. They also indicated that preparations to implement Critical Audit Matters (CAMs) were generally going well and expressed a desire that, going forward, conversations would focus on how CAMs affect the audit process.

What’s working well. According to the audit committee chairs, several approaches have been effective in maintaining audit quality. Among other things, the executives suggested:
  • asking if the audit firm has an annual audit quality or transparency report;
  • discussing how the auditor will address a previous PCAOB inspection report;
  • selecting relevant audit quality indicators to discuss with the engagement team;
  • conducting ongoing assessments of the engagement team;
  • dedicating portions of audit committee meetings to deep dives on topics such as governance and cybersecurity;
  • discussing new accounting and auditing standards directly with the auditor and with consultants as necessary; and
  • discussing how the audit firm uses technology in its work.
Inspections. In the report, the PCAOB staff also provided responses to common questions related to the basics of its inspection process. The staff noted that they use both risk-based and random methods when selecting audits for review and focus on risk factors that include economic trends, industry developments, capitalization changes, and inspection history. During an inspection, the staff explained, inspectors may focus on an auditor’s risk assessment processes, areas affected by economic trends or that present significant risks, and other quality control issues. The fact that the staff includes a deficiency in a report does not necessarily mean that financial statements are materially misstated or that material weaknesses are undisclosed, the report stated. However, the PCAOB does use the information collected during inspections to inform its inspection reports, standard-setting activities, and economic and research analysis work, the staff explained.

The report also noted that PCAOB has resources and training for audit committee members and remains committed to robust economic analysis to understand the effects of its standard-setting and oversight activities.

Tuesday, December 31, 2019

SEC plans update to auditor independence rules; Clayton and others issue audit committee reminders

By Mark S. Nelson, J.D.

The SEC proposed to amend the auditor independence requirements contained in Rule 2-01 of Regulation S-X to improve efficiency and effectiveness, said an SEC press release. The changes address five specific aspects of Rule 2-01, which was last significantly updated in the early 2000s but which the SEC press release said does not address recent evolutions in capital markets. Separately, SEC officials, including Chairman Jay Clayton, issued a statement reminding market participants of the role of audit committees, especially regarding year-end considerations. There will be a 60-day comment period after the Regulation S-X release is published in the Federal Register (Amendments to Rule 2-01, Qualifications of Accountants, Release No. 33-10738, December 30, 2019).

Rule 2-01. The proposal, if adopted, would remove the existing preliminary note and replace it with a new introductory paragraph that contains the same admonitions. More significant changes would be made to the following subsections of Rule 2-01:
  • Amend “affiliate of the audit client” (Rule 2-01(f)(4)) and “Investment Company Complex” (Rule 2-01(f)(14)) regarding affiliate relationships, including common control issues.
  • Amend “audit and professional engagement period” (Rule 2-01(f)(5)(iii)) to shorten the look-back period for domestic first time filers in assessing compliance with the independence requirements.
  • Amend Rule 2-01(c)(1)(ii)(A)(1) and (E) to add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships.
  • Amend Rule 2-01(c)(3) to replace the reference to “substantial stockholders” in the business relationship rule with the concept of beneficial owners with significant influence.
  • Replace transition and grandfathering provisions contained in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of merger and acquisition transactions. 
Statement on audit committees. Clayton, SEC Chief Accountant Sagar Teotia, and William Hinman, Director of the SEC's Division of Corporation Finance, issued a separate statement on the role of audit committees. According to these SEC officials, the “observations and reminders” are intended to emphasize that audit committee requirements set forth in the Sarbanes-Oxley Act are among that Act’s most effective provisions. The officials also said firms should consider the areas cited in the statement while ensuring that their audit committees have adequate resources.

Several general observations include: (1) ensuring that the tone at the top promotes the integrity of the financial reporting process; (2) encouraging audit committees to mull the monitoring practices of the auditor and the issuer; (3) encouraging audit committees to proactively engage with management and auditors regarding new accounting standards, such as those for revenue recognition and leases; (4) ensuring that audit committees have sufficient information about a firm’s internal controls over financial reporting; and (5) facilitating communications from auditors to audit committees under the PCAOB’s AS 1301 standard for such communications.

The SEC officials also provided several more targeted reminders regarding non-GAAP financial measures, the transition from LIBOR to a new reference rate, and the communication of critical audit matters.

The release is No. 33-10738.

Monday, December 30, 2019

CFTC awards whistleblower more than $1 million despite potential hurdles

By Lene Powell, J.D.

A whistleblower award of more than $1 million highlighted the CFTC’s support for internal reports and cooperation with other regulators. In granting the award, the CFTC overcame several procedural wrinkles, including that the whistleblower reported different wrongdoing than that ultimately charged and that the whistleblower’s Form TCF was not filed until after the CFTC’s investigation concluded.

Internal report to another regulator. According to the award, the whistleblower "initially submitted his/her information to another regulator through his/her company’s internal reporting procedures." The other regulator then passed the information along to the CFTC. The whistleblower subsequently gave an interview to Division of Enforcement staff and provided documents through the employer’s counsel.

The report states that the "employer acted as [the claimant’s] representative in submitting the information to the other regulator." The report to the other regulator was not considered mandatory.

"We have also decided to give credit to Claimant 1 for causing the case to be opened, because the information that Claimant 1 provided, albeit up through his/her compliance process and then over via the other regulator, was sufficiently specific, credible, and timely to cause the Commission to open an investigation," the report stated.

According to CFTC Director of Enforcement James McDonald, the CFTC is committed to working with other regulators to maximize enforcement effectiveness. "Today’s award shows how referrals from other regulators can have a meaningful impact on the Commission’s enforcement program, and lead to whistleblower awards from the CFTC," said McDonald.

Different misconduct reported. The CFTC noted that whistleblowers are eligible for award for a tip that leads to evidence of a violation the CFTC ultimately charges—even if the reported conduct itself does not form the basis for those charges.

"As the specific facts and circumstances of this matter demonstrate, the whistleblower does not have to identify the exact wrongdoing the CFTC ultimately charges—it is enough for their information to lead CFTC investigators directly to evidence of one or more of the agency’s claims," said CFTC Whistleblower Office Director Christopher Ehrman. "Here, the whistleblower identified a problem in one area, and our Division of Enforcement used that knowledge and the whistleblower’s subsequent assistance to uncover illegality in another."

Form TCR timing. Another wrinkle that could have potentially derailed an award was that the whistleblower filed a Form TCR to perfect his/her status as a whistleblower after the CFTC’s investigation concluded.

"[W]e find that Claimant 1 complied with the form and manner requirements of the Rules per the language of Rule 165.3(a), which does not require a whistleblower to submit information on a Form TCR in his/her initial submission," the report stated.

Award. The CFTC did not name the precise amount of the award, describing it as "more than $1 million."

A second claimant had also applied for an award, but that claim had previously been denied in a preliminary determination that subsequently became final.

Friday, December 27, 2019

Court tries to resolve long-running ‘securities’ misnomer under state precedents

By Mark S. Nelson, J.D.

An en banc opinion by a Florida district appeals court concluded that a trial judge erroneously entered judgment against a party asserting that a stock purchase agreement was a security and on a related counterclaim because that court was bound to apply defective Florida precedents which had relied on a flawed understanding of the U.S. Supreme Court’s Howey opinion. The appeals court explained that the Howey opinion set forth a test for determining if something is an investment contract and, thus, a security, but that Florida courts had used Howey in a logically untenable manner beyond this specific purpose (Githler v. Grande, December 20, 2019, Rothstein-Youakim, S.).

Lower court ruling. The case arose out of a deal by one investment advice radio program to acquire another such program. Marta Grande and her husband wanted to retire from the business of hosting their program and, through a number of friends and acquaintances, met Charles Githler, who hosted a similar program. The acquisition was to be done through Spot Link, Inc., and required the divvying up of hundreds of shares in the company, plus agreeing to various contingencies and issuing a note. Githler sued the Grandes after he was terminated as managing member of Spot Link, following the company’s conversion from an S corporation into an LLC. The trial court, relying on Florida precedents, concluded the stock purchase agreement at issue did not satisfy the Howey test and, thus, no securities were involved.

Howey in Florida. According to the appeals court, however, the Securities Act and Florida law use roughly the same definition of "security" and the question here was whether Howey should apply at all. The U.S. Supreme Court in Landreth (1985) had, explained the appeals court determined that Howey was inapt regarding a stock purchase agreement because application of Howey would undermine the Securities Act’s listing of many types of instruments that can be securities. As the appeals court would further explain, Florida courts had employed Howey to "define an entire category by one of its members."

The logic problem in Florida precedents was of somewhat recent origin. The Second District, where the Githler case was heard, had misapplied Howey in 1997 and 2002, 12 and 17 years, respectively, after Landreth; two other Florida appellate districts had applied Howey in a similar mistaken manner, but before the U.S. Supreme Court had decided Landreth. The Second District appeals court receded from its two prior opinions misapplying Howey and noted the conflict with other Florida appellate districts.

On remand, the trial court will have to apply the appellate court’s clarified approach to understanding the definition of "security." The trial court then will have to determine if the stock purchase agreement at issue in the case was a "security" and, if so, must it be registered or is it subject to a registration exemption.

The case is No. 2D17-4963.

Thursday, December 26, 2019

CorpFin issues guidance on technology risks associated with international business operations

By Joanne Cursinella, J.D.

The Commission’s Division of Corporation Finance has issued Disclosure Guidance: Topic No. 8, which discusses the disclosure obligations that companies should consider regarding intellectual property and technology risks that may occur when they engage in international operations. The SEC disclosure regime recognizes that a variety of new risks may arise over time and each of these risks may affect different companies in different ways. This guidance is a continuation of the Commission’s effort to guide public companies both in assessing materiality of risks and in drafting related disclosure that is material to an investment decision.

According to the guidance, the increased reliance on technology, coupled with a shift in the composition of many companies’ assets from traditional brick-and-mortar assets toward intangible ones, may expose companies to material risks of theft of proprietary technology and other intellectual property. Companies that conduct business in certain foreign jurisdictions; house technology, data, and intellectual property abroad; or license technology to joint ventures with foreign partners may have more significant exposure.

These companies should consider their disclosure obligations regarding risks related to the potential theft or compromise of data, technology, and intellectual property within the context of the federal securities laws and its principles-based disclosure system. The Commission has made it clear that its disclosure requirements apply to evolving business risks, even in the absence of specific requirements, but existing rules may also require such disclosure regarding the actual theft or compromise of technology, data, or intellectual property if it pertains to assets or intangibles that are material to a company’s business prospects. The guidance provides, as an example, that disclosure may be necessary in management’s discussion and analysis, the business section, legal proceedings, disclosure controls and procedures, and/or financial statements.

Sources of risk. One source of risk is a direct intrusion by private parties or foreign actors, including those affiliated with or controlled by state actors. But a company’s technology, data, and intellectual property may be subject to theft or compromise via more indirect routes as well, the guidance points out. For example, companies may be required to compromise protections or yield rights to technology, data, or intellectual property to conduct business or access markets in a foreign jurisdiction, either through formal written agreements or due to legal or administrative requirements in the host nation. The guidance provides four specifics: (1) when patent license agreements pursuant to which a foreign licensee retains rights to improvements on the relevant technology; (2) foreign ownership restrictions, such as joint venture requirements and foreign investment restriction; (3) the use of unusual or idiosyncratic terms favoring foreign persons; and (4) regulatory requirements that restrict the ability of companies to conduct business unless they agree to some type of arrangement that involves the sharing of intellectual property.

Assessing and disclosing risk. The Division encourages companies to assess the risks related to the potential theft or compromise of their technology, data, or intellectual property in connection with their international operations and how these risks may impact their business. When risks are deemed material to investment and voting decisions, they should be disclosed and specifically tailored to a company’s unique facts and circumstances.

When a company’s technology, data, or intellectual property is being, or previously was, materially compromised, stolen, or otherwise illicitly accessed, hypothetical disclosure of potential risks is not sufficient to satisfy a company’s reporting obligations, the guidance warns. It advises that companies should continue to consider this "evolving area of risk" to evaluate its materiality on an ongoing basis. As companies assess these risks and their related disclosure obligations, there are questions to consider with respect to their present and future operating plans. The guidance provides 12 bullet points of specific matters to consider.
  • Is there a heightened risk to your technology or intellectual property because you have or expect to maintain significant assets or earn a material amount of revenue abroad?
  • Do you operate in an industry or foreign jurisdiction that has caused, or may cause, you to be particularly susceptible to the theft of technology or intellectual property or the forced transfer of technology?
  • Have you directly or indirectly transferred or licensed technology or intellectual property to a foreign entity or government?
  • Have you entered into a patent or technology license agreement with a foreign entity or government that provides such entity with rights to improvements on the underlying technology?
  • Are you subject to a requirement that foreign parties must be controlling shareholders or hold a majority of shares in a joint venture in which you are involved?
  • Have you provided access to your technology or intellectual property to a state actor or regulator in connection with foreign regulatory or licensing procedures?
  • Have you been required to yield rights to technology or intellectual property as a condition to conducting business in or accessing markets located in a foreign jurisdiction?
  • Are you operating in foreign jurisdictions where the ability to enforce rights over intellectual property is limited as a statutory or practical matter?
  • Do you conduct business in a foreign jurisdiction or through a joint venture that may be subject to state secrecy or other laws?
  • Have conditions in a foreign jurisdiction caused you to relocate or consider relocating your operations to a different host nation?
  • Do you have controls and procedures in place to adequately protect technology and intellectual property from potential compromise or theft?
  • What level of risk oversight and management does the board of directors and executive officers have with regard to the company’s data, technology and intellectual property and how these assets may be impacted by operations in foreign jurisdictions where they may be subject to additional risks?

Tuesday, December 24, 2019

CorpFin issues guidance on confidential treatment applications

By Amy Leisinger, J.D.

The SEC’s Division of Corporation Finance has issued guidance on how to submit and what information to provide when filing an application objecting to public release of information otherwise required to be filed. When requesting confidentiality pursuant to Securities Act Rule 406 or Exchange Act Rule 24b-2, the staff states that an applicant should file the exhibit on EDGAR without the confidential information and thereafter submit a written application for confidential treatment. According to the staff, applicants should thoroughly consider the materiality of the omitted information and take care to avoid excessive omissions.

The guidance replaces and supersedes that provided in Staff Legal Bulletins 1 and 1A.

Confidential treatment. Rule 406 and Rule 24b-2 provide the means by which companies may object to public release of confidential information. Generally, applications for confidential treatment pursuant to the rules relate to material contracts required to be filed as exhibits. In March 2019, the Commission changed several exhibit filing requirements to allow companies to omit immaterial, competitive information without having to provide the SEC with the information and request staff approval. However, the process described in the rules is still available for confidential treatment applications, and, in some cases, remains the only available method to protect private information in filed exhibits.

Filing guidance. In the guidance, CorpFin staff notes that, to apply for confidential treatment under Rules 406 and 24b-2, an applicant must file the required exhibit and omit all confidential information while indicating where it has omitted information. The filing also must note that confidential information was filed separately with the Commission. Thereafter, the applicant must file a written application with the SEC’s Office of the Secretary objecting to public disclosure of the confidential information. As part of the process, the applicant needs to file one unredacted copy of the contract with the confidential portions identified and specifically cite the Freedom of Information Act exemption on which it relies. In addition, the applicant must justify the time period sought for confidential treatment and provide a detailed explanation concerning why disclosure of the information is unnecessary for the protection of investors. The applicant also must consent to the furnishing of the confidential information to other government entities, among other things.

The guidance notes that the staff also considers the materiality of the omitted information. If it is clear from the text that the information is not material, the staff will not object. However, the staff notes that, if materiality is unclear, it will discuss its concerns with the applicant and request an amended application and/or filing amendment as appropriate.

CorpFin reviews all applications for confidential treatment to determine whether the applicant has provided all information necessary to warrant a grant of confidential treatment and will request additional information as needed, according to the guidance. If the application is granted, the staff will issue an order and post it with the company’s filing history; if the applicant does not adequately respond, the application may be denied. A denial may be appealed to the Commission, the guidance explains.

A company that previously has obtained a confidential treatment order must file an application to continue to protect the confidential information, the guidance notes. The Division provides a short form application to extend the time for confidential treatment, and an applicant can affirm that the most recently considered application remains accurate and is not required to refile unredacted documents or provide the prior supporting information if the analysis remains the same. If the applicant reduces the extent of omitted information, it must file the revised redacted version of the exhibit on EDGAR when it submits the extension application, according to the staff.

Monday, December 23, 2019

Kirkland & Ellis partner examines the uncertain future of M&A litigation

By Matthew Solum, Kirkland & Ellis, LLP

M&A lawsuits, once predominantly filed in Delaware and other state courts, have shifted to federal court under Exchange Act Section 14(a) in the wake of the Delaware Chancery Court’s 2016 decision in In Re Trulia Stockholder Litigation, according to Matthew Solum of Kirkland & Ellis. In this article, he notes that the shift has raised a number of questions, including to what extent Section 14 provides a private right of action, what pleading standards attach to such an action, and whether Section 14 presents a viable theory of recovery for most plaintiffs once the transaction has closed and the threat of disruption to the deal is gone. He examines recent cases that address these questions, as well as whether freewheeling settlements that have become common in Section 14 cases may be facing a backlash from courts.

To read the entire article, click here.

Friday, December 20, 2019

PCAOB offers revised approach to quality control standards

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

The Public Company Accounting Oversight Board has approved a concept release presenting a potential approach to revising the agency's quality control (QC) standards. At its open meeting on December 17, 2019, the board voted to issue the concept release, which is aimed at strengthening requirements for audit firms' quality control systems and ensuring consistent, high-quality audits. The potential approach is based on the International Standard on Quality Management 1 (ISQM 1) that has been proposed by the International Auditing and Assurance Standards Board (IAASB), with certain modifications as appropriate for firms that are subject to PCAOB standards and rules.

"The input we receive from the public through this concept release will play an important role in the Board's consideration of an approach to revising our quality control standards," said PCAOB Chairman Duhnke in a news release. "We encourage all interested parties to review our release and share their views with us."

The PCAOB noted that agency adopted its current quality control standards in 2003, based on standards originally developed and issued by the American Institute of Certified Public Accountants (AICPA). Given the significant changes in the auditing environment that have occurred in the intervening years, however, the PCAOB's current standards do not reflect relevant developments affecting audit and assurance practices and firms' quality control systems. For example, firms have made a greater use of technology in performing engagements, and some firms have also significantly increased their focus on governance and leadership, incentive systems and accountability, and monitoring and remediation.

ISQM 1. In remarks on December 12 at AICPA’s Conference on Current SEC and PCAOB Developments, Board Member Duane DesParte observed that the PCAOB does not operate in a vacuum and continues to assess developments of other standard setters and regulators, such as the IAASB. The proposed ISQM 1 serves as a good starting point, stated DesParte, because many firms that conduct audits in accordance with PCAOB standards also conduct audits in accordance with international standards. Thus, it would not be practicable to have fundamentally different frameworks for those firms to follow. Moreover, unnecessary differences in QC standards could detract from audit quality by diverting firms' efforts from focusing on matters of fundamental importance to effective QC systems, according to the fact sheet summarizing the concept release.

As discussed in the concept release, proposed ISQM 1 is designed to focus firms' attention on proactively identifying and responding to quality risks that may affect engagement quality. Proposed ISQM 1 describes a firm’s system of quality management as consisting of eight components, which are designed to be highly integrated: (1) Governance and Leadership; (2) Firm’s Risk Assessment Process; (3) Relevant Ethical Requirements; (4) Acceptance and Continuance of Client Relationships and Specific Engagements; (5) Engagement Performance; (6) Resources (Human, Technological, and Intellectual); (7) Information and Communication; and (8) Monitoring and Remediation. The components of proposed ISQM 1 cover the elements of a QC system under the PCAOB’s current standards, although in some cases more broadly, while also including components not currently included in PCAOB standards.

The concept release notes, however, that while the PCAOB seeks to avoid unnecessary differences between a future PCAOB QC standard and a finalized international standard, incremental or alternative requirements may be necessary for firms performing engagements under PCAOB standards. For example, different requirements may be needed to:

  1. align with federal securities laws, SEC rules, and other PCAOB standards and rules;
  2. retain important topics in the PCAOB’s current QC standards that either are not covered in Proposed ISQM 1 or are not covered as specifically; 
  3. address specific emerging risks and problems observed through the PCAOB’s oversight activities; and
  4. provide more definitive direction to promote appropriate implementation of certain requirements by firms that are subject to PCAOB standards and rules. 
The agency also believes that any future QC standard should be scalable, so a firm can tailor its QC system appropriately based on its size and complexity and the nature of the engagements performed, commensurate with applicable risks to quality.

The Board requests comments on the concept release by March 16, 2020.