Tuesday, October 26, 2021

Cert. petition asks justices to clarify ‘deceptive’ trading by outsiders

By Mark S. Nelson, J.D.

A brief filed on behalf of Vitaly Korchevsky asks the Supreme Court to clarify the law of illegal securities trading with respect to Exchange Act Section 10(b) and Rule 10b-5 provisions addressing a “scheme or artifice to defraud” and “deceptive device or contrivance[s].” Korchevsky had been convicted for his alleged role in a hacking operation and for trading stocks based on information obtained from the hacking operation. In the district court, Korchevsky was convicted of, among other things, conspiracy to commit securities fraud and computer intrusions and securities fraud; the Second Circuit upheld Korchevsky’s several convictions (Korchevsky v. U.S., October 18, 2021).

Decision below—SQL injection and securities charges. The Second Circuit upheld the convictions of Vladislav Khalupsky and Korchevsky for accessing hacked corporate press releases and then trading the stocks of the companies whose press releases had been stolen. In reviewing the convictions, the court also concluded that: (1) the government's proof at trial did not constructively amend or prejudicially vary from the superseding indictment; (2) the district court did not abuse its discretion in its handling of a jury note presented to the court during deliberations regarding whether one of the defendants had received and traded on certain press releases; and (3) the district court's giving of a conscious avoidance jury instruction was not erroneous.

According to the government, an intermediary provided the conduit between two stock traders and two groups of Ukraine-based hackers who were able to circumvent security measures at three wire services that stored corporate press releases prior to publication. The hackers and the intermediary provided the traders with access to a server housing the purloined press releases, which contained information about pending corporate announcements that were potentially market-moving. When the initial phase of the alleged conspiracy fell apart, a different hacker continued to provide access to the stolen press releases and the conspiracy continued, albeit with slightly different arrangements.

In both instances, however, the traders shared the illicit profits from their trading with the intermediary. Khalupsky made a net profit of $3.1 million from the illegal trading, while Korchevsky made a net profit of $15 million, a 1,660 percent return on investment. On appeal, Khalupsky and Korchevsky challenged, among other things, the sufficiency of the evidence against them and their securities fraud convictions

The Second Circuit began its review of the securities counts brought under Exchange Act Section 10(b) by “dispatch[ing]” Korchevsky’s arguments regarding his lack of a fiduciary duty. Korchevsky had argued that there was no “scheme or artifice to defraud” because he owed no fiduciary duty to investors and that his deception did not target investors. For one, the court said that when a case involves trading by an outsider, rather than an insider, no fiduciary duty is required. Second, the court explained that deception need only track the requirement that there be deception “in connection with” the buying or selling of any security.

Next, the court addressed Korchevsky’s argument that the alleged computer hacking was not a “deceptive device or contrivance.” The court explained that the evidence showed how Korchevsky and others benefitted from a SQL injection attack to gain access to employee login information at the wire services, which them enabled the conspirators to access secured areas of the wire services’ computer systems. Although the court refrained from characterizing the legal status of the SQL injection, the court did further explain that the use of employee logins to move laterally through the wire services’ computer systems amounted to Korchevsky and others misrepresenting themselves as authorized users of those computer systems. As a result, the court concluded that Korchevsky had engaged in illegal behavior that fell within the plain meaning of “deception.”

Petition seeks clarity on fiduciary duty. Korchevsky's petition for certiorari asserted that the Second Circuit had misapplied the law in upholding Korchevsky's securities conviction. Specifically, Korchevsky argued, by analogy to the law of misappropriation-based insider trading, that the Second Circuit's reasoning could be read to apply broadly to almost any securities trading because the court did not adequately identify a specific fiduciary duty owed by Korchevsky.

Korchevsky further argued that the Second Circuit upheld his conviction on the theory that Korchevsky owed a general fiduciary duty to all market participants. According to Korchevsky, that broad of a theory of criminal liability would contravene the holdings in the Supreme Court's Chiarella and O'Hagan opinions, the former recognizing that a duty to disclose could arise in a misappropriation context, the latter applying such duty and theorizing that a person can owe a fiduciary duty to the source of material, nonpublic information.

Korchevsky’s petition summed up his argument thus: “As was true of the defendant in Chiarella, Mr. Korchevsky had no prior dealings with the investors. He was neither their agent, their fiduciary, nor a person in whom they had placed their trust and confidence. He was, in fact, a complete stranger who dealt with the investors only through impersonal and arms-length market transactions.”

The case is No. 21-580.

Monday, October 25, 2021

FSB offers suggestions to harmonize cyber incident reporting

By John Filar Atwood

In an effort to make cyber incident reporting more uniform across jurisdictions, the Financial Stability Board has issued recommendations that it believes will drive convergence in cyber reporting. The group’s ideas include identifying a minimum set of information that should be reported about cyber incidents, and identifying legal and operational impediments to sharing cyber information and working to reduce those barriers.

The FSB’s report follows its assessment of existing supervisory and regulatory practices, which found that fragmentation exists across sectors and jurisdictions concerning the scope of what should be reported for a cyber incident. The group also found differences in methodologies to measure severity and impact of an incident, the timeframes for reporting cyber incidents, and how cyber incident information is used.

The inconsistencies result in fragmentation in the reporting of cyber incidents, according to the FSB. Financial institutions that operate across jurisdictions are subjected to multiple reporting requirements for one incident, and financial regulators receive heterogeneous information for a given cyber incident which impacts their assessment of the risk to the financial institution and financial system. The FSB said that the goal of its report is to explore whether greater convergence in the reporting of cyber incidents could be achieved, including how authorities define a cyber incident.

Definition of cyber incident. In its research, the FSB found that the scope of cyber incidents required to be reported varies across jurisdictions and sectors. Some authorities do not distinguish between broader operational incidents and cyber incidents or define a ‘cyber incident’ more broadly than others, the FSB noted.

The FSB found that authorities often using ‘cyber incident’ interchangeably with ‘cyber event’, which is generally associated with ‘any observable occurrence in an information system’. In the FSB’s view, this may lead to excessive notification and reporting of incidents that can usually be managed by financial institutions.

Thresholds for reporting. The FSB also found that the thresholds for reporting cyber incidents vary across jurisdictions and sectors due to a lack of established methodology to measure impact and severity. In some cases, reporting thresholds are linked to the number or percentage of customers impacted, to market share or financial loss, or to qualitative indicators such as reputational risk, the FSB stated. Further, some authorities expect supervised institutions to define their own materiality thresholds, furthering differences in the materiality threshold across institutions.

Other discrepancies across jurisdictions are the reporting timeframe and how regulators use the reported information, according to the FSB. Regarding the timeliness of reporting, the FSB determined that it can range from ‘as soon as identified’ to 48 hours or longer. The group acknowledged that while providing early notifications to authorities would facilitate a timely supervisory response, requiring financial institutions to provide a full report within a short timeframe diverts resources from containing and addressing the cyber incident in a timely manner.

The FSB found that financial authorities use information from cyber incidents for different purposes depending on the relevant mandates, which may impact how they set their reporting requirements. In general, the FSB determined that more authorities use the reported information to monitor and assess vulnerabilities for a financial institution, rather than to assess how cyber incidents could pose risks to the financial system.

Information sharing. The FSB supports enhanced information sharing across jurisdictions about cyber incidents. The believes that better information-sharing arrangements would help to reduce fragmentation in cyber incident reporting and promote a common understanding of the related risks.

The FSB noted that many financial authorities have formal or informal information-sharing arrangements with one or more authority outside their jurisdiction, but there are substantial differences in the scope, depth and the form of such information sharing. Improvements in cooperation can be made through written cooperation arrangements between regulators, which cover timely notification and communication among authorities as well as cooperation in response and mitigation activities, the FSB suggested.

Enhancing the consistency of the structure, content and timeliness of reports would also improve information-sharing and authorities’ ability to respond to an incident, in the FSB’s opinion. The group said that this could include developing a standardized exchange format and methodology for cyber incident reporting or a shared protocol which facilitates cooperation.

Recommendations. Given its findings on cyber reporting across jurisdictions, the FSB offered three ways to achieve greater convergence in cyber incident reporting. First, the group suggests developing best practices by identifying a minimum set of types of information authorities may require related to cyber incidents. This set of information would help authorities in determining reporting thresholds, timeframes for reporting and notification, while recognizing that a one-size-fits-all approach may neither be appropriate nor possible, the FSB said.

Second, the FSB recommends identifying key information items that should be shared across sectors and jurisdictions, and any legal and operational impediments to sharing such information. The FSB believes this would facilitate more information-sharing and help authorities obtain a better understanding of impacts of a cyber incident across jurisdictions. A multilateral solution to information-sharing problems would be difficult, the FSB acknowledged, so it will be essential for FSB member jurisdictions to continue bilateral and regional efforts to reduce legal and operational barriers to information sharing.

Finally, the FSB believes a common language for cyber incident reporting is needed. In particular, the FSB urged regulators to consider a common definition for ‘cyber incident’ that avoids the reporting of incidents that are not significant for a financial institution or financial stability.

Friday, October 22, 2021

Public policy at forefront as Gensler considers stablecoins, gamification

By Anne Sherry, J.D.

SEC Chair Gary Gensler discussed the challenges the SEC faces in adapting its tripartite mission to emerging technologies such as stablecoins, DeFi, and direct trading platforms. Speaking to Georgetown Law Professor Chris Brummer at DC Fintech Week, Gensler stressed the need for the SEC to protect investors and promote fairness as the financial markets evolve. Gamified investing apps, predictive data analytics, and the concentration of assets into a handful of stablecoins all present issues for regulators.

In some respects, Gensler’s comments suggested that the task of keeping up with new technology is not a new challenge for the SEC. Gensler cited the SEC’s establishment, under the chairmanship of Arthur Levitt, of alternative trading systems in response to the proliferation of trading on online bulletin boards as the Internet became more widely adopted. In Gensler’s view, predictive data analytics could transform finance as significantly as the Internet did in the 1990’s. The central question, Gensler said, is how the SEC can continue to achieve its core public policy goals when new technologies come along and change the face of finance.

Specifically in the areas of artificial intelligence and predictive data analytics, Gensler expressed concerns about the further entrenchment of societal inequities that may be embedded in the underlying data. For example, aggregating consumer data from Fitbits and other devices and using that information to determine who is a good credit risk may embed society’s existing biases. Gensler believes there is not enough public debate around this issue. Under the Fair Credit Reporting Act, people have a right to know why they are denied credit, and he suggested regulators should consider policies to guard against bias and allow for explanations of these decisions.

The chair also sees a risk of conflicts of interest in some of these innovations. Are digital analytics platforms solely optimizing for the benefit of investors, or are they also optimizing for their own revenues? He noted that thirteen years after the bitcoin white paper, no one knows who Satoshi Nakamoto is. There is still an “off-the-grid, cryptographers’ approach” embedded in some of this innovation, he said.

Brummer observed that the rise of retail investing has brought new entrants to the capital markets, particular people of color and younger investors, and asked Gensler how he balances the risks and opportunities of these platforms. Gensler responded that, while investors are empowered to choose their risks, some of the digital engagement practices may steer users towards certain options via behavioral prompts or gamification. These apps are still subject to concepts of best interest, best execution, and the fiduciary duties of care and loyalty, he added. Two of the SEC’s three core objectives are investor protection and ensuring fair markets, and either way, financial inclusion is part of the agency’s remit.

Another issue for regulators as a whole is financial stability and systemic risk. While seeming to evade Brummer’s question about what role the SEC will have in regulating stablecoins, particularly after the CFTC’s large fine against Tether, Gensler highlighted some issues about the tokens more broadly. Stablecoins are a $130 billion asset category that is primarily concentrated on three platforms, raising questions of systemic risk. Gensler said that stablecoins serve not just to facilitate crypto trading but also to avoid fiat banking systems and the regulations that those entail, including anti-money-laundering and tax laws. All financial regulators are assessing stablecoins from the perspective of whether they are going to be like banks, what form their reserves take, and whether they fall within the AML rules, the chair said.

Thursday, October 21, 2021

GameStop report makes few firm conclusions, but points to need for more study

By Mark S. Nelson, J.D.

The SEC publishd a long-awaited report on the events of late January 2021 in which several “meme” stocks, like GameStop Corp, experienced significant volatility over a several-days-long period. The report makes few firm conclusions and suggests no singular explanation for the extraordinary volatility nearly 100 stocks, including GameStop, experienced, but the report does suggest that multiple structural aspects of U.S. securities markets may have played contributing roles that merit additional study. The tenor of the report, however, is broadly consistent with proposed regulations already placed on the SEC’s Spring 2021 regulatory agenda and with legislation introduced in Congress that would lessen the impact of industry conflicts of interest.

Key recommendations. The SEC’s GameStop report concluded that further study is needed of the following:
  • Forces that may cause a brokerage to restrict trading.
  • Digital engagement practices and payment for order flow.
  • Trading in dark pools and through wholesalers.
  • Short selling and market dynamics
Within these topics, the report tended to focus on the role of thinly-capitalized broker-dealers and the related possibility of further shortening the settlement cycle to reduce systemic risks, the role of off-exchange wholesalers, and the need for regulators to more closely track short sales via short sales reporting.

However, the report also concluded that the volatility in meme stocks suggested a “broad participation” by persons in U.S. securities markets while also noting that disagreement over a company’s prospects are to be expected but that they should result in price discovery instead of market disruptions.

For those who were looking for a detailed analysis of the phenomenon of meme stock trading, the SEC’s report may be a disappointment because the agency elected to confine its after-action review to issues related to the structure of U.S. securities markets.

SEC after-action review. The SEC’s report did not identify any single cause of the extreme market volatility in January 2021 and the report made only a few conclusions about discreet events within the larger set of events that constituted the unusual market activity observed in January 2021. Overall, the report said that about 100 stocks were involved and that some of these stocks experienced as much or more volatility than GameStop, but that GameStop, the focus of the SEC’s report, had experienced nearly all of the factors the SEC had identified as impacting “meme” stocks in January 2021: (1) big price changes; (2) big volume changes; (3) significant short interest; (4) frequent mentions in social media such as Reddit; and (5) significant coverage in the main stream media.

However, the SEC also said that GameStop itself was not new to such volatility, which had affected the company’s stock at times over a nearly two year period, albeit reaching a peak in January 2021. The SEC noted an increase in individual accounts trading GameStop during the study period. At a later point in the report, the SEC explained that the increase in individual account activity included accounts trading GameStop options; options trading, the SEC said, had been concentrated in three firms that accounted for 66 percent of such activity (the firms identified by the SEC are Robinhood, TD Ameritrade, and E*Trade Securities).

The SEC made some general conclusions with respect to the role specific types of funds may have played in the January 2021 market volatility. First, the report said that while some exchange-traded funds (ETFs) were impacted by the January 2021 market volatility, there were no clear signs that, at the one ETF featured in the report, that that fund’s creation/redemption or arbitrage mechanism had broken down. Second, the report suggested that hedge funds largely were not to blame. “Staff believes that hedge funds broadly were not significantly affected by investments in GME and other meme stocks,” said the report. “Staff did not observe that any advisers to private funds and registered funds experienced liquidity issues or difficulties with counterparties.”

In the longest section of the after-action review, the SEC observed that trading in GameStop exemplified the potential for short squeezes and gamma squeezes, but went on to conclude that these types of squeezes either played a smaller role or that evidence of their existence could not be obtained. First, the report said that a short squeeze was not a “main driver” of events in January 2021 and that positive sentiment about GameStop appeared to be a more significant factor. Second, there was no evidence of a gamma squeeze (where one hedges risk regarding call options on a company by buying the company’s stock) because options volume at the time favored put options instead of call options and market makers bought instead of wrote call options. Third, naked short sales (i.e., short sales in which the failure to borrow securities results in a failure to deliver securities) could not be adequately measured because “fails to deliver” are a poor measure of short selling activity and, with respect to GameStop, there was a lack of persistent fails to deliver.

The report made one additional set of observations about off-exchange market makers. Here, the report found that 80 percent of off-exchange trading in

GameStop was internalized (versus other venues such as alternative trading systems) and that three wholesalers accounted for 88 percent of internalized trades (the report mentioned two of the three firms: Citadel Securities (50 percent) and Virtu Americas (26 percent)). The report also examined liquidity in GameStop. For example, the report noted that despite an increase in volatility and a related decline in measures of liquidity, liquidity providers still provided liquidity but with fewer shares as GameStop’s share price continued to rise. The report also noted that GameStop’s stock experienced 40 limit up/limit down trading pauses over six days in January 2021.

Commissioners’ statements. SEC Chair Gary Gensler issued a brief public statement that largely repeated the GameStop report’s key recommendations. “January’s events gave us an opportunity to consider how we can further our efforts to make the equity markets as fair, orderly, and efficient as possible. Making markets work for everyday investors gets to the heart of the SEC’s mission,” said Gensler.

A joint public statement issued by Commissioners Hester Peirce and Elad Roisman questioned whether the GameStop report offered any conclusions upon which regulatory action could be based. Commissioners Peirce and Roisman also noted that the Commission had recently adopted a regulation to address quoted spreads in the National Best Bid or Offer (NBBO) regarding best execution for retail investors.

Commissioners Peirce and Roisman summarized their understanding of the GameStop report thus: “In the wake of an anomalous market event, it can be tempting to identify a convenient scapegoat and leverage the event to pursue regulatory actions without regard to the factual record. The report, however, finds no causal connection between the meme stock volatility and conflicts of interest, payment for order flow, off-exchange trading, wholesale market-making, or any other market practice that has drawn recent popular attention.”

Does the report portend further regulation? While the report made few conclusions, it did recommend four topics for further SEC study and potentially guidance or regulation: (1) forces that may cause a brokerage to restrict trading; (2) digital engagement practices and payment for order flow; (3) trading in dark pools and through wholesalers; and (4) short selling and market dynamics. Aspects of these topics dovetail with the SEC’s Spring 2021 regulatory agenda and with legislation introduced in Congress.

For example, the rulemaking agenda contains a pre-rule stage item on gamification that would address the panoply of digital engagement practices, including “gamification, behavioral prompts, predictive analytics, and differential marketing.” In August 2021, the SEC issued a request for information and comment on how broker-dealers and investment advisers address trading technology, including digital engagement practices such as gamification. SEC Investor Advocate Rick Fleming also has spoken on the question of whether gamification features in trading platforms could rise to the level of a recommendation under Regulation Best Interest.

A market structure item at the proposed rule stage would address “payment for order flow, best execution (amendments to Rule 605), market concentration” and other matters. Although payment for order flow and best execution are mentioned in the GameStop report, the SEC’s after-action review seemed to look more closely at market concentration as it related to options trading and internalization. Yet another item at the proposed rule stage would address broker-dealer liquidity stress testing, which could in turn address the GameStop report’s discussion of thinly-capitalized broker-dealers.

Moreover, a regulatory agenda item on the settlement cycle, also at the proposed rule stage, could further shorten the settlement cycle. A few years ago, the Commission shortened the settlement cycle for most securities from T+3 to T+2. The GameStop report noted that equities are currently settled on a T+2 basis and options are settled on a T+1 basis.

Lastly, two items on the SEC’s regulatory agenda would address short sales and the lending/borrowing of securities. The first item would implement the Congressional mandate contained in Dodd-Frank Act Section 929X(a), which requires the Commission to adopt rules to require, in the context of short sales, the public disclosure of “the name of the issuer and the title, class, CUSIP number, aggregate amount of the number of short sales of each security, and any additional information determined by the Commission following the end of the reporting period.” These disclosures would have to occur on at least a monthly basis. A second agenda item would implement Dodd-Frank Act Section 984(b)’s mandate for the Commission to “increase the transparency of information available to brokers, dealers, and investors, with respect to the loan or borrowing of securities.”

Some of these regulatory agenda items also have counterparts in the 117th Congress. The gamification issue would be addressed by a bill (H.R. 4685), sponsored by Rep. Sean Casten (D-Ill), that would require a GAO study of the gamification of stock trading. Studies typically can get bipartisan support on their way from committee to the floor when bills explicitly authorizing agency rules might not, but it is unclear if this bill will get such support because a Republican amendment offered by Rep. Warren Davidson (R-Ohio) was handily rejected by Democrats who said it would gut the bill, although a later colloquy between Rep. Casten and Rep. Bill Huizenga (R-Mich) at least suggested a remote possibility that later revisions could help the bill’s chances. However, Congressional action in the form of a study may or may not have its desired impact because the Gensler-led SEC already has placed gamification on its regulatory agenda. The Casten bill was reported favorably by the House Financial Services Committee in late July 2021 by a vote of 28-23.

The Order Flow Improvement Act (H.R. 4617), sponsored by Rep. Brad Sherman (D-Calif), would require the SEC to study the many facets of payment for order flow (PFOF), including whether broker-dealers should be required to disclose to customers information about the degree of price improvement received on each order so that customers can compare the services offered by different broker-dealer firms. The SEC would have to report to Congress on its findings within six months of enactment, although the SEC could pursue rulemaking on the subject before the study is completed. Representative Sherman said that, unlike other versions of the bill that have been floated, it would not ban PFOF. Republicans on the committee had called foul over a provision that would explicitly allow the SEC to act before the study is completed, although Rep. Sherman suggested that he might be able to accept some technical changes to the bill, but not the wholesale revisions contained in an amendment proposed by House FSC Republicans. The House FSC favorably reported the bill, also in late July 2021, by a vote of 28-22.

A third bill introduced by House FSC Democrats would address the issue of trading ahead, which the GameStop report mentioned in the regulatory overview section of the report but otherwise did not discuss in detail. H.R. 4619, sponsored by Rep. Al Green (D-Texas), would explicitly ban market makers from engaging in the practice of trading ahead. The GameStop report’s brief discussion of the existing ban on trading ahead noted The Financial Industry Regulatory Authority’s Rule 5320, which bans the practice and requires members to have a written methodology regarding the execution and priority of pending orders that is consistent with other FINRA rules. A comment on the bill submitted by The North American Securities Administrators Association, Inc. (NASAA) urged FINRA to mull whether Rule 5320 goes far enough in protecting retail investors, while The Securities Industry and Financial Markets Association (SIFMA) and the American Securities Association (ASA) separately echoed the view of some Republican House FSC members that the bill would duplicate existing limits on trading ahead. The House FSC favorably reported the bill in late July 2021 by a vote of 27-22.

Wednesday, October 20, 2021

PwC survey reveals boards’ increasing focus on ESG

By Anne Sherry, J.D.

The latest Corporate Directors Survey from PricewaterhouseCoopers finds that boards are significantly more receptive to ESG issues compared to their attitudes just a year ago. Although few directors favor mandatory ESG reporting or disclosure, the vast majority reported that their companies disclose some information voluntarily. Nearly every director said their board is doing something to improve diversity, but few companies have increased compensation or other benefits to attract diverse talent.

Diversity and inclusion. The survey identifies several ways in which directors have overall become more focused on ESG since 2020. For example, more than half of directors support tying executive compensation to diversity and inclusion goals, representing a 13 point increase from 39 percent in 2020. Whereas last year 71 percent of directors said that board diversity would happen naturally, only 33 percent believe that now.

Overall, directors have shifted their diversification efforts from gender towards racial and ethnic diversity (PwC observes that 28 percent of directors on S&P 500 boards are female, but only 5 percent are Black and 3 percent Latinx). While most directors agree that diversity brings unique perspectives, increases board and corporate performance, and improves relationships with shareholders, a small majority of directors also believe that diversity is driven by political correctness, and more than a quarter of directors said that it results in the nomination of unneeded or even unqualified candidates.

ESG reporting. The survey revealed a significant gap between the importance of ESG and companies’ preparedness: 64 percent of directors said that ESG is linked to their company strategy, but only 25 percent said their board understands ESG risks very well. Two-thirds of directors favor the current system of voluntarily reporting ESG information; only 18 percent believe mandatory reporting would be preferable. Again, however, there is a disconnect: 94 percent of directors said their companies offer some voluntary ESG disclosure, but only 28 percent said the board has a strong understanding of the company’s messaging on ESG and sustainability.

Board dynamics. Some of the directors’ responses suggested that boards are having trouble ensuring that directors are the right fit. Nearly half of directors, 47 percent, said that at least one current board member should be replaced, even though most directors did not have complaints about their peers’ performance as directors. Survey respondents overall praised the assessment process of their boards, while at the same time criticizing the process for being a “check the box” exercise and putting limits on directors’ ability to be frank.

PwC also polled directors on the effectiveness of virtual board meetings necessitated by the COVID-19 pandemic. A little more than half of the directors said that meetings became more efficient, but this was the only attribute that improved from the virtual setting. Many more directors thought meetings were less effective than thought they were more effective; director engagement and board culture also took a hit, according to most respondents.

Tuesday, October 19, 2021

Supreme Court asked to look at the breadth of SLUSA ‘in connection with’ requirement

By Rodney F. Tonkovic, J.D.

A petition for certiorari asks the Supreme Court to address whether the Ninth Circuit erred in adopting a narrow interpretation of the SLUSA's "in connection with" prong. In this case, the appellate court reversed a district court's ruling that the SLUSA precluded investors from pleading a state law claim and a federal securities claim based on the same conduct. The petitioner argues that the Ninth Circuit gave too narrow a reading to "in connection with," requiring that the alleged deception induce a specific transaction in a particular covered security. The petition urges the Court to take up the matter and resolve a circuit split between courts using this narrow interpretation and those reading the language more broadly to require a transaction just coinciding with a transaction in a covered security (Edward D. Jones & Co. v. Anderson, October 12, 2021).

"In connection with" requirements. At issue in this action is the interpretation of the SLUSA's prohibition of class actions premised on state law and alleging a material misrepresentation or omission "in connection with the purchase or sale of a covered security." This requirement was given a broad reading by the Court in 2006 in Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, holding that it is enough that the fraud coincide with a securities transaction. In 2014, the Court affirmed the "coincide" requirement in Chadbourne & Parke LLP v. Troice while emphasizing that the SLUSA bar applies to misrepresentations with a material connection to the purchase of a covered security. In Troice the Court held that the plaintiffs had no ownership interest in the financial instruments at issue, so the claims involved uncovered securities and were not precluded by the SLUSA.

Transfer to fee-based accounts. The petitioner is Edward D. Jones & Co. (Edward Jones), a financial services firm headquartered in St. Louis, Missouri. The respondents are three "buy-and-hold" investors, meaning that they conduct little to no trading each year. This case arose from investors' decisions to transfer assets in their commission-based accounts into managed, fee-based advisory accounts. The accounts were transferred, and Edward Jones began to conduct trades on the investors' behalf.

The investors filed suit in the Eastern District of California alleging that the fee-based accounts were not suitable for buy-and-hold investors and resulted in significantly higher fees. Edward Jones, the investors alleged, incentivized its advisers to recommend fee-based accounts and generate higher fees, whether or not they were suitable; in fact, the advisers allegedly failed to conduct any suitability analysis at all. The complaint alleged violations of the antifraud provisions of the Exchange Act, plus claims under California and Missouri common law. In an unreported opinion, the district court dismissed the complaint with prejudice, ruling that the SLUSA precluded the investors from pleading a state law fiduciary duty claim and a federal securities claim based on the same conduct. The court explained that the plaintiffs characterized the lack of a suitability analysis as an omission for the federal fraud claim but not as an omission for the state law fiduciary duty claim.

The Ninth Circuit reversed, finding that the claims were not barred by the SLUSA. The court held that the alleged breach was not "in connection with" an investment decision involving a covered security because the investors did not allege that they would have purchased or sold different covered securities had the defendants conducted the suitability analysis. Rather, the plaintiffs paid a fee regardless of the transactions Edward Jones took on their behalf. According to the Ninth Circuit, Troice brought a more demanding implied materiality element into Dabit's "coincide" test. Here, the alleged deception was material to the decision to transfer accounts—the breach was complete when the accounts were transferred—but was not intrinsic to any investment decisions and was thus not materially connected to a securities transaction.

Circuit split. The petition asks the Court to resolve a circuit split as to whether Dabit's "coincide" standard was altered by Troice. According to Edward Jones, the Seventh and Eighth Circuits continue to apply the broader Dabit standard. On the other hand, the First, Third, and now Ninth Circuits apply Troice even when there is no dispute about whether the deception related to covered securities. These circuits read Troice broadly to hold that the "in connection with" requirement is satisfied only when the alleged deception induces an investment decision regarding a particular covered security. These divergent standards need to be resolved by the Court, the petition asserts.

Conflict with precedent. In addition, the Ninth Circuit's standard conflicts with Supreme Court precedent. The petition argues that the appellate court's definition of "in connection with" conflicts with SEC v. Zandford, U.S. v. O'Hagan, and Dabit. Building on the earlier cases, Dabit interprets the "in connection with" prong consistently with the language in Exchange Act Section 10(b) and Rule 10b-5, holding that it is sufficient that the alleged fraud coincide with a securities transaction, by the plaintiff or someone else. Later, the majority in Troice expressly rejected that that decision modified Dabit, but the Ninth Circuit, the petition urges, ignored the context of Troice—the distinction between covered and uncovered securities—to focus on the implied materiality element. In the present case, the petition stresses, there was no dispute over covered versus uncovered securities. And, moreover, there was no question that the investors had ownership interests in covered securities involved in transactions made to further the alleged scheme.

Important question. Finally, the petition argues that the Ninth Circuit's narrow interpretation is inconsistent with the SLUSA's language and objectives. Here, the petition again references Dabit, where the Court indicates that Congress must have been aware of the broad interpretation given to the phrase "in connection with" when that key phrase was imported into the SLUSA. To interpret "in connection with" as requiring a direct causal link contradicts the plain meaning of the phrase. The Ninth Circuit's interpretation also upsets the regulatory scheme governing the markets and securities industry by allowing securities claims framed under state law to proceed, the petition says, which undermines Congress’ intended reforms in the PSLRA and SLUSA.

The petition is No. 21-552.

Monday, October 18, 2021

SEC signals tougher approach to investigations, enforcement remedies

By Amanda Maine, J.D.

At this years Practising Law Institute’s SEC Speaks, top officials in the Division of Enforcement indicated that the staff will be taking a harder line in its approach to investigations and remedies sought. In addition to placing some restrictions on the Wells process such as the submission of white papers, the staff will also be seeking admissions in settlements for some of the more egregious cases, a policy which fell out of favor under the last chairman.

New era for remedies. Enforcement Director Gurbir S. Grewal, former New Jersey Attorney General who was appointed to the position in June, outlined a series of changes that the Division is implementing for the better protection of investors. One of the most significant changes is embracing the policy of requiring admissions from respondents in the most egregious cases, a policy which had fallen by the wayside under Chair Gary Gensler’s predecessor Jay Clayton.

Deputy Director Sanjay Wadhwa said that it is true that “neither-admit-nor-deny” settlements allow the Division to use its resources more effectively, including returning funds to harmed investors more quickly. However, obtaining admissions serves as an important tool in punishing and deterring certain forms of misconduct, he added. Among the circumstances that might lead the staff to seek admissions include cases involving egregious misconduct where the markets or large number of investors were harmed, where the bad actor engaged in behavior that obstructed the Commission’s processes, and in cases where admissions would greatly amplify the deterrent effect of the action, Wadhwa said. He advised that the front-line staff that is best positioned to determine whether a settlement should include admissions.

Grewal spoke of other remedies the staff will seek against wrongdoers. Officer-and-director bars may be imposed for the protection of investors. A respondent may be subject to such a bar even if he or she has never before served in those positions, he said. Instead, this decision will depend on whether the individual is likely to serve as an officer or director of a public company in the future, he explained.

In addition, the Commission may seek conduct-based injunctions, he said. These injunctions, which enjoin the defendant from engaging from specific conduct in the future, can encompass a wide variety of activities, including restrictions on stock trading, participating in securities offerings, and restricting the ability of lawyers to draft opinion letters. Requiring respondents to commit to specific undertakings will also continue, Grewal advised. In certain cases, the staff will require undertakings tailored to address the underlying violation and to effect future compliance, including limiting the functions or operations of the company or requiring the company to hire an independent compliance consultant that will make recommended changes to the company’s policies and procedures intended to avoid the charged misconduct in the future, according to Grewal.

Wells meetings. Grewal said that defendants can also expect some changes to the Wells process with a view towards making it more streamlined. For example, the deputy director will be present for Wells meetings that involve novel cases; however, more routine cases will involve the presence of front-line staff such as unit chiefs, he explained. While he and Deputy Director Wadhwa will still sit in on some Wells meetings, it should not be expected of every Wells meeting.

Wadhwa also discussed the Wells process, in particular the use of “white papers.” According to the deputy director, these papers have “taken on a life of their own” and sometimes defendants only make their Wells submission after finding that the staff was not moved by the arguments presented in these white papers. When counsel submits multiple and duplicative white papers, it wastes the staff’s time and resources, he admonished. Nearly all arguments made in the white papers also appear in the Wells submission, Wadhwa said, and do little to help advance the dialogue between the staff and counsel while taking up valuable time and resources and delay the staff’s recommendation to the Commission.

While in some cases, white papers may be valuable, but in most instances, this has not been the case. Instead, they have become the vehicle of choice for counsel to make their arguments to the staff while avoiding making a Wells notice, which may be a disclosable event to a client, Wadhwa noted. As part of drive to empower front-line staff to advance an investigation more swiftly, the senior staff will defer to the considered judgment of the front-line staff as to whether they want to issue a Wells notice or accept a white paper.

Wadhwa declared that when a Wells meeting is granted, the staff will want it to take place two weeks or less from the date of the Wells submission. Wadhwa acknowledged that it is a recurring problem where both sides encounter scheduling conflicts that invariably arise. According to Wadhwa, this involves an “easy fix” – if a Wells meeting is warranted, then counsel will be expected to agree to a date and time at such meeting at the time of the Wells decision. When the meeting does take place, he expects counsel to present arguments why an SEC enforcement action not justified. However, he warned that the staff will have already read counsel’s submissions closely. The staff will have questions, so be prepared for rigorous debate on the facts and violations at issue. In addition to telling the staff about what counsel perceives as litigation risks to the SEC at trial, counsel must also be familiar with factors that favor the SEC, he advised.

Friday, October 15, 2021

CorpFin officials provide updates on Division’s powerhouse agenda

By Lene Powell, J.D.

SEC officials from the Division of Corporation Finance provided updates at the SEC Speaks conference on the Division’s jam-packed agenda, including in the areas of SPACs, issues around Chinese companies, 10b5-1 trading plans, proxies and proxy advice, and disclosures relating to climate, human capital and diversity, among many other topics.

The SEC Speaks conference was sponsored by the Practising Law Institute (PLI). The Division of Corporation Finance panel was held October 12 and was moderated by Renee Jones, director. Panelists included Tamara Brightwell, associate director; Lisa Kohl, acting deputy director; Betsy Murphy, associate director; Michelle Anderson, associate director; and Michael Seaman, acting chief counsel.

SPACs. SPACs are a major area that the SEC is looking at for rulemaking, given a large rise in the number of these public offerings. Michelle Anderson noted that Chair Gensler is concerned whether SPAC investors, particularly retail investors, are appropriately protected in the current regime.

Given the complexity of information in this area, staff is looking at:
  • Are investors able to understand the cost of investing in SPACs?
  • Are SPAC providing clear disclosure about how the SPAC will seek to identify acquisition targets and evaluate the period of time in which it intends to complete a business combination transaction, and any conflicts of interest that may be present?
  • Are SPACs providing clear disclosure about fees the SEC sponsors and affiliates are receiving the value of the sponsors’ interest in the combined company, and the potential dilution that investors will face at various levels of redemption? In particular, SPACs should describe how the terms of warrants issued to sponsors differ from those of public warrants included in the offered IPO units, and the dilutive effects of sponsors warrants. Also, if a SPAC plans to seek or has obtained additional funding by selling securities and private offerings, it should disclose how the terms of those securities issued or to be issued compared to the terms of the securities offered in the IPO.
  • Are investors able to understand the risks associated with the potential conflict of interest and incentives of the SPAC sponsors and other SPAC insiders?
  • Are there ways to improve the quality of other disclosures, including the use of projections?
  • What is the potential for regulatory arbitrage associated with going public via de-SPAC, and the lack of traditional gatekeepers that are normally present in traditional methods of going public?
China. According to Renee Jones, the SEC is focused on making sure that the filings of China-based issuers contain clear and prominent disclosure about the risks associated with investing in those companies. In particular, there are special disclosure considerations when there are Variable Interest Entities (VIE) involved.

Lisa Kohl noted that Chair Gensler issued a statement at the end of July on investor protection issues, highlighting recent regulatory developments and the continued use of the VIE structure. Companies often use VIEs to structure around restrictions on foreign ownership in certain industries and businesses in China. Investors may not understand VIEs well, and the SEC is trying to elicit better disclosure on that.

SEC staff has been issuing several areas of comments about the Chinese regulatory environment and the VIE structure, said Kohl.
  • On the Chinese regulatory environment, the SEC is looking for disclosures around recent government led cybersecurity reviews. The SEC is also asking companies to state explicitly whether they have all requisite permissions necessary to operate from entities like the CSRC and the cyberspace administration of China, and to state explicitly whether any permissions have been denied.
  • Another regulatory aspect is limitations on the PCAOB’s ability to inspect China based issuers auditing firms. Under the Holding Foreign Companies Accountable Act (HFCAA), the trading prohibitions that companies using audit firms and jurisdictions that the PCAOB determined that cannot fully inspect and investigate will incur starting in 2024. The SEC is looking for disclosure around this.
  • Further on the HFCAA, the PCAOB adopted a new rule at the end of September which sets forth the framework that the PCAOB will use to determine which jurisdiction is enabled to investigate and inspect completely. That rule now moves to the commission for approval under the 19d-4 process. Chair Gensler has been clear that expects that those determinations should be able to be made by the end of this calendar year, and that there will be list of the jurisdictions that the PCAOB determines they cannot effectively investigate completely.
  • In addition, the Commission adopted interim final amendments to implement the disclosure and submission requirements and the HFCAA. Kohl would expect that the Commission will come up with the list of identified issuers in 2022 once the 2021 annual reports are filed.
  • On VIEs, given the importance of the VIE structure and attendant risks, the SEC is looking for prominent disclosure earlier in the document.
  • The disclosure should allow investors to understand that oftentimes they are investing in a shell company incorporated often in the Cayman or British Virgin Islands, and that this shell company listed company often has only service and other contractual arrangements with the Chinese operating company.
  • The disclosure should also highlight that regulatory authorities in China could disallow this structure, which would result in a material change to the company's operations, and very likely a material adverse effect on a company's share price.
  • The price of ADS is a related issue for the VIE structure. The SEC is asking companies to provide more disclosure about how cash and earnings are transferred through the organization, and an explicit disclosure about whether transfers dividends or distributions have been made to date from the VIE. The SEC wants it to be readily apparent to investors where the assets of the collective company structure are and how hard they would be to reach if, for example, the VIE structure was disallowed.
Climate. Kohl noted that former Acting Chair Allison Herren Lee had instructed the staff to review companies’ climate-related disclosures. Betsy Murphy expanded on this public comment, that the SEC received more than 550 unique comment letters in response. Most of commenters supported mandated climate disclosure rules, and many cited a need for more consistent and comparable disclosure on climate-related risks and opportunities.

Following on the request for public input on climate, Chair Gensler has said he wants to have a proposed rule available. He has asked staff to specifically consider, consistent with commentary input, a number of areas in formulating recommendations. For example:
  • Whether the disclosures should be included in a company's annual report on Form 10k;
  • How qualitative disclosures could answer key questions about how a company's leadership manages climate-related risks and opportunities, and how these factors feed into the company's strategy.
  • The types of quantitative disclosures that the rules should require, such as those related to greenhouse gas emissions, financial impacts of climate change and progress towards climate related goals and greenhouse gas emissions disclosure.
  • How companies might disclose their Scope One and Scope Two emissions, and whether they should have to disclose Scope Three emissions as well.
  • Whether there should be industry specific metrics, such as for the banking, insurance or transportation industries.
  • Whether companies should provide scenario analyses on how their businesses might adapt to the range of possible physical, legal market and economic changes that they might have to contend with in the future.
Turning to currently existing disclosures, Kohl noted that staff released a “Dear Issuer” letter that provided examples of the types of climate related comments that staff may issue in the course of filing reviews. Although the sample comments are not an exhaustive list, a particular area of focus is if companies provide more expansive disclosure in Corporate Social Responsibility reports or CSR report, than in Commission filings. Staff is looking to see if a company has not provided disclosure about applicable legislative and regulatory developments or climate-related expenditures, and if those perhaps might be important to the company. This may arise when many of the companies in the same industry discuss or disclose a particular regulation. If a company that hasn't mentioned it, staff may ask for analysis on that, said Kohl.

Kohl also highlighted as a practice point that as companies craft their disclosures, they really should consider the commission’s 2010 guidance on climate. Many of the comments in “Dear Issuer” letter really track and are consistent with issues that the Commission raised in 2010, said Kohl.

Anderson noted that the SEC’s International Corporate Finance Office (OICF) has been actively engaged in the initiative of the International Financial Reporting Standards or IFRS foundation to establish an International Sustainability Standards Board, through the SEC's membership and participation in IOSCO. The SEC’s participation at this point involves technical preparatory work, such as providing guidance on the development of a prototype that could serve as a basis for reporting standards. However, any disclosure standards eventually to be issued by the Standards Board would be subject to its own due process, said Anderson.

Human capital and diversity. Turning to another area of ESG disclosures, Murphy said staff is working hard to develop recommendations on human capital disclosure. As with climate, the SEC has heard that investors want more consistent and comparable disclosures to enable them to compare company's management of their human capital resources. Some of the factors the SEC is considering for more tailored disclosure include workforce turnover, skills and development training, compensation benefits, workforce demographics, including diversity, health and safety.

Another area in the “Social” column of ESG relates to diversity of board members and nominees. Some investors have called for enhancement of the Reg S-K Item 407 disclosure. Currently, the rule requires information about whether and if so, a board’s nominating committee considers diversity in identifying director nominees. This item requires additional disclosure if the company has a policy regarding its consideration of diversity. Some institutional investors have asked for rule changes that would require companies to present information about their director nominees’ gender, race and ethnicity in a structured format, said Murphy.

Cybersecurity. The Division is also considering recommendations in the area of cybersecurity, said Murphy. Given the frequency, magnitude and cost of cybersecurity incidents, it is critical that companies inform their investors about their cybersecurity risk governance practices and provide timely disclosure about material cyber security risks and incidents. Both the division and the commission have issued interpretive guidance on cyber security in the past, and the Division is considering whether the commission should adopt rules that would be helpful in this area, said Murphy.

10b5-1 trading plans. Murphy explained that about 20 years ago, the Commission adopted Exchange Act Rule 10b5-1, which provides an affirmative defense for corporate insiders and companies to buy and sell stock under prearranged trading plans, as long as they adopt these plans in good faith before becoming aware of material nonpublic information.

Currently there are no mandatory disclosure requirements, said Murphy. Chair Gensler has expressed concern that these plans have led to gaps in the SEC's insider trading enforcement regime. Accordingly, the Division is considering whether more disclosure regarding the adoption and modification of Rule 10b5-1 plans by individuals and companies could enhance investor confidence.

Staff is considering several recommendations in this area, including:
  • Whether there should be a limit on the number of 10b5-1 plans that insiders can maintain.
  • Whether there should be a “cooling off” period. Sometimes insiders or companies trade as early as the same day they adopted the 10b5-1 plan. Staff will consider whether they should be subject to mandatory cooling off period before they can make their first trade. Some have suggested four to six months is the appropriate length of a cooling off period, said Murphy.
Proxies and proxy advice. Michelle Anderson gave an update on rulemaking work in the area of proxies and proxy advice.

Regarding universal proxies, the adoption of final rule for universal proxies is on the Commission's short term Regulatory Flexibility agenda, said Anderson. The Commission proposed rules back in 2016 that would require that all issuer and dissident nominees be presented on a universal proxy card, allowing shareholders to vote by proxy for any mix of director nominees—just as they could if they attended the meeting in person. The proposed rules also would establish new procedural and other requirements for director elections.

Given developments in corporate governance since 2016, the Commission reopened the comment period for the 2016 proposal earlier this year to solicit additional public input on the proposed rules. The SEC received more than 30 comment letters. Most commenters generally supported the adoption of the universal proxy rules, including a mandatory use of universal proxy cards. Support for universal proxy cards appears to have grown since 2016, said Anderson.

The minimum solicitation threshold for using universal proxy cards continues to be an area of commentary, with some commenters recommending a threshold greater than what was proposed back in 2016, which was a majority of voting power entitled to vote on the election. The SEC also received strong views on whether investment companies and business development companies should be subject to the final universal proxy rules. Staff is considering all of these views and actively working on finalizing the rules for the Commission's consideration, said Anderson.

Turning to proxy advice rules, Anderson noted that Chair Gensler has directed staff to review the rules for proxy voting advice that the Commission adopted in 2020. The 2020 rules were designed to ensure that clients of proxy voting advice businesses have reasonable and timely access to transparent, accurate and materially complete information on which to make voting decisions. However, some commenters continue to express concerns that the 2020 rules expose proxy voting advice providers to increase litigation risks, impose increased compliance costs on those businesses, and impair the independence of proxy voting advice. Staff is considering these views and formulating recommendations for next steps.

Other rulemakings. Other areas of rulemaking include:
  • Share repurchases. Currently, the SEC requires quarterly disclosure about issuers share repurchases pursuant to Regulation S-K Item 703, which was adopted in 2003 and has remained unchanged since then. Given that share repurchase activity has increased in recent years, staff is considering how to update and enhance this disclosure.
  • Rule 144. Amendments to Rule 144 were proposed in December 2020 regarding Form 144 and well as risk of unregistered distributions in connection with sales of securities acquired Upon the conversion or exchange of certain market adjustable securities. Some comments in response to the release describe market adjustable securities as manipulative and abusive, while others expressed concern about eliminating a source of funding for companies that may not have any other borrowing options.
  • Filing fee disclosure rules and fee payment methods. This would consolidate the filing fee information needed to calculate the fees the companies and funds paid in connection with their registration statements and other transactions. After an extended transition period, the idea would be to require a structuring of that fee information to move the fee process from a highly manual process to an automated one. Also, rather than having the filing fee tables on the cover pages of filings, the Divisions recommended that that information moved to an exhibit to the filings.
  • Clawbacks and pay versus performance. Proposing releases in these areas were issued in 2015. To start the process of implementing those provisions of the Dodd Frank act, staff is considering next steps on both of those sets of rules.
  • Exempt offerings. The Division is considering recommending that the Commission seek public comment on ways to further update the Commission's rules related to exempt offerings.
  • Payments on resource extraction, on which the Commission adopted rules in late 2020.
Beneficial ownership modernization. Chair Gensler has directed staff to consider ways to enhance market transparency, including through revisions to the current beneficial ownership, record reporting requirements and regulation 13d-g. Some view the 10-day initial filing deadline. Another commonly raised issue that some have strong views on is the application of the beneficial ownership rules to security based swaps and other derivatives.

Thursday, October 14, 2021

PCAOB offers guidance on evaluating reliability of audit evidence obtained from external sources

By John Filar Atwood

In response to requests from auditors for clarity on applying the requirements of AS 1105, Audit Evidence, the PCAOB issued guidance that addresses the relevance and reliability of information from external sources that the auditor plans to use as audit evidence. The guidance also discusses the relationship between the quality and quantity of audit evidence in the guidance document.

AS 1105 outlines what constitutes audit evidence and establishes requirements regarding designing and performing audit procedures to obtain sufficient appropriate audit evidence. It has come to the PCAOB’s attention through its outreach efforts that the expanded use of information from sources external to the company is affecting the volume and nature of information available to auditors to use in the performance of audits.

In particular, advances in technology have improved accessibility and expanded the volume of information available to companies and their auditors from external sources. Some comes from traditional external sources of information such as regulatory agencies and industry data providers that now have interactive applications that can provide real-time industry data to companies. Newer, nontraditional external sources, such as web data aggregators and social media platforms, are more prevalent, the PCAOB noted, and provide information such as product reviews, weather patterns, and customer web traffic data to inform business and financial reporting decisions.

If the auditor plans to use this information as audit evidence, it must evaluate the relevance and reliability of the information, regardless of whether it has been used by the company in preparing the financial statements, the PCAOB stated.

Sufficiency and appropriateness. In the guidance, the PCAOB notes that an auditor is required to obtain sufficient appropriate audit evidence to provide a reasonable basis for the auditor’s opinion, where sufficiency is the measure of the quantity of the evidence, and appropriateness is the measure of its quality. The guidance states that in order to be appropriate, audit evidence must be both relevant and reliable in providing support for the auditor’s conclusions.

The concepts of relevance and reliability are interrelated, the guidance notes, and information that is more relevant but obtained from a less reliable source, or information that is less relevant but obtained from a more reliable source, may need to be supplemented to provide more persuasive audit evidence. The amount of evidence needed also depends on the purpose of the audit procedure, with substantive procedures and tests of controls requiring more persuasive evidence than risk assessment procedures, according to the guidance.

In general, as the risk of material misstatement increases, the amount of evidence that the auditor should obtain increases, as does the need for relevant and reliable audit evidence, the PCAOB notes. To supplement evidence that is less relevant or obtained from a less reliable source, auditors are increasingly turning to external sources and must evaluate both the relevance and reliability of that information, the PCAOB said.

Guidance on relevance. The guidance acknowledges that in some situations whether external information is relevant to the objective of the audit procedure performed may be readily apparent, but less so in others. The audit effort needed to evaluate the relevance of external information will vary.

The guidance provides the example of banks using historical loss information from other financial institutions to estimate current expected credit losses. According to the guidance, an auditor’s evaluation of the relevance of this external information could be informed by: (1) whether the loan products of the bank and other financial institutions are similar; (2) whether the bank’s loans and the other institutions’ loans were originated with similar underwriting standards; (3) whether the other financial institutions are similar to the bank in customer base; and (4) whether the borrowers have a similar geographic location.

To determine the nature and strength of any relationship between this information and the company’s transactions, and to substantiate conclusions reached, the auditor may need to perform additional procedures, according to the guidance. For example:
  • A company could use customer reviews of its products from a social media website to monitor customer satisfaction and identify any emerging quality issues. This information could inform the auditor’s understanding of how the company collects information about potential quality problems and identifies a need for changes to warranty reserves. However, to determine whether social media reviews provide relevant evidence to support conclusions from substantive analytical procedures performed for a warranty reserve, the auditor would need to further understand how closely the negative customer reviews are correlated with product returns or warranty claims, taking into consideration the company’s business, the industry, and the nature of the company’s products.
  • Some research suggests that weather data may be used to predict retail customer behavior and sales trends. However, before using the weather data in developing certain expectations, the auditor would need to understand the relationship between weather data and company activities to determine the relevance of the data to the audit objective. This may involve, among other things, comparing historical weather trends and historical trends in the company’s revenue.
Other considerations that may be pertinent to evaluating the relevance of external information include the aggregation and age of external information. The guidance notes that in some cases, the relevance of external information may increase if the information is disaggregated. For example, when testing the valuation assertion of residential loans that are measured based on the fair value of the collateral, disaggregated sales data for residential properties by geographic location would likely provide more relevant audit evidence than combined sales data for both commercial and residential properties by geographic location.

The guidance indicates that the age of the external information and the time period it covers are also important in considering the information’s relevance. For example, in performing substantive analytical procedures over a utility company’s revenue, the relevance of census data to the auditor’s expectations of revenue and to achieving the desired objective of the procedure could vary depending on whether there have been significant expansions or contractions in the related population since the data was collected.

The guidance also warns that a certain type of information used as audit evidence in a prior audit may become less relevant in subsequent audits due to changes in the information or the account to which the evidence relates.

Guidance on reliability. According to the guidance, the reliability of audit evidence depends on the source and nature of the evidence and the circumstances under which it is obtained. The guidance provides multiple examples of factors that may affect the auditor’s evaluation of the reliability of external information, including these related to the source of the information: (1) expertise or reputation of the external source; (2) extent of regulatory oversight of the external source; and (3) relationship of the external source to the company.

Factors related to the nature of the information include whether the information has been originated, aggregated, or adjusted by the external source. The guidance notes that processing errors during the aggregation may reduce the reliability of the output, and that adjusted information may be more susceptible to processing error and bias than the original data.

Another relevant factor for the auditor is whether the information has been subject to review or verification, the guidance states. Information that has been subject to review or verification procedures would likely be more reliable than information that has not been reviewed or verified, according to the guidance.

Finally, the guidance advises that auditors should be aware of the circumstances under which information is obtained. Specifically, the auditor should consider whether the information was obtained directly by the auditor, because information obtained directly generally is more reliable than information obtained indirectly. Auditors also should weigh whether the information was obtained through a complex process, where the more complex the process, the greater the likelihood that a processing error may occur, the guidance notes.

Factors affecting reliability should be considered in combination, the guidance continued. In addition, if external information is subject to restrictions, limitations, or disclaimers, the auditor should evaluate the effect of the restrictions, limitations, or disclaimers on the reliability of that evidence. The guidance also states that if audit evidence obtained from more than one source is inconsistent with that obtained from another, or if the auditor has doubts about the reliability of external information, the auditor should perform the audit procedures necessary to resolve the matter and should determine the effect, if any, on other aspects of the audit.

Wednesday, October 13, 2021

Proposed model rules will help to combat unpaid arbitration awards and fines

By R. Jason Howard, J.D.

The North American Securities Administrators Association (NASAA) has announced that following approval by its board of directors, it is seeking public comment regarding proposed model rules concerning the unpaid arbitration awards and regulatory fines by state-licensed broker-dealers and agents or investment advisers and investment adviser representatives.

Proposed rule. If adopted by NASAA membership, the proposed model rules would “make it an unethical business practice for a broker-dealer, agent, investment adviser or investment adviser representative registered in a jurisdiction to fail to pay an arbitration award or fine entered against the person.” The proposed model rules will provide a basis for enforcement actions to address unpaid Financial Industry Regulatory Authority (FINRA) arbitration awards by allowing NASAA member jurisdictions to “prevent the registration of firms and individuals in any capacity if the firm or individual has an outstanding arbitration award.”

Specifically, the model rules will add the following provisions to the dishonest or unethical business practices of broker-dealers, agents, investment advisers, and investment adviser representatives:
  • Failing to satisfy an arbitration award resulting from a client or customer-initiated arbitration;
  • Attempting to avoid payment of any client or customer-initiated arbitration; or
  • Failing to satisfy the terms of any order resulting from a regulatory action taken against the registrant.
“This proposal seeks comment on a model rule that would require financial professionals to meet their regulatory obligations including payment of arbitration awards and sanction those applicants or registrants who fail to fulfill those obligations,” said Melanie Senter Lubin, NASAA President and Maryland Securities Commissioner. “I wish to thank the members of NASAA’s Broker-Dealer Section Committee for their work in developing this rule proposal for comment.”

The NASAA website has instructions on how to submit comments. The deadline for public comment is November 4, 2021. After the deadline, the proposed rules may be presented to NASAA members for approval and adoption as either new rules or regulations.

Tuesday, October 12, 2021

Dirks personal benefit test not a required element for criminal insider trading

By Rodney F. Tonkovic, J.D.

A district court rejected a proposed jury instruction that the "personal benefit test" applies to securities fraud charged under Title 18. The defendant in this case was charged with securities fraud for participating in an insider trading scheme. The government maintained that it does not have to prove that a tipper received any "personal benefit" from an alleged tip, while the defendant argued that the requirement, which exists in cases brought under the Exchange Act, should also apply to Title 18. The court concluded that there were no convincing legal or policy reasons to import the personal benefits test into Title 18 (U.S. v. Ramsey, October 4, 2021, Pratter, G.).

Insider trading. In May 2019, defendant Mark Wayne Ramsey was charged with securities fraud for participating in an insider trading scheme perpetrated by a professional football player and former investment banker. Ramsey was the friend and roommate of NFL football player Mychal Kendricks (then with the Philadelphia Eagles). An investment banker, Damilare Sonoiki, began tipping Kendricks about upcoming corporate mergers that Sonoiki's investment bank was retained to advise, and Kendricks traded based upon this information.

The indictment against Ramsey alleged that Kendricks gave Ramsey access to his brokerage account. Relying on the material, non-public information they received from Sonoiki, Kendricks and Ramsey purchased call options between July 2014 and November 2014 in the target companies, profiting when the mergers were announced and the value of the options rose. During the period of the conspiracy, Kendricks allegedly provided, among other things, $15,000 to Ramsey for his participation in the scheme. On September 29, 2021, after a six-day trial, Ramsey was found guilty on six out of ten counts of securities fraud and conspiracy to commit securities fraud.

Personal benefit needed? At issue was a charge under Section 1348(1) of Title 18. Under that section the government must prove beyond a reasonable doubt: knowing participation in a scheme to defraud; fraudulent intent; and that the scheme to defraud was in connection with a security of a certain issuer. The parties disagreed over the definition of "scheme to defraud." Specifically, the parties disputed whether a charge of securities fraud under Title 18 based on the misappropriation theory of insider trading requires proof that the tipper received a "personal benefit" from the tip. Ramsey argued that the same personal benefit test required under the Exchange Act applies under Title 18.

The personal benefit test does not apply. The court was not persuaded by Ramsey's argument for both legal and policy reasons. Addressing the legal reason first, the court noted that only one court has engaged in any substantive analysis of this issue. In U.S. v. Blaszczak, the Second Circuit took a close look at Titles 15 and 18 and concluded that the personal benefit test does not apply to Title 18. In reaching this conclusion, the panel read Dirks v. SEC (U.S. 1983) as establishing the personal benefit test based on the statutory purpose of the Exchange Act and to enforce Congress's intent to eliminate the use of inside information for personal advantage. This statutory context does not exist for Title 18, which is based on an embezzlement theory of fraud and where there is no requirement that an insider has breached a duty to the property owner. In addition, the panel said the Section 1348 provides a different and more broad enforcement mechanism than that found in Title 15. For these reasons, the Second Circuit declined to extend the personal benefit test to Title 18.

Ramsey argued that the Second Circuit's reasoning and conclusion were "bunk," as the opinion puts it, because Blaszczak was vacated and remanded by the Supreme Court in January 2021. The order granting certiorari, vacating, and remanding ("GVR"), however, did not mention the personal benefit test, and it cannot be inferred from the remand whether or not the Court was interested in the question, the court said. Vacated or not, the court said that the reasoning in Blaszczak remains persuasive. Too, as a matter of law, a GVR is not precedential. The court accordingly found that Ramsey failed to offer any convincing reason to import the personal benefit test into Title 18.

No policy reason. The court then found that as a matter of policy, concluding that the personal benefit test does not apply to offenses under Title 18 makes logical sense. The court noted that numerous courts have discussed the broad language of Section 1348 and the policy choices behind it. The purpose of the section and policy behind it supports the argument that Congress intended to make proof of an offense of securities fraud less demanding under Title 18 than it is under Title 15.

The case is No. 2:19-cr-00268.

Monday, October 11, 2021

Kirkland & Ellis partner examines recent shift in Delaware shareholder derivative litigation

By Matthew Solum, Kirkland & Ellis, LLP

Two recent decisions by the Delaware Supreme Court that were rendered within days of each other have shifted the landscape of shareholder derivative litigation, according to Matthew Solum of Kirkland & Ellis. He discusses the ruling in Brookfield Asset Management v. Rosson, which overturned 15 years of precedent on whether certain shareholder claims are direct or derivative. He also reviews the decision in United Food & Commercial Workers Union v. Mark Zuckerberg, et al. and Facebook, Inc., which created a new test for demand futility in derivative cases, and clarified older precedent that did not account for more recent developments in Delaware law.

To read the entire article, click here.

Friday, October 08, 2021

Facebook whistleblower asserts company concealed the extent of harm it causes

By Anne Sherry, J.D.

In a rare look at a process that is usually anonymous and confidential, 60 Minutes published some of the complaints filed with the SEC by Facebook whistleblower Frances Haugen. Haugen appeared on the program and testified before a Senate subcommittee to describe the harms that Facebook’s algorithms cause to users’ and others’ mental and physical well-being. In complaints filed with the SEC, Haugen identified material statements Facebook officials have made about the company’s policies and practices that contradict its actual practice and the effects of its algorithms.

Whistleblower complaints. The whistleblower complaints published by 60 Minutes describe a range of undisclosed or misrepresented effects of the current structure of Facebook’s platforms and their algorithms. One of the disclosures concerns hate speech; Haugen alleges that Facebook publicly stated that it proactively removes over 90 percent of identified hate speech when internal records show that as little as 3 to 5 percent of hate speech is actually removed. Another complaint takes issue with CEO Mark Zuckerberg’s statements to Congress that Facebook does not harm children or profit from social media addiction, when Facebook’s research actually revealed that Instagram made thoughts of suicide and self-injury, as well as eating issues such as anorexia and bulimia, worse for 13.5 percent and 17 percent of teen girls, respectively. According to that internal research, “We make body image issues worse for 1 in 3 teen girls.”

The other whistleblower complaints describe how Facebook contributes to global division and ethnic violence by prioritizing resources to certain countries over others; failed to address the known occurrence of human trafficking and domestic servitude via Facebook and Instagram; misled the public about equal enforcement while in fact it was whitelisting high-profile users; and contributed to the January 6 insurrection at the U.S. Capitol.

According to the complaints, these misrepresentations and omissions are important to investors for two reasons. First, investors will be harmed by the information’s coming to light, causing users to use the platforms less, resulting in less advertising revenue. Second, some investors will not want to invest in Facebook knowing the harm that it facilitates.

Senate testimony. In her Senate testimony, Haugen repeatedly pointed to the ways Facebook’s algorithms harm users and foment misinformation and violence. For example, she said that young users looking for healthy recipes are very quickly steered to content that promotes eating disorders. Facebook also dedicates the vast majority of its content-moderation resources towards English-language moderation because those tend to be the most profitable regions for the company, allowing for situations like the use of Facebook to incite violence and genocide in Ethiopia, where six languages are spoken. Haugen said she does not believe that content moderation is the solution; it has to rest in changes to the ways Facebook’s algorithms incentivize and reward outrage and misinformation. These can be simple changes, she said: for example, simply requiring that users have clicked on a link before they can share it.

Haugen also does not believe that Facebook should be broken up, stating that the same issues would persist at separate companies. Instead, she argued for regulatory oversight as well as transparency via full access to research data regarding Facebook. Even Facebook’s own oversight board does not have insight into the company’s algorithms, she said. This is “like the Department of Transportation regulating cars by watching them drive down the highway. Imagine if no regulator could ride in a car, pump up its wheels, crash test a car, or even know that seat belts could exist.” Without understanding what causes the problems with Facebook, its regulators cannot craft specific solutions, Haugen said.

Thursday, October 07, 2021

Appeals court reinstates lawsuit alleging crypto pump-and-dump

By Anne Sherry, J.D.

The Second Circuit reinstated a fraud lawsuit against a cryptocurrency issuer by vacating a district court’s dismissal of the complaint. The appeals court concluded that the Southern District of New York erred by relying on the defendants’ evidence that the ICO occurred entirely overseas as grounds to dismiss the complaint under Morrison. The court should have assessed the state-law claims under New York’s own laws for extraterritoriality. Furthermore, the court should have allowed the plaintiffs to amend the complaint even though they did not file a formal motion. The decision was issued by summary order, without precedential effect (Barron v. Helbiz, Inc., October 4, 2021, per curiam).

The plaintiffs bought HelbizCoin, a cryptocurrency issued by Helbiz, Inc., and its CEO. Their lawsuit alleges that Helbiz and its CEO represented that Helbiz would use proceeds of the coin’s ICO to build a smartphone-based transportation rental platform and market it to potential users. HelbizCoin would be the exclusive currency by which customers could pay for vehicle rentals, causing its value to rise as more users bought the coin to access the platform. After the ICO, the plaintiffs allege, Helbiz and the CEO reneged on these promises and kept the money raised in the offering for themselves, causing the price of HelbizCoin to plummet. As Helbiz prepared to go public in 2020, the company announced that the coin would be destroyed and delisted from cryptocurrency exchanges and that holders would receive Ethereum for their coins. According to the plaintiffs, though, this offer was hollow because most of the people who had bought HelbizCoins in the ICO had already sold to cut their losses.

The plaintiffs brought common law claims as well as claims under New York statutes. The district court, sua sponte, requested briefing on whether the complaint was subject to dismissal under Morrison v. National Australia Bank Ltd. (U.S. 2010), and the defendants provided evidence that HelbizCoin was created and issued abroad by an unaffiliated Singaporean party, and that U.S. citizens were barred from purchasing the cryptocurrency under the terms and conditions of the offering. The district court the district court concluded that the case involved neither securities listed on a domestic exchange nor domestic purchases of securities and dismissed the complaint under Morrison. It also denied leave to amend the complaint to plead additional facts about domestic sales and purchases of HelbizCoin.

On appeal, the Second Circuit concluded that the district court erred by applying Morrison to the plaintiffs’ state law claims. Morrison concerned federal securities claims and did not assert that its analysis applies to claims not brought under Exchange Act Section 10(b). While Helbiz and the other defendants argued that the plaintiffs’ claims were substantively Section 10(b) claims, this was not a fair reading of the complaint, the circuit court wrote. Any determination that the claims lack adequate domesticity must be made under a tailored approach that, in addition to analyzing any Section 10(b) claims under Morrison, separately analyzes any state law claims under New York’s rules for extraterritoriality.

The Second Circuit also held that the district court abused its discretion by not granting the plaintiffs leave to amend the complaint to add allegations regarding the citizenship of a purported U.S. citizen who bought HelbizCoin domestically, to clarify the domesticity of the ICO and purchases of the coin, and to make a separate claim under Section 10(b). Although the plaintiffs did not formally move to amend, their briefing to the district court repeatedly stated that they were willing to amend to avoid dismissal. Leave to amend should be freely granted, even in the absence of a formal motion. Amendment would not be clearly futile, as the allegations the plaintiffs wanted to add could cure jurisdictional defects or extraterritoriality concerns.

Finally, the district court should not have considered the defendants’ affidavit and the ICO’s terms and conditions in dismissing the complaint. These exhibits were not “integral” to the complaint, which did not mention the documents. The plaintiffs also asserted that at least one plaintiff was never asked to consent to the terms and conditions when purchasing HelbizCoin. The district court erred in relying on these documents and construing them most favorably to the defendants.

The case is No. 21-278.

Wednesday, October 06, 2021

Chair Gensler seeks staff review of ETP rules

By Mark S. Nelson, J.D.

SEC Chair Gary Gensler issued a public statement in which he said he had directed Commission staff to review the rules applicable to exchange-traded products (ETPs) with respect to the risks such products pose to both retail investors and sophisticated investment managers. Gensler said in his public statement that the review was part of a “broader look” at ETPs.

“Though the listing and trading of these products, including the listing and trading of the two ETPs that the Commission voted to approve last Friday, can be consistent with the Exchange Act, that doesn’t mean the products are right for every investor,” said Gensler. “I encourage all investors to consider these risks carefully before investing in these products. I believe that potential rulemaking could strengthen the investor protections around these products.”

Gensler’s public statement focused on risks associated with investments in ETPs, which are designed for very short-term investments but which many investors may mistakenly hold for longer periods of time because they lack adequate knowledge about how ETPs function, their purposes, and their risks. Gensler also mentioned that some ETPs have features that can amplify an investor’s gains or losses by significant multiples.

For example, a basic explainer available on the website of the Financial Industry Regulatory Authority Inc. describes the several types of leveraged ETPs. First, a “leveraged” ETP would seek to deliver a gain/loss that is a multiple of some index (e.g., 2x or 3x). Second, an “inverse ETP” would seek to deliver the opposite gain/loss of some index. A “leveraged inverse ETP” would seek to deliver a multiple of the opposite of the gain/loss of some index.

“Most geared ETPs ‘reset’ every day, which means they are only designed to accomplish the stated leveraged or inverse objective on a daily basis—these ETPs don’t make any promises as to how their returns will compare over a longer period, which can make the products risky long term—or even medium-term—investments,” said the FINRA document.

ETPs also typically have a complex structure centered around a trust arrangement. The trust may issue baskets of shares and then only authorized participants can create or redeem baskets.

With respect to virtual currencies, the SEC has yet to approve an ETP because of concerns about fraud in underlying virtual currency markets, among other things. It is unclear from Gensler’s public statement whether virtual currency-themed ETPs are part of the staff review. Other Commissioners, such as Commissioner Hester Peirce, have previously called for the SEC to approve virtual currency ETPs while also questioning whether these proposed ETPs have been treated differently by the Commission than older ETPs focused primarily on more traditional investments such as precious metals.

Gensler has recently suggested that the Investment Company Act might be the proper legal regime for virtual currency-themed ETFs, a subset of ETPs. “When combined with the other federal securities laws, the ’40 Act provides significant investor protections for mutual funds and ETFs,” said Gensler in remarks a few days ago. “I look forward to staff’s review of such filings.”