Monday, January 30, 2023

Cert. petition seeks remand of Liu net profits issues

By Mark S. Nelson, J.D.

A petition for certiorari filed in the U.S. Supreme Court seeks a remedy akin to a grant, vacate and remand (GVR) in order to have the lower federal courts properly apply the methodology established by the justices in Liu v. SEC. According to the petition, the district court, issuing its disgorgement order pre-Liu, used a calculation that would no longer be permitted under Liu, which was decided before the Seventh Circuit affirmed the district court’s disgorgement award to the SEC. The petition asks the justices to grant the petition, summarily reverse the Seventh Circuit, and then remand the case to the district court for a reconsideration of the disgorgement issue that is consistent with Liu or otherwise to strike the disgorgement award. Depending on whether a lower court finding is moot, the petition added, it also may be necessary for the SEC to show that it would be infeasible to distribute any disgorgement award to harmed investors (Goulding v. SEC, January 20, 2023).

Adviser Act allegations. Petitioner Randall Goulding became the target of an SEC enforcement action in 2009 in which the SEC alleged that Goulding violated numerous provisions of the Investment Adviser’s Act. Specifically, the petition recounts that the SEC claimed Goulding failed to keep accurate books and records, facilitated loans and other transfers of funds to third parties, used some funds for his personal use, facilitated valuation errors, and produced inaccurate quarterly reports.

The district court, in 2019, after holding a bench trial, found Goulding liable for the SEC’s civil charges. The district court also awarded the SEC disgorgement based on a calculation that relied on the difference between certain deposits and withdrawals, thus resulting in a disgorgement award of $642,422. In 2022, several years post-Liu, the Seventh Circuit affirmed the district court.

Net profits ignored? According to the petition, the disgorgement award ran afoul of the Supreme Court’s Liu opinion because it failed to account for both the net profits and investor benefit prongs of Lui’s methodology for calculating disgorgement amounts that are not penalties. The petition recited that, under Liu, a non-penalty disgorgement award must: (1) not exceed the defendant’s net profit from wrongdoing; and (2) be awarded for the benefit of investors.

Specifically, the petition asks three interrelated questions:
  • Does an award of disgorgement violate the principles announced by the Supreme Court in Liu where the defendant's withdrawals from a business were not linked to alleged wrongdoing in the context of a business that was at least partially legitimate and conducted in a non-fraudulent manner?
  • Can a district court shift the burden of calculating the amount of disgorgement to a defendant when the SEC is unable to make the calculation itself?
  • Can a district court order disgorgement to be sent to the Treasury when the SEC has not shown the infeasibility of distributing funds to known, aggrieved investors?
The first two questions can almost be collapsed into a single question because they both essentially turn on the petition’s asserted failure of the lower courts to use net profits as the touchstone for the disgorgement award. As a result, said the petition, the pre-Liu burden-shifting framework would only meet the demands of Liu if a disgorgement award were based on net profits and awarded for the benefit of investors. Moreover, the petition noted that the lower courts did not deduct from the disgorgement award legitimate revenues from some business activities.

With respect to infeasibility, the petition asserted that the district court and the parties are aware of the 328 investors who are individuals and entities that invested with Nutmeg Group as limited partners. As a result, the petition asks for the SEC to be required to provide a plan to distribute disgorged funds to harmed investors or, alternatively, for the SEC to demonstrate that such distribution is infeasible.

The case is No. 22-687.

Friday, January 27, 2023

Securities class actions declined in 2022 for fourth straight year, NERA report says

By John Filar Atwood

The number of new securities class actions filed in 2022 declined to 205 from 210 in 2021, the fourth consecutive year of the downward trend, according to research from NERA Economic Consulting. The NERA report attributes the four-year decline from 431 cases in 2018 partly to the smaller number of merger-objection and Rule 10b-5 cases filed.

The report also notes that the number of resolved cases, both dismissed and settled, fell to 214 in 2022 from 248 in 2021. The decline in resolutions reflected the decrease in dismissed non-merger-objection and non–crypto unregistered securities cases, according to the report.

The aggregate settlement amount for cases settled in 2022 was $4 billion, nearly $2 billion higher than the inflation-adjusted amount for 2021, NERA noted. More cases settled for higher values in 2022, with the average settlement value increasing by over 70 percent to $38 million.

According to NERA, the median settlement value in 2022 increased by over 50 percent to $13 million. The largest in 2022 was the $809 million settlement against Twitter for a case filed in California in 2016.

Filing trends. The report indicates that lawsuits against defendants in the health technology and services industry and the electronic technology and services sector were the most common in 2022, each accounting for 27 percent of total cases. Over the past four years there has been a drop in the aggregate number of cases filed in the Second, Third, and Ninth Circuits, but most of the new filings are still concentrated in those jurisdictions, the report notes.

One-third of the cases filed in 2022 included an allegation related to misled future performance, which was the most common allegation for the year, according to NERA. Cases with an allegation related to a regulatory issue comprised 26 percent of 2022’s filings compared to 19 percent in 2021.

Crypto cases. The report states that there were 25 crypto-related federal class actions suits filed in 2022, up from 10 in 2021. Most of the 2022 cases (16 of 25) related to unregistered crypto securities. It was easily the highest annual total for crypto class actions since the first case was filed in 2016, the report notes.

The report briefly discusses ESG-related cases, noting that 2022 saw the settlement of a 2018 class action filed against CBS Corp. The suit, which alleged widespread workplace sexual harassment by CBS executives, settled for $14.75 million.

NERA tallied four cases related to allegations of bribery or kickbacks in 2022, and three that related to a cybersecurity breach. The number of Covid cases increased to 24 last year from 20 in 2021, while cases related to special purpose acquisition companies rose slightly from 24 in 2021 to 25 last year.

Attorneys’ fees and expenses. The report indicates that in 2022 aggregate plaintiffs’ attorneys’ fees and expenses amounted to $1.05 billion, the first time since 2018 that the number exceeded $1 billion. The total is more than double the 2021 aggregate amount of $512 million.

NERA notes that although there are year-to-year fluctuations in the aggregate fees and expenses, the trend in the median of plaintiffs’ attorneys’ fees and expenses as a percentage of settlement amount has remained stable. Fees and expenses represent an increasing percentage of settlement value as settlement value decreases, the report states. For 2022 settled cases with a settlement value of $1 billion or higher, fees and expenses accounted for 8.8 percent of the settlement value but increased to more than 30 percent for cases with a settlement value under $10 million.

Thursday, January 26, 2023

SEC re-proposes ABS conflicts of interest rule

By Rodney F. Tonkovic, J.D.

In its first open meeting of 2023, the SEC unanimously approved the re-proposal of a 2011 rule prohibiting certain conflicts of interest in the context of asset-backed securities. Proposed Rule 230.192 would implement Securities Act Section 27B and prohibit transactions involving or resulting in material conflicts of interest between a securitization participant and an investor in an asset-backed security. The rule would apply to the underwriter, placement agent, initial purchaser, or sponsor of an ABS and prohibits entering into certain conflicted transactions. Comments are due 30 days after publication in the Federal Register or March 27, 2023, whichever is later (Prohibition Against Conflicts of Interest in Certain Securitizations, Release No. 33-11151, January 25, 2023).

Section 27B. In the aftermath of the late-2000s financial crisis, the 2010 Dodd-Frank Act added Section 27B to the Securities Act. This section prohibits certain persons who create and distribute asset-backed securities ("ABS") from engaging in any transaction that would involve or result in a material conflict of interest with any investor within one year of the closing of the sale of the ABS. Section 27B is not effective until the Commission issues a final rule implementing this prohibition. To that end, in September 2011 the Commission proposed a new rule substantially incorporating the text of Section 27B while providing exceptions for certain activities. After two extensions, the comment period ended in February 2012. According to the Commission, the new proposal takes into account feedback on the earlier release and developments in the market since that time.

Proposed rule. The proposal would add new Securities Act Rule 192 to implement the prohibition outlined in Section 27B. The proposed rule would apply to an underwriter, placement agent, initial purchaser, or sponsor of an ABS. For the purposes of the rule, "asset-backed security" would have the same meaning as used in Section 3 of the Exchange Act (covering both registered and unregistered offerings) and would further encompass synthetic asset-backed securities and hybrid cash and synthetic asset-backed securities.

Chair Gensler said: "This re-proposed rule is designed to help address conflicts of interest arising with market participants taking positions against investors' interests. Further, as required by Section 621 of the Dodd-Frank Act, the re-proposed rule provides exceptions for risk-mitigating hedging activities, bona fide market making, and certain liquidity commitments. These changes, taken together, would benefit investors and our markets."

Conflicted transactions. At its core, the proposing release says, the rule is intended to "prevent the sale of ABS that are tainted by material conflicts of interest." The rule would prohibit a securitization participant from directly or indirectly entering into such a "conflicted transaction" for one year after the date of the first closing of the sale of the ABS. For the purposes of the rule, a "conflicted transaction" means:
  • A short sale of the ABS;
  • The purchase of a CDS or other credit derivative pursuant to which the securitization participant would be entitled to receive payments upon the occurrence of a specified adverse event with respect to the ABS; or
  • The purchase or sale of any financial instrument (other than the relevant ABS) or entry into a transaction through which the securitization participant would benefit from the actual, anticipated, or potential: adverse performance of the asset pool supporting or referenced by the ABS; loss of principal, default, or early amortization event on the ABS; or decline in the market value of the ABS.
There is also a materiality component: there must be a substantial likelihood that a reasonable investor would consider the transaction important to the investor's investment decision, including a decision whether to retain the ABS.

Exceptions. As set forth in Section 27B, the proposed rule carves out exceptions for risk-mitigating hedging activities, liquidity commitments, and bona fide market-making activities. A securitization participant relying on these exceptions would be required to implement programs to ensure compliance with the requirements applicable to the exceptions, including written policies and procedures. In addition, proposed Rule 192(d) would provide that transactions designed to circumvent the prohibition will be deemed to violate the rule.

Departures. During the meeting, the Commissioners each took a moment to mark the departures of Renee Jones, the Director of the Division of Corporation Finance, and General Counsel Dan Berkovitz. Appointed Director in June 2021, Jones will depart on February 3, 2023, and return to her previous faculty position at Boston College Law School. Her replacement will be the Division's current Deputy Director, Erik Gerding. Berkovitz, who was appointed General Counsel in November 2021, is leaving the SEC on January 31, 2023, after over three decades in public service, including stints at the CFTC as Commissioner and as General Counsel. He will be replaced by Megan Barbero, currently SEC Principal Deputy General Counsel.

The release is No. 33-11151.

Wednesday, January 25, 2023

Sullivan & Cromwell named as debtors’ lead counsel in FTX bankruptcy case despite objection

By Suzanne Cosgrove

Bankruptcy court Judge John Dorsey Friday approved Sullivan & Cromwell’s role as FTX debtors’ counsel, brushing aside a weeklong flood of filings, prominent among them an objection filed by Andrew R. Vara, U.S. Trustee. Vara said S&C’s disclosures were “wholly insufficient” to evaluate whether the firm was conflict-free in a case that involves ongoing investigations (In re FTX Trading Ltd., January 20, 2023, Dorsey J.).

FTX filed for Chapter 11 bankruptcy protection on November 11, 2022, and John J. Ray III, an attorney with a history of specializing in bankruptcy restructuring cases, including that of Enron, took over as CEO. Sam Bankman-Fried, the former FTX CEO, is under house arrest in California awaiting trial on various fraud charges.

As previously reported by Securities Regulation Daily, Judge Dorsey earlier dismissed objections to Sullivan & Cromwell’s retention by a bipartisan group of four U.S. senators who sent a letter to the court that argued the law firm had a conflict of interest in the case. They also urged the judge to appoint an independent examiner to investigate the cryptocurrency company’s collapse.

Quinn Emanuel Urquhart & Sullivan, LLP has been approved as special counsel and AlixPartners, LLP as a forensic investigation consultant.

Sparse application details. According to the trustee’s filing, Vara’s concerns included the fact that Ryne Miller, “one of the most senior attorneys within the FTX organization” and identified in some documents as FTX US’s former general counsel, was a partner at Sullivan & Cromwell until about 14 months before the cryptocurrency exchange filed for bankruptcy. Sullivan & Crowell’s application failed to provide any detail about the type of services S&C provided to the debtors, including as the debtors were collapsing, he said. In addition, “S&C’s close connection with an insider of the debtors also renders S&C too conflicted to investigate debtors’ downfall,” he said.

Insider also files objection. On Thursday, former FTX attorney Daniel Friedberg–who had once been the exchange’s chief regulatory officer – weighed in, filing a declaration in support of an amended objection of Warren Winter to an order authorizing the retention and employment of the law firm. His declaration indicated Miller was a partner at Sullivan & Cromwell LLP, with a background in CFTC licensing and SEC matters, when he was hired as general counsel of FTX.US and counsel for Alameda, as well as FTX International. According to Friedberg, Miller’s salary was paid by FTX.US and Alameda, but he also performed services for FTX International.

Objectors Warren Winter and Richard Brummond then filed an emergency ex parte application for adjournment of the Friday hearing on an order authorizing the employment of Sullivan & Cromwell, but the request was denied, and the court proceeded as scheduled.

Current FTX CEO backs S&C. John J. Ray III, took the other side of the argument, Tuesday filing a declaration in support of Sullivan & Cromwell’s hiring, as well as Quinn and Alix.

Under a heading titled “Putting Out a Dumpster Fire–Our First 70 Days,” Ray said the “advisors are not the villains in these cases. The villains are being pursued by the appropriate criminal authorities largely as a result of the information and support they are receiving at my direction from the debtors’ advisors.”

In an interview with the Wall Street Journal published Thursday Ray also said he has set up a task force to explore restarting FTX.com, the company’s international exchange. He told the Journal that some customers like the platform’s technology, which suggests there might be value in reviving it.

Wresting control of a “chaotic” situation. “Given the terrible state of the debtors (when the bankruptcy filing was made) and the challenges left behind by the founders, having immediate access to the entire S&C team has been critical to bringing order to what was quite literally an out of control, chaotic situation,” Rays said in his filing.

“If the retention of any of S&C, Quinn or Alix were to be denied, limited or impaired for any reason, the interest of the Debtors’ customers and creditors, as well as the state and federal regulators and prosecutors with whom these advisors engage on a daily basis, would be severely, if not irreparably harmed,” he said.

Ray said he would directly supervise the work of S&C, Quinn and Alix. As for Ryne Miller, he said Miller is employed by Debtor West Realm Shires, Inc., “but has no day-to-day responsibilities.”

The case is No. 22-11068-JTD Doc 553, January 20, 2023.

The case is No. 22-11068-JTD Doc 548, January 20, 2023.

The case is No. 22-11068-JTD Doc 546, January 20, 2023.

The case is No. 22-11068-JTD Doc 496, January 13, 2023

The case is No. 22-11068-JTD Doc 530, January 19, 2023.

The case is No. 22-11068-JTD Doc 535, January 19, 2023.

The case is No. 22-11068-JTD Doc 511, January 17, 2023.

Tuesday, January 24, 2023

SOX whistleblower asks High Court to clarify burden of proof

By Anne Sherry, J.D.

A former employee of UBS who lost a retaliation suit under Sarbanes-Oxley is appealing to the Supreme Court. The Second Circuit held that retaliatory intent is a required element of a whistleblower claim, particularly given the statute’s admonition that an employer not “discriminate … because of whistleblowing.” But the whistleblower’s cert petition argues that Sarbanes-Oxley shifts the burden to the employer to prove a lack of retaliatory intent as an affirmative defense (Murray v. UBS Securities, LLC, January 13, 2023).

The employee was a commercial mortgage-backed security strategist and executive director at UBS Securities. He claimed that CMBS division personnel pressured him to create reports bolstering the company’s activities, regardless of his independent, research-based opinions to the contrary. Rather than succumb to the pressure, the employee complained to his superiors and continued to turn out honest reports. Nine months later, he was fired. The employee sued for retaliatory termination under both the Dodd-Frank Act and Sarbanes-Oxley Act Section 806(a), with UBS maintaining that it terminated him as part of a reduction in staff during an economic downturn. The district court dismissed the Dodd-Frank whistleblower protection claim, but the SOX claim survived.

The Second Circuit reversed, holding that SOX requires a whistleblower to prove retaliatory intent. Under the statute, no covered employer “may discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee … because of whistleblowing.” Discriminatory action “because of” whistleblowing requires retaliatory intent, the court reasoned. The court had previously interpreted nearly identical language in the Federal Railroad Safety Act as requiring evidence of retaliatory intent, another reason to interpret SOX consistently with that holding.

In his petition for certiorari, the whistleblower points to the burdens of proof incorporated by reference in the SOX provision (“An action brought under paragraph (1)(B) shall be governed by the legal burdens of proof set forth in section 42121(b) of title 49, United States Code.”). That section in turn requires the whistleblower to make a prima facie showing that the protected conduct “was a contributing factor in the unfavorable personnel action.” According to the petitioner, once the whistleblower meets his burden of showing that the whistleblowing was a “contributing factor,” the burden shifts to the employer to demonstrate that it would have taken the adverse action anyway.

This burden-shifting framework, common to at least ten other whistleblowing statutes, derives from the Whistleblower Protection Act of 1989, whereby Congress replaced a standard that imposed an “excessively heavy burden” on employees. The petition states that the new contributing-factor standard was specifically intended to overrule existing case law and that the bill’s sponsor said the word “contributing” does not require plaintiffs to produce any evidence proving a retaliatory motive.

According to the petitioner, the Second Circuit’s decision created a circuit split by departing from the Fourth, Fifth, Ninth, and Tenth Circuits, none of which require SOX whistleblowers to prove their employer’s improper motive as part of their case in chief. The question presented is important because the SOX whistleblower provisions are critical to the integrity of the national economy; the statute is meant to provide uniform protection to whistleblowers; the appeals court’s position conflicts with the position of the Department of Labor; and the Supreme Court’s resolution of the dispute would benefit the other whistleblower statutes that incorporate the burden-shifting framework.

Finally, the petition urges that this case is the right vehicle for resolving the question presented. Every other issue related to liability has been decided in the petitioner’s favor. The extensive record shows that the petitioner met the standard used in the circuits outside the Second, and the Second Circuit recognized that the jury found the whistleblowing activity was a contributing factor to the petitioner’s termination. The jury also found that UBS had not shown it would have fired the petitioner if not for the whistleblowing activity. If the Second Circuit had not required proof of retaliatory intent, it would have affirmed the jury’s verdict in the petitioner’s favor.

The case is No. 22A-438.

Monday, January 23, 2023

Nexo agrees to settle SEC, state crypto charges for $45 million

By Mark S. Nelson, J.D.

Among the factors fueling the ongoing uptick in SEC crypto enforcement actions is the agency’s focus on crypto firms whose products and services bear the hallmarks of lending platforms and has meant the SEC is more frequently citing Reves, a Supreme Court opinion defining when notes are securities, in additional to the Howey standard that has dominated SEC crypto enforcement previously. The latest such case involved Nexo Capital Inc., which agreed to pay the SEC $22.5 million and to pay multiple state jurisdictions over $24 million. Nexo settled the SEC’s charges without admitting or denying the agency’s findings (In the Matter of Nexo Capital Inc., Release No. 33-11149, January 19, 2023).

SEC Chair Gary Gensler remarked on the settlement via press release. “Compliance with our time-tested public policies isn’t a choice,” said Gensler. “Where crypto companies do not comply, we will continue to follow the facts and the law to hold them accountable.”

EIP product. According to the SEC, Nexo offered its Earned Interest Product (EIP) to U.S. investors. Investors would tender crypto to Nexo, which would then place the crypto in interest-bearing accounts and use the crypto to generate further profits, all the while paying interest to investors for the use of their crypto. There were flexible and fixed versions of the EIP in which “flexible” investors could make withdrawals of crypto and interest at any time, but “fixed” investors’ crypto and interest were locked-up for a stated period of time before they could be withdrawn.

The SEC’s order stated that, as of March 2022, Nexo had 3.7 million global users and $13.7 billion in global assets; U.S. investors numbered 112,000 and U.S. assets totaled $2.7 billion.

The SEC alleged that Nexo sold the EIP without a registration statement and without a valid registration exemption. The SEC also said the EIP constituted investment contracts and notes and, thus, were securities. Under the Supreme Court’s Reves opinion, notes are compared against products that are not securities and if a family resemblance between these two groups of products is lacking, the item in question may be a security. Here, the SEC emphasized that Nexo used investor funds for its lending operations and to pay interest to EIP investors, EIP was sold to a wide segment of the public, EIP was promoted as an investment, and there was no alternative to the SEC’s regulatory regime to oversee EIP.

The SEC made similar arguments to the effect that EIP investments also were investment contract and, thus, securities under the Supreme Court’s Howey opinion. Among other things, the SEC said EIP funds were pooled such that EIP investors’ fortunes rose/fell together; EIP funds also were deployed by Nexo for its own profit, so Nexo’s fortunes were likewise joined to those of EIP investors. Moreover, Nexo created a reasonable expectation that it would use its managerial and entrepreneurial efforts to generate profits for others.

Settlement terms. The SEC charged that Nexo violated Securities Act Sections 5(a) and 5(c) by engaging in the EIP program without a registration statement or valid registration exemption. The settlement, which Nexo entered without admitting or denying the SEC’s findings, requires Nexo to cease and desist from further similar violations of the federal securities laws and to pay a civil money penalty of $22.5 million.

A key driver of the settlement was that Nexo voluntarily began to shut down its U.S. operations in February 2022 after the SEC brough charges against a similar crypto scheme. By December 2022, the SEC said Nexo had stopped taking EIP investment in some states and planned to phase-out all U.S. products and services soon after April 1, 2023.

State settlement. Nexo also agreed to settle state charges brought by New York, California, Indiana, Kentucky, Maryland, Oklahoma, South Carolina, Vermont, Washington, and Wisconsin. Under the settlement, each member jurisdiction in the North American Securities Administrators Association may claim at least $424,000 of the total $22.5 million settlement. New York obtained an additional $1.5 million related to charges that Nexo offered and sold unregistered securities on its Nexo Exchange, bringing New York’s total recovery to $1.9 million, and the total state settlement amount to more than $24 million.

For its part, Nexo must pay a combined fine of $24 million to resolve the state charges. In New York, for example, Nexo also will be subjected to a five-year securities industry bar and the company must tell its EIP investors to withdraw their funds by April 1, 2023. Nexo also must segregate investor funds and cannot use them for speculative activities.

New York Attorney General Letitia James addressed via press release the notion that crypto firms are above the law. “Nexo ignored repeated warnings by my office to register and today they are paying the price for their wrongdoing,” said James. “The days of crypto companies acting like the rules do not apply to them are ending.”

The release is No. 33-11149.

Friday, January 20, 2023

Mighty Earth makes whistleblower submission to SEC over JBS green bonds

By Mark S. Nelson, J.D.

The climate group Mighty Earth has filed a whistleblower submission with the SEC in which it asks the agency to investigate potential securities fraud at the Brazilian company JBS SA, one of the largest meat packing companies in the world, regarding how JBS made certain determinations and calculations about a green bond issuance. Mighty Earth said in a press release announcing its submission that JBS’s actions amounted to greenwashing.

Growing emissions. According to Mighty Earth, JBS’s issuance of green bonds or sustainability-linked bonds was premised on a goal of achieving net zero emissions by 2040, but that in reality the determinations made in creating the bonds omitted information about the company’s Scope 3 emissions, which allegedly account for 97 percent of the company’s carbon footprint.

“The fact that the meat company arguably responsible for more climate pollution and deforestation than any other in the world was able to raise $3.2 billion through green bonds is an indictment of the utter lack of safeguards in the world of ESG investing,” said Mighty Earth’s CEO Glenn Hurowitz. “JBS’ success in duping investors shows that SEC needs to step in right away to set clear rules about what does or doesn’t count as sustainable.”

According to Hurowitz, JBS’s Scope 3 emissions would include items such as animal slaughter operations, methane emissions, and deforestation. Hurowitz further claimed that JBS’s carbon footprint was growing, not declining, during the relevant time period. Hurowitz cited data showing JBS’s emissions grew between 17 percent to 56 percent over the five-year period from 2016 to 2021.

Mighty Earth’s press release also linked to a second party opinion provided to JBS by ISS ESG. That document also noted the absence of Scope 3 emissions data.

In a related LinkedIn post, Hurowitz emphasized the need to look beyond companies’ self-reported data. Said Hurowitz: “More broadly, we believe that this case shows how investors need to look at the actual performance of companies, and not just rely on self-reporting and greenwashing. SEC should explicitly require Scope 3 emissions be included in reporting.”

Hurowitz’s post later added: “I hope SEC acts. But our ultimate aspiration is that JBS and the meat industry transform so this kind of case is unnecessary.

Thursday, January 19, 2023

Petition asks SEC to clarify policies on credit ratings agencies

By Rodney F. Tonkovic, J.D.

A group of researchers and policy advisors has asked the SEC to clarify certain aspects of its policies concerning credit ratings agencies. The petition asks the Commission to clarify policies that are contrary to the Dodd-Frank Act in that the reforms mandated by Congress in the Act remain unfulfilled. To that end, the petitioners propose that the Commission: clarify that Office of Credit Ratings annual reports will include NRSRO names; clarify that NRSROs are subject to liability under Section 11; and clarify how Regulation FD applies to NRSROs. The petitioners believe that these clarifications could be implemented immediately based on the Commission's current statutory authority.

Objectives. A primary goal of the petitioners is to put relevant academic research in front of the Commission to help ensure its approach is consistent with the Dodd-Frank mandate. According to the petition, scholars started to take a more critical view of credit ratings agencies in the late 90s. In this "regulatory license" view, the market for credit ratings was distorted by the fact that regulators and market participants relied on credit ratings when making substantive legal rules.

After the 2007-2008 financial crisis, government investigations found that credit ratings agencies were key enablers. The Dodd-Frank Act subsequently amended the securities laws to enhance the accountability and oversight of credit ratings agencies.

The petitioners lament the fact that the same dangers and market distortions that led to the financial crisis potentially remain today. The credit ratings market is once again dominated by a few major players: "Simply put, credit ratings remain enormously important but have little informational value," the petition says.

While the SEC has made efforts to remove NRSRO references from its rules, many institutions continue to rely on credit ratings. The petition focuses on three areas where there are ongoing and significant risks that can be addressed and then minimized by the Commission. Doing so would also comply with the Dodd-Frank statutory mandate.

NRSRO names. The petition first asks that the Commission clarify that Office of Credit Ratings ("OCR") annual reports will include NRSRO names. There are currently nine credit ratings agencies registered as NRSROs. Moody's and S&P dominate the market, and the rest are significantly smaller. The OCR is required to examine each NRSRO and produce an annual report of any material regulatory deficiencies. While serious deficiencies have been documented, the OCR does not identify which NRSRO was involved.

The petition accordingly proposes that the OCR describe violations more precisely. The current transparency failures conflict with the Dodd-Frank mandate that information about credit ratings be freely available and easily accessible. Naming names would help hold ratings agencies accountable and should be implemented through a stated change in policy, the petition says.

NRSRO liability. Next, the Commission should clarify that NRSROs are subject to liability under Section 11. Dodd-Frank stripped NRSROs of their insulation from liability for misstatements incorporated into offering documents. Soon thereafter, however, a no-action letter allowed credit ratings disclosure to be omitted from a prospectus, and this relief soon became permanent. The petitioners view this as flouting the obvious intent of Congress.

The petitioners argue that credit ratings agencies enjoy the profits from their ratings without the risk of liability as experts under Section 11. So, the petition proposes that the Commission make it clear that NRSROs are subject to liability under Section 11, which does not require new rules and could be accomplished through a policy statement. Alternatively, the Commission could just withdraw its 2010 no-action letter.

Regulation FD. Finally, the Dodd-Frank Act also required that the SEC revise Regulation FD to remove an exemption for entities whose primary business is credit ratings. In implementing this requirement, the Commission deleted the provision exempting NRSROs but noted potential circumstances under which NRSROs could continue to receive selective disclosures of material non-public information—that is, they could claim an exemption as "temporary insiders."

The petitioners are divided on this issue: some see the value in credit ratings agencies being able to consider additional information under Regulation FD, while others believe that issuers are flatly prohibited from disclosing inside information to NRSROs. All agree, however, that the market would benefit from the Commission clarifying its stance in a policy statement.

The petition is No. 4-799.

Wednesday, January 18, 2023

FINRA adds financial crimes section to its annual examinations report

By John Filar Atwood

FINRA’s 2023 report on its examinations and risk monitoring program includes a new section on financial crimes with staff insights that originated from FINRA’s market surveillance activities. The report, which is intended to help member firms enhance their compliance programs, also covers the following topics that were not included in previous reports: manipulative trading, fractional shares, Regulation SHO, and fair pricing for fixed income securities.

The report covers 24 topics in total and identifies the applicable rules for member firm compliance programs, summarizes noteworthy findings from recent examinations, and outlines effective practices that FINRA observed. Along with the new topic areas, this year’s report highlights topics of perennial interest such as cybersecurity, the consolidated audit trail, and order handling and best execution.

Financial crimes. In the new financial crimes section, FINRA said that in the area of cybersecurity and technological governance it has observed instances of ineffective account access authentication, such as a lack of multifactor authentication for login access to the firm’s systems. It also has observed ineffective processes for validating the identity of customers opening new accounts or detecting suspicious activity associated with the opening of new accounts.

Other problems include firms implementing a generic identity theft prevention program that is not adequate for the firm’s size and complexity. In addition, the staff found instances where firms were notmonitoring network activity to identify unauthorized copying or deletion of customer or firm data, and not monitoring outbound emails to identify sensitive customer data in text or attachments.

Effective practices undertaken by firms include completing regular backups of critical data and systems and ensuring the backup copies are encrypted and stored off-network. Some firms regularly assess their cybersecurity risk profile based on changes in the firm’s size and business model and newly identified threats, and some monitor the internet for any new imposter domains that pretend to represent the firm or a registered representative, FINRA noted. The staff also approved of firms that have implemented systems that scan outbound email text and attachments to identify and potentially block sensitive customer information or confidential firm data.

Manipulative trading. In the area of manipulative trading, the staff observed instances where firms did not identify specific steps and individuals responsible for monitoring for manipulative conduct. Other firms did not design and establishing surveillance controls to capture manipulative trading or did not adequately monitor customer activity for patterns of potential manipulation, according to FINRA.

Effective practices identified by FINRA include maintaining and reviewing customer and proprietary data to detect manipulative trading schemes, and monitoring activity occurring across multiple platforms, that also may involve related financial instruments or multiple correlated products. The staff also observed instances where firms designed a robust surveillance program to detect firms’ customers engaging in potential momentum ignition trading, and developed a robust supervisory system to safeguard material, non-public information to prevent front running and trading ahead.

Fixed income fair pricing. In this section of the report, FINRA noted that some firms are determining the prevailing market price incorrectly by not following the contemporaneous cost presumption or the waterfall required by FINRA Rule 2121 and MSRB Rule G-30. Firms also are using mark-up/mark-down grids without periodically reviewing and updating them and charging substantial mark-ups in short-term fixed-income securities that may significantly reduce the yield received by the investor.

Appropriate practices in this area include documenting the prevailing market price for each transaction, even if it does not require a mark-up disclosure, and conducting periodic reviews of the firm’s mark-ups/mark-downs and comparing them with industry data provided in industry analysis reports. The staff also found the effective use of exception reports or outside vendor software to ensure compliance with FINRA Rule 2121 or MSRB G-30, including periodic reviews and updates of the reports’ parameters so they perform as intended as market conditions change.

Regulation SHO. On this topic, FINRA staff indicated that it has seen instances where firms have failed to distinguish bona fide market making from other proprietary trading activity that is not eligible to rely on Reg. SHO’s bona fide market making exceptions. Those have included quoting only at maximum allowable distances from the inside bid/offer, posting quotes at or near the inside ask but not at or near the inside bid, only posting bid and offer quotes near the inside market when in possession of an order, and displaying quotations that are not firm and are only accessible to a small set of subscribers to a firm’s trading platform.

The staff said that it has also seen firms relying on the guidance under Question 4.4 of the SEC’s Reg. SHO FAQ but not taking steps to confirm that locates are not reapplied to short sales of threshold or hard to borrow securities. Some firms do not have a process in place to prevent the execution of any short sale orders in threshold or hard to borrow securities that involve the application of locates, the staff added.

According to FINRA, effective practices include developing supervisory systems for, and conducting supervisory reviews of, market making activity to ensure that any reliance on Reg. SHO bona fide market making exceptions is appropriate. The staff also encouraged firms to develop appropriate policies and procedures to adhere to the guidance provided in Question 4.4 of the SEC’s Reg. SHO FAQ.

Tuesday, January 17, 2023

New study on Exxon internal climate change forecasts could fuel lawsuits

By Lene Powell, J.D.

Providing possible new fuel for securities fraud lawsuits, a new study published in Science found that Exxon’s internal projections on climate change accurately forecast warming consistent with subsequent observations. Exxon’s projections were also consistent with independent academic and government models. The findings are potentially significant because they could provide support for securities fraud lawsuits alleging that Exxon’s internal predictions were accurate and inconsistent with public representations.

Study finds Exxon predictions were largely accurate. The study is the first systematic quantitative evaluation of Exxon internal modeling of the effect of fossil fuels on climate change.

According to the study, Exxon internal memos were previously made public that indicated Exxon has known since the late 1970s that its fossil fuel products could lead to global warming with “dramatic environmental effects before the year 2050.” However, numerical and graphical data produced by Exxon scientists visually demonstrating this has received little attention, the study says.

The study found:
  • In private and academic circles since the late 1970s and early 1980s, ExxonMobil predicted global warming correctly and skillfully;
  • 63 to 83 percent of the climate projections reported by ExxonMobil scientists were accurate in predicting subsequent global warming;
  • ExxonMobil scientists correctly dismissed the possibility of a coming ice age in favor of a “carbon dioxide induced ‘super-interglacial’”;
  • ExxonMobil scientists accurately predicted that human-caused global warming would first be detectable in the year 2000 ± 5;
  • ExxonMobil scientists reasonably estimated how much CO2 would lead to dangerous warming.
The study was conducted by G. Supran, S. Rahmstorf, and N. Oreskes. Funding information cites the Rockefeller Family Fund grant and Harvard University Faculty Development Funds.

Implications for securities fraud lawsuits. According to the study, while ExxonMobil Corp and Mobil’s public communications promoted doubt about climate change, internal documents as well as peer-reviewed Exxon and ExxonMobil studies overwhelmingly acknowledged that climate change is real and human-caused.

Quantitative demonstrates that internally, Exxon was accurately predicting that carbon emissions would cause climate change, while publicly downplaying or denying these effects, could provide ammunition for securities fraud lawsuits. But first investors would have to show that Exxon did deceptively downplay the effects of carbon emissions caused by its products.

From a slightly different angle, the New York State Attorney General sued Exxon Mobil in 2018, alleging that the company misled investors regarding the risk that climate change regulations posed to its business. Exxon Mobil won dismissal of the action in 2019 when the court found that the Attorney General did not show that Exxon obscured the true costs to its business.

Notably, in that case, the judge stated, “Nothing in this opinion is intended to absolve ExxonMobil from responsibility for contributing to climate change through the emission of greenhouse gases in the production of its fossil fuel products. ExxonMobil does not dispute either that its operations produce greenhouse gases or that greenhouse gases contribute to climate change.”

Investors would need to clear hurdles in piecing together securities fraud actions using the results of the new study. Investors would need to show that any contradictions between Exxon’s public statements and internal forecasts were material misrepresentations or omissions; that the investors relied on the misrepresentations; and that they were damaged as a result. Proving the elements of securities fraud sufficiently to satisfy pleading standards could be challenging.

But even if any such lawsuits fail, Exxon Mobil will likely face new ESG-related reckonings based on the new revelations about its accurate assessments of the effect of carbon emissions on climate change.

Monday, January 16, 2023

Dr. King's Universal Appeal Will Never Fade

[In commemoration of Martin Luther King, Jr. Day, we republish a post by the late Jim Hamilton from January 18, 2010, honoring Dr. King and his legacy.]

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

In our age of sometimes bitter legislative partisanship, let us pause to remember the lessons of Dr. Martin Luther King, who we honor today. Dr. King appealed to our common humanity and a shared sense of social justice. I am fairly certain that, if he had seen our recent financial disaster, Dr. King would have decried the short-term risk taking and excessive bonuses. In his letter from a Birmingham jail, Dr. King wrote that, lamentably, it is an historical fact that privileged groups seldom give up their privileges voluntarily. Individuals may see the moral light and voluntarily give up their unjust posture; but, groups tend to be more immoral than individuals. Amen to that, Dr. King, and thank you for liberating the South from itself. I recently read that no international company, be it Toyota, BMW, Mercedes, or Siemens, would have ever come to and had a large presence in the segregated South. I believe that is a true statement.

Friday, January 13, 2023

SEC sues to compel Covington & Burling to disclose names of clients affected by cyberattack

By John Filar Atwood

The SEC has brought an action in the D.C. District Court seeking to compel multinational law firm Covington & Burling LLP to divulge the names of clients impacted by a November 2020 Microsoft Hafnium cyberattack. The Commission is investigating whether any persons involved in or impacted by the attack have been engaging in violations of federal securities laws through access to material, non-public information about Covington’s clients (SEC v. Covington & Burling LLP, January 10, 2023).

The facts, which are outlined in a declaration by an SEC enforcement attorney, indicate that cyber attackers gained unauthorized access to Covington’s IT network including access to non-public information of 298 of its clients that are regulated by the SEC. Covington admitted that a foreign actor intentionally and maliciously accessed its clients’ files.

As a result, the Commission, through its Enforcement Division, is investigating whether the attackers, or any other person, may have accessed and traded on the basis of material, non-public information concerning the cyberattack. The staff also is investigating whether any person may otherwise have made materially false or misleading statements, or omitted to state material facts, concerning the impact of the cyberattack in violation of federal securities laws.

Subpoena. As part of its investigation, the SEC issued a subpoena to Covington in March 2022 that called for the production of certain documents related to the attack. Covington complied with all elements of the subpoena except for the request (Request No. 3) for the name of any public companies that were impacted by the unauthorized activity, the nature of the suspected unauthorized activity concerning the companies, and any communications provided to the companies concerning the suspected unauthorized activity. The law firm refused Request No. 3 citing its confidentiality obligations under the D.C. Rules of Professional Conduct.

After lengthy negotiations on the matter, the SEC agreed to reduce Request No. 3 simply to the names of the 298 public companies impacted by the attack. However, the parties were still unable to reach an agreement, so the Commission is now seeking an order to compel compliance with the subpoena or an order to show cause why the first order should not be issued.

In support of its request, the SEC argued that neither Covington’s position as a victim of a cyberattack, nor the fact that it is a law firm, insulate it from the Commission’s investigative responsibilities. Further, the SEC claimed that the subpoena, including Request No. 3, satisfies all requirements for subpoena enforcement, does not infringe on any privilege, is not unduly burdensome, and would not cause Covington to violate the D.C. Rules of Professional Conduct.

Citing U.S. v. Powell, the Commission claimed that an administrative agency’s investigative subpoenas should be judicially enforced if the following criteria are met: 1) its investigation will be conducted pursuant to a legitimate purpose, 2) the subpoena seeks information that may be relevant to the purpose, 3) the information sought is not already within the SEC’s possession, and 4) all administrative steps required have been followed.

Legitimate purpose. The SEC reasoned that its inquiry has a legitimate purpose because it is being conducted pursuant to authority vested in the Commission by Congress. Congress gave the SEC broad authority to conduct investigations into whether any person has violated federal securities laws, the SEC notes, and in this case it is concerned that the cyber attackers viewed or extracted material non-public information.

The SEC needs access to the names of the 298 impacted clients, it claims, because it then can use its investigatory tools to identify any suspicious trading in those companies’ securities, and investigate whether such trading was part of an illegal trading scheme based on material non-public information obtained in the attack. The subpoena is within the scope of the Commission’s Congressionally-authorized law enforcement powers, it stated, and therefore has a legitimate purpose.

On the matter of whether the information sought by Request No. 3 is relevant to the investigation, the SEC noted that the Commission is investigating whether there have been violations of the federal securities laws in connection with the attack. The Commission added that the kinds of violation being investigated—possible insider trading and/or improper disclosure—are violations for which the agency has brought enforcement actions many times in the past.

The Commission confirmed that the information sought is not in its possession because Covington has refused to produce it and the SEC has no other way to obtain it. The SEC acknowledged that it can use its proprietary tools to survey the market for potential illicit trading in the shares of all publicly traded companies, but without knowing which companies are Covington’s clients, the staff would be unable to do that for companies involved in the attack.

Privileged and protected information. The SEC believes that Request No. 3 does not infringe on any privilege or the D.C. Rules of Professional Conduct. In its opinion, the subpoena does not call for protected information, and the Commission is not seeking privileged communications between Covington and its clients. Moreover, in agreeing to limit Covington’s response to Request No. 3 to only the names of impacted regulated clients, the SEC argued that it has eliminated the risk that any attorney-client communications would be responsive to the subpoena.

The SEC urged the court to agree with its view that the identity of clients impacted by the cyberattack is not privileged. The Commission noted that the list of 298 impacted clients is not protected work product prepared in anticipation of litigation. Rather, Covington prepared the list with the business intention of reaching out to inform clients that their information had been accessed.

The SEC further argued that even if the identity of impacted clients could be considered work product, the information would be factual work product over which the privilege doctrine is not absolute. The work product privilege is overcome, in the SEC’s view, because the Commission has a substantial need for the client list and cannot, without undue hardship, obtain its substantial equivalent by other means.

D.C. rules of conduct. The Commission believes that the D.C. Rules of Professional Conduct specifically permit law firms to produce client confidential information in response to a valid subpoena. It noted that D.C. Rule of Professional Conduct 1.6(a)(1) generally prevents an attorney from “knowingly... reveal[ing] a confidence or secret of the lawyer’s client.” However, Rule 1.6(e)(2)(a) provides an exception to the general rule and permits the lawyer to “reveal client confidences or secrets” when “required by law or court order.”

The SEC noted that the D.C. District Court has previously held that a subpoena is a court order subject to exception under Rule 1.6(e). Specifically, in a case relating to Cooke Legal Group, the court held that Rule 1.6 did “not bar [the law firm] from complying with the instant subpoena, but instead specifically permits the firm to do so” because of the application of the Rule 1.6(e) exception.

The Commission further noted that multiple other courts have interpreted similar provisions in state ethics rules to allow the production of documents in response to subpoenas from executive agencies, including subpoenas issued by the SEC. In cases such as Selevan v. SEC, FTC v. Trudeau and SEC v. Sassano, the courts held that a validly issued subpoena from an executive agency was sufficient to overcome the party’s objection under the Rule 1.6(e) exception. Accordingly, the SEC argued that its subpoena’s requested information falls squarely within the Rule 1.6(e) exception and requires Covington to produce responsive information.

The case is No. 1:23-mc-00002.

Thursday, January 12, 2023

CFTC brings its first oracle manipulation case on decentralized exchange

By Elena Eyber, J.D.

The CFTC filed an enforcement action in the federal district court in New York charging Avraham Eisenberg with a fraudulent and manipulative scheme to unlawfully obtain over $110 million in digital assets from a purported decentralized digital asset exchange. This is the CFTC’s first enforcement action for a fraudulent or manipulative scheme involving trading on a purported decentralized digital asset platform, and its first involving a scheme called “oracle manipulation” (CFTC v. Eisenberg, January 9, 2023).

“The CFTC will use all available enforcement tools to aggressively pursue fraud and manipulation regardless of the technology that is utilized,” said Acting Director of Enforcement Gretchen Lowe. “The CEA prohibits deception and swap manipulation, whether on a registered swap execution facility or on a decentralized blockchain-based trading platform.”

Oracle manipulation. The complaint alleges that on October 11, 2022, Eisenberg unlawfully misappropriated over $110 million in digital assets from Mango Markets, a purported decentralized digital asset exchange, through oracle manipulation. Eisenberg created two anonymous accounts on Mango Markets, which he used to establish large leveraged positions in a swap contract whose value was based upon the relative price of MNGO, the “native” token of Mango Markets, and USDC, a stablecoin. Eisenberg then artificially pumped up the price of MNGO by rapidly purchasing substantial quantities of MNGO on three digital asset exchanges that were the inputs for the oracle, or data feed, that Mango Markets used to determine the value of Eisenberg’s swap positions.

As a result of Eisenberg’s manipulative trading, the price of MNGO as reported by the oracle, jumped over 13-fold during a 30-minute span, resulting in a temporary, artificial spike in the value of Eisenberg’s swap positions. Eisenberg then cashed out his illicit profits by using the artificially inflated value of his swaps as collateral to withdraw over $110 million in digital assets from Mango Markets, essentially bankrupting the platform. Subsequently, in an attempt to evade liability, Eisenberg agreed to return a portion of the misappropriated digital assets on the condition that Mango Markets agreed to not pursue any criminal investigations or freezing of funds. Eisenberg ultimately returned $67 million to Mango Markets, while retaining $47 million worth of digital assets.

Relief sought. The CFTC seeks civil monetary penalties, disgorgement of any ill-gotten gains, restitution, permanent trading and registration bans, and a permanent injunction against further violations of the Commodity Exchange Act (CEA).

Statement of Commissioner Johnson. “It is imperative that all market participants understand that conduct like Eisenberg’s will be subject to enforcement action in accordance with our mandate. While there are many benefits to responsible innovation, customers must remain vigilant. Fraudsters who seek to take advantage of an unsuspecting public will exploit popular interest in innovative financial technology and perpetrate scams that separate investors from their hard-earned money. This case illustrates these dangers, underscores the ever-present threats, and demonstrates that—no matter the asset class—effective enforcement and customer protections must be among our highest priorities” said Commissioner Johnson in her statement.

Statement of Commissioner Pham. “This complaint makes clear that ‘perpetual futures’ can constitute swaps. A swap is a swap, even by any other name. I commend the relentless efforts of the Division of Enforcement staff to use the CFTC’s broad Dodd-Frank authority to aggressively pursue fraud and manipulation. Although some things—like technology—change, some things stay the same—like the CFTC’s mandate to protect the public and market integrity against wrongdoing” said Commissioner Pham in her statement.

The case is No. 1:23-cv-00173.

Wednesday, January 11, 2023

MSRB publishes criteria on business continuity and disaster recovery testing

By Anne Sherry, J.D.

The Municipal Securities Rulemaking Board published its criteria for designating participants in business continuity and disaster recovery testing. The SEC requires the MSRB to require registrants to participating in testing at least annually. Under its own rules, the MSRB designates mandatory participants in functional and performance testing.

Under the MSRB’s criteria, the Board will designate the top five MSRB registrants in each of three systems. The MSRB wrote that these selection criteria are designed to ensure participation by registrants reasonably determined to be the minimum necessary for the maintenance of fair and orderly markets should the MSRB need to activate its business continuity and disaster recovery plans.

For the Real-Time Transaction Reporting System, the MSRB will designate the five registrants with the most municipal security trades in a calendar month prior to the testing. For the Short-Term Obligation Rate Transparency system (SHORT), the MSRB will designate the top five registrants acting as program dealers for auction rate securities or marketing agents for variable rate demand obligations that reported interest rate resets to SHORT in a calendar month prior to testing. Finally, for the Electronic Municipal Market Access system (EMMA), the Board will designate the top five registrants by par amount underwritten in a calendar month prior to testing.

In all events, it is contemplated that the top five for each system accounts for at least 30 percent of activity on that system. If not, the MSRB will select however many top registrants are needed to collectively represent at least 30 percent of activity.

The MSRB will notify all selected participants at least 45 calendar days before the testing, providing information about the manner of testing and instructions for participation.

Tuesday, January 10, 2023

Commissioner Mersinger disagrees with CFTC’s Fall 2022 regulatory agenda

By Elena Eyber, J.D.

The CFTC has published the Fall 2022 regulatory agenda of rulemaking matters that it expects to propose or finalize over the next year. Commissioner Mersinger does not object to the rulemaking matters set out in the CFTC’s agenda but disagrees with the agenda’s: (1) withdrawal of two rule proposals based on recommendations from a CFTC Global Markets Advisory Committee (GMAC) report prepared by its Subcommittee on Margin Requirements for Non-Cleared Swaps; and (2) omission of proposals to amend several rules that Mersinger believes are “unworkable, ambiguous, and/or inefficient, and which have been the subject of never-ending staff no-action relief or other workarounds because the CFTC has failed to address these issues by rulemaking.”

Uncleared margin rules. The GMAC report made several recommendations to the Commission to tailor the CFTC’s uncleared margin rules to account for the practical and operational challenges arising when they are applied to financial end-users that have only recently come into scope of those rules, such as pension plans, endowments, insurance providers, and mortgage service providers. The Commission implemented four of the GMAC report’s recommendations. The Commission also included a proposed rulemaking to implement two more of these recommendations in its regulatory agenda that was published in the Spring 2022. This rulemaking would have proposed: 1) revising the definition of a margin affiliate to prevent triggering the requirement to exchange initial margin with certain eligible seeded investment funds for a limited, three-year period; and 2) eliminating a provision disqualifying securities in certain money market funds from being used as eligible initial margin collateral.

According to Mersinger, the Commission has withdrawn this proposed rulemaking from the agenda without an explanation. “Thoughtful consideration is now necessary as to whether the margin rules should appropriately be tailored to account for the unique, practical challenges posed by the exchange of margin when one of the counterparties is a financial end-user instead” said Mersinger. Further, Mersinger believes the proposals “would harmonize our margin requirements with the way these issues are handled by our international colleagues in other major market jurisdictions, which would enhance compliance and coordinated regulatory oversight.”

According to Mersinger, not putting them out as proposals for public comment wastes taxpayer dollars because the staff has already devoted significant resources to preparing a draft notice of proposed rulemaking regarding these two recommendations, ignores the value added to the CFTC’s policymaking by the Advisory Committees, disregards the hard work of GMAC members, and runs directly counter to the Commission’s core value of transparency to market participants about the CFTC’s rules and processes.

Failure to address unworkable rules. Mersinger noted that she has publicly commented on multiple instances in which the Commission has failed to address unworkable, ambiguous, or inefficient rules.

Mersinger pointed out that one of the examples of an unworkable rule is Rule 37.6(b). Rule 37.6(b) requires that a swap execution facility (SEF) provide each counterparty with a confirmation of the transaction. When it adopted this rule, the Commission explained that, for uncleared swaps, SEFs could satisfy the written confirmation requirement by incorporating by reference terms in agreements previously negotiated by the counterparties, provided that such agreements were submitted to the SEF ahead of execution. However, the Commission recognized that the proviso that a SEF must obtain such documentation from the parties to an uncleared swap ahead of execution was not workable and created impractical burdens for SEFs.

According to Mersinger, despite the Commission’s awareness of this defect, it has not amended Rule 37.6(b) to fix the problem. This has forced the staff to issue four no-action letters providing relief from this SEF confirmation requirement. Further, when the Commission has granted SEF registrations, it has had to include in its registration orders an extended discussion about the single issue of swap confirmations in order to ensure a level playing field by requiring new SEFs to comply with the same conditions that currently registered SEFs must comply with in order to rely on the staff no-action relief.

Lastly, Mersinger stated that excessive reliance on staff no-action relief diverts resources away from core agency responsibilities and into the processing of multiple requests for no-action relief simply to maintain the status quo. Additionally, Mersinger stressed that unworkable or unclear rules can neither be complied with by market participants nor justly enforced by the Commission, and only by adopting realistic rules that clearly define the CFTC’s expectations can the CFTC hold those who violate those rules accountable. Mersinger is disappointed that the CFTC’s agenda does not include notice-and-comment rulemakings to create long-term solutions to the known problems.

Monday, January 09, 2023

Bitcoin mining case spotlights the potential litigation risks of business model pivots

By Mark S. Nelson, J.D.

Shareholders of CleanSpark, Inc. adequately pleaded violations of the federal securities laws against the company in a putative class action suit alleging the company hid details of its business model change from the alternative energy and software markets to Bitcoin mining through the acquisition of a data center company that once was an asset of another company that went bankrupt. Because the complaint adequately alleged a primary violation of federal securities laws, the court also declined to dismiss controlling person claims against CleanSpark’s CEO and chair (Bishins v. CleanSpark, Inc., January 5, 2023, Preska, L.).

Merger critiqued as unrealistic. The crux of the case turns on CleanSpark’s business pivot away from alternative energy to software and ultimately to Bitcoin mining. The complaint alleged that CleanSpark sought to acquirer ATL Data Centers, Inc. with the goal of expanding ATL’s power capacity while simultaneously cutting ATL’s energy costs.

However, a report published by a short seller implied that previous attempts to merge ATL with another company fell through because ATL would soon lose its subsidized power rate. The short seller would later reveal that it believed CleanSpark had lowballed ATL’s mining costs. Both times the short sheller published reports on CleanSpark, CleanSpark’s stock price incurred significant drops.

The complaint bolstered claims made in the short seller’s report by including claims by confidential witness who was a former general manager of ATL’s bankrupt predecessor. According to the former manager, ATL’s earlier merger attempt was dogged by ATL’s certification lapses and safety issues. The former manager also said she believed CleanSpark’s CEO, Zachary Bradford, was aware of the prior troubles at ATL because he sent her comments in response to her revelations. The former manager also said the time frame for closing CleanSpark’s acquisition of ATL was unrealistic.

The plaintiffs filed a putative class action securities fraud case against CleanSpark. The class period was alleged to cover December 10, 2020, to August 16, 2021.

Omissions. The court addressed three sets of alleged material omissions by CleanSpark. First, CleanSpark’s CEO allegedly misled investors or omitted information about when ATL would become a corporate entity while also omitting information about the bankruptcy of ATL’s predecessor. The court concluded that the statements or omissions were actionable and that the PSLRA’s safe harbor for forward-looking statements was inapt because the statements involved historical facts rather than forward-looking statements.

In a second set of alleged misstatements, CleanSpark’s chair attempted to compare CleanSpark to other big players in the market that had become bullish on Bitcoin in an effort to validate CleanSpark’s strategy. CleanSpark argued that the statements were mere corporate puffery, but the court concluded that the statements were “too specific and too grounded in the present” to be puffery. The company’s chair also had not mentioned the earlier busted merger deal for ATL. As result, the omissions could be material.

Lastly, CleanSpark argued that its estimates of when ATL’s expansion would be completed were nonactionable puffery or opinions. However, the court concluded that the estimates were actionable and that the PSLRA’s safe harbor for forward-looking statements was again inapt, this time because the statements lacked meaningful cautionary language.

Scienter. The court first addressed whether CleanSpark’s omission of ATL’s corporate history met the scienter standard. Here, the court concluded that the complaint alleged a strong inference of scienter largely because CleanSpark executives would have known that the assets that would become ATL were still part of ATL’s predecessor’s bankruptcy proceedings.

Second, the court reasoned that scienter had been pleaded regarding the allegedly misleading estimated completion date for ATL’s expansion. CleanSpark argued that its executives’ statements were either puffery, opinions, or that a better interpretation of the statements existed, namely that the company’s CEO believed the estimate and that the former manager’s timeline was unpersuasive. The plaintiffs countered that the better inference was that CleanSpark’s CEO refused to accept that the estimate was wrong. According to the court, the complaint alleged that CleanSpark’s CEO told the former manager that her timeline was insufficient because he had already publicly offered a different timeline. As a result, the court concluded that the plaintiff’s inference was cogent and at least as compelling as CleanSpark’s inference.

Reliance. CleanSpark sought to counter any allegations in the complaint regarding the Basic presumption of reliance by arguing that the plaintiffs could not have relied on statements made after a date certain. However, the court said this argument was limited to statements made after that date but would not cover statements made before the date cited by CleanSpark and, thus, the presumption could apply to earlier statements.

CleanSpark also sought to counter the plaintiffs’ invocation of the Affiliated Ute presumption by arguing that the case was about affirmative misstatements. Here, the court reasoned that the complaint primarily alleged omissions, the subject matter of the presumption and, thus, the presumption applied.

Loss causation. The complaint largely pleaded loss causation via corrective disclosure predicated on the short seller’s reports. CleanSpark argued that the first short seller report was based on public information and did not reveal the omitted facts relied on by the plaintiffs. The plaintiffs countered that precedents show that the short seller report was still relevant and that the subject matter had been hidden in a distant company’s bankruptcy proceedings. According to the court, the plaintiffs’ understanding of the applicable precedents was correct and that loss causation can be based on third party analyses of public information. The court also expressed reservations about applying CleanSpark’s precedent at the motion to dismiss stage of the case.

The court also addressed the plaintiffs’ assertion that, with respect to CleanSpark’s estimates, the risk had materialized. The court briefly analyzed the complaint and concluded that it had sufficiently pleaded loss causation for the estimates arising from materialization of the risk.

The case is No. 1:21-cv-00511.

Friday, January 06, 2023

Court affirms SEC win in priestly short-and-distort scheme

By Anne Sherry, J.D.

The First Circuit affirmed a victory for the SEC against a hedge fund adviser charged with conducting a short-and-distort scheme. After a jury found the defendant liable for three false statements, he appealed on the basis that the First Amendment sheltered some of the statements and that the verdict had insufficient evidentiary support. But the statements were of fact, not opinion, and the verdict had a sufficient basis, the court reasoned (SEC v. Lemelson, January 3, 2023, Lynch, S.).

The Commission charged hedge fund adviser Gregory Lemelson and his investment advisory firm, Lemelson Capital Management, with scheming to drive down the price of a pharmaceutical company's stock. In May 2014, Lemelson took a short position in Ligand Pharmaceuticals Inc. on behalf of a hedge fund he advised and partly owned. According to the SEC, after establishing his short position, Lemelson made a series of false statements intended to shake investor confidence in Ligand, lower its stock price, and increase the value of his position. By October 2014, Lemelson had covered his short position and generated approximately $1.3 million in illegal profits.

The SEC won partial summary judgment and secured a guilty verdict in the ensuing jury trial. The Massachusetts district court judge ordered a civil penalty and five-year injunction. Lemelson appealed, arguing that his statements were protected by the First Amendment and that the SEC failed to introduce sufficient evidence to support the jury’s determination that the statements were of fact rather than opinion, were material, and were made with scienter.

Facts, not opinion. The first false statement at issue was Lemelson’s claim that Ligand’s investor relations representative had told him that its largest royalty-generating drug was “going away.” In another report concerning Ligand, Lemelson made two additional challenged statements: that a Ligand licensee (Viking) did not intend to conduct any preclinical studies or trials and that Viking’s financial statements were unaudited. The First Circuit disagreed that the statements concerning Viking were opinions that could enjoy First Amendment protection. Neither was prefaced by words signaling uncertainty, such as “I think” or “I believe.” Both were factually contradicted by Viking’s S-1, and Lemelson testified that he had been mistaken about the unaudited financials.

Materiality. The court also concluded that the SEC introduced sufficient evidence for a rational jury to find the three statements material. The Commission demonstrated the importance of the “going away” drug and the Viking license to Ligand’s bottom line and produced evidence showing that investors were alarmed and concerned about the statements and communicated these concerns to Ligand. The jury also considered evidence that Lemelson himself took credit for the decline in Ligand’s stock value.

Scienter. The court disagreed with Lemelson as to the sufficiency of the jury’s basis for finding scienter. The jury could have credited the IR representative’s testimony that he did not say the critical drug was “going away” and find that Lemelson intentionally or recklessly chose to misconstrue the conversation. A reasonable jury could also infer that Lemelson understood from the Viking S-1 that Viking’s financials were audited and that the company intended to manage preclinical studies and trials, but intentionally or recklessly made statements to the contrary. Lemelson testified that he studies the S-1 carefully and that he knew a Form S-1 cannot be filed without audited data. Furthermore, Lemelson’s portfolio had a substantial short position that, while not by itself proving scienter necessarily, could be the basis for an inference that Lemelson would have carefully researched Viking and thus been aware that his statements were misleading.

Injunction. Finally, the district court did not abuse its discretion in imposing an injunction. The district properly weighed the three relevant factors for imposing an injunction by examining the egregious nature of the violation, noting that Lemelson would be in a position to violate Section 10(b) and Rule 10b-5 again due to his occupation as an investment adviser and hedge fund manager, and determining that Lemelson had failed to recognize the wrongfulness of his conduct. Lemelson leaked confidential information about the lawsuit to the press and said in post-verdict argument that he would “never regret the things [he] did.” The district court also contrasted Lemelson’s case with other cases involving egregious conduct, finding that his violation lay somewhere in the middle of the spectrum of egregiousness, and issued only a five-year injunction accordingly.

The case is No. 22-1630.

Thursday, January 05, 2023

2022 produces fewest IPOs since 2016

By John Filar Atwood

From the outset it was clear that the 2022 IPO market could not possibly match the record-breaking pace of 2021, and it turns out that it could not duplicate the four years before that either. The year produced 175 IPOs, the lowest annual deal total since 2016’s 117 new issues. Measured by aggregate proceeds, the $19.8 billion raised in the 175 offerings was the smallest amount since 2003 ($17.7 billion) and the second lowest total in 30 years. The year ended slowly with seven new issues in December, one more than in November but well below the 61 IPOs completed last December. The last two deals of the year were completed by Coya Therapeutics and Alpha Time Acquisition. Coya, a developer of T-cell enhancement therapies, raised $15 million in its public market debut last week. Sixteen pharmaceutical preparations companies went public in 2022, accounting for nine percent of the year’s deals. Blank check Alpha Time Acquisition was in public registration for a little more than three weeks, far less than the 2022 average of 126 days in registration for IPO companies.

New registrants. The week’s activity included five new registrations, all of which were filed by non-U.S. entities. Prepackaged software companies IMMRSIV and Ruanyun Edai Technology registered their plans for offerings in the U.S. Singapore-based IMMRSIV provides software solutions with a focus on education, training, and tourism. Ruanyun Edai offers AI-based education services at the K-12 levels in China. Prime Number Capital, the lead underwriter for IMMRSIV, also was hired by new registrant Galaxy Payroll Group. Galaxy is a British Virgin Islands-incorporated holding company that operates out of Hong Kong. Through subsidiaries, the company provides payroll outsourcing services in China. Earlyworks became 2022’s sixth U.S. IPO registrant that is headquartered in Japan. The company uses blockchain technology to provide software and system development services across multiple industries. Colombia-headquartered Merqueo Holdings hopes to raise $13.5 million in a U.S. offering. Merqueo is a digital grocery retailer with operations in Colombia and Brazil. The last IPO in the U.S. by a Colombian company was in January 2019. The pace of preliminary registrations slowed to 15 in December after 18 in November. For the year, 260 companies filed new registrations compared to 1,308 last year.

Withdrawals. Three companies withdrew their pending registrations last week, bringing the year’s total to 174. Only 47 filers withdrew in 2021. Four Springs Capital Trust was the first REIT to file a Form RW since August 2021. The November 2021 registrant last amended its registration in January 2022. Lakeview Acquisition and USA Acquisition pushed to 122 the number of blank check withdrawals in 2022. Blank check companies accounted for 70 percent of the Forms RW filed during the year.

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

Wednesday, January 04, 2023

Sarbanes-Oxley protections did not extend to overseas Morgan Stanley attorney whistleblower

By Lene Powell, J.D.

An attorney employed by Morgan Stanley subsidiaries in Japan and Hong Kong had no recourse under Section 806 of the Sarbanes-Oxley Act (SOX) for alleged whistleblower retaliation after he raised concerns about possible securities law violations. Although Morgan Stanley is a U.S. corporation, the employment contracts at the foreign subsidiaries were governed by the foreign jurisdictions. The D.C. Circuit agreed with the DOL Administrative Review Board that Section 806 does not have extraterritorial application and the facts of the case did not give rise to a domestic application of SOX (Garvey v. Administrative Review Board, U.S. Dept. of Labor, December 23, 2022, Edwards, H.).

Alleged whistleblower retaliation. Christopher Garvey was employed as a “regional coverage lawyer” by the Morgan Stanley Japan Group in Tokyo from 2006 to 2011 and Morgan Stanley Asia Limited in Hong Kong from 2011 to 2016. Both corporations are foreign subsidiaries of Morgan Stanley, a U.S. corporation. Garvey alleges that between late 2014 and early 2016, he raised concerns with his superiors in New York regarding potential U.S. law violations by Morgan Stanley employees, including insider training, market manipulation, U.S. tax fraud, and other forms of corporate corruption.

According to Garvey, he resigned in 2016 after receiving a pay cut and a “blunt recommendation to find a job elsewhere” after raising the concerns. He also contends he lost the services of the attorney he retained because Morgan Stanley threatened to pursue disciplinary actions against the attorney for breach of professional obligations.

Garvey filed a pro se complaint with OSHA for alleged retaliation in violation of SOX Section 806, which was dismissed for failure to allege an adverse employment action. Garvey sought review by an Administrative Law Judge (ALJ), whose adverse decision was then reviewed by the DOL Administrative Review Board (“Board”). The Board rejected his complaint on the grounds that, by its terms, SOX Section 806 (18 U.S.C. § 1514A) does not have extraterritorial application and the facts of the case did not give rise to a domestic application of SOX. Garvey petitioned for review by the U.S. Court of Appeals for the D.C. Circuit.

No extraterritoriality for SOX Section 806. In its extraterritoriality analysis under Morrison and its progeny, the three-judge panel found that Garvey did not rebut the presumption against extraterritoriality.

First, the panel found that the Board properly held that the text, context, and legislative history of Section 806 do not contain a clear, affirmative indication that Congress intended the provision to apply extraterritorially. The panel also determined it did not need to decide whether Chevron deference was due the Board’s decision, as it found that the statute and applicable law are clear, and the Supreme Court has clarified that Chevron deference does not apply where the statute is clear.

After examining precedent in Carnero (1st Cir.) and Aramco (U.S.), the panel was unconvinced by Garvey’s argument that Section 806 reaches some companies that have a presence in foreign countries.

“Section 806 similarly may prohibit retaliation by foreign companies listed on U.S. securities exchanges, but we cannot thereby infer that it prohibits retaliation claims by anyone at those companies who is employed exclusively outside the United States,” the panel wrote.

The panel also rejected Garvey’s contention that Section 806 must have extraterritorial reach because it prohibits retaliation against an employee reporting conduct that the employee reasonably believes violates 18 U.S.C. § 1343 (wire fraud) and 18 U.S.C. § 1348 (securities fraud), and these statutes have at least some applications abroad. The panel found the relationship too tenuous.

Given that Congress has had ample opportunities since SOX’s passage in 2002 to amend Section 806 to give it extraterritorial effect, the panel agreed with the First Circuit that Congress’s silence regarding extraterritorial reach in Section 806 strongly suggests a lack of congressional intent to allow a cause of action in a case such as Garvey’s.

No domestic application of Section 806. The panel next found that Garvey’s complaint did not present a permissible domestic application of the law.

The panel held that the clear focus of Section 806 is on regulating employment relationships—specifically prohibiting covered employers from retaliating against employees for engaging in the protected activities enumerated in the statute. The panel rejected Garvey’s contention that Section 806 is focused on preventing corporate or securities fraud by prohibiting retaliation against whistleblowers and thus should apply whenever the fraudulent conduct reported would affect U.S. investors. This was not what the text of the statute directs, said the panel.

“Section 806 was not intended to cure all the ills of the securities markets; it addresses only retaliatory conduct by certain regulated companies against certain employees who engage in enumerated protected activities …Not all companies are covered, and not all employees are protected. And there is no cause of action under Section 806 for securities fraud,” the panel wrote.

Given the focus on regulating employment relationships, the locus of Garvey’s work and the terms of his employment contract were critically important. It was undisputed that, at all relevant times, Garvey’s exclusive places of work were outside the U.S., in the Morgan Stanley Japan Group in Tokyo and in Morgan Stanley Asia Limited in Hong Kong. Further, Garvey agreed to an employment agreement governed by the laws of Hong Kong, under “the exclusive jurisdiction of its courts and the Labour Tribunal.”

It was unavailing that Garvey alleged that corporate decisionmakers in the U.S. directed the retaliation campaign against him, the fraudulent activity impacted U.S. markets, id. and Morgan Stanley intimidated his chosen counsel, imperiling his whistleblower complaint under U.S. laws. These allegations did not change the overseas locus of Garvey’s employment nor make the conduct domestic. Unless a statute provides otherwise, a U.S. law regulating an employee’s terms and conditions of employment does not automatically confer protections to individuals, like Garvey, who have opted to work outside the U.S., said the panel.

Post-termination harassment of plaintiff’s attorney not relevant. Finally, the panel disagreed with Garvey’s assertion that alleged harassment of his attorney was itself an adverse employment action and domestic application of Section 806. The alleged conduct occurred after Garvey’s employment at Morgan Stanley Asia Limited ended and did not impact the terms and conditions of his employment. Moreover, there was no evidence that either Morgan Stanley or Morgan Stanley Asia Limited sought to negatively affect Garvey’s post-employment opportunities.

“Absent interference with an employee’s current employment or future employment prospects, contested actions arising after employment has terminated do not constitute adverse employment actions,” the panel wrote.

Accordingly, these allegations were not within the compass of protections afforded by Section 806.

Board judgment upheld. The panel affirmed the Board’s judgment and denied Garvey’s petition for review.

This is case No. 21-1182.

Thursday, December 29, 2022

PCAOB Chair stresses need to regain handle on audit quality

By Anne Sherry, J.D.

PCAOB Chair Erica Y. Williams emphasized the importance of audit quality in a keynote address at the AICPA & CIMA Conference on Current SEC and PCAOB Developments. Williams warned that audits are trending in the wrong direction, with a third of those inspected showing insufficient evidence to support their opinions. The Chair also spoke about a proposal on the confirmation process, which was scheduled to be taken up at an open meeting of the Board on December 20.

Audit quality. Williams discussed how the Enron and WorldCom scandals led to the enactment of the Sarbanes-Oxley Act, which in turn established the PCAOB. While audit quality has improved over the 20 years since, companies face challenges and uncertainties due to the pandemic, and there are more incentives for fraud. Yet audit quality is declining, Williams said.

Inspections in 2021 found that audits with Part I.A deficiencies—where staff believe the audit firm failed to obtain sufficient appropriate evidence to support its opinion on the financial statements or internal control over financial reporting—increased 4 percentage points over 2020. Fully a third of audits contained Part I.A deficiencies. For 2022, the PCAOB is also seeing increased comment forms, which usually result in inspection findings.

Williams said that while the reasons for deficiencies likely vary from firm to firm, some firms said that the pandemic, remote auditing, the Great Resignation, and competition for talent make it difficult to maintain stable audit teams and train new hires. “As we near the end of 2022, these factors are no longer new, and no one should be caught off guard by the challenges they present,” Williams warned. Furthermore, some of the auditing deficiencies have been recurring since well before COVID-19.

The Chair also highlighted some unethical behavior that the PCAOB has sanctioned this year, including exam cheating, modifying work papers, noncooperation with investigations, using confidential PCAOB information, and quality control failures. Firms have a responsibility to enforce the highest ethical standards, and the PCAOB will not tolerate unethical behavior, Williams said. The Board will use its enforcement tools, as evidenced by this year’s imposition of the highest total penalties in PCAOB history.

PCAOB projects. The PCAOB is now working from the most ambitious standard-setting agenda in its history, Williams said, involving the updating of 30 standards within 10 standard-setting projects. The new quality control standard, which is open to public comment through January, was a “watershed moment” because quality control systems are the foundation of how firms approach audits.

The Board also finalized stronger requirements for audits involving multiple audit firms and is on track to issue a proposal on the confirmation process. This proposal was scheduled to be taken up at an open meeting on December 20.

After confirmation, the PCAOB is on track to update requirements on illegal acts by clients, going concern, attestation standards, and due professional care. There are also four projects on the midterm standard-setting agenda and several projects on the separate research agenda. Specifically, the Board will leverage what it learned from its 2015 concept release on firm and engagement performance metrics while evaluating the current environment around this topic. The plan is to move this to the standard-setting agenda in 2023.

Williams quoted Senator Sarbanes as saying, “Trying to maintain high standards is a difficult job.” It is the PCAOB’s job, and the Board is driven by its mission to protect investors. The official asked the audience to keep investors in mind when upholding high standards in audit quality: “Resist complacency, sharpen your focus and meet your responsibility to verify the honesty our system depends on with a vigilance that is worthy of their trust.”