Tuesday, July 07, 2020

CEO sold out shareholders for higher post-merger comp, plaintiffs alleged

By Anne Sherry, J.D.

Investors in Towers Watson & Co. rebutted the business judgment presumption by adequately pleading that the Towers CEO negotiated an unfavorable merger in exchange for a lucrative compensation package with the post-merger company. Reversing the chancery court, a majority of the Delaware Supreme Court determined that the CEO’s conflict would have been material to the Towers board. One justice dissented on the basis that the board already knew the CEO would likely get a pay raise and the details of a secret presentation about the pay proposal did not add anything material (City of Fort Myers General Employees’ Pension Fund v. Haley, June 30, 2020, Valihura, K.).

The lawsuit centers around the 2016 merger of equals between Towers and Willis Group Holdings to form Willis Towers Watson. Unbeknownst to Towers stockholders or the board, their CEO, while he was leading the merger talks on behalf of Towers, had been discussing post-merger compensation with the CIO of ValueAct, a critical institutional stockholder of Willis. This CIO proposed a compensation plan with the post-merger entity that could increase the Towers CEO’s pay fivefold. When the merger was announced, analysts and others criticized it as a bad deal for Towers; both ISS and Glass Lewis recommended that Towers stockholders vote no and hold out for a better price. Towers’s CEO renegotiated the transaction terms to increase the special dividend, and although the proxy advisors still cautioned that the merger consideration fell short, 62 percent of Towers stockholders voted for the deal.

Among the lawsuits to emerge from the deal was the plaintiffs’ breach-of-duty suit in the Delaware Court of Chancery. The plaintiffs alleged that Towers’s CEO, due to a material conflict, negotiated to give Towers stockholders the minimum consideration that they would accept. The chancery court dismissed this complaint on the basis that the plaintiffs failed to rebut the business judgment rule. In the trial court’s reasoning, the Towers board already knew that their CEO would also run the company post-merger and that his compensation would increase because the post-merger company would be so much larger. Even knowing this conflict, the Towers board appointed the CEO as lead negotiator and kept apprised of negotiations. The court also reasoned that ValueAct’s proposal was nonbinding and reflected an upside potential based on "pie-in-the-sky" outcomes.

Reversal. On de novo review, however, the Delaware Supreme Court found that the chancery court erred in dismissing the breach-of-duty claim against the CEO. The business judgment presumption did apply because there was no change of control involved in the merger between widely held public companies. However, the plaintiffs rebutted the presumption by adequately alleging that the ValueAct proposal, made during an atmosphere of deal uncertainty, would have been material to the board. The fact that the proposal was nonbinding did not sway the high court from its conclusion that the CEO should have disclosed the proposal to the board.

Furthermore, even if the Towers CEO kept the board generally apprised of the merger negotiations, the plaintiffs alleged that he did not disclose that he had discussed his compensation with ValueAct. Towers’s compensation committee chair testified in an appraisal proceeding that he would have wanted to know about those discussions and the magnitude of the pay increase. The plaintiffs adequately pleaded that a reasonable board member would have found the CEO’s interest in the proposal to be a significant fact in evaluating the merger. The high court accordingly reversed chancery’s dismissal and remanded the plaintiffs’ claims that ValueAct and its CIO aided and abetted the Towers CEO’s breach of fiduciary duty.

Dissent. Justice Vaughn dissented from the opinion. Although he agreed with the majority’s legal analysis, he came to a different conclusion after applying the legal principles to the facts as pleaded. In his view, the conflict of interest was obvious, and the Towers board was aware that the CEO was materially self-interested. Once the Towers board proposed that the CEO continue serving in that role at the combined company, everyone concerned knew that he stood to receive a substantial pay raise. The ValueAct presentation did not alter or add anything material to the nature of the conflict. Justice Vaughn was unswayed by the testimony of the compensation committee chair, noting that the "isolated answer" in the context of the appraisal proceeding did not amount to a well-pleaded allegation or an allegation that he would have considered the presentation significant to deciding whether to approve the merger agreement.

The case is No. 368, 2019.

Thursday, July 02, 2020

NASAA strongly supports senior victim and investor choice bills

By Jay Fishman, J.D.

The North American Securities Administrators Association (NASAA) through its current President and New Jersey Securities Bureau Director, Christopher Gerold, expressed strong support for two Senate bills: (1) the Edith Shorougian Senior Victims of Fraud Compensation Act (S. 3487); and (2) the Investor Choice Act of 2019 (S. 2992). Gerold said that NASAA looks forward to working with Sens. Tammy Baldwin and Bill Cassidy on S. 3487 and Sen. Jeff Merkley on S. 2992 to get both bills passed.

Edith Shorougian Senior Victims of Fraud Compensation Act. Regarding this first bill, known as "Edith’s Bill," Gerold explained that the bill would amend the Victims of Crime Act of 1984 (VOCA) to enable eligible seniors victimized by financial fraud to be reimbursed from the Crimes Victim Fund. This legislative allowance, he said, would compensate seniors where no comparable financial assistance currently exists, by including individuals over 60 years of age in state victim compensation programs.

Gerold emphasized that enacting this bill has never been more timely in light of COVID-19 because the pandemic has placed many seniors at an elevated risk of financial fraud while they spend more time in isolation to protect themselves from infection. Moreover, this isolation has prevented seniors’ relatives and friends from visiting, causing the seniors to rely on the Internet for socialization, online shopping, banking and electronic payments. These "senior lifestyle changes" unfortunately present opportunities for fraudsters to prey on them.

Investor Choice Act of 2019. This second bill would allow investors to have their disputes with broker-dealers and investment advisers resolved in a forum the investors choose. Gerold proclaimed that currently when investors enter into contracts with broker-dealers or investment advisers, they are required to abide by pre-dispute clauses mandating the disputes be resolved in a FINRA arbitration forum. Unlike other customer disputes, which can be resolved in court or through alternative dispute resolution processes, disputes with broker-dealers and investment advisers unfairly disadvantage retail investors by requiring that the disputes be resolved by only FINRA arbitration, Gerold stated. Gerold emphasized that retail investors will be much more likely to participate in the securities marketplace if they trust it. And one important way to gain that trust would be to permit the investors to choose the forum for resolving their broker-dealer and investment adviser disputes.

Wednesday, July 01, 2020

SEC staff provides filing relief amid COVID-19 concerns

By Amy Leisinger, J.D.

The SEC staff has issued three statements regarding filing obligations in the wake of COVID-19. Specifically, Commission divisions have noted that enforcement would not be recommended if persons and entities are unable to mail certain regulatory communications to clients due to international mail service restrictions or if executives are unable to readily provide physical signatures on required filings. Overall, "best efforts" will protect financial service providers from potential liability, according to the SEC staff.

Temporary mail service suspensions. The staff of the Trading and Markets and Investment Management divisions noted receipt of inquiries regarding requirements to mail certain communications to customers who have not consented to electronic delivery. Some jurisdictions have experienced disruptions in international mailings, and the SEC staff explained that it will not recommend the Commission take enforcement action for failure to deliver impacted international mailings to recipients in affected jurisdictions so long as delivering entities send email notifications to staff identifying the specific mailings affected and prominently publish relevant information on their public websites.

These persons and entities must use reasonable best efforts to timely deliver documents electronically on a temporary basis and to obtain the consent of the affected recipient to electronic delivery. They must also maintain records reflecting satisfaction of these obligations and monitor the status of mail delivery to affected jurisdictions.

The staff stated that this position is temporary and expires on the date that a common carrier resumes mail delivery of impacted international mailings in an affected jurisdiction.

Regulation S-T. Together with the Division of Investment Management and the Division of Trading and Markets, CorpFin addressed the authentication and document retention requirements under Regulation S-T Rule 302(b) in light of logistical issues raised by the spread of the coronavirus disease. Rule 302(b) requires that each signatory to electronically filed documents manually sign a document acknowledging the electronic signature and retain that document. The staff explained that it expects compliance as practicable but that, given concerns related to COVID-19, some persons and entities may experience difficulties satisfying the requirement. In light of these difficulties, the staff stated that it will not recommend enforcement action if a signatory retains a manually signed document authenticating the electronic signature indicating the date and time the signature was executed and if the filer maintains policies and procedures governing the process.

The staff noted that this statement is temporary and that notice will be published at least two weeks before termination.

Form submission. Separately, CorpFin noted logistical difficulties in submitting certain forms (other than Forms 144) on paper given the spread of COVID-19. In light of ongoing concerns, the staff statement made a temporary statement covering those who submit the following forms:
  • various reports by foreign private issuers on Form 6-K;
  • Forms 11-K pursuant to Regulation S-T Rule 101(b)(3);
  • reports pursuant to Rule 101(b)(5) of Regulation S-T; and
  • unabridged foreign language documents and English translations of annual budgets pursuant to Regulation S-T Rule 306.
The division explained that staff would not object if the documents are submitted via email in lieu of mailing and that the relief will remain effective until the staff provides public notice. The staff noted that filers may continue to submit these documents to the SEC mailroom but that there may processing delays.

Tuesday, June 30, 2020

Justices preserve CFPB but with presidential ability to fire director at will

By Mark S. Nelson, J.D.

The Supreme Court issued its long-awaited opinion on the constitutionality of the Consumer Financial Protection Bureau’s single director structure. The CFPB was one of the signature pieces of the Dodd-Frank Act reforms and was created for the purpose of brining a degree of independence to consumer financial regulations. A somewhat fractured majority held that the CFPB’s single director structure fell outside of exceptions to federal agency organizational principles and, thus, violated separation of power principles, although the court was able to sever the offending provision from the CFPB’s organic statute to preserve the agency. As a result, the CFPB continues to exist, but its director is removable by the president at will. Justice Kagan led a four justice opinion concurring in the majority’s severability analysis, but otherwise dissenting regarding the scope of the majority’s understanding of court precedents regarding how Congress and the president coordinate on the creation of federal agencies. Justice Thomas also wrote separately to disagree with the court’s severability analysis (Seila Law LLC v. CFPB, June 29, 2020, Roberts, J.).

The case began when Seila Law received a civil investigative demand from the CFPB regarding the firm’s debt-related legal services. Seila Law challenged the CFPB’s single director structure arguing that it violated, among other things, separation powers.

The CFPB was created in the wake of the Great Recession at the urgings of its chief sponsor, Sen. Elizabeth Warren (D-Mass). The goal of the CFPB was to enhance consumer protections across a wide swath of the consumer financial services sector. The CFPB was designed as an agency with a single director whom the president could remove only for good cause. This structure was chosen by Congress to ensure a degree of independence for the CFPB.

The Supreme Court has previously upheld agencies structured with good cause removal provisions in their organic statutes. Chief Justice Roberts, however, explained that the “exceptions” available for such agencies only reach agencies designed to be led by a group of principal officers and to certain inferior officers whose duties are narrowly defined. The single director structure, according to the court, therefore violated separation of powers principles under Article II of the U.S. Constitution, which requires that the president take care to faithfully execute the laws.

Concurring/dissenting opinions. Justice Thomas, joined in concurrence by Justice Gorsuch, said the court moved in the right direction by limiting a key precedent to multimember agencies, without overruling that precedent. However, Thomas dissented to the extent he believed the court should not have addressed the issue of severability. Justice Roberts, in a portion of the opinion joined only by himself and two other justices, responded to what Justice Thomas characterized as an “aggressive” severability decision: “JUSTICE THOMAS would have us junk our settled severability doctrine and start afresh, even though no party has asked us to do so. *** We think it clear that Congress would prefer that we use a scalpel rather than a bulldozer in curing the constitutional defect we identify today.”

The four-justice dissent, led by Justice Kagan, by contrast, agreed with the court’s severability analysis but dissented from the broad sweep of the majority’s attempt to limit the types of federal agencies that can be subject to good cause removal: “The majority’s general rule does not exist. Its exceptions, likewise, are made up for the occasion—gerrymandered so the CFPB falls outside them. And the distinction doing most of the majority’s work—between multimember bodies and single directors—does not respond to the constitutional values at stake.”

Sen. Warren reaction. Senator Warren responded to the Supreme Court’s opinion with a series of tweets. The principal point made by the senator was this: “Even after today’s ruling, the @CFPB is still an independent agency. The director of that agency still works for the American people. Not Donald Trump. Not Congress. Not the banking industry. Nothing in the Supreme Court ruling changes that.”

The case is No. 19-7.

Monday, June 29, 2020

Appellate panel gives green light to Regulation Best Interest

By Amanda Maine, J.D.

In an opinion issued on Friday evening, a Second Circuit panel held that the Dodd-Frank Act authorizes the SEC to promulgate Regulation Best Interest and that the SEC’s action was not arbitrary and capricious under the Administrative Procedure Act. The court’s decision comes just days before the rule’s June 30 compliance date (XY Planning Network, LLC v. SEC, June 26, 2020, Park, M.).

Regulation Best Interest. The Commission approved Regulation Best Interest (Reg BI) in June 2019 by a vote of three-to-one. Reg BI imposes a “best interest obligation” on broker-dealers, requiring them to act in the best interest of a retail customer at the time a recommendation is made. The best interest obligation is distinguished from the fiduciary duty imposed on investment advisers by the Investment Advisers Act. While the Commission did consider a uniform fiduciary standard for both broker-dealers and investment advisers, it ultimately rejected it, explaining in the adopting release that a one-size-fits-all approach would risk reducing investor choice.

Two groups consisting of an investment adviser interest group, XY Planning Network LLC (XYPN) and its member firm Ford Financial Solutions; and a group of states and the District of Columbia, challenged the legality of Reg BI, arguing that Section 913 of the Dodd-Frank Act requires the SEC to adopt a rule holding broker-dealers and investment advisers to the same fiduciary standard. The SEC asserted that the language of Dodd-Frank grants broad permissive rulemaking authority to implement Section 913, including Regulation Best Interest. A Second Circuit panel heard oral arguments on June 2.

Standing. The appellate panel first dispensed with standing arguments, finding that the state petitioners lacked standing to challenge Reg BI. The state petitioners had argued that Reg BI would diminish their tax revenues from investment income by allowing broker-dealers to provide conflicted advice to customers, which would be prohibited under a uniform fiduciary standard. The court was not convinced, finding that the state petitioners had not shown a direct link between Reg BI and their tax revenues and describing their argument as “too attenuated and speculative” to support standing.

However, the court found that XYPN and Ford Financial Solutions did establish Article III standing. Ford Financial had argued that Regulation Best Interest would create a significant risk that clients would not be able to differentiate Ford Financial’s fiduciary duty from the lower duty that broker-dealers owe their clients, harming Ford Financial’s ability to attract customers. By identifying an impairment to a specific business practice, Ford had made a concrete showing that it is likely to suffer financial injury, which is enough to show competitor standing, according to the court.

Legality of Reg BI under Dodd-Frank. The court then turned to the heart of the matter: whether the Dodd-Frank Act authorizes the SEC to promulgate Regulation Best Interest. At focus was the language in Section 913(f) stating that the SEC “may commence a rulemaking…to address the legal or regulatory standard of care” for broker-dealers. Dodd-Frank Section 913(g) states that the SEC “may promulgate rules to provide that, with respect to [broker-dealers], when providing personalized investment advice about securities to a retail customer…the standard of conduct for such [broker- dealers]…shall be the same as the standard of conduct applicable to an investment adviser.”

XYPN and Ford Financial had argued that Section 913(g) of the Dodd-Frank Act requires the SEC to adopt a rule holding broker-dealers to the same fiduciary standard as investment advisers. The court pointed to what it called the key language in each of the provisions: the use of the word “may.” According to the court, this language gives the SEC broad permissive rulemaking authority, including the authority to promulgate Regulation Best Interest. Rather than narrowing the scope of Section 913(f) as the petitioners argued, Section 913(g) simply provides a separate grant of rulemaking authority. Congress gave the SEC the authority to promulgate rules under either section or even to make no rule at all, the court declared.

The court also pointed to the discretionary language in Section 913(f) that allows the SEC to act “as necessary and appropriate in the public interest” to address the legal standards of care. This language further demonstrates that that Congress delegated broad, discretionary authority encompassing the promulgation of Reg BI, according to the court. Finally, the court dismissed the petitioners’ argument that Section 913(f) is a procedural authorization and only Section 913(g) provides substantive content for any such rulemaking. This approach would render meaningless the substantive portions of Section 913(f) that follow the broad grant of rulemaking authority, according to the court.

“Although Regulation Best Interest may not be the policy that Petitioners would have preferred, it is what the SEC chose after a reasoned and lawful rulemaking process,” the court stated.

Not arbitrary and capricious. Finally, the court rejected the petitioners’ contention that Regulation Best Interest is arbitrary and capricious. They first argued that Reg BI is based on an incorrect interpretation of the “solely incidental” and “special compensation” prongs of the broker-dealer exemption from the Investment Advisers Act. The court stated that the petitioners had failed to explain how the SEC’s interpretation of the broker-dealer exemption made Reg BI “arbitrary, capricious, or otherwise not in accordance with law.”

The petitioners had also argued that the rule is arbitrary and capricious because the SEC did not address evidence that consumers are not meaningfully able to differentiate between the broker-dealer and investment adviser standards. The court pointed out that the SEC had considered evidence of consumer confusion and found the benefits of decreased costs and consumer choice favored adopting a best interest obligation for broker-dealers. The court observed that the SEC considered several thousand comment letters and rejected proposed alternatives in concluding that the best interest standard will best achieve its goals. This decision, said the court, was not arbitrary and capricious.

“Petitioners’ preference for a uniform fiduciary standard instead of a best-interest obligation is a policy quarrel dressed up as an APA claim,” the court remarked.

Having found that the Dodd-Frank Act authorized the SEC to promulgate Regulation Best Interest and that it was not arbitrary and capricious, the court denied the petition for review.

Dissent on standing. Judge Sullivan, concurring in part and dissenting in part, agreed with the court’s reasoning on rejecting the petitioners’ challenge on the merits and the states’ lack of standing, but stated that he would have dismissed both petitions in their entirety because, in his view, the investment advisers also lacked standing to challenge Reg BI. According to Judge Sullivan, the impairment of a marketing tactic based on a competitor’s characterization of a government regulation does not rise to the level of a legally cognizable injury-in-fact for standing purposes. Ford Financial had not demonstrated a “concrete, particularized, and actual or imminent injury,” and thus lacked standing to challenge Reg BI, he advised.

Clayton reaction. In a tweet posted to the SEC’s Twitter account on Friday night, Chairman Jay Clayton stated: “We welcome today’s decision by the Second Circuit upholding Regulation Best Interest. As of next Tuesday, whether they choose to work with a broker-dealer or an investment adviser, Main Street investors will be entitled to recommendations and advice in their best interest—the financial professional cannot put its interests ahead of the investor.”

The case is No. 19-2886-(ag)L.

Friday, June 26, 2020

Securities Docket webcast examines impact of COVID-19 on financial reporting and enforcement

By Amanda Maine, J.D.

Representatives from Latham & Watkins and FTI Consulting discussed compliance, financial reporting, and litigation considerations in light of the COVID-19 pandemic during a recent webcast hosted by Securities Docket. The panelists drew on SEC guidance related to disclosing the impacts and risks associated with the pandemic and examined litigation related to COVID-19 issues.

Financial reporting. Todd Rahn, senior managing director at FTI, said that COVID-19 has resulted in an unprecedented amount of stress and uncertainty in financial disclosures. There is a wealth of information available on the pandemic which has impacted disclosures, he advised, and the SEC has provided guidance on financial disclosures, the most recent of which was issued by the SEC’s Office of the Chief Accountant earlier this week.

Rahn stressed that SEC registrants must approach upcoming quarterly filings with a real-time, fresh focus towards the ongoing impact of COVID-19 on business operations. Some key considerations for registrants include revenue recognition, the company’s financial condition, results of operation, supply chain interruptions, human capital constraints, and reforecasting given the availability of new information, Rahn said. He emphasized that fair value accounting and estimates permeate through all these areas.

The pandemic has also highlighted the importance of robust controls and procedures, Rahn said. Maintaining internal controls over financial reporting has presented challenges due to COVID-19, including those related to working from home, the health of personnel, and supply chain disruptions.

Rahn also discussed impairment charges related to the pandemic. It is important to provide as much information as possible relating to an impairment charge, and the disclosure must be specific and not boilerplate, he said. The quarter-to-quarter disclosures need to be specific to the company and not just a roll-forward of those made in the prior 90 days, he added. FTI Managing Director Marion L. Duffy also discussed the issue of impairment, echoing Rahn’s comments that impairment analysis needs to be backed up. While having robust impairment accounting policies is good, overly aggressive accounting in the time of COVID is not a good idea. You shouldn’t use impairment charges related to COVID-19 to hide what should have been disclosed before, she advised.

Keith L. Halverstam, a partner at Latham & Watkins, discussed whether COVID-19 disclosures should be made in the near term on Form 8-K or if they should be disclosed on Form 10-Q. He warned against “kitchen sink disclosure,” emphasizing that cutting and pasting boilerplate language is not explaining how the pandemic is affecting a business. Doing so can put the company at risk of litigation, he cautioned. Halverstam said that he advises his clients to wait until the next 10-Q to update their COVID-19 disclosures. However, in certain circumstances, it may be appropriate to file a Form 8-K when previous disclosures are no longer current, he added.

Based on the SEC’s guidance released to date, Halverstam recommended that companies drafting their Forms 10-Q and 10-K focus on:
operating results, capital and financial resources;
  • cost of or access to capital;
  • compliance with credit agreement covenants;
  • ability to service debt;
  • material COVID-19-related contingencies;
  • timely accounting of assets on the balance sheet;
  • material impairments or restructuring charges;
  • challenges or material costs associated with implementation of business continuity plans;
  • demand for products and services;
  • supply chain impacts;
  • ability to maintain operations in light of remote work arrangements; and
  • impact on operations of travel restrictions and border closures. 
Halverstam also advised against using the term “material adverse effect” when it comes to making COVID-related disclosures related to company operations. While it might look good to the SEC, other parties such as the company’s lenders might see it as a violation of a covenant, making it harder for the company to draw on their revolving credit. Instead of using “material adverse effect,” companies can say, for example, that the pandemic has had “significant effects on revenue,” he recommended.

Ryan J. Maierson, a partner at Latham & Watkins, discussed the disclosure of non-GAAP financial information. He noted that the SEC was an “early mover” in providing guidance on non-GAAP disclosures related to COVID-19, which was discussed in CorpFin’s Topic No. 9 guidance issued on March 25. The SEC had this foresight because there are a number of non-GAAP measures that companies regularly report, the reconciliation of which becomes more challenging in light of the uncertainty introduced by the pandemic, according to Maierson.

The SEC’s guidance reiterated that if a non-GAAP measure is used, it still must be reconciled to a GAAP financial measure. However, because the measure may be impacted by COVID-19-related adjustments requiring additional information and analysis to complete, the SEC will not object to companies reconciling a non-GAAP financial measure to preliminary GAAP results that either include provisional amounts based on a reasonable estimate, or a range of reasonably estimable GAAP results, Maierson advised. He emphasized, however, that provisional or estimated non-GAAP reconciliation must explain why it is incomplete and what additional information would be needed to complete the accounting.

Litigation and enforcement. Rob Malionek, a partner at Latham & Watkins, said that Halverstam’s suggestions to companies for drafting their Forms 10-Q and 10-K also make a good list for litigation risk assessment. There have been a number of lawsuits filed related to COVID-19, including actions against cruise lines (including Norwegian Cruise Lines), a wrongful death lawsuit filed against Walmart, lawsuits against Lyft and Uber alleging labor law violations, claims related to the CARES Act’s Paycheck Protection Program (including a lawsuit against Wells Fargo), and lawsuits against insurance companies claiming that business interruption coverage excludes losses related to COVID-19, Malionek said.

Christopher Clark, a former prosecutor and currently a partner at Latham & Watkins, said that mitigating COVID-19 litigation risks involves companies taking proactive steps to review and update their risk disclosures. Pointing to guidance from the SEC itself, he said that companies can mitigate risks by providing their investors with insight regarding their assessment of, and plans for, addressing material risks to their business and operations. He also noted that the SEC has reminded companies to avoid selective disclosures and to disseminate COVID-19 information broadly. Clark further advised that proactive disclosures can help mitigate future damage claims. Erring on the side of more disclosure can mitigate both the securities litigation risk and damage claims in the event a litigation does happen, he explained.

Thursday, June 25, 2020

CFTC adopts swaps-related and Volcker Rule amendments, proposes rules on electronic trading

By Lene Powell, J.D.

In a busy open meeting, the CFTC adopted final rules relating to swaps clearing, as well as final rule amendments to Volcker Rule provisions addressing covered funds. The Commission also withdrew a previous proposal on automated trading and introduced a new proposal addressing electronic trading. Finally, the Commission proposed to extend the compliance date for certain margin requirements for smaller swaps entities.

The meeting included staff presentations and was held via conference call due to the COVID-19 (coronavirus) pandemic.

Electronic trading. The Commission took two related actions relating to electronic trading. First, by a 3-2 vote, the Commission withdrew a previous proposal and supplemental proposal called “Regulation Automated Trading” or “Reg AT.” The proposal, issued in 2015, and supplemental proposal, issued in 2016, would have imposed rigorous requirements relating to automated trading.

According to Tarbert, Reg AT was overly prescriptive and would have established certain specific controls that would not have kept up as technology evolved. He also believes the proposal suffered from other fatal flaws, including requiring market participants that use algorithmic trading methods to register with the CFTC and make their source code available to the CFTC upon request. In Tarbert’s view, it was best to withdraw the proposals altogether and start anew.

The new proposal, “Electronic Trading Risk Principles,” broadens the focus from automated trading to all electronic trading, which Tarbert said accounts for 96 percent of all trading overseen by the CFTC. The proposal takes a principles-based approach to prevent, detect, and mitigate market disruptions and system anomalies that can arise during electronic trading due to many causes. As examples of market disruptions, Tarbert cited excessive messages, fat finger orders, or the sudden shut off of order flow from a market maker.

The proposal would establish three Risk Principles:
  1. Exchanges must have rules to prevent, detect, and mitigate market disruptions and system anomalies associated with electronic trading. This would include fashioning rules applicable to all traders governing items such as onboarding, systems testing, and messaging policies.
  2. Exchanges must have risk controls on all electronic orders to address those same concerns.
  3. Exchanges must notify the CFTC of any significant market disruptions and give information on mitigation efforts. 
Tarbert explained that implementation of the Risk Principles would be subject to a reasonableness standard, such an exchange would be in compliance if its rules and its risk controls are “reasonably designed” to meet the above objectives. The CFTC would have the ability to monitor compliance by the exchanges and would have avenues to sanction non-compliance.

Commissioner Dan Berkovitz dissented from the withdrawal of the Reg AT proposal, but offered qualified support for the new proposal. According to Berkowitz, Reg AT was a comprehensive approach for addressing automated trading in Commission regulated markets, and the comments received are worth evaluating going forward. In his view, the new proposal recognizes the need to update the Commission’s regulations to keep pace with the speed, interconnection, and automation of modern markets. However, he is not yet convinced and looks forward to public comment on whether the proposal is sufficiently detailed or comprehensive to effectively address those risks.

Commissioner Rostin Behnam also voted against withdrawing the Reg AT proposal, and in addition voted against issuing the new proposal. Behnam believes that the proposal does not minimize the potential for market disruptions and other operational problems that may arise from the automation of order origination, transmission or execution, and create structures to absorb and buffer breakdowns when they occur. He also believes it does not particularly require exchanges to do anything new or differently. This could be confusing for market participants and could set them up for more than they bargained for in the future, said Behnam.

“[W]hen there is a technology failure—and there will be—will the Commission stand by its principles or will it fashion an enforcement action around a black swan event so that everyone walks away bruised, but not harmed?” said Behnam.

Volcker Rule. Prior to the open meeting, the Commission had voted via seriatim to adopt final rule amendments to the Volcker Rule by a 3-2 vote. The proposal, issued by the Commission in January 2020, follows other targeted revisions and specifically addresses covered funds. The proposal was issued jointly as an interagency rule with the CFTC, SEC, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and the Board of Governors of the Federal Reserve System (FRB).

According to Tarbert, the final rule amendments begin to address the over-breadth of the covered funds definition and related requirements. Specifically, the Volcker Rule will now no longer be applied to certain investments including credit funds, venture capital funds, customer facilitation vehicles, and family wealth management vehicles. The amendments also modify several existing exclusions from the prohibition on activities related to private equity and hedge funds for foreign public funds, loan securitizations, and small business investment companies.

Both Berkovitz and Behnam dissented from the final rule adoption. In Berkovitz’s view, the new rules allow banks to take greater risks without adequate assessment of those risks, and are not necessary for the banking industry to succeed. Similarly, Behnam believes the amendments erode existing protections against systemic risk.

Inter-affiliate swaps clearing exemption. By a 5-0 vote, the Commission voted to finalize amendments to the CFTC regulation that exempts certain affiliated entities within a corporate group from the swap clearing requirement. The amendments were proposed in December 2019.

As Tarbert explained, just as the government does not regulate loans between family members, transactions between affiliated entities in a corporate family are subject to less oversight than arms-length transactions with external entities. However, in implementing swaps clearing requirements under the Dodd-Frank Act, anti-evasionary measures were adopted to prevent entities from using inter-affiliate swaps to shuffle transactions over to jurisdictions that had not yet adopted comparable clearing requirements. To allow time for foreign clearing regimes to be deemed comparable, CFTC staff issued no-action relief, creating temporary alternative compliance frameworks that over 70 eligible affiliate counterparties located outside the U.S. have relied on.

However, as Berkovitz explained, some compatibility determinations have not occurred as anticipated. In order to provide legal certainty and make the anti-evasionary condition workable for international corporate groups in the absence of foreign clearing regimes determined to be comparable to U.S. requirements, the Commission adopted final rule amendments to make permanent the temporary alternative compliance frameworks.

“By codifying this relief, we are providing the swaps market with clarity, certainty, and transparency—consistent with the CFTC’s mission, core values, and strategic objectives,” said Tarbert.

Post-trade name give-up. By another 5-0 vote, the Commission voted to adopt final rules restricting the practice of post-trade name give-up. The rules were introduced in a proposal in December 2019, which received support from key stakeholders.

As several commissioners explained in a joint statement, “name give-up” is an industry practice from a time when most swaps were arranged directly between counterparties rather than through a regulated exchange. Because these over-the-counter swaps were not centrally cleared, market participants needed to know their counterparty’s identity in order to manage to credit risk. As a result, trades were not anonymous.

As many swap transactions have moved onto regulated exchanges following the Dodd-Frank Act and central clearing has addressed the credit risk issue, many have questioned whether there is still a need for post-trade name give-up for cleared swaps. Some have criticized the practice as anticompetitive, an obstacle to broad and diverse participation on swap execution facilities (SEFs), and potentially inconsistent with numerous provisions of the Commodity Exchange Act (CEA) and Commission regulations.

The final rule prohibits name give-up for swaps that are executed anonymously and intended to be cleared. It does not apply to swaps that are not intended to be executed anonymously, such as trades done via a name-disclosed request for quote. The rule also includes a limited exception for “package transactions” with at least one component that is an uncleared swap or a non-swap instrument. The rule includes a phased implementation schedule.

According to the joint statement, the commissioners believe that by protecting trading anonymity where it is possible to do so, the rule promotes swaps trading on SEFs and fair competition among market participants. The commissioners observed that the name give-up issue “can be a bit of a lightning rod” and said CFTC staff stands ready to work with market participants and operators to resolve any issues.

Phase 6 margin requirements. Finally, the Commission voted 5-0 to propose the extension of the compliance date for “Phase 6” margin requirements by one year to September 1, 2022. Currently, smaller swaps entities are scheduled to come into compliance with certain margin requirements by September 1, 2021. Berkovitz noted that this would be the second extension for these entities, and is not convinced that another extension is really needed, given that entities have had years to prepare. However, given hardships imposed by the COVID-19 pandemic and the fact that other jurisdictions have also slowed compliance, Berkovitz supported issuance of the proposal.

Wednesday, June 24, 2020

Chamber of Commerce’s CCMC calls for postponement of phase two of CAM reporting

By John Filar Atwood

In light of the circumstances created by the COVID-19 pandemic, the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness (CCMC) has asked the PCAOB to postpone the effective date for implementing phase two of reporting critical audit matters (CAMs). The CCMC recommended a one-year delay, with the option of voluntary early implementation.

In a comment letter responding to the PCAOB’s request for feedback on stakeholders’ initial experiences with auditor reporting of CAMs, the CCMC noted that because of the pandemic other accounting and auditing standard-setters such as the Financial Accounting Standards Board, the Auditing Standards Board, and the American Institute of Certified Public Accountants have postponed the effective dates for implementing their new standards. The CCMC urged the PCAOB to do the same.

Under a phased implementation plan, the PCAOB’s auditor reporting standards related to CAMs took effect for fiscal years ending on or after June 30, 2019 for large accelerated filers. The second effective date, which affects the audits of all other companies to which the CAM requirements apply, is for audits of fiscal years ending on or after December 15, 2020.

The SEC has asked the PCAOB to complete a post-implementation review, including some analysis between effective dates for CAMs. The PCAOB intends to complete the interim analysis before the second phase of CAM implementation begins.

The CCMC said that it supports post-implementation reviews of accounting and auditing standards. It noted, however, that phased implementation provides an opportunity for the PCAOB to consider necessary adjustments to its standards.

Due to the spread of the coronavirus and the accompanying shutdown of the U.S. economy, this is not a time for business as usual for any stakeholder, the CCMC said. Instead, all stakeholders are busy meeting their professional and personal responsibilities, and will be forced to do so for the foreseeable future as the industry works to navigate a path forward.

Advantages to a delay. Under these circumstances, the CCMC suggested that the PCAOB postpone the effective date for phase two of CAM reporting. The group cited what it sees as several advantages to this approach.

First, in addition to giving some relief during difficult times, postponement would provide an opportunity for a high-quality implementation of the second phase of CAM reporting, hopefully when the distractions from the pandemic are diminished, the CCMC stated.

Second, given the PCAOB’s concern about conducting an interim review of auditor reporting of CAMs before the second phase of implementation of the requirements, postponing the phase two effective date would provide extra time for the PCAOB to consider evidence from an interim analysis and make any necessary adjustments related to auditor reporting of CAMs, according to the CCMC. The group added that postponement would provide adequate time for phase two auditor reporting to incorporate any adjustments, which otherwise would not occur under the PCAOB’s current approach.

Third, the CCMC believes that postponing the effective date for phase two, while allowing for voluntary early implementation, would also facilitate the PCAOB’s post-implementation review of CAM reporting standards by expanding the conditions for, and circumstances of, the PCAOB’s phased implementation.

Comments from the U.K. The PCAOB also received comments from the U.K.’s Institute of Chartered Accountants in England and Wales (ICAEW). The ICAEW believes that the new CAM reporting requirements have made the audit report more relevant and informative to investors and other financial statement users. The group commended the PCAOB for its ongoing review of the new requirements.

The ICAEW said that while investors expect to see improvements in auditor reporting over time, they also expect changes in auditor reporting requirements where necessary. The U.K. accounting body said that the PCAOB should avoid excessive focus on failures in execution, particularly if it becomes clear that investors are looking for something different. In its view, standard-setters should seek to align their respective requirements to a greater extent than they have to date.

Investors, analysts, users, preparers and auditors of financial statements all have an interest in the differences between CAMs as reported in the U.S., and key audit matters (KAMs) reported in the U.K., Europe and elsewhere, according to the ICAEW. The group said that as the PCAOB develops its thinking in this area, it can afford to be clear about the differences, what it can learn from experience in other jurisdictions, and what it believes are the limitations of reporting under different regimes.

The ICAEW believes that the PCAOB is aware that investors are interested in these matters and that some auditors seek to minimize the differences in reporting where possible. It noted that the PCAOB has chosen to adopt a reporting model that diverges from the model adopted by the IAASB. The ICAEW stated that in the coming months and years, the PCAOB will be called on to defend that position, and to modify it, if investors believe it is warranted. The group encouraged the PCAOB to seek to understand the differences through its public outreach, as well as privately, to better serve investors.

Tuesday, June 23, 2020

Disgorgement not exceeding amount of net profits is permissible equitable relief

By Rodney F. Tonkovic, J.D.

Answering a question left open in Kokesh v. SEC, the Supreme Court held that a disgorgement award that does not exceed a wrongdoer's net profits and is awarded for victims is permissible equitable relief. Writing for the Court in Liu v. SEC, Justice Sotomayor said that equity practices have long authorized stripping wrongdoers of ill-gotten gains and that Congress incorporated these longstanding equitable principles into Exchange Act Section 21(d)(5), thus prohibiting the Commission from seeking an equitable remedy in excess of the net profits from the wrongdoing. The Ninth Circuit's judgment is accordingly vacated, and the case is remanded for proceedings consistent with the opinion. In dissent, Justice Thomas argued that disgorgement is not a traditional equitable remedy and can never be awarded under Section 21(d)(5) (Liu v. SEC, June 22, 2020, Sotomayor, S.).

Origins of disgorgement. Under Exchange Act Section 21(d)(5) (15 U.S.C. §78u(d)(5)), the SEC can seek "equitable relief" before a federal court. Since Congress did not define "equitable relief," courts have had to determine what this means, and, since the 1970s, have found that the SEC could obtain what was originally called "restitution," that is, depriving a defendant of the gains of wrongful conduct. This remedy, Justice Sotomayor noted, has more recently been referred to as disgorgement (a distinction also noted by Justice Thomas in his dissent).

In Kokesh, the Court held that the disgorgement often sought by the SEC in enforcement cases is a penalty for purposes of the five-year statute of limitations contained in 28 U.S.C. §2462 (covering civil fines, penalties, or forfeitures). The holding in Kokesh was a narrow one, and the Court did not address whether a penalty under §2462 could still qualify as equitable relief under Section 21(d)(5), and explicitly said that it was not opining on the authority of federal courts to order disgorgement in SEC enforcement proceedings.

The case against Liu. In this case, two defendants in a civil enforcement action challenged a district court's order that they disgorge almost $27 million raised from investors in an EB-5 fraud scheme. The Ninth Circuit, in an unpublished decision, affirmed, explaining that Kokesh left the question of federal courts' authority to award disgorgement for another day, so that case was not, as the defendants argued, irreconcilable with longstanding Ninth Circuit precedent. The circuit panel rejected Liu's argument that the disgorgement award failed to account for business expenses as "unjust" under circuit precedent and held that the proper amount of disgorgement is "the entire amount raised less the money paid back to the investors."

The petition. The Supreme Court granted certiorari in Liu v. SEC (18-1501) on November 1, 2019, for a petition asking whether the SEC may seek and obtain disgorgement from a court as "equitable relief" for a securities law violation in light of the Court’s ruling in Kokesh that such disgorgement is a penalty. The petition argued that Congress authorized the Commission to seek only injunctions, civil monetary penalties, and equitable relief. Applying the reasoning behind Kokesh, if disgorgement is a penalty, it falls outside the scope of equitable relief and thus lacks any statutory authority.

A long history of profits-based remedies. In Liu, the question of whether courts possess authority to order disgorgement in SEC enforcement proceedings was now squarely before the Court. At the outset, Justice Sotomayor undertook the "familiar" task of analyzing whether a particular remedy falls into the categories of relief that were typically available in equity. She noted that equity practices have long authorized (under various labels) stripping wrongdoers of ill-gotten gains and that courts, in order to avoid transforming an equitable remedy into a penalty, have restricted the remedy to awarding a wrongdoer's net profits to the victims.

According to Justice Sotomayor, Congress incorporated these longstanding equitable principles into Section 21(d)(5), thus prohibiting the Commission from seeking an equitable remedy in excess of the net profits from the wrongdoing. Over the years, however, courts have awarded disgorgement in ways that are in tension with equity practice: ordering the proceeds of fraud to be deposited in Treasury funds; imposing joint-and-several-liability; and by declining to deduct legitimate expenses from the receipts of the fraud. While the Commission maintained that a more expansive interpretation of the equitable disgorgement remedy has the tacit support of Congress, Justice Sotomayor said, however, that even if Congress used the term "disgorgement" as a sort of shorthand reference to Section 21(d)(5) in other statutes, this does not "silently rewrite the scope of what the SEC could recover in a way that would contravene limitations embedded in the statute," that is, a defendant's net profits.

Guidance for lower courts. The Court held that a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under Section 21(d)(5). Applying these principles to this case, the petitioners argued that their disgorgement award was unlawful under traditional equity practice because it: failed to return funds to the victims; imposed joint-and-several liability; and failed to deduct business expenses from the award. Because the parties focused on the broad question of whether any form of disgorgement may be ordered, Justice Sotomayor addressed these issues briefly in order to provide guidance on remand.

First, the equitable nature of the profits remedy generally requires the return of a defendant's gains to benefit the victims. In this case the SEC did not return the bulk of the funds to the victims due to an inability to collect them, and, suggested that the practice of depositing disgorgement funds with the Treasury may be justified where it is not feasible to distribute the funds to investors. In any event, there was no specific order directing any proceeds to the Treasury, and, if one is entered on remand, the lower courts may evaluate whether that order would be for the benefit of investors under Section 21(d)(5).

Next, Justice Sotomayor said that imposing joint-and-several liability runs against the rule in favor of holding defendants individually liable. But, she continued, the common law did permit liability for partners engaged in concerted wrongdoing. On remand, then, the Ninth Circuit should determine whether the petitioners, who were married, can be found liable for profits as partners in wrongdoing or if individual liability is required.

Finally, courts must deduct legitimate business expenses before awarding disgorgement. In this case, the district court declined to deduct Liu's business expenses on the theory that they were incurred to further the fraudulent scheme. Some of Liu's expenses went toward lease payments and cancer-treatment equipment that could have value independent of the scheme, so the question becomes whether those expenses are legitimate or wrongful gains "under another name." The lower court should examine whether including those expenses in a profits-based remedy is consistent with the equitable principles underlying Section 21(d)(5), Justice Sotomayor said.

Dissent. Justice Thomas dissented, agreeing with the Court's declining to affirm the Ninth Circuit's decision, but taking issue with the decision to vacate and remand, saying that he would reverse the judgment. According to Justice Thomas, disgorgement is not a traditional equitable remedy and can never be awarded under Section 21(d)(5). He maintains that disgorgement is a 20th-century invention and has no basis in historical practice as a traditional form of equitable relief. The dissent notes further that prior to 2005, the SEC lacked the power to seek equitable relief in cases like this one and that disgorgement is a judicially-created remedy. If the majority accepts disgorgement as an available remedy, Justice Thomas concludes, it should at least limit the order to be consistent with traditional equity. That is, the order should be limited to each petitioners profits, it should not be imposed jointly and severally, and the money paid by the petitioners should be used to compensate their victims.

What's next? The opinion in Liu affects two petitions asking essentially the same question that have been pending awaiting the outcome in this case. Having addressed the issue, the Court is likely to issue orders in the near future denying certiorari or granting, vacating, and remanding consistent with the holding in Liu.
  • Team Resources v. SEC (19-978) asks whether the SEC may obtain disgorgement from a federal court as an equitable remedy for securities violations despite the Supreme Court's determination in Kokesh that disgorgement is a penalty. The petitioners recognized that the Court granted the petition in Liu v. SEC asking the same question, and both parties agreed that the petition be held pending the decision in Liu.
  • Next, Jalbert v. SEC (19-1310) asks whether a federal government agency's order imposing unauthorized penalties labeled "disgorgement" is void in relevant respects because the agency did not have the power to impose penalties without explicit congressional authorization (the petition separately frames the same question in terms of a separation of powers violation). A key difference in this case, however, is the fact that the petitioner waived the right to judicial review of the SEC order at issue as part of a settlement, leading to the First Circuit's affirming the district court's dismissal on those grounds.
Finally, Congress has also advanced legislation that would clarify, once and for all, the SEC's authority to seek, and for a federal court to order, disgorgement. The House version of the bill would allow a 14 year limitations period on disgorgement, while the Senate version retains the 5-year limitations period in 28 U.S.C. §2462. Moreover, the Senate version would grant the SEC authority to seek restitution in addition to disgorgement, which the House version does not mention. The House passed its version in November 2019, but the Senate version remains in committee.

The case is No. 18-1501.

Monday, June 22, 2020

Muni industry buoyed by SEC to make voluntary disclosures, conference participants say

By Amanda Maine, J.D.

At a recent SEC-hosted event on secondary market disclosure practices in the municipal securities industry, participants discussed hot topics in the area of secondary market disclosure, including those relating to COVID-19 issues. Panelists applauded SEC guidance issued in May that encouraged the disclosure of voluntary, non-routine information on the impact of COVID-19, including making forward-looking statements. Speakers during an earlier panel had also spoken positively about voluntary disclosures in the municipal market.

COVID-19 disclosures. Mark Kim, executive vice president and chief operating officer of the Municipal Securities Rulemaking Board (MSRB), provided an overview of disclosures the MSRB’s EMMA system has recorded, noting in particular those related to the COVID-19 pandemic. SEC Rule 15c2-12 requires the disclosure by municipal securities issuers of Material Financial Obligation—Incurrence or Agreement Events (called "Event 15 disclosures"). Kim noted that there has been a significant increase in the number of Event 15 disclosures in the last three months on EMMA, coinciding with the pandemic.

According to Kim, since the end of May, there have been approximately 7,400 disclosures on EMMA that reference COVID-19, including 2,174 in the primary market and 5,268 continuing disclosures. He cited in particular event notices for reserve fund drawdowns, delinquent principal/interest payments, and one instance of bankruptcy precipitated by the effects of the pandemic. Kim also pointed out that the second week in May saw a sharp increase in COVID-19 disclosures submitted to EMMA, observing that in the previous week, SEC Chairman Jay Clayton and Office of Municipal Securities Director Rebecca Olsen had issued a joint statement (the Joint Statement) encouraging municipal issuers to make voluntary disclosures discussing the current and anticipated effects of COVID-19.

Lisa Washburn, managing director at research firm Municipal Market Analytics, said that her firm has also been cataloguing COVID notices since mid-March, although it differs from Kim’s EMMA list in that it leaves off boilerplate notices that do not include specifics, rating changes, or inability to meet continuing disclosure obligations due to COVID. The notices that she does catalogue include those that discuss utilization, revenues, expenses, liquidity, and reserves, she explained. The most useful disclosures are those that provide information on the impact of COVID-19 on the borrower’s operations and finances and the management’s response, according to Washburn.

Washburn observed that she has never seen so many voluntary disclosures before by borrowers on EMMA, and speculated that this may be due to the SEC’s Joint Statement. However, Washburn added that there are tens of thousands of issuers in the municipal market, so the disclosures she is tracking represent only a fraction of that. In addition, the voluntary disclosures may demonstrate a "positive bias" in that issuers that have taken the time to consider the impact of the pandemic and proactively disclose this information are probably those with better management, she advised.

Dan Deaton, a partner at Nixon Peabody, also praised the Joint Statement, especially for providing critical guidance in plain English. The SEC recognized the needs of investors in this challenging market for information, and stakeholders are clamoring for information from local issuers, Deaton said. The Joint Statement also cracked open the topic of forward-looking information by stating that the SEC would not try to second-guess good-faith efforts, he remarked. In addition, he heralded the SEC’s encouragement to issuers to take an iterative approach to COVID-19, as opposed to a once-and-final approach.

Deaton also addressed the Office of Municipal Securities’ Staff Legal Bulletin No. 21 (OMS), which provides staff views on the application of the antifraud provisions to statements made by issuers of municipal securities in the secondary market. SLB 21 clarified that the antifraud provisions apply to any statement of a municipal issuer that is reasonably expected to reach investors and the trading markets. According to Deaton, by focusing on the "total mix of information" available to the investor, an analysis that permeates the corporate securities market, SLB 21 takes the focus away from documents and annual filings and redirects it to the current information that is out there which might mislead investors and makes sure that good policies and procedures are in place. The Joint Statement and SLB 21 complement each other regarding COVID-19, he said.

Timeliness and deadlines. The panelists also discussed a recommendation made by the Fixed Income Market Structure Advisory Committee (FIMSAC) at its February meeting regarding the timeliness of financial disclosures in the municipal securities market. As Kim explained, some disclosures required to be made pursuant to a continuing disclosure agreement (CDA) involve a due date that is contingent on an event (for example, 90 days after the auditor issues its final opinion) where there is no way to know at the present time when that event will happen. FIMSAC recommended that the SEC explore ways to make disclosure deadlines for annual financial information and audited financial statements more certain and predictable, allowing municipal issuers to commit to a date without the contingency language.

Deaton said that with the annual report being fixed on one particular date, it doesn’t permit different kinds of information that can come out much earlier. For example, an issuer might have information available on its website shortly after the fiscal year, but the full annual information package might not be available for another five months as they wait for the audit to be completed. By being tied to a final statement, it can preclude issuers from making fresh, ongoing evaluations that are necessary for the marketplace. The mechanistic process centering around specific dates and forms constrains issuers from providing meaningful information that they have, he said.

Washburn said that she is more concerned about the timeliness, completeness, and accessibility of ongoing financial disclosures versus the actual compliance with the CDA. She noted that since the CDA is issuer-created, the information provided and the time it is provided is not consistent across buyers. Measuring compliance against timeliness with a CDA is flawed, Washburn advised. Noting that for many issuers, the audit is the only non-event disclosure that is posted on EMMA, Washburn speculated that more frequent, unaudited information posted on EMMA in a timely manner might alleviate some of the focus on the audit timing.

Friday, June 19, 2020

Class actions slow somewhat due to COVID-19, but are expected to recover

By Lene Powell, J.D.

Securities and antitrust class action filings have dipped this year due to the coronavirus pandemic, but things look to pick back up, according to Peter Hansen, chairman of Battea Class Action Services. In a webinar by the Council for Institutional Investors (CII), Hansen said the slowdown comes amid a trend of increased class action filings over the past several years, and he expects the overall high filing rate to continue.

The webinar, “State of Securities & Antitrust Class Action Litigation and Impact of Covid-19,” was moderated by Lucy Nussbaum, a CII research analyst.

Class action trends. According to Hansen, class action filings have been trending higher over the last several years. Currently, Battea is seeing around 450 class actions filed per year. In 2020, most cases are coming from the health, technology, electronic services, and financial services sectors, he said.

Hansen pointed to several factors contributing to the increase in filings. Litigation finance services have increased funds available to pursue class actions. In addition, increasingly automated access to information and digital discovery and analysis are making processes more efficient. Against the steady backdrop of a highly competitive business culture, with the ongoing motive to “push the numbers” sometimes crossing the line into actionable wrongdoing, these developments are helping to drive growth in class actions.

However, the courts do a good job of vetting cases and getting rid of frivolous actions, said Hansen. Battea is currently seeing a dismissal rate of around 51 percent. Hansen does not anticipate that either the case filings or dismissal rate will change due to any initiative by the courts.

Another trend has been an increase in international cases and in “mega cases” with large damages, said Hansen. In part this is due to an increase in large financial derivatives antitrust cases, for example cases involving the rigging of foreign exchange (FX) and LIBOR benchmarks. Damages are also on the upswing overall. Hansen noted that the S&P is currently at a very high value, so stock drops are amplified. Damage amounts are larger, and so are the settlements.

Impact of COVID-19. The coronavirus pandemic has caused a slowdown in class actions:
  • The number of case filings has dropped in 2020 by about 20 percent.
  • Courts have been slower to approve settlements. Battea has had a little over 50 settlements approved so far this year, compared to prior years which had 60 to 80 approved by this time.
  • Approval of distributions has also been slower. Battea has had 40 distributions approved, versus 50 to 80 in prior years. 
Hansen sees this impact as not particularly significant. While there has been some slowdown in court processes and file production, he thinks that some of the backlog has been cleared and the pace will pick back up again.

Regarding class actions specifically arising out of the pandemic, Hansen pointed to five:
  • Inovio Pharmaceuticals, Inc. The company allegedly claimed to have developed a COVID-19 vaccine, but this was not true, resulting in a stock drop.
  • SCWorx Corp. The company allegedly misrepresented orders in production of COVID-19 tests.
  • Phoenix Tree Holdings. A Chinese real estate development company said it was not impacted by COVID-19, even though they had many properties in Wuhan, the epicenter of the pandemic in China.
  • Zoom. Amid an enormous rise in popularity of the video call provider during the pandemic, the software was discovered to not have anywhere near the level of encryption and security as advertised.
  • Norwegian Cruise Lines. Salespeople were allegedly directed to tell customers it was not possible to get COVID-19 in tropical temperatures. “They were selling trips like hotcakes,” said Hansen. 
Antitrust class actions. According to Hansen, antitrust cases can be more complex and difficult to prove than “plain vanilla” equities class actions, particularly in the area of financial derivatives. However, there is a lot of money in them, so it is worth it for investors to pay attention, he said.

Financial antitrust cases can be challenging because sometimes it takes a long time to emerge that there was an injury, said Hansen. For example, in the benchmark manipulation cases, people didn’t know for sure if pricing and spread were a function of collusion and manipulation. As a result, people didn’t have a recorded loss on the books, as would happen with a big drop in equity position. In addition, there are many discrete financial instruments involved. In the LIBOR case, there were many different swaps issued by many different issuers, at different times, with different durations. There was also a mix of over-the counter and exchange-traded plaintiffs.

As a result, the problem of damage assessment or assertion is too much for many, Hansen said. Custodians have largely given up on following these cases on behalf of their clients, and some of Battea’s competitors have taken some “very costly shortcuts” for their clients. Even with Battea’s investment in systems and expertise, “it really keeps us up at night,” said Hansen. Despite these difficulties, Battea is currently following about 35 cases, of which about half have settled or partially settled, and half are going through the courts. The complexity is definitely a challenge, but there’s a lot of settlement money in these actions, Hansen said.

Hansen has not seen any specific impact on antitrust class actions from the pandemic. Cases are continuing to see movement. For example, a Mexican government bond case had an icebreaker settlement a few weeks ago, and a Fannie Mae case settled for $85 million. There have been several new cases filed recently, including an action against Bank of America for bond suppression.

International class actions. Hansen discussed areas where international class actions differ from domestic class actions, often posing unique challenges.

First, there are differences in jurisdictions in class action structures, said Hansen. For example, in Germany, there is a single model plaintiff and it is possible to put up joint multiple coalitions. In contrast, in the U.K., there is more of a “carbon copy” concept, where 50 to 100 investors can sue together, but they’re really 50 or 100 individual investors in one complaint. Every man is technically for himself, but there is one shared funder and law firm. Denmark also follows this model. In the Dutch jurisdiction, an association foundation can pursue a lawsuit. Individual investors do not sue directly, but instead have a representative organization sue. In addition to the structural differences, there are also differences between jurisdictions in statutes of limitation, capital markets law, and damages provisions.

Another issue is anonymity. Hansen explained that in the U.S., it’s possible to remain anonymous, but in Europe it really is not. The defendant will know who you are, and possibly the public as well. This can cause a crimp in signing up clients. For example, the firm Scott + Scott brought an FX lawsuit in the U.S., but literally could not get anybody to sign up in Europe to sue their counterparts. There has been something of a change on this front in the U.K., however, with a new antitrust law that allows a representative party to represent the class. This might be helpful in terms of people participating, said Hansen.

A further issue is that damages models are not published, said Hansen. Of course, investors want to know what the losses are before they spend a lot of time debating if they should participate. There are a lot of coalitions and its very fee and lawyer-driven, and investors need to try and decipher who to go with. But class action services firms can help distill these choices, and Battea expects a significant growth in international litigation, Hansen said.

Lead plaintiffs and opt-outs. One area that has changed dramatically in the past three years is the competition for lead plaintiff, said Hansen. While it has always been a race for law firms to be appointed as counsel and to find investors with big losses that they can represent, that process has become very automated, with systems developed to track 13F filings and identify large holders.

Increasingly, some law firms, as soon as they lose the race to be appointed lead counsel, will “do a 180 overnight” and propose that claimants should opt out, asserting that the appointed lead counsel will not do a good job. However, some firms that get appointed are very formidable, said Hansen, and investors need to do their own analysis and not be “sweet-talked” into an opt out on short notice.

Looking ahead. Fundamentally, Battea does not anticipate any real changes over the long term but expects to see impacts over the short term. In Hansen’s view, second quarter earnings will likely kick off some real action, and this will continue for the rest of the year. Hansen noted that corporate insiders are facing a sky-high market on one side, but possibly presiding over a massive drop in business on the other side.

“So if you don’t pre-announce your shortcomings while selling insider stock, you’re literally underwriting a case against yourself,” said Hansen.

In response to a question from the audience about financial reporting amid ongoing economic uncertainty, Hansen acknowledged that much of companies’ financial reporting in the next few months will be complete guesses and may take advantage of relaxed application of some of the rules on loan lapses. In that context, it may be harder to claim material representation, as issuers may get the benefit of the doubt on financial valuation estimates.

Hansen thinks we will see a mixed bag in this area, as companies can certainly claim force majeure to some degree. However, if companies are not forthcoming about pre-announcing failing results, or if the current crisis exposes a real weakness in the business, Hansen believes we could see “some earnings surprises and some very solid cases.”

Thursday, June 18, 2020

House Finance subcommittee explores cybercriminals’ exploits in the time of COVID-19

By Brad Rosen, J.D.

The Subcommittee on National Security, International Development and Monetary Policy of the House Financial Services Committee recently held a virtual hearing titled Cybercriminals and Fraudsters: How Bad Actors Are Exploiting the Financial SystemDuring the COVID-19 Pandemic. The witnesses, all cybercrime experts in their own right, included Amanda Senn, chief deputy director, Alabama Securities Commission, and on behalf of the North American Securities Administrators Association (NASAA); Tom Kellermann, head of Cybersecurity Strategy, VMware; Kelvin Coleman, executive director of the National Cyber Security Alliance; and Jamil Jaffer, executive director of the National Security Institute. The hearing was overseen by Emanuel Cleaver (D-Mo) and was joined by Ranking Member French Hill (R-Ark).

Cyberattacks against financial institutions surge. A May 2020 survey of financial institutions found that cyberattacks against the sector surged 238 percent during the COVID-19 crisis, as set forth in the Committee’s hearing memo. Additionally, 80 percent of the surveyed banks reported a year-on-year increase in cyberattacks. Moreover, the number of cybersecurity complaints to the FBI’s Internet Crime Complaint Center in the last four months spiked from 1,000 daily before the pandemic 4,000 incidents in a day at times. The number of complaint reports received by the FBI in the first four months of 2020 approaches the total of those received for all of 2019. The volume of attacks, as reported by many of the largest financial institutions, moved across the globe towards the U.S. in line with the movement of the virus.

One important shift in attacks against financial institutions in the COVID-19 crisis has been a move from "heists" (when opportunistic criminals seek to steal data and money before exiting an environment) to ‘hostage situations’ (when cybercriminals aim to remain persistent on a financial institution’s network for the long term). Further, ransomware attacks against the financial sector have increased nine-fold since the start of the crisis.

Work-from-home creates a target rich environment for cyberfraudsters. Cyber vulnerabilities for financial institutions and other victims have been exacerbated by the unusually large numbers of employees in the U.S. working remotely, as noted in the committee’s memo. According to the National Cyber Security Alliance (NCSA), "basic security measures need to be taken to protect the individual and enterprise from cyber criminals who are taking advantage of lax telework security practices." Some of the methods used by cyber criminals to target victims involve traditional attack strategies, but some have been modified or combined to further exploit the unique challenges and anxieties posed by the COVID-19 pandemic. Some of the methods being employed are:
  • Malware—software intended to gain access or cause damage to a computer or network, often while the victim remains oblivious to the fact there's been a compromise;
  • Ransomware—software designed to deny access to a computer system or data until a ransom is paid;
  • Man-in-the-Middle Attacks—cyber eavesdropping on conversations between two parties and intercept data through a compromised but trusted system;
  • Phishing—the use of email or text messages designed to trick the victim into giving personal information that allows the criminal to steal passwords, account numbers, Social Security numbers, and access to email, bank, or other accounts;
  • Business Email Compromise—the use social engineering to craft email messages that appear to come from known sources making legitimate requests such as a money transfer or access to a computer network; and
  • Cyber-supported Fraud Schemes—scams such as benefits fraud, charities fraud, and crowdfunding scams, which leverage email and identification (ID) issues and often typical during disasters.
These cyber-related attacks on the U.S. financial system by bad actors, including nation states, state-sponsored or protected criminals, or transnational criminal organizations, have been on the upswing.

Fraudsters will use the COVID-19 crisis to fleece mom and pop investors. State and provincial securities regulators are standing on the front lines in the fight against the criminals and opportunists looking to abuse America’s investing public according to the testimony of Amanda Senn, appearing on behalf of NASAA. Senn noted that opportunistic fraudsters will use COVID-19, much like they have used other crises, in their attempts to victimize main street investors. To counter these efforts, NASAA has formed a COVID-19 Enforcement Task Force, consisting of state and provincial securities regulators, to identify and stop potential threats to investors that arise from the COVID-19 crisis. The initiative, which is led by NASAA, includes more than 100 investigators from the vast majority of its member jurisdictions. The task force is using online investigative techniques to identify websites and social media posts that may be offering or promoting fraudulent offerings, investment frauds, and unregistered regulated activities.

In response to a question from Financial Services Committee Chairman Maxine Waters (D-Calif), about the vulnerabilities of seniors and minority communities to financial scams, Senn noted that state regulators know their communities, and are well positioned to work in concert with private industry to further investor education and awareness.

The U.S. Secret Service should be moved back to Treasury. In his testimony, Tom Kellerman strongly advocated for pending legislation that would move the U.S. Secret Service (USSS) back to its original home at the Department of Treasury from the Department of Homeland Security, where it is currently situated. He noted that while the Secret Service is best known primarily for protection; it also performs financial, counterfeit currency, and cybercrime investigations. Cosponsors of the legislation Roger Williams (R-Texas) and Denny Heck (D-Ore) also voiced their vigorous support for the realignment of the USSS.

Jamil Jaffer echoed these sentiments about the Secret Service in his testimony as well. He also recommended that the committee consider the establishment of a unit within the Treasury Department that would have access to real-time threat intelligence from the national security community, including DHS, FBI, NSA, and U.S. Cyber Command, as well as directly from the financial services industry.

In his testimony, Kelvin Coleman also underscored the importance of establishing partnerships between the public and private sector players in an effort to build a more secure, connected world. He also urged that Congress consider making game changing investments in cybersecurity awareness and education, noting Congress can and should play an important role in making sure Americans understand the many dangers of inadequately securing their systems, devices, and information.

Wednesday, June 17, 2020

Court vacates SEC’s NMS transaction fee pilot

By Anne Sherry, J.D.

The D.C. Circuit Court of Appeals struck down an SEC pilot program to randomly assign certain stocks into test groups with different fee and rebate structures. Agreeing with the exchanges that challenged the program, the court said that the Commission exceeded its statutory authority by instituting the test merely to “shock the market” to determine whether additional regulation was needed. One concurring judge wrote that while the SEC needed to do more to stake a position on why there is a problem and how the rule would help address it, the agency does have the authority to conduct experimental pilots even without specific authorization from Congress (New York Stock Exchange LLC v. SEC, June 16, 2020, Edwards, H.).

Rule 610T. The SEC adopted the transaction fee pilot on December 19, 2018, to study NMS stocks and the effects that exchange transaction fee and rebate pricing models may have on order routing behavior, execution quality, and general market quality. Created under New Rule 610T of Regulation NMS, the pilot intended to subject exchange transaction-fee pricing, including "maker-taker" fee-and-rebate pricing models, to new temporary pricing restrictions across three test groups. The pilot would have lasted for a maximum of two years with a potential one-year sunset period and applied to all NMS stocks and equities exchanges. Absent the pilot program, exchanges are subject to a $0.0030 per share fee cap on orders against a protected quotation.

SEC lacked delegated authority. Applying an analysis under Chevron (U.S. 1984), the court granted the petitions for review filed by the NYSE and other exchanges. Step one of Chevron is to decide “whether Congress has directly spoken to the precise question at issue.” The SEC allowed that it lacked express authority to adopt Rule 610T but argued that it had implied authority under the Exchange Act and was entitled to deference under step two. However, the court reasoned that step two does not come into play if the agency acted in excess of its statutory authority. Nothing in the Exchange Act authorizes such an “aimless, one-off” regulation that imposes costs and burdens just to gather data to identify if there is a problem that needs fixing. Furthermore, Exchange Act Section 23 prohibits the SEC from adopting a rule “that would impose a burden on competition not necessary or appropriate in furtherance of [the Act’s] purposes.” The SEC never made a determination that the regulatory requirements of the pilot program—as distinguished from the goal of data collection—were necessary or appropriate to maintain fair and orderly markets.

The appeals court stressed repeatedly that the pilot is a “one-off” regulation designed to gather data. “Normally, unless an agency’s authorizing statute says otherwise, an agency regulation must be designed to address identified problems,” the court wrote. The pilot program lacked support from any regulatory agenda describing the problems it was meant to address. While the SEC identified maker-taker fees and rebates as a subject of disagreement among stakeholders, it did not take a side in those debates, identify any shortcomings in existing rules, or propose rules that might address any perceived problems. The transaction fee pilot, instead, was intended to shock the market to collect data so that the SEC could consider whether regulation was necessary. “This was an unprecedented action that clearly exceeded the SEC’s authority under the Exchange Act,” the court wrote. In contrast, the SEC’s tick size pilot program was also an experimental rule, but it followed from a Congressional command to study the impacts of the tick size.

The SEC relied heavily on a 1973 Supreme Court opinion, Mourning, to support its argument that the pilot was permissible because it was “reasonably related” to the purposes of the SEC’s enabling legislation. But Michigan v. EPA, decided after Mourning, makes clear that a “necessary or appropriate” provision in an enabling statute does not necessarily empower the agency to make rules that are not otherwise authorized. Another Supreme Court opinion indicates that the “reasonably related” language in Mourning means little post-Chevron. Instead, Mourning applies only when the court determines that Congress did delegate authority for the agency action. Here, the SEC lacked that delegated authority.

Concurrence. While the tone of the majority opinion is that the SEC was clearly in the wrong—it even quotes from the petitioners’ brief in whole to illustrate the problems with the pilot—concurring Judge Pillard wrote separately to say that it was a close case. The SEC does have statutory authority to engage in experimental action and has a history of conducting pilot programs even without congressional action. The problem here is that the agency also must evaluate whether the burdens of the rule are necessary and appropriate, which it did not do. Despite nearly 10 years of studying the issue, the SEC failed to take a side and, moreover, devoted only three lines of its 104-page rule to identifying the problem that the pilot program was supposed to resolve.

The SEC also made no assessment of whether the fee structure or its effects are harming investors. Even if it lacks evidence to that point, the Commission still needs a basis for action that is consistent with its mandate. Judge Pillard suggests that on remand the SEC “must stake a position that there is a problem within its regulatory ambit that it has sufficient reason to think exists and that—at least without contrary evidence accessible through its planned informational intervention—it has grounds to believe continuing the status quo will do more harm than good.”

The case is No. 19-1042.

Tuesday, June 16, 2020

CII praises initial critical audit matters disclosures, calls for improvements

By Amanda Maine, J.D.

In a letter to the PCAOB responding to the Board’s request for comments on the initial impact of the communication of critical audit matters (CAMs), the Council of Institutional Investors (CII) said that CAM communications have improved the ability of investors to analyze companies’ financial statements and make financial decisions and have, in general, improved the quality of financial reporting. However, CII believes that auditors need to do a better job at explaining the outcome and key observations related to the CAMs that are described in the audit report.

CAMs. In 2017, the PCAOB adopted a new audit reporting standard requiring the communication of CAMs in the annual auditor’s report. CAMs are defined as matters that are communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements; and (2) involved especially challenging, subjective, or complex auditor judgment. The SEC approved the new standard in October 2017, and it became effective for effective for audits of large accelerated filers for fiscal years ending on or after June 30, 2019 (and December 15, 2020, for audits of other issuers).

In April 2020, the PCAOB issued a document soliciting comments from stakeholders on the implementation of CAMs. The questions were aimed at different categories of stakeholders, including investors, analysts, and other financial statement users. For these users, the PCAOB inquired how CAM communications have changed the ability to analyze companies’ financial statements, if they have affected interactions with management, and whether some CAMs have been more useful than others.

CII comments. In its letter, CII stated that it has reviewed more than 190 audit reports that contain CAMs. While CII cautioned that at this stage, it does not have the benefit of examining changes resulting from the new standard that will become more evident after a period of years of data collecting, it believes that there is “ample evidence” that the communication of CAMs has already benefited investors and the capital markets. These benefits include investors adding CAM reviews to their due diligence process when making investment decisions, gaining a better understanding of the quality of a company’s financial statements, and facilitating more constructive conversations with management, according to CII.

CAM communications have also improved investor understanding of management disclosures by providing a contextualized presentation of the issues underlying the CAMs in the auditor’s report, CII said. CII cited in particular disclosures involving critical accounting estimates (CAEs), which, while different from CAMs, can be informative for investors who compare both measures. CAMs can also help investors better understand the complexities of GAAP, making them more inclined to support opportunities to improve, simplify, and reduce the costs of financial reporting, CII explained.

CII stated that CAM communications have improved the quality of financial reporting generally. For example, CII cited a research paper indicating that disclosure of a tax-related CAM appears to eliminate the use of tax expense as an earning management tool, which can benefit investors by increasing scrutiny by both management and auditors of matters underlying the CAMs, CII advised. In addition, communication of CAMs has led to an improvement in internal control over financial reporting, according to CII, noting that a corporate survey found that 62 percent of audit committees have used CAMs to identify ICFR issues and to consider changes to improve their ICFR.

While its initial review of CAM disclosure indicates that the standard has improved audits and financial reporting, there is room for more improvement, CII noted. For example, as CII General Counsel Jeff Mahoney pointed out in his remarks at February’s SEC Investor Advisory Committee, auditors are failing to provide more information about the outcome of audit procedures and key observations, which is required as part of the standard. Those kinds of explanations are exactly the type of disclosures that investors wanted to know about during the development of the standard, CII reiterated. Without these critical auditor insights, the quality of the CAMs will continue to be “uneven,” according to CII.