Monday, November 30, 2020

IMVU can offer VCOIN without federal registration

By Mark S. Nelson, J.D.

IMVU, Inc. may issue its VCOIN without registering the token under federal securities laws provided that the company’s coin offering adheres to stated conditions. The no-action relief to IMVU marks the third time the Division of Corporation Finance has said it would recommend that the Commission not bring an enforcement action if a token is not registered as a security under the federal laws (no-action letter; incoming letter).

Conditions of VCOIN offering. IMVU is a Redwood City, California company that develops online communities such as the IMVU "online three-dimensional avatar-based social communit[y]," considered by IMVU to be one of the largest of its kind. The no-action letter issued to IMVU listed eight conditions agreed to by the company for its token offering. Specifically, absent changed circumstances, the no-action letter said enforcement forbearance would be recommended if:
  • IMVU will not use proceeds from the sale of VCOIN to finance its Upgrade, which has been fully developed and will be fully functional and operational immediately upon its launch and before any VCOIN is sold;
  • VCOIN will be immediately usable for its intended purpose at the time it is sold;
  • IMVU will impose specified limits on VCOIN purchases, conversions, and transfers;
  • VCOIN holders will be subject to KYC/AML checks when they establish Open Wallets and thereafter on an ongoing basis;
  • VCOIN will be made continuously available in unlimited quantities and at a fixed price, and IMVU will always generate enough supply of VCOIN to maintain VCOIN’s fixed price;
  • IMVU will not promote or support listing or trading of VCOIN on any third-party trading platform;
  • IMVU will market and sell VCOIN to Users solely for consumptive use as a means of exchanging value on, and in connection with, the Platform; and
  • IMVU will require Users who purchase VCOIN from IMVU to affirm that, among other things, they are acquiring the VCOIN for consumptive use and not for speculative purposes.
Three offerings compared. SEC staff in April 2019 published a "Framework for Investment Contract Analysis of Digital Assets" in which the staff explained the various criteria it uses to evaluate whether a token is a security subject to the registration requirements of federal securities laws. Depending on the particular token offering, the framework can be scaled up or down to address specific issues raised by the structure and intent of the offering.

Previously, CorpFin extended similar no-action relief to two other companies. In one instance, TurnKey Jet, Inc., a Florida-based Delaware company, planned to offer a tokenized business jet service (no-action letter, incoming letter). In the other instance, Pocketful of Quarters, Inc. (PoQ), a Delaware private corporation with its headquarters in Connecticut, developed its Quarters token to facilitate gamers’ ability to use a single token across multiple, participating online video gaming environments thus reducing the "frustrations" gamers had voiced about having to deal with holding a unique coin for each game they play (no-action letter, incoming letter).

A comparison of the three no-action letters’ conditions suggests a number of similarities. For one, all three letters require the companies not to use proceeds from token sales to develop their platforms, which must be fully functional and operational before token sales begin. Second, the tokens must be useable for their intended purpose at the time of sale. Third, all three letters impose limits on transfers and related conversions or other transactions. Fourth, tokens must be continuously available at a fixed price. Fifth, the tokens must be marketed and sold for a consumptive purpose on the platform; the IMVU letter further specifies that VCOIN buyers must affirm their consumptive purpose in acquiring tokens as opposed to having a speculative purpose.

However, there are some differences in the conditions applicable to the three tokens. For example, only the IMVU and PoQ letters explicitly mention KYC/AML checks, but the incoming letter for TurnKey Jet does discusses these matters at length. Likewise, only the IMVU letter specifically mentions that tokens must not be promoted or supported on third-party trading platforms. But again, PoQ and TurnKey Jet said in their incoming letters that their tokens would not be tradeable on such platforms due to restrictions on users and the economic infeasibility of trading the tokens for speculative purposes.

Wednesday, November 25, 2020

Biden victory signals abrupt U-turn in federal regulatory direction, priorities

Out with the old, in with the new. Except this time, what’s new is familiar territory: a return to more traditional policies, process, and personalities. The 2020 presidential election of Joe Biden is sure to usher in a revival of many Obama-era priorities — expanding health care access, environmental protections, worker rights, international trade alliances, anticorruption measures, disaster preparedness, corporate accountability, etc. — all familiar Democratic themes in the pre-Trump White House. In short, what’s old may well be new again.

A new white paper, written by Wolters Kluwer editorial staff and authors, lays out the likely policy scenarios and outcomes across a range of key practice areas: health care, labor and employment, tax, securities and corporate governance, international trade, antitrust, intellectual property, cybersecurity and privacy, financial services, and others. Attention to how the changes will affect specific constituencies (e.g., employers, hospitals, insurers, banks, corporate boardrooms, taxpayers, and government contractors) will help the attorneys and other professionals who advise them to prepare for the next chapter in this nation’s history.

Tuesday, November 24, 2020

OCIE and its director review issues with compliance programs

By Amy Leisinger, J.D.

The SEC’s Office of Compliance Inspections and Examinations has issued a risk alert to provide an overview of notable compliance issues related to Advisers Act Rule 206(4)-7 (the "Compliance Rule"). Times have changed, but the need for investor protection remains the same, according the staff.

Compliance rule. Under Rule 206(4)-7, it is unlawful for a registered investment adviser to provide advice unless the adviser has adopted and implemented written policies and procedures reasonably designed to prevent violations; an adviser must consider fiduciary and regulatory obligations, as well its specific operations, and formalize policies and procedures to address them. The rule also requires each adviser to conduct a review of its policies and procedures at least every year and consider the need for interim reviews in response to significant compliance events and developments, according to OCIE.

A chief compliance officer must administer a firm’s compliance policies and procedures and should be empowered to develop and enforce them. The CCO should have a position of sufficient seniority and authority within the organization to compel others to adhere, the alert states.

Notable deficiencies and weaknesses. In its alert, OCIE identified multiple examples of deficiencies related to the Compliance Rule. OCIE staff observed advisers that did not devote adequate resources to information technology and staff training regarding compliance. Further, CCOs did not appear to devote sufficient time to fulfilling their responsibilities, and compliance staff did not have sufficient resources to implement an effective compliance program. Some advisers that had significantly grown but did not add compliance staff saw failures in implementing or tailoring their compliance policies and procedures, the staff explains.

According to the alert, OCIE staff also observed CCOs who lacked sufficient authority within the advisory firm to develop and enforce appropriate policies and procedures. Advisers where senior management appeared to have limited interaction with their CCOs led to limited knowledge about the firm’s leadership, transactions, and business operations.

OCIE staff also saw advisers that did not implement or perform actions required by their written policies and procedures, the report states. Some advisers did not train their employees, implement compliance procedures regarding trade errors, advertising, best execution, conflicts, disclosure and other requirements, according to OCIE staff.

Where firms maintained written policies and procedures, OCIE staff observed deficiencies or weaknesses with establishing, implementing, or appropriately tailoring written policies and procedures regarding portfolio management, marketing, trading practices, disclosures, fees, and privacy safeguards.

OCIE encourages each adviser to review its policies and procedures to ensure that they are tailored to the adviser’s business.

COVID-19. In recent remarks, OCIE Director Peter Driscoll noted that OCIE continues to be fully operational, finding alternative ways to complete exams without the benefit of on-site interactions. The staff has engaged in outreach efforts with many advisers and investment company complexes to assess the impacts of COVID-19, he explained, including challenges with operational resiliency and fund liquidity. Issues with implementing business continuity and pandemic plans have been minor and were addressed quickly, according to the director. New needs during the pandemic may bring risks that need to be evaluated by knowledgeable compliance departments, Driscoll said.

CCOs. Compliance staff faces numerous difficulties that have only increased because of COVID-19, the director stated. A firm’s compliance program is critical to the protection of investors, and OCIE tries to assist by being as transparent as possible about common deficiencies. Internal conflicts have played a role in creating conflicts, but we do see good practices where CCOs are included in business planning and strategy discussions for their meaningful input, Driscoll stated.

"A good CCO can be a true ‘value-add’ to the business; by keeping up with regulatory expectations and new rules, CCOs can assist in positioning their firms not only to avoid costly compliance failures, but also provide pro-active compliance guidance on new or amended rules that may provide advisers with additional business options," he said.

When an adviser has changed CCOs recently or frequently, OCIE staff is likely to question the change, the director explained. The cause or blame for compliance problems should not land only on the CCO, according to Driscoll, and it is crucial to provide sufficient resources for compliance with applicable laws and regulations.

"CCOs should not and cannot do it alone and should not and cannot be responsible for all compliance failures," he concluded.

Monday, November 23, 2020

Clayton looks ahead to areas in need of Commission attention

By John Filar Atwood

As his tenure as SEC Chairman winds down, Jay Clayton outlined for the next Commission the issues that he believes require immediate improvements. On his list were a review of money market funds, the rules surrounding residential mortgage-backed securities offerings, modernizing the proxy system, remaining Dodd-Frank rulemakings, and improving climate-related disclosures.

Before looking to the future, he reviewed the agency’s many accomplishments during his time as chairman in remarks to the Economic Club of New York. Those efforts addressed the SEC’s core mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation, and Clayton took a moment to address what he believes is a growing misconception that in order to promote one part of the agency’s mission it must detract from another.

In Clayton’s view, this is a false choice and inconsistent with the SEC’s history. He said that the SEC can simultaneously address each part of its mission, and has been doing so for more than 80 years. The most recent example is its work to revamp the exempt offering framework, he said. Those rules allow businesses to more easily navigate the regulatory framework while embedding investor protections into the process, he noted, to concurrently help both small businesses and investors.

Money market funds. With that as a backdrop, Clayton discussed issues he thinks will need further attention from the incoming Commission, starting with money market funds. He said there is no doubt that the SEC needs to re-examine prior reforms as well as the performance of money market funds over the recent period.

He referenced recent comments by Division of Investment Management Director Dalia Blass in which she asked whether the potential for the imposition of redemption gates drove market behavior, and whether the current money market fund rule’s risk limitations provide funds with the necessary liquidity to meet heightened redemptions. Clayton said he expects a review of this area also to include forward-looking assessments to ensure that the policy decisions and modernizations implemented can address issues that have led the government to backstop some money market funds twice within 12 years.

Asset-backed securities. Securitizations is another area where the SEC’s regulations have not functioned as intended, according to Clayton. He noted that since the asset-backed securities rules were revised in 2014, no SEC-registered offerings of residential mortgage-backed securities (RMBS) have occurred. In comparison, in the five years ended June 30, 2019, Fannie Mae and Freddie Mac issued $4.47 trillion in face amount of RMBS, he added.

Clayton emphasized that the asset-backed securities rules need to be overhauled, based on public comments and suggestions the Commission has received. He noted that the staff currently is reviewing RMBS asset-level disclosure requirements, including through discussions with the Federal Housing Finance Agency, with an eye toward facilitating SEC-registered offerings.

Proxies. Clayton also said that he hopes the Commission will continue its work to modernize the proxy system, particularly to improve ways for issuers to engage with their shareholders more directly. In his view, rules surrounding OBO/NOBO (objecting beneficial owners/non-objecting beneficial owners) are overdue for reexamination, as is the growing use of Form 13F by issuers to address the proxy rules’ shortcomings.

Dodd-Frank rulemakings. The Dodd-Frank Act required more than 80 rulemakings and dozens of reports and studies from the Commission. On his watch, the SEC moved a number of the rulemaking efforts forward—the Title VII security-based swap regulatory regime and hedging disclosures, among others—but a handful of the rules still remain undone, Clayton said.

One unfinished rulemaking relates to compensation clawbacks, but he noted that market developments have in some cases overtaken the Dodd-Frank mandate. Progress in the area of shareholder engagement has helped, he said, and in some cases companies’ clawback policies already go beyond what would be required by the Dodd-Frank Act.

Climate-related disclosures. In this area, Clayton acknowledged that to the extent they are material, issuers are already required to disclose the current and expected future effects of climate-related issues on their operations and performance. In his view, it is critical that this disclosure be "decision-useful," meaning that it actually give investors the ability to incorporate the climate-related information into their investment decision process.

Clayton said he has often heard that climate-related disclosure could be more useful if it were uniform. He believes, however, that standardization can be difficult across industries, especially in the context of forward-looking information which would require uniform assumptions about the future.

He is of the opinion that any standardization should be approached on a sector-by-sector basis, starting with those that already use metrics to track and assess climate-related risks. He closed by hinting that he may have more to say on this important issue in the near future.

Friday, November 20, 2020

Petition asks High Court to examine the scope of Reg. S-K Item 105

By Rodney F. Tonkovic, J.D.

A petition for certiorari asks the Supreme Court to resolve a circuit split on the level of knowledge required to trigger an obligation to disclose under Item 105 of Regulation S-K. In this case, the Third Circuit held that Item 105 requires that companies disclose facts unknown to them at the time of disclosure and, further, to disclose uncharged, unadjudicated wrongdoing. The petition argues that the Third Circuit's decision, if left standing, will expose public companies to significant, hindsight-based liability (M&T Bank Corporation v. Jarosalwicz, November 15, 2020).

The case involves the disclosure requirement in Item 105 of Regulation S-K. Item 105 imposes an affirmative obligation to disclose material factors that make an investment in the registrant speculative or risky.

Compliance concerns. In 2012, M&T Bank Corporation agreed to merge with another bank, Hudson City Bancorp, Inc., and filed a joint proxy with the SEC. Pursuant to Item 503 of Regulation S-K (since amended and recodified as Item 105), the proxy discussed the risk factors of the merger. Among these factors was the risk that regulators could delay or halt the transaction based on the Federal Reserve's evaluation of the companies' efforts to thwart money laundering (BSA/AML), but M&T explained that it believed that its policies and procedures were compliant.

Shortly before the shareholder vote, M&T and Hudson announced that the Federal Reserve Board had identified regulatory concerns about M&T's BSA/AML and that regulatory approval would be delayed. Undeterred, shareholders approved the merger. M&T worked over the next two years to address these concerns, and the Fed issued an order approving the merger in September 2015.

Journey through the courts. A few weeks before the merger closed, a class of Hudson shareholders brought a suit alleging that the joint proxy had omitted material risks associated with the merger, in violation of Exchange Act Section 14(a). The plaintiffs asserted, essentially, that M&T had negligently failed to discover its noncompliant practices and thus had failed to comply with Item 105. The district court dismissed the action, finding that regulatory risks had been adequately disclosed.

In late 2018, the Third Circuit issued an opinion vacating the dismissal of the Section 14(a) claim to the extent that it was premised on a failure to comply with Item 105. This opinion was subsequently vacated in light of the Court's dismissal of the petition in Emulex. In June 2020, the Third Circuit concluded, as it did in the 2018 opinion, that the BSA/AML deficiencies and consumer checking practices posed significant risks to the merger before M&T issued the joint proxy. Because the proxy omitted these material deficiencies and weaknesses, the plaintiffs met their pleading burden, the court said, adding that it did not matter whether or not M&T had actual knowledge of any shortcomings—the risk to the merger posed by an upcoming regulatory inspection triggered the need for disclosure.

Cert petition. The petition first argues that the Third Circuit's decision conflicts with the decisions of two other circuits regarding the scope of Item 105. First, in Silverstrand Investments v. AMAG Pharmaceuticals (2013), the First Circuit held that the plaintiffs stated an Item 105 claim where the defendant failed to disclose serious adverse events even though it knew about them. The Third Circuit, the petition asserts, splits from the First Circuit in not requiring actual knowledge of the allegedly-omitted facts; in this case, the plaintiffs did not allege that M&T knew of the BSA/AML deficiencies at issue—only that it "failed to detect" its alleged noncompliance. Unlike the Third Circuit, the First Circuit did not hold that knowledge of imminent regulatory scrutiny was enough to state a claim, and this, the petition says, creates a split on the question of whether actual knowledge is required to trigger a disclosure obligation.

Next, the plaintiff in City of Pontiac v. UBS AG (2014) alleged that UBS AG violated Item 105 by failing to disclose that the bank was engaged in tax evasion, while disclosing that it was being investigated by the DOJ. Even though it ultimately was revealed that UBS had violated the tax laws, the Second Circuit rejected this argument, stating that Item 105 does not create a duty to disclose "uncharged, unadjudicated wrongdoing." If the Second Circuit's standard were applied here, the petition says, the Third Circuit would have dismissed the claim. Instead, the Third Circuit distinguished M&T's disclosures as being more generic than UBS's. That case, however, did not rest on the specificity of the disclosures, the petition maintains, and the information at issue is exactly the sort of unadjudicated wrongdoing that the Second Circuit found to be outside of the ambit of Item 105.

Finally, the petition argues that the Third Circuit was simply wrong. First, the SEC has never suggested that Item 105 requires disclosure of facts unknown to the company, and has advised that disclosures are delimited by facts of which registrants are aware. Secondly, to ask companies to disclose unadjudicated wrongdoing is to require them to judge the lawfulness of their own conduct, and this can only be known in hindsight, the petition says. In this case, M&T believed that its BSA/AML procedures complied with the law, and said so.

The petition concludes by contending that the Third Circuit has created "a nightmare scenario" for reporting companies, in which they are required to disclose facts as yet unknown to them. So long as some high-level risk can be alleged, disclosure of unknown facts that later cause the risk to materialize would be required. Moreover, given the Third Circuit's status as the domicile of choice for U.S. companies (i.e., Delaware), this outlier position could become the de facto national standard.

The petition is No. 20-678.

Thursday, November 19, 2020

FINRA, SIFMA voice concerns on SEC’s proposed ‘finders’ exception

By Amanda Maine, J.D.

The Financial Industry Regulatory Authority (FINRA) and the Securities Industry and Financial Markets Association (SIFMA) submitted comment letters to the SEC expressing their concern about the Commission’s proposed exemption from broker-dealer registration requirements for so-called "finders." Both organizations commented on the lack of oversight should the exemption be finalized, with SIFMA noting that it could affect the perception of the integrity of U.S. markets.

Proposed exemption. The Commission approved the proposed exemption for comment on a 3-to-2 vote. The exemption would create two classes of finders: Tier I and Tier II. A Tier I finder would be limited to providing contact information of potential investors in connection with only a single capital-raising transaction by a single issuer in a 12-month period and could not have any contact with a potential investor about the issuer. A Tier II finder would be permitted to solicit investors on behalf of an issuer with certain limitations on solicitation activity: (1) identifying, screening, and contacting potential investors; (2) distributing issuer offering materials to investors; (3) discussing issuer information included in any offering materials, provided that the Tier II finder does not provide advice as to the valuation or advisability of the investment; and (4) arranging or participating in meetings with the issuer and investor.

Both tiers of finders would be subject to additional restrictions, such as not engaging in general solicitation, having a reasonable belief that the investor is an accredited investor, and limitations on participating in the offering itself. At a recent meeting, the SEC’s Small Business Capital Formation Advisory Committee voted to support the proposed exemption, with enumerated qualifications it recommended that the SEC consider.

FINRA. In its letter, FINRA noted that it only regulates broker-dealers’ private placement activities, while most private placements occur either directly with investors or through other intermediaries. According to FINRA, by creating a separate category of exempt private placement brokers that would not be identified to regulators, subject to examination, or subject to broker-dealer regulatory requirements, the SEC would create significant risks to investors.

One of FINRA’s main objections to the proposed exemption concerns Tier II finders. The exemption would allow these unregistered finders to engage in capital-raising activity without the routine oversight and examination by regulatory authorities that registered brokers face, FINRA warned. Tier II finders would not have to possess any minimum knowledge or competency with respect to securities to qualify for the exemption, and there would be no assurance that such individuals have the knowledge, skills, integrity, or competency to serve investors or issuers in capital raising activities, asserted FINRA.

FINRA also expressed its concern that despite the prohibition on finder participation in the preparation of issuer sales materials, the lack of oversight could result in the preparation of sales materials by finders that are designed to maximize sales at the cost of compliance with standards requiring such communications to be fair and balanced. In addition, the prohibition on Tier II finders to make recommendations to prospective investors would be difficult to detect or enforce, FINRA said.

As an alternative to the proposed exemption, FINRA recommended a system that promotes its Capital Acquisition Brokers (CABs), which are broker-dealers that engage in a limited range of activities, including advising companies and private equity funds on capital raising and corporate restructuring and acting as placement agents for sales of unregistered securities to institutional investors. According to FINRA, CABs can act as finders or placement agents in connection with the sale of newly issued unregistered securities or in connection with a change of control of a private company and are subject to FINRA rules, which can be used to accommodate a category of brokers similar to the SEC’s proposed Tier II finders. Unlike the proposed exemption, CABs would be subject to core regulatory requirements such as having a supervisory system reasonably designed to achieve compliance with applicable laws and regulations, FINRA advised.

SIFMA. While SIFMA stated that it appreciates the SEC’s efforts to address this issue given the present lack of clarity on the topic, it advised that the proposed exemptive order may not provide an appropriate framework for finder activity. Echoing FINRA’s recommendation, SIFMA said that SEC should consider alternatives such as promoting CABs.

SIFMA also warned that the SEC should take into account the potential effects the exemption might inflict on the reputation of the U.S. capital markets, especially concerning integrity and reliability. According to SIFMA, authorizing this type of uninformed solicitation risks creating a market perception that people soliciting investments lack knowledge and information about the securities and issuers for which they are soliciting, and that such solicitations are unreliable. This perception, according to SIFMA, would undermine decades of efforts by the Commission to bolster public confidence in financial markets.

SIFMA cautioned that the framework proposed by the SEC is not tailored to the goal of promoting small business capital formation because it does not include any limit on offering size, as one transaction or in the aggregate. And while the proposed exemptive order purports to be narrowly tailored, SIFMA remarked that it does not define "smaller issuer" or limit the size of the issuer that could engage a finder, adding that there are several non-reporting companies that do not fit the commonly understood definition of "small."

Echoing concerns raised by the North American Securities Administrators Association (NASAA), SIFMA urged the SEC to work with state regulators to provide clarity and consistency regarding the types of activities in which finders and other limited purpose brokers may engage. SIFMA also cast doubt on the basis for the proposed exemptive order, stating that it does not provide economic analysis sufficient to meaningfully address the merits of the proposed framework, nor does it address reasonable alternatives.

Instead of issuing an exemptive order, SIFMA recommended that the Commission use the notice and comment rulemaking process to implement changes relating to finders. This would allow the public to provide meaningful comments and analysis to assist the SEC in:
  • identifying the need for the action and explaining how the proposed framework would meet that need;
  • articulating the appropriate economic baseline against which to measure the proposed framework’s likely economic impact;
  • identifying and evaluating reasonable alternatives to the proposed approach; and
  • assessing the potential economic impact of the proposed framework and reasonable alternatives, in light of quantitative and qualitative costs and benefits of each.
Because the proposed exemptive order by design implements a framework for an entire industry, compared to a firm-specific or transaction-specific exemption, it is, de facto, a rule and it should only be considered through the formal rulemaking process under the Administrative Procedure Act, SIFMA implored.

Wednesday, November 18, 2020

'Wall Street in the crosshairs': Mayer Brown partners preview financial services regulation and enforcement in the Biden Administration

By Lene Powell, J.D.

As the pieces of a new administration under President-elect Biden continue to fall into place, Democratic control of the Senate looks unlikely, and the progressive wing looks to exert strong pressure on the center, Mayer Brown partners have been analyzing how these political forces might play out for financial services regulation and enforcement.

In a presentation on November 12, Andrew Olmem, Michael Levy, and Larry Platt discussed predictions for how a focus on environmental issues will affect financial services, what more aggressive enforcement of financial crimes will look like, and how an emphasis on reducing racial equality and increasing minority homeownership might make progress, among other topics.

No blue wave. At the outset, Olmem noted that the analysis focuses on regulation rather than legislation. If the Democrats do retake the Senate as a result of the two runoff elections in Georgia on January 5, he would expect to see a "very aggressive" legislative agenda that would include financial services. But at the moment, it appears that Republicans will retain at least one of the Georgia seats.

Agency leadership. If the Biden Administration does pursue its agenda mainly through regulation, this will slow forward motion in some areas due to the timing of openings, said Olmem. On the one hand, he does expect the administration to be able to take control of the SEC quickly, as Chair Jay Clayton is slated to leave by the end of the administration. He also expects the administration to be able to install a new director at the CFPB by sometime next year, though the choice will be tempered by a Republican Senate.

But other key regulatory terms do not coincide with presidential terms, Olmem pointed out. For example, Fed governors are appointed for 14-year terms, and those will cycle off over the next couple of years. Similarly, Randy Quarles’s four-year term as Vice Chair for Supervision at the Fed does not end until October 2021.

Strong focus on environmental issues. Olmem believes the Biden Administration will pursue stronger environmental regulation as a number one goal. Environmental policy is an area that unifies the Democrats, from progressives to moderate suburban districts. Therefore, he expects this to be at the forefront.

Olmem sees this affecting financial services regulation in two ways:
  • The SEC is expected to consider requiring public companies to make environmental disclosures. Specifically, Olmem foresees the SEC imposing mandates within the next two years for companies to beef up disclosures relating to carbon footprint, including their support for carbon energies and what their expectations are about reducing their carbon footprint.
  • Olmem "fully expects" financial regulators to impose new capital charges or other supervisory requirements on lending by financial services companies to companies that have high reliance on carbon energy, particularly energy companies. This might come in the form of strict and transparent capital charges, and also possibly in the form of supervisory guidance in informal instruction from bank supervisors. What exact form this will take will depend largely on who is appointed at the banking regulators, not only at the Fed but also at the Comptroller of the Currency and FDIC, said Olmem.
Other regulatory areas of focus. Olmem expects to see several other areas of regulatory focus:
  • Non-bank lending, especially mortgage lending and servicers. Quarles and Clayton recently analyzed the impact of the COVID-19 pandemic on the financial system and both analyses found that non-banks underperformed or were not resilient enough. Olmem "fully expects" the Biden Administration to use the Financial Stability Oversight Council (FSOC) to examine where non-banks need to have stronger supervision. As in the Obama Administration, which designated several companies including several large insurers as systemically important institutions requiring enhanced supervision, he expects the Biden Administration to look to designate companies again, once it has sufficient votes from FSOC members.
  • Treasury market reform. Systems testing also showed that the Treasury market underperformed and needs some structural changes to make it more resilient. Olmem expects a review of the regulation of broker-dealers, as well as discussion of whether there should be central clearing for Treasury securities and reexamination of the role of primary dealers.
  • GSE reform. Led by Treasury Secretary Mnuchin and FHFA Director Mark Calabria, the Trump Administration has been working to end the decades-long conservatorship of Ginnie Mae and Freddie Mac. The Biden Administration may continue that course or may pause and take it in a different direction. Olmem "fully expects" to get some guidance in the next two or three months because there is a Supreme Court case pending on the validity of Treasury support for the GSE. The Supreme Court may invalidate it, forcing Treasury and FHFA to come up with a new regulatory regime. So GSE reform is likely an area that the Biden Administration is going to have to tackle pretty quickly, said Olmem.
  • CFPB and consumer lending. Olmem noted that the administration indicated it would support the creation of a public credit ratings bureau, whose ratings would be eligible to use at any federal lending program, as a way to replace the current private system. Even if that does not come into existence, he foresees a lot of CFPB attention on credit bureaus. In addition, Olmem "fully expects" that the financial regulators will finalize a new Community Reinvestment Act rule in the coming year. Olmem also thinks a new Biden-appointed CFPB director will make the agency "much more aggressive" on enforcement.
  • Infrastructure. Olmem foresees an infrastructure bill coming in the next year.
Stronger enforcement of financial crimes. In Michael Levy’s view, the Biden Administration will be "considerably more aggressive" than the Trump Administration in enforcing against financial crimes. Broadly, Levy expects a stronger appetite for taking on large publicly traded companies and financial institutions. Under Chair Clayton, the SEC has shifted to a focus on retail investors. Levy expects the pendulum to swing back to larger scale matters. He also foresees stronger support for whistleblowers, with continued large bounty awards being paid by the SEC.

Levy also predicts a strong focus on accounting fraud that has not been seen since the days of Enron and WorldCom. In recent weeks, there have been press reports of two large U.S. companies facing large-scale accounting fraud investigations by the SEC.

"I think, in a nutshell, Wall Street will be in the crosshairs of a new SEC," said Levy.

In the short term, Levy thinks the emphasis on pandemic-related fraud will continue, especially involving PPP and other stimulus programs. In the longer term, Levy thinks there will be a stronger DOJ focus on money laundering and BSA sanctions matters, as well as corruption generally.

Levy also foresees a stronger emphasis on areas where there is a perception of an unfair playing field, for example tax evasion, insider trading, and market manipulation like spoofing. Levy also expects a renewed focus on the FCPA, for which President Trump expressed strong dislike, as international cooperation and engagement is likely to accelerate under the Biden Administration. In addition, Levy thinks there will be stronger antitrust and environmental enforcement.

Levy said new scandals might also arise in areas we are not able to predict now, just as nobody foresaw scandals involving Enron, WorldCom, or credit default swaps. The unanticipated nature of future scandals highlights the importance of maintaining and improving compliance efforts, because it’s easier to stop a problem from happening than it is to extricate oneself from a government investigation sometime in the next four years, said Levy.

DOJ: hammers and nails. Levy explained that, perhaps contrary to popular perception, white collar enforcement is actually often more active and aggressive under Republican administrations than under Democratic administrations. For one thing, Republicans need to prove they’re tough on white collar crime, while Democrats need to prove they’re tough on street crime. Also, Democrats tend to address white collar issues through regulation and legislation, while the Republican perspective is that more regulation isn’t needed, you just need to lock up the bad apples.

However, the current administration has disrupted that paradigm with a decline in white collar enforcement, said Levy. And the Biden Administration may disrupt the pattern as well. If it cannot address issues through regulation or legislation, it is likely to come under pressure from the progressive wing to step up enforcement, said Levy.

Consequently, Levy foresees a lot of resources being devoted to white collar investigations. With more resources, there will be more investigations, because when you’re a hammer, everything is a nail. He also predicts a "much more aggressive" approach to penalties, with individual negotiations being much tougher, and the DOJ seeking "significantly larger" dollar amounts. He also thinks there will be a return to "regulation through enforcement," using DPAs, NPAs, and post resolution monitors.

Further, particularly if Sally Yates becomes Attorney General, Levy expects a greater focus on individual accountability, with companies being pushed hard to provide information about individual employees in order to receive cooperation credit. However, he does not think the administration will roll back policies designed to prevent "piling on," where you get multiple agencies and jurisdictions investigating, resulting in double and triple penalties.

CFPB enforcement. Levy expects CFPB enforcement to be very active, with Senator Elizabeth Warren pushing very hard around consumer protection and access to capital. Especially if the Democrats do not retake the Senate, they are going to have to satisfy the progressive wing that they are acting against systemic racism. A focus on investigating and enforcing in the private sector and particularly in financial services is likely to be very high on that list, said Levy.

CFTC enforcement. Touching briefly on the CFTC, Levy said that it has actually been one of the only agencies that has become more active and aggressive in the past four years. It has asserted jurisdiction under the FCPA for the first time in the statute’s more than 40-year history. And like the DOJ, they have aggressively pursued spoofing cases.

Housing. Speaking on housing issues, Platt thinks fair lending to pricing will be "huge," and redlining and disparate impact cases will return. He foresees a strong focus on access to credit and access to capital. A recent Harvard Joint Center for Housing study shows that over the next 15 years, over 70 percent of new household formation will be people of color.

But when talking about access to credit, it’s about more than just enforcing the law, said Platt. It’s about trying to address the underlying issues that lead to persons of color having materially lower homeownership rates. One issue is going to be requirements for ability to repay. He thinks the new administration will continue with a CFPB proposal that would loosen standards and make price a more important factor than debt to income ratio or prescribed underwriting requirements. Platt also expects a big emphasis on alternative income verification, with a look at how to provide credit scores for unbanked borrowers.

Platt also foresees more efforts to enable persons of color, who typically have less family generational wealth, to access the home lending market, through down payment assistance or other means. In addition, he expects a new focus on building housing stock, which could even lead to some deregulation of construction. Finally, he thinks there will be more efforts made in the area of home retention, particularly with the moratorium on evictions expiring at the end of the year and $70 billion in unpaid rents that will come due.

As the administration transition continues to unfold, Wolters Kluwer invites practitioners to stay informed via Securities Regulation Daily and the WK Securities team on Twitter at @WK_Securities.

Tuesday, November 17, 2020

State regulators ask SEC to put the brakes on finders exemption

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

The North American Securities Administrators Association (NASAA) has asked the SEC to withdraw its proposal to exempt certain individuals who are compensated for locating potential investors in private offerings from the registration requirements of the Exchange Act. In a comment letter opposing the Commission’s proposal to create a new federal broker-dealer exemption for these private placement "finders," NASAA President Lisa Hopkins wrote that the rule would expand the private market without providing any equivalent effort to protect investors from the enhanced risk of fraud in an area that remains prone to abuse. Separately, the chief securities administrators of 30 states joined NASAA in opposing the SEC’s proposal, writing that rulemaking that facilitates unlicensed intermediaries in the private market runs directly counter to the public interest.

On October 7, 2020, the SEC voted 3-2 to propose a limited, conditional exemption from broker registration requirements for "finders" who assist issuers with raising capital in private markets from accredited investors. The proposed exemption from the broker registration requirements of Exchange Act Section 15(a) would permit natural persons to engage in certain limited capital raising activities involving accredited investors. The proposal would create two classes of exempt finders—Tier 1 finders and Tier 2 finders—and sets forth conditions tailored to the activities of each tier that would permit eligible persons to accept transaction-based compensation for their fundraising efforts.

Regulatory vacuum. NASAA reminded the SEC it has repeatedly informed the Commission of the prevalence of abuse in the private market, noting that state enforcement actions against unregistered persons have more than doubled since 2015. NASAA also cited a study of fraud published in August 2020 by the SEC's the Commission’s Division of Economic and Risk Analysis (DERA), in which the staff observed that "fraud is more likely to occur when there are fewer outside gatekeepers like underwriters, analysts and regulators." This expresses precisely NASAA’s concern with the proposal, Hopkins wrote, because "it would remove regulatory oversight from the persons most likely to engage in misconduct in the situations in which fraud and other violations are most likely to occur."

NASAA took no comfort in the proposal's assurance that finders would not be excused from the antifraud provisions of the federal securities laws and "other applicable laws." NASAA observed that the proposal would exempt persons who would otherwise be required to register as broker-dealer representatives from important oversight requirements imposed by FINRA and other SROs. The benefits of SRO oversight that would be lost include examinations to establish minimal competency to deal with investors; background checks that capture circumstances such as bankruptcies and liens; continuing education requirements; recordkeeping requirements; and customer dispute mechanisms. The proposal would also undermine efforts by state regulators and the SROs to develop systems to help investors identify problematic intermediaries by exempting finders from registration and its attendant recordkeeping systems, Hopkins wrote, and may even attract persons whose disciplinary records make them unemployable by reputable firms.

NASAA took the SEC to task for ignoring previous recommendations to coordinate an exemptive framework with state securities regulators, including a 2005 report by the American Bar Association’s Task Force on Private Placement Broker-Dealers, which recommended that federal and state regulators should "work to establish a simplified system of registration" for finders. This recommendation was further supported by the SEC’s Advisory Committee on Small and Emerging Companies, which recommended similar measures in letters to the Commission in 2015 and 2017. In addition, the 2017 Treasury Department Report cited in the SEC’s proposal also recommended that the SEC, FINRA, and the states develop and implement a new "broker-lite" regulatory regime on finders.

In NASAA's view, these previous recommendations in favor of registration make sense because finders engage in activities which are core broker-dealer activities, including introducing investors to issuers, evaluating investors for suitability, and receiving transaction-based compensation. Moreover, as state law requirements would continue to apply, state securities regulators will need to respond to a newly-created regulatory vacuum. "Given previous recommendations to coordinate and previous communications with the staff on this issue, state securities regulators are surprised to the point of alarm; the Commission gave no clear signal that it was considering abandoning regulation in this area," Hopkins wrote.

If the SEC chooses to implement an exemptive order, NASA suggested that the Commission should, at a minimum, make the following changes:
  • Finders should be required to conduct due diligence on the issuers they promote.
  • The exemption should apply only to natural persons.
  • Only U.S. residents should be allowed to be exempted.
  • Finders should be limited to primary offerings.
  • The exemption should define the conflicts of interest that a finder would be required to disclose.
  • Finders should be more clearly prohibited from conducting general solicitation by being required to solicit only persons with whom they have a substantial, pre-existing relationship.
  • The written disclosures must be clarified and strengthened, making clear that the finder must disclose: the amount of compensation he or she is receiving from an issuer, regardless of the form; any relationship or affiliation with any officer or director of the issuer; and any prior regulatory or disciplinary action taken against the finder by a financial regulator.

Monday, November 16, 2020

Commissioners Peirce and Roisman object to Andeavor penalty

By Mark S. Nelson, J.D.

SEC Commissioners Hester Peirce and Elad Roisman issued a public statement dissenting from the Commission’s imposition of a $20 million penalty on Andeavor LLC for failing to have adequate internal accounting controls that would reasonably assure compliance with the company’s share buyback policy. Peirce and Roisman explained that they disagreed with the majority’s application of Exchange Act Section 13(b)(2)(B) to conduct that is not more closely related to accounting matters. The Peirce-Roisman statement comes nearly a month after the Commission issued its order against Andeavor.

Inadequate accounting controls. Andeavor’s CEO directed the company’s CFO to begin the process of buying back up to $250 million of company shares at a time when Andeavor’s CEO was about to resume discussions with another company to acquire Andeavor. Andeavor’s board had previously authorized a $2 billion buyback plan in 2015 and 2016 subject to a policy stating that the buybacks must not occur when the company possesses material nonpublic information (MNPI).

The company eventually executed buybacks pursuant to a Rule 10b5-1 plan for 2.6 million shares at $97 per share. Within about a six week period after initiating the buyback, Andeavor agreed in principle to be acquired by Marathon Petroleum Corp. Marathon’s acquisition of Andeavor was publicly announced in late April 2018 and the deal was priced at $150 per share.

Andeavor, without admitting or denying the SEC’s findings, agreed to a cease and desist order and to pay a civil money penalty of $20 million. "As described in the SEC’s order, Andeavor’s Board of Directors set clear lines around when the company could buy back its shares, but Andeavor failed to have a process that was reasonably designed to ensure that it stayed within those lines," said SEC Enforcement Director Stephanie Avakian.

Catch-all provision? The Commission vote to impose a penalty on Andeavor was 3-2, as revealed in a public statement issued by Commissioners Peirce and Roisman. According to Peirce and Roisman, the provision relied on by the majority, Exchange Act Section 13(b)(2)(B), was intended to address accounting-specific issues and was not intended to function as a catch-all provision for violations outside of the accounting procedures context, such as the "abbreviated and informal process" cited by the majority in the Andeavor order. Peirce and Roisman also noted that a Section 13(b)(2)(B) violation does not require a showing of scienter, while a violation of Exchange Act Rule 10b-5 would require such showing.

Peirce and Roisman also observed that the Andeavor matter presented several "complications." For one, the Andeavor buyback was done pursuant to a Rule 10b5-1 plan—an exception that they said allows a company to conduct a buyback while in possession of MNPI if certain requirements are met—and, among other things, that the acquisition talks with Marathon had been suspended for a period of time. They further noted that Andeavor’s board had authorized the buyback. As a result, Peirce and Roisman viewed the Commission’s order, the first of its kind said the commissioners, as an attempt to broaden the reach of Section 13(b)(2)(B) to more generalized failures to implement internal controls.

Commissioners Peirce and Roisman concluded their statement thus: "While we agree that Andeavor’s decision processes in this case left substantial room for improvement, and inadequate processes may expose a company to potential Rule 10b-5 liability, we doubt it is our role under Section 13(b)(2)(B) to second guess management’s decision processes on matters that do not directly implicate the accuracy of a company’s accounting and financial statements."

Friday, November 13, 2020

FIA panel focuses on seminal CFTC climate change report and industry responses to growing perils

By Brad Rosen, J.D.

As climate change is increasingly being recognized as a source of major risk to financial stability, the financial industry finds itself at crossroads as it responds to both regulatory demands and investor pressures to provide instruments reflecting environmental concerns and demands from regulators to improve the reporting of the climate change related financial risks. A group of derivatives leaders engaged in a far-ranging discussion of these topics in a panel titled Managing the Risk of Climate Change: The Role of Markets, at the FIA’s recent Expo-V Conference 2020, a virtual event in light of the ongoing COVID-19 pandemic.

Setting the stage. In her opening remarks, panel moderator Athena Eastwood, a partner at the law firm Willkie Farr & Gallagher, observed that there has been a lot of recent attention on the dangers climate risk may impose on the financial system, noting that central banks have been increasingly vocal that a series of disruptive weather events could lead to the next systemic financial crisis. She also pointed to the emerging private sector trend of enhanced scrutiny of investment portfolios for carbon intensity, corporate commitments to reduce carbon emissions, as well as agricultural and energy market participants’ commitment to reducing carbon their footprints.

Additionally, Eastwood highlighted the CFTC’s recently released seminal report titled Managing Climate Risk in the U.S. Financial System, which was issued by a subcommittee of the CFTC’s Market Risk Advisory Committee (MRAC). That paper contained 53 actionable recommendations to mitigate the risks to financial markets posed by climate change. Eastwood, a subcommittee member, also pointed to the FIA’s policy paper How Derivative Markets are Helping the World Fight Climate Change, which focuses on the products and platforms that can help the world transition to a low carbon future. That paper was meant to compliment the CFTC’s report, and both works informed the panel’s discussion of how financial market players are currently involved in fighting climate change, as well as potential public-private partnerships to build a more sustainable economic future.

Key takeaways from the CFTC report. In his remarks, CFTC Commissioner Rostin Behnam, the MRAC sponsor and the driving force behind the agency’s efforts in the climate change arena, noted that the subcommittee’s diverse composition consists of representatives from the banking, agricultural, energy, and insurance industries, as well as institutional investors, data providers, environmentalists, and academia. He commended the subcommittee’s inspired work to reach consensus and approve the report 34-0.

Additionally, Behnam underscored the report’s number one recommendation to put a price on carbon but noted that it was the only one of the 53 recommendations that could not be implemented by a federal agency. The commissioner also pointed to one crucial statement contained at the report’s beginning which provides, "Climate change poses a systemic risk to the US financial system and its ability to support the economy."Behnam then reflected upon the large number of weather events in the recent past, including west coast wildfires and gulf coast storms, and noted it is incumbent on all of us to start thinking about how these subsystemic shocks to regional economies can lead to larger systemic shocks to the financial system. Some other key takeaways in the report, according to Behnam, include:
  • Disclosures. The report contains a comprehensive discussion on disclosures, a tough area to reach consensus noted the commissioner. The report also highlights the need for getting more information, better information, and more transparent information from investor and regulatory perspectives.
  • Stress testing. The report recommends that stress testing be conducted under various climate scenarios, and consideration should be given to how to use existing frameworks by prudential regulators and market regulators. The report concludes that stress testing of financial institutions will lead to better preparation in the event of a climate emergency.
  • Harmonization. The report stresses the need to work together both domestically and internationally with other regulators. Behnam noted this is an iterative process and that climate change is not linear in terms of the risks that it poses. He also pointed to the need for market participants to leverage each other’s resources to address risks on a global basis.
  • Data. The report points to the need to better sift through and share data, and think about what data can tell us to better mitigate climate risks. Additionally, agreeing upon taxonomies is essential as data and information is increasingly shared with various counterparts.
In response to an audience question, Behnam indicated that he had not spoken to the incoming Biden administration, but that the president-elect’s team has put out public documents on climate change. In fact, the Biden team recently announced that it would look to issue an executive order early on requiring public companies to disclose climate risks and the greenhouse gas emissions in their operations and supply chains.

Climate derivatives grow as the policy tool of choice. Daniel Scarbrough, the president of IncubEx Inc., an incubator for exchange traded products with a focus on environmental markets, observed that market-based solutions have a proven track record of success and are increasingly the policy tool of choice to solve environmental challenges. In support of this assertion, Scarbrough pointed to some of the following metrics:
  • Roughly 3 billion tons of carbon emissions are currently regulated under compliance trading regimes versus global emissions of over 40 billion tons. Thus, there is a long way to go in this space.
  • 29 states and the District of Columbia have renewable portfolio standards.
  • Total global environmental open interest has increased over four times from 650,000 contracts in 2009 to over 3 million currently.
  • U.S. open interest has grown dramatically from 100,000 contracts to 1 million contracts currently.
Scarborough also noted that he has seen increased hybridization between the compliance and voluntary credit markets over time. He has also observed voluntary products being adopted for mandatory programs, a development he sees as promising.

Financial institutions commit to carbon neutrality. William McCoy, a managing director at Morgan Stanley, described a number of commitments his firm has made towards a carbon neutral future. These include:
  • In 2017, Morgan Stanley announced its commitment to attain carbon neutrality for its global operations by 2022 and sourcing 100 percent of its global energy needs through renewable energy sources and using carbon offsets for remaining emissions.
  • In 2018, the firm announced its commitment to provide $250 billion in low carbon financing by 2030. Thus far, $80 billion has been mobilized towards that goal, including the support of clients with clean tech financing and sustainable bonds issuance.
  • In September 2020, Morgan Stanley announced a commitment to achieve net zero financed emissions by 2050. Net zero financed emissions refers to the aggregate emissions attributed to those firms that are receiving financing from the company.
McCoy also indicated that more investors and fund managers are adopting sustainable investment strategies and are demanding ESG products. He also noted there is evidence that ESG oriented equities and taxable bonds outperformed their market benchmarks in the first half of 2020. McCoy also observed that market participants are using ESG derivatives as part of overall ESG strategies as noted in the FIA’s policy paper.

Clearing and climate. Pauline Engelberts, a chief operations officer with ABN AMRO Clearing Bank, noted that her institution is in ongoing dialogue with clients, regulators, and exchanges, and engages the whole value chain with regard to climate change related risks. In particular, she noted that ABN AMRO screens companies based on carbon intensity, and is piloting a sustainability dashboard with its clients to identify ESG biases and impacts and to promote engagement on the issue. Engelberts acknowledged the difficulties associated with a lack of standardization and harmonization with respect to climate-related metrics. "We would welcome standardization but aren’t going to wait around for it and miss the boat," she stated.

Concluding thoughts. Towards the end of the panel session, Commissioner Behnam recalled the observations of a leading thinker in the climate space after the issuance of the CFTC’s report who noted: "we missed the housing crisis that lead to the financial crisis; we missed the COVID-19 pandemic crisis; let’s not miss the climate crisis." Behnam urged industry players to pool their intelligence, innovation, and the entrepreneurial spirit of the derivatives market that has existed for decades, and work together to solve the climate problem.

Thursday, November 12, 2020

OCIE’s Multi-Branch Initiative uncovers compliance and supervisory deficiencies

By Anne Sherry, J.D.

The SEC’s Office of Compliance Inspections and Examinations released a risk alert detailing its observations from the Multi-Branch Initiative, a series of examinations of investment advisers operating from geographically dispersed locations. OCIE looked at 40 advisers, most of which had at least 10 branch offices, and found that some had not fully implemented policies and procedures addressing activities occurring in geographically dispersed operations. The Initiative particularly focused on two areas: compliance programs and supervision and investment advice.

Compliance and supervision. According to the risk alert, OCIE cited the "vast majority" of advisers for at least one deficiency related to Investment Advisers Act Rule 206(4)-7 (the "Compliance Rule"). More than half of advisers’ policies and procedures were outdated, inconsistently applied, inadequately implemented, or not enforced. Often, advisers failed to recognize that they had custody of client assets and/or failed to adequately implement and oversee their fee billing practices, leading to overcharging.

OCIE also found supervision deficiencies related to portfolio management, trading and best execution, and the failure to disclose disciplinary actions or other material information. Advisers also had deficiencies related to advertising: presentations omitting material disclosures, unsupported claims or superlatives, falsely stated professional experience and credentials, and third-party rankings or awards that omitted material facts.

Several advisers were cited for code of ethics deficiencies. These advisers failed to comply with reporting requirements, review transactions and holding reports, properly identify access persons, or include all required provisions in their codes of ethics. For example, some codes of ethics omitted the review and approval process required before supervised persons could invest in limited or private offerings. Codes also omitted initial and annual holdings report submissions and/or quarterly transaction report submissions.

Investment advice. OCIE also cited more than half the examined advisers for deficiencies related to portfolio management. Many of these involved oversight of investment decisions. Here, staff identified issues with mutual fund share class selection and disclosure; wrap fee programs; and rebalancing. Several advisers did not fully and fairly disclose conflicts of interest or financial incentives. In other cases, advisers were cited for the lack of documentation demonstrating their best-execution analysis; completing principal transactions from the firms’ inventory without prior client consent; and inadequately monitoring supervised persons’ trading.

Staff observations. On the plus side, OCIE staff identified some compliance-promoting practices that firms may wish to borrow for their oversight efforts. Some advisers adopted and implemented policies and procedures applicable to all office locations and all supervised persons, whether employees or independent contractors. The policies and procedures in some cases included aspects associated with individual branch offices. They also specifically addressed compliance practices necessary for the effective oversight of branch offices.

Advisory firms reviewed key activities at branch offices at least annually, including validating that branch offices undertook reviews of their own portfolio management decisions, designating individuals within branch offices to provide portfolio management monitoring, consolidating trading activities at branch offices into the advisers’ overall testing, and conducting compliance reviews that did not solely rely on self-reporting. Advisers also established compliance policies and procedures to check for prior disciplinary events when hiring supervised persons and periodically reviewing disciplinary histories. Finally, most advisers required compliance training for branch office employees, tailoring the training to the areas identified on branch office reviews as needing improvement.

OCIE said that in response to the staff’s observations, advisers amended disclosures, revised policies and procedures, and changed certain practices. OCIE encourages advisers to keep in mind the unique risks and challenges inherent in geographically dispersed operations when designing and implementing compliance and supervision frameworks.

Wednesday, November 11, 2020

SEC commenters to ponder state trust custody of digital assets

By Jay Fishman, J.D.

A Wyoming Banking Division no-action letter (NAL) to the SEC’s Investment Management Division and FinHub Staff on Wyoming- and other state-chartered public trust companies’ custodial rights over their clients’ digital assets prompted the Commission to request public comments on the matter.

Wyoming NAL. The NAL basically stated that Wyoming law permits a Wyoming-chartered public trust company to provide custodial services for digital as well as traditional assets. The NAL additionally brought the Investment Advisers Act of 1940 and Rule 206(4)-2 (the "Custody Rule") into the discussion by proclaiming that a Wyoming state-chartered public trust company may serve as a Custody Rule-defined "qualified custodian" under the "bank" definition in the Advisers Act. The NAL has asked the SEC to weigh in on this scenario.

SEC response. The Commission began by reiterating the SEC-registered investment adviser’s fiduciary duty to exercise care over their clients’ assets, along with the critical role qualified custodians play in safeguarding those assets. The SEC acknowledged that since this is a complicated process based on individual facts and circumstances, only certain financial institutions possessing key characteristics can be qualified custodians. The SEC has now been asked by Wyoming’s Banking Division to consider whether under federal and state law, Wyoming- and other states’-chartered public trust companies can be included among the SEC-permitted financial intermediaries to act as qualified custodians over their clients’ assets, particularly their clients’ digital assets.

SEC comment request. To consider the issue, the Commission has asked the public to comment by email under a subject line headed "Custody Rule and Digital Assets." To generate the discussion, the SEC has asked commenters to consider the following questions:
  • Do state chartered trust companies possess characteristics similar to those of the types of financial institutions the Commission identified as qualified custodians? If yes, to what extent?
  • In what ways are custodial services that are provided by state-chartered trust companies equivalent to those provided by banks, broker-dealers, and futures commission merchants? In what ways do they differ?
  • Would there be any gaps in—or enhancements to—protection of advisory client assets as a result of a state-chartered trust company serving as qualified custodian of digital assets or other types of client assets?
  • How do advisers assess whether an entity offering custodial services satisfies the definition of qualified custodian in the Custody Rule?
  • What qualities does an adviser seek when entrusting a client’s assets to a particular custodian? Do the qualities vary by asset class? That is, are there qualities that would be important for safeguarding digital assets that might not be important for safeguarding other types of assets? If so, what qualities and why? Should the rule prescribe different qualities based on asset class, or should the rule take a more principles-based approach and allow advisers to exercise care in selecting a custodian?
  • Are there entities that currently satisfy the definition of qualified custodian under the Custody Rule that should not be included within that definition because they do not meet the policy goals of the rule? If so, which ones and why? Conversely, are there entities that currently do not satisfy the definition of qualified custodian but should? If so, which ones and why?

Tuesday, November 10, 2020

A look ahead at the Biden Administration

By Mark S. Nelson, J.D.

President-elect Joe Biden, who has been projected by major news organizations to be the winner of the 2020 presidential election, has called on Americans to heal the country’s bitter political divisions as he begins his presidential transition process. But Biden’s centrist campaign strategy, once it is translated into administration policy, may still encounter political headwinds that will be influenced by multiple factors: (1) the composition of the Senate, which is likely to remain undecided until a dual run-off election in Georgia in January; (2) the exact size of the Democratic majority in the House, also still unclear; and (3) the prospect of legal challenges to future Biden Administration regulations in federal courts that President Trump and Senate Majority Leader Mitch McConnell (R-Ky) have tilted heavily in favor of a conservative judicial philosophy.

With respect to securities regulation, these political realities may place greater emphasis on what the Biden Administration can achieve by way of incremental regulatory policy choices rather than via major financial legislation, at least until the next mid-term elections offer voters another chance to shape Congress. Moreover, the Congressional Review Act would be an unrealistic approach to rolling back Trump-era regulations absent a Democratic White House, House, and Senate. Thus, depending on the outcome of yet undecided Senate races, it is unlikely that the Biden Administration could use the CRA in the aggressive manner as did the Trump Administration during its first two years in office, in which President Trump symbolically chose the SEC’s resource extraction issuers regulation as the first regulation his administration targeted under the CRA.

The following discussion suggests how the Biden Administration may impact several key areas of securities regulation.

The Biden Transition. The Biden transition team has established a website ( to house news about the team’s progress as inauguration day approaches. The website states as priorities the continued fight against the COVID-19 pandemic, economic recovery, racial equity, and measures to address climate change.

With respect to economic recovery, the Biden team has stated that, as president, Biden will seek to reverse at least "some" of the Trump tax reform provisions that became law in 2017, especially regarding corporations. While the transition team statement is short on details, it is possible to envision consideration of adjustments to corporate tax rates, business deductions and exemptions, taxation of dividends, and tighter restrictions on corporate inversions in which U.S. companies re-incorporate overseas to lower their U.S. tax bills.

The transition team also has made racial equity a key goal. Racial equity in the securities regulation context could mean reintroduction of the several corporate diversity and inclusion bills that were passed by the House during the 116th Congress and which target racial equity on corporate boards and in executive management roles. One also could foresee that federal agency Offices of Minority and Women Inclusion (OMWIs), such as those at the SEC and the CFTC, could take on even greater significance. Moreover, it seems plausible that the Biden Administration would reverse measures taken recently by President Trump to ban certain types of racial trainings in employment settings, such as trainings that emphasize critical race theory.

Climate change is another key goal stated by the Biden transition team. Here, the team has stated that Biden intends to recommit the U.S. to the Paris Agreement, which President Trump abandoned early in his presidency. The Biden Administration’s recommitment to fighting climate change at the macro level likely would presage greater emphasis on climate change by agencies such as the SEC, although the details of how specifically that would be achieved, possibly through new public company disclosures, remains somewhat unclear.

In terms of criminal justice, securities practitioners will recognize a familiar name on the Biden transition team Advisory Board in Sally Yates, former Deputy Attorney General of the U.S. Department of Justice, whom President Trump fired when she refused to enforce the Trump Administration’s travel ban. Yates is perhaps best known in corporate law circles, however, for the "Yates memo" in which she outlined then-DOJ policy on individual accountability and corporate wrongdoing.

Finally, according to multiple media reports, President-elect Biden will lean on former CFTC Chairman Gary Gensler for advice on oversight of the financial industry. Gensler was one of the first agency heads to begin to implement the Dodd-Frank Act’s derivatives reforms following the Great Recession. Gensler has recently been Professor of the Practice of Global Economics and Management at MIT Sloan School of Management, Co-Director of MIT’s Fintech@CSAIL and Senior Advisor to the MIT Media Lab Digital Currency Initiative. In the latter post, regarding digital currencies, Gensler has at times suggested virtual currencies such as Ripple may have been investment contracts and, thus, securities, but his background in the subject matter also could suggest a potential opportunity for him to advise the Biden Administration more broadly on the appropriateness of existing federal regulations and guidance on digital assets.

The Biden Administration, however, may face legislative roadblocks to a broader reorganization of federal financial regulators unless Democrats are able to achieve control of the Senate. Even then, a razor-thin majority could make it necessary to scale back larger plans in order to ensure passage of financial legislation that is more incremental in scope. For example, a financial regulator revamp and consolidation on the scale proposed by Wolters Kluwer outside expert Joel Seligman in his new book "Misalignment: The New Financial Order and the Failure of Financial Regulation" (published by Wolters Kluwer Incorporated) might have to await a more favorable legislative environment after the next midterm elections or even a second Biden Administration. Such a large-scale reform may be difficult to sell when many current economic problems have arisen because of the COVID-19 pandemic rather than from specific financial system defects, although authors like Seligman contend that such systemic financial defects still exist and must be addressed.

SEC personnel. Public attention will inevitably turn to who may become chair of the SEC in the Biden Administration. Current Commissioner Allison Herren Lee, a Democrat, has demonstrated on two fronts the potential to shift SEC policy. She recently argued forcefully for more fulsome disclosures regarding climate change. Lee also has suggested how the SEC could pursue regulations with a greater mix of prescriptive and principles-based requirements, an issue she debated in an extended colloquy with Republican Commissioner Hester Peirce at the end of the Commission’s open meeting to adopt further revisions to Regulation S-K in August 2020.

Former Commissioner Robert Jackson, Jr. could be another potential candidate. As commissioner, Jackson operated his own economic research shop that produced a number of speeches on key topics in which he grounded his views on his own data analysis. In an email to reporters upon his departure from the SEC, he included a quote from former Commissioner Kara Stein that suggested he may be contemplating a return to public service: "Rob has been a relentless advocate for making sure our modern markets remain the fairest and most efficient in the world. I hope our country will be fortunate enough to have him engage in public service again in the future," said Stein. Jackson is an Independent and if he was selected as chairman he would continue a recent trend of Independents heading the SEC (Clayton from the Trump Administration, and Mary Jo White and Mary Schapiro from the Obama Administration).

At least one media outlet has speculated that current SEC Chairman Jay Clayton, who recently sought the Trump Administration’s blessing to change to a different job nearer to his New York City home, could leave the SEC significantly before the Biden Administration takes office. That could open the door to a brief, but potentially consequential, chairwomanship by Peirce, who has advocated for more aggressive action to promote blockchain-related interests, such as cryptocurrency-based exchange-traded funds and to protect the early distribution of tokens from being deemed securities transactions. A federal law allows the president to designate an SEC chair, a power that President Obama used to designate Elisse Walter as SEC chairwoman for a brief period before White become chairwoman. President Trump recently demoted Federal Energy Regulatory Commission (FERC) Chairman Neil Chatterjee after Chatterjee took policy positions perceived to be contrary to the Trump Administration, thus showing an inclination by President Trump to make such agency personnel changes even in the waning days of his administration. However, the more typical scenario is that a lame duck agency head will remain in their position until the incoming administration is about to begin, as did Chairwoman White until just days before President Trump was inaugurated in January 2017.

Enforcement. The Biden Administration SEC could be expected to pursue more enforcement cases and to bring cases against some larger targets. That is not to say that the Clayton-era SEC did not have some big cases but, to some extent, the most recent SEC enforcement statistics were the product of the agency’s program to encourage self-reported violations.

The Clayton SEC also adopted revisions to the whistleblower program that many see as potentially weakening the program. Nevertheless, the SEC recently awarded a record $114 million award to a single whistleblower. The Biden Administration could be expected to mull ways to strengthen the whistleblower program, which could come in the form of regulatory changes or legislation that would essentially reverse the Supreme Court’s Somers opinion, holding that a whistleblower must report to the SEC in order to partake of the Dodd-Frank Act’s anti-retaliatory provisions. The Biden Administration also could pursue bills previously introduced in Congress to establish a PCAOB whistleblower program.

Moreover, the recent popularity of SPACs could move the SEC in the future to take a closer look at some of these transactions. Chairman Clayton has already issued a warning about SPACs in the context of Regulation Best Interest and COVID-19 investments.

ESG disclosures. The Biden transition team has already flagged climate change as a key regulatory objective. One could expect the Biden Administration SEC to pursue additional ESG-related disclosures from public companies. There are potentially a range of regulatory options from traditional regulations, to executive orders, to legislation. With respect to legislation, bills in the 116th Congress would have required the SEC to establish ESG metrics (See, e.g., H.R. 4329).

Retail investors, shareholders, proxies, and the Volcker rule. The SEC adopted Final Regulation Best Interest in mid-2019 but the regulation only came into force in mid-2020 when firms were required to comply with its requirements. The Second Circuit rebuffed a legal challenge to the regulation, but a future SEC could still seek to establish a uniform fiduciary standard, as the Dodd-Frank Act also allows in addition to the approach taken by the Clayton SEC. The Biden Administration would have the option of pursuing such standard, tweaking Regulation Best Interest to enhance investor protections, or by aggressively enforcing violations of Regulation Best Interest.

The Clayton SEC also adopted final rules imposing new requirements on proxy advisers and raised the eligibility requirements for shareholder proposals. Many investor advocates view both as potentially harmful to investors, but they especially view the increased eligibility requirements for shareholder proposals as especially unfair because of the new tiered structure, which favors wealthier investors.

The Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (S. 2155) heralded an era of looser restrictions on banks, including roll backs regarding the Volcker rule. Any changes to the Volcker rule regulations would require coordination by the SEC and multiple other federal financial regulators.

If the Biden Administration were to pursue regulatory changes to Trump-era regulation, it would have to justify those changes via new notice and comment rulemakings.

SEC guidance. Despite Chairman Clayton’s efforts to reign-in SEC guidance by admonishing securities practitioners that staff guidance is legally non-binding, the SEC has continued to issue quite a lot of guidance. One potential target for the Biden Administration could be the withdrawal of guidance issued by Clayton’s predecessor, Acting Chairman Michael Piwowar. Piwowar had issued guidance (Piwowar statement; updated statement) that instructed public companies that the SEC would not recommend enforcement if they did not comply with the conflict minerals due diligence requirement contained in Form SD. Many companies have continued to report on their due diligence despite the guidance.

COVID-19. The SEC has issued extensive relief to companies and other filers regarding the COVID-19 pandemic. The SEC has pursued numerous COVID-19-related trading suspensions and Chairman Clayton has called on public companies to practice good hygiene by telling executives to refrain from stock trades when companies may be disclosing COVID-19 information. However, a recent rulemaking petition from the Chamber of Commerce calls for the SEC to use its exemptive authority to limit securities law suits over COVID-19. Conventional wisdom might suggest that the Biden Administration would be cool to such proposals.

The Biden Administration also could impact COVID-19 relief legislation by potentially seeking to further limit executive compensation at companies receiving aid. The Biden Administration also could seek to curb existing CARES Act provisions that allow the Treasury Secretary to waive limits on executive compensation. The impact of the Biden Administration would likely depend on whether another COVID-19 aid package was enacted before the Trump Administration leaves office or after Biden becomes president.

Blockchain. The presence of Gary Gensler among those advising President-elect Biden on financial oversight matters suggests that the incoming administration could reconsider federal policy regarding blockchain and digital assets. However, it seems unlikely that the Biden Administration would overturn one Trump-era executive order barring the trading of Venezuelan virtual currency. In March 2018, President Trump issued an executive order that states: "[a]ll transactions related to, provision of financing for, and other dealings in, by a United States person or within the United States, any digital currency, digital coin, or digital token, that was issued by, for, or on behalf of the Government of Venezuela on or after January 9, 2018, are prohibited as of the effective date of this order [the order states that it became effective on March 19, 2018]."

Monday, November 09, 2020

Moses & Singer’s Allan Grauberd and Howard Fischer examine details of new accredited investor rules

By Allan Grauberd and Howard Fischer, Moses & Singer LLP

In a follow-up to a March discussion, the authors look at the details of the recently adopted accredited investor amendments, including some proposed elements that were left out of the final rules.

Moses & Singer partners Allan Grauberd and Howard Fischer discuss the changes the SEC has put in place in its final rules on the definition of "accredited investor," which will go into effect December 8. They look at how the agency expanded what qualifies as accreditation in several ways, including by importing the "knowledgeable employee" framework from the Investment Company Act. After reviewing the treatment of certain entities such as registered advisers and limited liability companies in the new rules, they review some of the pieces of the original proposal that failed to make it into the final rules.

To read the entire discussion, click here.

Friday, November 06, 2020

SEC advisory committee makes recommendations for remote work, digital delivery, and e-authorization

By Amanda Maine, J.D.

During a special meeting of the SEC’s Asset Management Advisory Committee (AMAC), members unanimously approved a preliminary recommendation of its Operations Panel to expand the use of digital tools to comply with certain Commission regulations relating to the delivery of documents, remote work, and digitized methods of authorization. In the first months of the pandemic, the Commission and FINRA had provided temporary relief from regulations requiring mail delivery, physical presence for supervision and testing, and manual notarization and signature requirements. The AMAC recommended permanent regulatory changes to these rules that will outlast the duration of the pandemic.

Digital delivery. The AMAC recommended that the SEC update its rules and interpretations to permit firms to use an investor’s digital address (such as an email or smart phone telephone number) as the primary address when delivering regulatory documents. It should also amend its rules to replace "written notification" or notification "in writing" with a requirement to "furnish" or "provide" documents.

In the recommendation, the AMAC noted that there is a long-term trend of greater use of digital communications and increased investor preference to receive documents and brokerage information electronically versus paper sent through the mail. The COVID-19 pandemic only increased this movement towards digital, the committee stated. It also said that from a customer identity protection standpoint, mailed paper documents have the disadvantage of having to be disposed of compared to a document stored on a financial institution’s secure website. In addition, the potential for mis-delivery and theft of information is greater with paper delivery as it can be dependent on third parties for printing and delivery.

Remote work. The AMAC also recommended that the SEC work with FINRA to modernize internal inspection requirements to provide firms with the flexibility to conduct remote technology-assisted inspections and to revise its office registration and inspection requirements. The SEC should also coordinate with the North American Securities Administrators Association (NASAA) and FINRA to make remote testing capabilities permanent for securities licenses and make permanent exemptive relief from the in-person voting requirements for mutual fund boards.

Noting that the pandemic triggered an unprecedented shift to "work from home" for financial services employees, the AMAC recommended that the SEC work with FINRA to allow member firms to conduct remote inspections for 2020 and 2021. It also stated that video conferencing tools can be used to conduct inspections and that technical advancements allow firms to supervise employee and customer activities remotely. In addition, AMAC noted that FINRA and NASAA used a successful online testing service pilot and recommended that it remain a permanent option for firms even post-pandemic.

E-authorizations. The AMAC recommended that the SEC adopt rules to digitize methods of authorization, including those relating to manual wet signature requirements and notarizations. According to the recommendation, online video software technology and remote notaries have been well-used during the pandemic and effectively took the place of a physical presence requirement. In addition, electronic authentication can also provide an additional layer of security through the use of two-factor authentication or audit trails, which might make them even more reliable than manual processes, AMAC stated.

Dematerialization. Finally, the AMAC called for the SEC to hold a staff roundtable about dematerialization of paper security certificates. The recommendation notes that the costs to process physical certificates has increased, with many of these costs borne by investors. The SEC should seek input from issuers, transfer agents, broker-dealers, clearing corporations, banks, investors, regulators, exchanges, underwriters, and industry experts at this dematerialization roundtable.

Discussion. SEC Chairman Jay Clayton said that COVID-19 provided a "real-time stress test" for asset managers and other market participants on their ability to operate remotely while complying with regulatory requirements that were designed for an environment with vastly different operational characteristics. He remarked that the Commission last substantively addressed electronic delivery over 20 years ago. "Our regulations should not cling to the mails and paper as the default or preferred paradigm for communications," Clayton advised.

Commissioner Hester Peirce also welcomed the recommendations for laying the foundation for a more flexible, technology-based regulatory structure, rather than doing so in an ad hoc manner through temporary exemptive relief. Peirce also posited that firms should be able to tell new customers clearly and in advance that they are a "digital-only" firm without paper documentation. It would then be up to the potential customer to give their business to the firm, she explained.

AMAC member Mike Durbin of Fidelity Institutional said that Peirce’s idea might result in an asymmetry depending on whether the "digital-only" designation applied to new clients or a current client opening a new account. In that case, it should probably be anchored around clients or households rather than accounts, he said.

Neesha Hathi of Charles Schwab said that her firm probably would not embrace the idea that customers wouldn’t have a choice to stick with paper but added that newer firms may want to go in that direction. For existing customers, firms could notify legacy accounts that they would be switching to digital on a certain date, and customers opposed to the change could let the firm know their opposition. AMAC Chairman Ed Bernard of T. Rowe Price agreed that with proper notice, many legacy accounts could be transitioned to fully-digital.

Thursday, November 05, 2020

Chamber of Commerce calls for COVID-19 litigation reform

By Rodney F. Tonkovic, J.D.

The U.S. Chamber of Commerce has submitted a petition for rulemaking on COVID-19-related litigation. The petition argues that there has been an "explosion" of securities class action filings in recent years, often of dubious merit, and there is a strong likelihood that events related to the COVID-19 pandemic will be the basis of additional securities litigation, at least some of it spurious. The chamber maintains that the SEC has, and should exercise, its authority under the PSLRA to act against unjustified COVID-related claims.

Growth in event-driven claims. According to the petition, there has been an explosion in securities litigation in the past three years. Congress enacted the PSLRA 25 years ago in response to a high level of frivolous suits, and filing activity now exceeds the levels that led to the enactment of the PSLRA. A significant driver of this increase has been the growth of event-driven claims, the petition says, that is, lawsuits filed shortly following the decline in a company's stock after a negative event such as an oil spill or a plane crash.

The petition notes that the PSLRA was enacted in large part due to abusive, lawyer-driven suits "often based on nothing more than a company's announcement of bad news, not evidence of fraud." This pattern has returned with rapidly-filed claims designed to force defendants into settlements. Generally, the lawyers contend that the company's statements misrepresented the risk of the negative event, or that the company was obligated to disclose the risk of the event but failed to do so. The legitimacy of these suits is highly suspect, the chamber says.

COVID suits. The chamber says that a number of COVID-19 securities cases have already been filed, and more are expected in the coming months as the pandemic has wrought havoc on the stock markets. One observer has said that there are already 20 such suits, covering defendants in a variety of industries. These cases are likely just the tip of the iceberg, the petition asserts, and more suits will follow as the pandemic grinds on.

Commission action. The petition maintains that the SEC has the authority under the PSLRA to protect against unjustified COVID-19-related claims and that that authority should be exercised. According to the chamber, the PSLRA's introduction of safe harbors for forward-looking statements was meant to deter the filing of meritless claims, but there are a number of holes in these provisions and they may no longer be having their intended effect.

The PSLRA's legislative history confirms that the statutory safe harbors were meant to be a "starting point" and that the Commission can and should consider adopting regulatory reforms, the petition says. To that end, the chamber suggests three actions that the Commission should consider taking:
  • The Commission should use its authority under the PSLRA to bar liability for statements about a company's plans or prospects for getting back to business, resuming sales or profitability, or other statements about the impacts of COVID-19, whether forward-looking or not, so as long as suitable warnings are attached.
  • Alternatively, the Commission should consider limiting liability for all such statements to circumstances in which the plaintiff can prove that the speaker had actual (subjective) knowledge of its falsity.
  • Finally, the Commission should require inclusion in financial statements of a statement reminding users that a number of the elements of financial statements are determined on the basis of projections of future business or market conditions and stating that due to the tremendous uncertainties flowing from the pandemic, there is a greater possibility of variation than in the past. The Commission should then bar liability for claims based on statements that satisfy these warnings or, alternatively, treat them as the equivalent of opinions.
The chamber requests that the Commission consider this issue and initiate the rulemaking process as soon as possible.