Monday, June 17, 2019

Violations of the SOX whistleblower provision are not shareholder fraud under SOX

By Rodney F. Tonkovic, J.D.

A Fourth Circuit panel has shot down claims that the refusal to sign a conflict of interest form was a protected activity under the SOX whistleblower provision. A Northrop Grumman employee complained that signing the company's conflict of interest form bound her to its arbitration policy, which, she maintained, was pre-suit arbitration in violation of SOX. The panel remanded and instructed the ALJ to enter judgment in favor of Northrop, concluding that an alleged violation of the pre-suit arbitration provision did not constitute information concerning fraud against shareholders and was thus not a protected activity (Northrop Grumman Systems Corp. v. United States Department of Labor, June 13, 2019, Quattlebaum, A.).

Squabble over arbitration policy. The case is rooted in a former Northrop Grumman System Corp.'s longstanding opposition to the company arbitration policy. Crisell Seguin filed a defamation suit against Northrop in 2007, asserting that her supervisor made false statements about her in a performance review. The Virginia state court granted Northrop's motion to compel arbitration pursuant to its arbitration policy, which covers employee claims related to their employment. Seguin appealed, maintaining throughout that she was not bound by the arbitration policy, and, ultimately, her writ of certiorari was denied by the Supreme Court in 2010.

After this litigation, Seguin continued to raise concerns about the arbitration policy, and related corporate policies and procedures. Among other concerns, she said that she had been exempted from the policy by senior Northrop executives and that this exemption rendered the company's SEC filings inaccurate. Seguin also refused to sign Northrop's Conflict of Interest form, which she claimed bound unwitting employees to the arbitration policy. This refusal led to her suspension in early 2011, but she was reinstated after signing the form. Seguin was terminated in May 2011 due to a reduction in force in her department.

Seguin then filed a complaint with OSHA, alleging that her termination violated SOX. In 2015, a Department of Labor administrative law judge found that Northrop's termination of Seguin violated the SOX whistleblower provision. Essentially, the judge concluded that Seguin's refusal to sign the Conflict of Interest form constituted protected activity. This was affirmed by the DOL Administrative Review Board in May 2017, which agreed that Northrop's requiring employees to sign the form "effectively secured an employee’s agreement to the company’s mandatory arbitration policy, which Seguin contended violated the SOX prohibition against pre-dispute arbitration agreements." Northrop then appealed to the Fourth Circuit.

Not protected. On appeal, Northrop argued that the ARB erred in holding that Seguin engaged in protected activity. The DOL argued in turn that Seguin reasonably believed that Northrop's arbitration policy violated §1514A(e) of the SOX whistleblower provision, which prohibits pre-suit arbitration of SOX claims. The DOL contended that §1514A(e) is a provision of "Federal law relating to fraud against shareholders," that is, one of the enumerated categories of protected activities under §1514A(a)(1).

The panel disagreed with the DOL's argument that violations of the SOX whistleblower provision itself constitute fraud against shareholders. That clause of §1514A(a)(1) is not a "broad, catchall provision," the court said, and none of Seguin's complaints involved any of the elements of fraud. Simply put, the court said, the DOL's interpretation was contrary to law—Seguin's complaint did not constitute shareholder fraud and was not afforded whistleblower protection under §1514A. To hold otherwise would ignore the parameters of the statute and improperly expand its scope, the court said.

Even if the court accepted the DOL's position, it concluded that Seguin's beliefs were not objectively reasonable. A reasonable person would not believe that the conflict of interest form incorporated Northrop's arbitration policy, the court said, because the form never even mentions that policy and because Seguin was explicitly told that the form had "nothing to do" with the arbitration policy. And, if the form did incorporate the arbitration policy, it would not be reasonable to believe that the policy violated §1514A(e). By its own terms, the policy, which does not apply to claims "as to which an agreement to arbitration . . . is prohibited by law," would not apply to SOX whistleblower claims.

Finally, the court concluded, no reasonable person in Seguin's position could believe that the alleged violation of §1514A(e) constituted shareholder fraud. None of Seguin's complaints showed an objectively reasonable belief that Northrop intentionally misrepresented or omitted material facts to investors. The court accordingly remanded the case to the ALJ with instructions to dismiss Seguin's administrative complaint and enter judgment in favor of Northrop.

The case is No. 17-1811.

Friday, June 14, 2019

Disclosure issues dominate PLI panel on SEC Corp Fin issues

By Amanda Maine, J.D.

This year’s Practising Law Institute 34th Midyear SEC Reporting & FASB Forum featured a discussion on recent developments at the Division of Corporation Finance from the regulatory and private practice perspectives. The panelists tackled topics such as the Commission’s proposal to adjust accelerated filer definitions to relieve certain companies from the auditor attestation requirement for internal controls and the implementation of amendments under the FAST Act.

FAST Act. Melissa Raminpour, accounting branch chief in the SEC’s Division of Corporation Finance, outlined amendments implementing the FAST Act’s provisions modernizing and simplifying certain disclosure requirements in Regulation S-K, which the Commission approved on March 20, 2019. One of the amendments generally permits exclusion of discussion of the earliest of the three years financials in MD&A if the discussion was included in a prior SEC filing.

The FAST Act rule amendments also included a new rule on redacted exhibits, Raminpour said. Unlike the confidential treatment request (CTR) process that preceded it, the new rule does not require writing to the staff for permission to redact certain exhibits. Instead, issuers can redact it, and the staff will review the redaction when the filing is received, Raminpour explained. The new process also protects redacted material from being subject to FOIA requests and eases the SEC’s record retention burdens. Raminpour noted that the redacted exhibits process will be separate from the regular comment letter process, which helps protect information from being inadvertently disclosed. She added that issuers should not send the staff information unless they ask for it and that comments on the redacted exhibits will be addressed orally over the phone.

Proposal on acquired and disposed business disclosures. Kendra Decker, who leads the SEC Regulatory Matters group at Grant Thornton, discussed the Commission’s May 3 proposal concerning financial disclosures about acquired and disposed businesses. One aspect of the proposed rules is updating the significance tests under Regulation S-X Rule 102(w). While the asset test for significance will remain the same, under the proposed amendments, the revised investment test would compare investment in acquired business to aggregate worldwide market value of registrant's voting and non-voting common equity. According to Decker, this revision is a result of waiver requests from companies who say that their total assets aren’t a reflection of the market value of the company. In addition, the income significance test would simplify net income component calculation by using income or loss from continuing operations after income taxes. The proposed rule would also include a new provision relating to investment company acquisitions, which are currently treated the same way as other companies.

Other aspects of the proposal include an amendment to S-X Rule 3-05, which would, inter alia, permit registrants to provide the acquired business’s audited abbreviated financial statements without first seeking relief from the Commission in certain circumstances. It would also expand the use financial statements prepared according to IFRS and simplify pro forma financial information, Decker said.

Decker recommended reading Commissioner Robert Jackson’s statement on the proposal, noting that while he did vote in favor of issuing the proposing release, he expressed concern that it could lead to companies painting a better picture of acquisitions to investors even when it may not be in the interest of the long-term investor.

Proposed changes to definitions of accelerated filer and large accelerated filer. Decker also drew attention to the Commission’s proposed amendments to the definitions of accelerated filer and large accelerated filer. The proposal was approved for comment by a 3-to-1 vote at an open meeting on May 9 with Commissioner Jackson dissenting. The proposal is aimed at tailoring these definitions to exclude certain companies from the auditor attestation for internal controls requirement under the Sarbanes-Oxley Act. The premise, according to Decker, is meant to include “pre-revenue” companies that are growing but feel that capital would be better spent on operations rather than expenses related to an ICFR audit. These companies tend to include a lot of biotech and pharmaceutical companies that spend a great deal of resources on research and development, Decker explained.

Frequency of quarterly reporting. The SEC, possibly in response to an August 2018 tweet by President Trump, issued a request for comment on the nature and timing on quarterly reporting by public companies and its impact on earnings releases and guidance. Decker pointed out that the SEC has in the past solicited comments on streamlining SEC reporting, including the value of quarterly reporting, which it addressed in a 2016 concept release.

Decker noted that the SEC has received around 70 comment letters on the Commission’s request for comment, which was significant because it is in the “pre-proposal” stage. Most stakeholders would wait until it hits the proposal stage to send a comment letter, she said. The staff is currently poring through the letters, but it is not currently on the Commission’s regulatory flexibility agenda, so Decker does not anticipate new activity on the issue for a while.

Reporting considerations and practice issues. Raminpour advised that issues the staff considers when reviewing financial statements include cybersecurity and the impact of current events. Regarding cybersecurity, the staff will expect companies to disclose in MD&A if a cyber breach has resulted in material costs to the company. The company should also consider disclosing the magnitude of the breach, whether remedial actions were taken, and if it implicated the company’s internal controls. According to Raminpour, it is more likely that the staff will have comments if there is an actual cyber breach as opposed to just outlining the risk of a cyber breach.

Current events that companies should take into consideration when disclosing risk factors include Brexit, interest rate changes, and tariffs, Raminpour advised. Regarding Brexit, Raminpour recommended consulting Corporation Finance Director Bill Hinman’s March 2019 speech in London where he outlined six Brexit-related disclosure questions that the staff will have in mind when evaluating annual reports. Companies should also disclose how they are impacted by interest rate changes, including the impact on liquidity and the not-to-distant future demise of LIBOR. Raminpour also said that companies should disclose how recently-imposed tariffs might impact operations, including the cost impact on the company.

Thursday, June 13, 2019

ICI recommends improvements for fund proxy processes

By Amy Leisinger, J.D.

In a letter in response to the SEC’s roundtable on the proxy process, the Investment Company Institute stressed the importance of proxy voting to funds as both institutional investors and issuers. However, the organization’s letter focused on proxy issues arising in funds’ roles as issuers, particularly with regard to the fact that their shareholder bases are made up mostly of diverse retail investors. Shareholder approval can be difficult to obtain when funds attempt to track down the beneficial owners of fund shares, and ICI recommended that the SEC take steps to adjust the “majority vote” requirement and to permit funds to communicate directly with beneficial shareholders. The organization also suggested improvements to disclosure delivery and layering capabilities.

Proxy challenges. In its letter, ICI noted that investment companies face additional challenges in obtaining quorums and shareholder approval given the diffuse nature of their shareholder pools. Funds have large numbers of retail investors, according to ICI, and these types of shareholders are less likely to vote. In some cases, the organization explained, funds encounter difficulties in communicating with their shareholders, as many investors’ funds are held in omnibus accounts under the names of intermediaries, and it can be difficult to obtain accurate individual identifying information. In addition, ICI noted the sheer volume of proxy materials in connection with the combination of funds in a complex addressed in proxy materials and the attendant costs. These problems are often compounded by the need to resend proxy materials if a quorum is not established on the first try, ICI stated.

Shareholder approval and voting. “[T]he costs and difficulties associated with fund proxy campaigns are enormous and will not improve without regulatory intervention,” ICI opined. For example, the Investment Company Act requires a majority vote of outstanding voting securities to implement certain changes to fundamental policies and agreements, but there is no compelling reason that shareholders need to approve all policies designated as “fundamental,” especially when the change would not be material to fund strategies or risks, the organization explained. As such, ICI recommended that the SEC consider using a disclosure-and-notice approach with regard to certain fundamental policies and allow for board approval. Adequate notice, together with redemption rights, would protect shareholders while minimizing costs, according to ICI.

In addition, the organization suggested that the Commission use its exemptive authority to create a new means by which to satisfy the “majority vote” requirement. Specifically, ICI advanced a Commission rule change that would allow a fund with 75 percent or more of shares affirmatively voting at a meeting to satisfy the requirement so long as holders of more than one-third of total outstanding voting securities are represented at the meeting. In addition, ICI also put forward a requirement of unanimous board approval of the proposed action. This change would provide funds with a more practical means by which to obtain shareholder approval of actions that a large number of shareholders and the board itself approved, ICI stated, and shareholders would still have the ability to “vote with their feet” if they do not agree.

Proxy delivery. ICI also advocated a change that would allow funds to deliver proxy materials directly to shareholders as opposed to going through intermediaries. To facilitate this change, the Commission could require intermediaries to compile and provide shareholder information for funds for the purpose of distributing proxy materials, the organization stated. ICI explained that this would improve shareholder communications while simultaneously lowering proxy solicitation costs, which would save shareholders money.

The organization also put forward the suggestion that the SEC should permit funds to include the proxy card with the initial proxy notice. The current restriction on including the proxy card adds more steps to an already complicated process and may confuse shareholders (evidenced by some returning the notice with markings attempting to vote), according to ICI. Allowing issuer funds to include the proxy card in the same mailing would reduce cost while improving shareholder participation in voting, according to ICI.

Disclosure layering. Finally, ICI recommended that the SEC allow additional use of layering, linking, and incorporation by reference in proxy materials. Under this approach, funds could provide information beyond that currently provided in a notice in a more succinct manner than currently seen in proxy statements, ICI stated. In addition, proxy materials would be more “shareholder-friendly,” and investors would still have access to complete information in online materials, the organization explained.

“Proxy statements ought to be engaging. In practice, their sheer bulk conspires against shareholder participation in the proxy process and generates enormous cost,” ICI concluded.

Wednesday, June 12, 2019

SEC adopts amendment to single issuer exemption for broker-dealers

By Rodney F. Tonkovic, J.D.

The SEC has adopted an amendment to clarify an exemption for broker-dealers from a reporting rule. The amendment fixes an inadvertent error in Rule 17a-5(e) to provide that a broker-dealer would not be required to engage an independent public accountant to certify the broker-dealer’s annual reports if, among other things, the securities business of the broker-dealer has been limited to acting as broker (agent) for a single issuer in soliciting subscriptions for securities of that issuer (Amendment to Single Issuer Exemption for Broker-Dealers, Release No. 34-86073, June 10, 2019).

Inadvertent error. Most registered broker-dealers must file an annual financial report and either a compliance or exemption report. Under Rule 17a-5, broker-dealers are requires to include with their annual reports an independent public accountant's report covering the financial report and, as applicable, the compliance or exemption report. There is an exemption under Rule 17a-5(e)(1)(i)(A) for broker-dealers whose securities business is limited to acting as a broker for "the issuer" and several other conditions are met.

The rule release notes, however, that the language "the issuer" is the result of an inadvertent error introduced in 1977. While the Commission clarified in a later release that it meant "an issuer," the error was reintroduced in a 2013 amendment. In September 2018 the Commission proposed an amendment to correct the error, and the amendment was adopted as proposed.

Single issuer exemption. The amendment to Rule 17a-5(e)(1)(i)(A) clarifies that the exemption applies to a broker-dealer whose securities business has been limited to acting as broker (agent) for a single issuer in soliciting subscriptions for securities of that issuer. In sum, a broker or dealer would not be required to engage an independent public accountant to provide the required reports if:
  • the securities business of the broker or dealer has been limited to acting as broker for a single issuer in soliciting subscriptions for securities of that issuer;
  • the broker has promptly transmitted to the issuer all funds and promptly delivered to the subscriber all securities received in connection with the transaction; and 
  • the broker has not otherwise held funds or securities for or owed money or securities to customers. 
The Commission noted in the release that it does not believe that an expansion of the exemption to include broker-dealers that provide broker-dealer services for more than a single would be appropriate. The broker-dealers to which this exemption applies are typically affiliates of the issuer, and, as an agent, the broker-dealer can legally bind the issuer. So, requiring that an independent public accountant audit this information would not provide a meaningful benefit to the issuer, and the risk of harm to the issuer is mitigated by its ability to access information about its agent, the Commission explained.

The release is No. 34-86073.

Tuesday, June 11, 2019

Chairman Giancarlo bids swaps industry farewell at FIA IDX conference in London

By Brad Rosen, J.D.

In his final speech to the Futures Industry Association at the 12th Annual International Derivatives Expo (IDX) in London, Chairman Giancarlo recounted his previous efforts to streamline the CFTC’s cross-border swaps framework, what is happening now at the agency, as well as what we can expect in the future on this front.

In remarks titled Recalibrating the CFTC’s Cross-Border Regulation: Current Status and Next Steps, the chairman described three proposed rulemakings that are currently being considered by the Commission. He also shared his thoughts regarding comparability determinations for non-U.S. jurisdictions, as well as an approach to addressing cross-border issues relating to non-U.S. trading platforms.

First principles. Before discussing the details or substance of the anticipated proposed rulemakings, the chairman set forth first principles which inform his approach to cross-border regulation. These include:

Conceptually, the CFTC’s swaps authority “shall not apply” to activities outside the United States unless those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States” set forth in the Dodd-Frank Act. Accordingly, determining what is “direct and significant” to the U.S. financial system should be at the heart of the CFTC’s approach to cross-border issues.

A distinction must be made between swaps reforms that are designed to mitigate systemic risk on one hand, and swaps reforms that address market and trading practices on the other. Systemic risk reforms include swaps clearing, margin for uncleared swaps, dealer capital, and recordkeeping and regulatory reporting, and these reforms seek to mitigate the type of risk that may have a “direct and significant” connection with the U.S. Reforms that are focused on market and trading practices in a foreign jurisdiction are not likely to have a “direct and significant” connection with the U.S.

The CFTC should act with deference to non-U.S. regulators in jurisdictions that have adopted comparable G20 swaps reforms.  In doing so, the CFTC should seek stricter comparability for substituted compliance with requirements intended to address systemic risk and afford more flexible comparability for substituted compliance with requirements intended to address market and trading practices.

Current rulemaking initiatives. According to Chairman Giancarlo, CFTC staff has prepared three rulemakings that are now being considered by the full Commission.  The chairman intends to call these proposals for a vote before he leaves the CFTC. The proposed rulemakings are as follows:
  • DCO registration with alternative compliance. The first proposal addresses the registration of non-U.S. derivatives CCPs, commonly referred to as derivatives clearing organizations (DCOs). Under this proposal, a framework will be created under which non-U.S. DCOs that do not pose a substantial risk to the U.S. financial system would have the option of being fully registered with the CFTC as a DCO if they meet their registration requirements through compliance with their home country requirements.
  • Exempt DCO. The second proposal contemplates giving non-U.S. DCOs that do not pose a substantial risk to the United States, and that are subject to “comparable, comprehensive supervision and regulation” by appropriate regulators in the DCO’s home jurisdiction, the option to be exempt DCOs under an enhanced framework. This option would permit exempt DCOs to offer customer clearing to U.S. eligible contract participants (i.e., other than U.S. retail customers) through foreign clearing members that are not registered as FCMs.
  • Swap entity cross-border. The third rule proposal would address the registration and regulation of non-U.S. swap dealers and major swap participants, as well as foreign branches of U.S. banks.  Specifically, the proposal addresses the cross-border application of the swap dealer and major swap participant registration thresholds.  If adopted, the proposal would replace the related portions of the cross-border guidance issued by the CFTC in 2013, the cross-border rules proposed by the CFTC in 2016, and certain related staff no-action letters and guidance. 
Comparability and substituted compliance. Chairman Giancarlo further noted that the rulemaking proposals are complemented by a series of comparability determinations that the CFTC has issued and plans to consider in the near future. He asserted that “A commitment to deference must be a fundamental component of the Commission’s cross-border framework.”

In this area, the chairman also pointed to the recent substituted compliance determination recently granted by the Commission to Australia with respect to margin requirements for uncleared swaps. The agency also amended a previous substituted compliance determination for Japan with respect to the uncleared margin requirements. Further, the CFTC granted substituted compliance for the EU with respect to the uncleared margin requirements. Giancarlo urged the agency to continue making additional comparability determinations wherever appropriate.

Approach to non-U.S. swaps trading venues. While the CFTC’s recent proposed amendments SEF rules did not address non-U.S. swaps trading venues, Chairman Giancarlo believes that the CFTC should be committed to trying to make comparability determinations for trading venues in all the major swaps jurisdictions. He noted that over 90 percent of global swaps activity takes place in these venues.  He also observed that the CFTC already has exempted trading venues from registration as SEFs in the EU and Singapore, and a comparability assessment for trading venues in Japan is close to completion.  In case of Brexit, the CFTC already announced the intention to extend the exemption from registration as SEFs to U.K. trading venues consistent with the CFTC’s arrangement with the EU.

Concluding words. The chairman concluded his remarks underscoring that the CFTC must remain a leader in global swaps reform. He observed, “With the proper balance of sound policy, regulatory oversight, outcomes-based regulatory deference and a little bit of courage, world derivatives markets will continue to evolve in responsible ways and continue to help grow the global economy, creating a future of untethered aspiration where creativity and economic expression is a social good in its own right, and a source of human growth and human advancement.” And with that, Chairman J. Christopher Giancarlo bid, “Farewell.”

Monday, June 10, 2019

Proposed legislation would allow delisting of foreign companies that dodge U.S. audit rules

By Mark S. Nelson, J.D.

Recently introduced legislation sponsored by Sen. Marco Rubio (R-Fla) and Rep. Mike Conaway (R-Texas) would allow for the delisting of foreign companies whose auditors cannot be inspected by the PCAOB. Although the bill comes at a time of rising trade tensions between the U.S. and China, one of the main targets of the bill, the inability of U.S. regulators to obtain foreign company audit papers has been a long-simmering issue. The proposed legislation is backed by a cadre of four Republican Senate and House sponsors and has bipartisan support from a group of three Democratic senators and representatives, including presidential candidate Sen. Kirsten Gillibrand (D-NY).

Name and shame provisions. The Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges (EQUITABLE) Act (S. 1731; H.R. 3124) would curb listings by some foreign issuers in several ways. First, the Commission would be required to publish a list of foreign issuers for whom a foreign public accounting firm prepared an audit report but the PCAOB is unable to inspect the accounting firm because of positions taken by local authorities in that country. The Commission also would have to list each covered foreign public accounting firm that prepared an audit subject to the bill’s requirements and list the jurisdiction in which each covered foreign public accounting firm is organized or operating. The PCAOB would provide data on at least an annual basis for the Commission to compile the list.

Moreover, the bill would mandate annual disclosures by foreign issuers on Forms 10-K and 20-F. Specifically, an issuer would have to disclose: (1) the fact that it is audited by a covered foreign public accounting firm; (2) the percentage of its shares owned by governmental entities in a covered jurisdiction; (3) whether governmental entities in the covered jurisdiction have a controlling financial interest in the issuer; and (4) the names of Chinese Communist Party officials who sit on the issuer’s board of directors.

The bill also contains related disclosures that broker-dealers would have to make to investors seeking to trade shares of foreign issuers. The SEC would have to adopt rules to implement the bill within 270 days after enactment with the bill’s name and shame provisions becoming effective upon the Commission finishing its rulemaking.

Exchange listing standards. The EQUITABLE Act also would require exchanges to amend their rules to prohibit some foreign issuers from listing shares in the U.S. For one, the bill would ban such listings if an issuer is audited by a covered foreign public accounting firm, although this provision would apply only to listings sought after enactment.

Second, beginning in 2025, U.S. exchanges would be barred from listing shares of an issuer that has thrice appeared (in consecutive years) on the SEC’s list of foreign issuers for whom a foreign public accounting firm prepared an audit report and which firm the PCAOB is unable to inspect. This second ban, however, would be relaxed if an issuer submits to the Commission an audit report prepared by a registered public accounting firm the PCAOB can inspect. Exchanges would be required to finish changes to their rulebooks, with Commission approval, within one year of enactment.

Long-running access issue. The PCAOB has noted on its website that it often seeks to enter into cooperative arrangements with overseas audit regulators, although these arrangements are not always possible to achieve. As a result, the PCAOB sometimes is unable to access foreign jurisdictions for purposes of conducting inspections. The PCAOB has listed countries where it has conducted inspections of registered firms. The PCAOB, however, has also noted that it generally cannot inspect firms based in Hong Kong that have audit clients with operations in mainland China.

The sponsors of the EQUITABLE Act cited a joint statement by top SEC and PCAOB officials issued in December 2018 that acknowledged progress in obtaining access to audit papers in some jurisdictions, but cautioned that access remained problematic regarding PCAOB-registered auditing firms in China. The bill’s sponsors also cited data from the U.S.-China Economic and Security Review Commission that identified 156 Chinese companies (among them 11 state-owned enterprises) listed on three U.S. exchanges that accounted for $1.2 trillion in market capitalization (the study deemed a company state-owned if it had 30 percent or more state ownership).

“If China-based companies want to list on stock exchanges or access capital markets in the U.S., we should make them comply with American laws,” said Sen. Rubio. “The EQUITABLE Act makes it clear that there is a price for the Chinese government and Communist Party’s disregard for the rules of responsible economic and financial engagement in international capital markets.”

Presidential contender Gillibrand echoed the call for greater transparency regarding foreign companies. “Chinese firms should not be allowed to play by a different set of rules than American companies, yet they are currently allowed to operate on our stock exchanges without the same oversight that American companies have to comply with,” said Sen. Gillibrand.

Representative Conaway emphasized his view that the Chinese government “manipulates” legal requirements to insulate Chinese companies from global accounting best practices: “Beijing shows no apprehension while obstructing attempts to audit Chinese companies or breaking U.S. law. Without the EQUITABLE Act, the Chinese government will only escalate this malicious pattern of conduct.”

Friday, June 07, 2019

IOSCO examines market fragmentation, ways to enhance cross-border deference

By Amy Leisinger, J.D.

The Board of the International Organization of Securities Commissions has published a report considering instances of fragmentation in cross-border markets and suggesting means by which regulators can minimize its adverse effects. Fragmentation, the separating of markets into segments by location or product and/or participant type, can arise as an unintended consequence of regulation, according to the organization. However, the use of deference can mitigate the potential adverse effects of fragmentation, IOSCO states, and enhanced cooperation in the process could help as regulators interact with businesses operating in multiple jurisdictions.

Fragmentation. The report identifies a variety of instances where respondents to a survey noted that financial regulation may have given rise to harmful fragmentation in the securities and derivatives markets in the form of a reduction in cross-border flows, increased costs, and potential regulatory arbitrage. According to IOSCO, fragmentation arising from regulation can be due to differences in jurisdictional implementation of financial reforms, a lack of international harmonization, or jurisdictional inability or lack of authority to engage in deference. Respondents indicated that Brexit, discontinuation of benchmarks, and emerging new sectors could lead to additional fragmentation going forward, the report states.

Deference. In 2015, IOSCO released a report including three approaches for cross-border regulation: (1) exemptions or substituted compliance; (2) recognition of a foreign regime as equivalent; and (3) passporting with a common set of rules governing firms operating in multiple jurisdictions. Deference among regulators through the use of these cross-border regulatory tools has increased significantly, according to IOSCO, and bilateral arrangements such as Memoranda of Understanding (MoUs) are now a common tool. The use of deference can help to mitigate the risk of fragmentation for global cross-border markets, the organization states.

However, IOSCO finds, challenges exist for jurisdictions using deference. A lack of clear processes and procedures and decreased transparency regarding the criteria that will form the basis of a deference assessment can create uncertainty, according to the organization. Respondents also indicated that developing a clear understanding of individual regulatory frameworks and comparing regulatory systems that operate on different bases can be a challenge, the report notes, and that keeping up with foreign legislative changes is also difficult. Some respondents proposed to standardize the process for deference and to encourage jurisdictions to develop high-level comparability summaries of their requirements versus international standards, the reports states.

Potential solutions. IOSCO explains that enhancing cooperation among authorities could further assist in addressing adverse effects on the financial system stemming from market fragmentation, and the organization is building a central repository of MoUs between jurisdictions to provide more transparency regarding cooperative efforts. The report also proposes other potential measures that IOSCO and other authorities could consider to minimize the risks of fragmentation of global markets. In particular, the report suggests that IOSCO could serve as a forum for the exchange of information among its members about other jurisdictions’ markets and legislative frameworks and varying approaches to cross-border regulation. This also could serve as a means by which to facilitate a discussion of whether there are sound practices that can be put in place regarding deference tools, the report explains.

Thursday, June 06, 2019

Senate confirms Tarbert to be CFTC chairman

By Mark S. Nelson, J.D.

The Senate confirmed Heath Tarbert to succeed J. Christopher Giancarlo as the CFTC’s next chairman. Tarbert’s taking of the helm at the CFTC continues a post-Dodd-Frank Act trend of presidents selecting a chairman with prior experience at the Treasury Department. Tarbert easily cleared two procedural votes one day ago on his nominations to be a CFTC commissioner and to be the agency’s chairman. Tarbert was later confirmed to be a commissioner by a vote of 85-9 and to be chairman by a vote of 84-9.

Complicated rulemakings ahead. Upon being sworn in as CFTC chairman, Tarbert will face a limited budget and pressing rulemakings on challenging topics. Chief among these rulemaking priorities will be the handling of position limits. Tarbert testified at his confirmation hearing that observers should remember these rules deal with "speculative" position limits and that bona fide hedgers should be able to use an exemption. The unfinished rulemaking on Regulation AT (Automated Trading) also awaits the CFTC’s next chairman.

Tarbert generally was well-received by the Senate Agriculture Committee during its hearing on his nomination. Tarbert told lawmakers of the benefits of Dodd-Frank Act swaps and derivatives reforms, while also stating that the CFTC must balance innovation in financial markets versus protecting markets and customers. Ranking Member Debbie Stabenow (D-Mich) had cautioned Tarbert that the agency must finish its Dodd-Frank Act rulemakings. Tarbert was also questioned about his views on a wider range of topics, including enforcement, cross-border rules, and cybersecurity.

Change in leadership expected in July. Although it is unclear exactly when Tarbert will be sworn in as the CFTC’s chairman, outgoing Chairman Giancarlo first suggested in a speech in London that he would formally step down in mid-July and later clarified in a statement congratulating Tarbert that he was committed to remaining chairman until July 15.

“During my time of service, it has been a priority to transform the CFTC into a 21st Century regulator for today’s digital markets. With Dr. Tarbert’s confirmation, I know the agency is in safe hands to continue this transition,” said Giancarlo.

U.S. Treasury Secretary Steven Mnuchin issued a statement in which he acknowledged Giancarlo’s “successful” chairmanship and said that Tarbert, who is currently the acting

Under Secretary for International Affairs at Treasury, would promote competitive commodities markets as CFTC chairman. “I am grateful to Heath for his service to the nation, and in particular his leadership at Treasury where he has worked to promote U.S. interests, financial stability, and economic growth with foreign governments and multilateral organizations. Heath also led Treasury’s efforts with Congress to modernize the Committee on Foreign Investment in the United States (CFIUS),” said Mnuchin. “I look forward to working with Heath in his new capacity and know that he will advance CFTC’s efforts to foster transparent, competitive, and financially sound markets.”

Senator Pat Roberts (R-Kan), chairman of the Senate Agriculture Committee, likewise praised Tarbert's confirmation. “I applaud the Senate’s quick, bipartisan action to confirm Dr. Tarbert to head the CFTC. He has the support of a range of agricultural groups, and I’m confident he will lead the CFTC well.”

The CFTC is an independent federal agency established in the mid-1970s. Under Commodity Exchange Act Section 2(a)(2)(B), the chairman is the CFTC's chief administrative officer and serves as chairman at the president's pleasure. The President, however, may appoint a new chairman at any time subject to the advice and consent of the Senate, but the commissioner who was chairman may finish his term as a commissioner.

Wednesday, June 05, 2019

IPOs are keeping pace with 2018 through first five months

By John Filar Atwood

One company completed its IPO last week, bringing the total number of deals in May to 32. That is the highest monthly total since last July, and 12 more new issues than were completed in April. Through the end of May, the IPO market is keeping pace with 2018 with 86 new issues, compared to 90 in the first five months of last year. Proficient Alpha Acquisition was the lone new issuer last week. It raised $100 million to pursue the acquisition of an Asia-based financial services company. The offering was the first lead manager assignment of the year for I-Bankers Securities, which served as lead underwriter on four IPOs in 2018.

New registrants. The week’s activity included seven new registrations, including those filed by pharmaceutical companies Morphic Holding and Karuna Therapeutics. Seven SIC 2834 companies have filed preliminary IPO registrations in the past two weeks. Morphic is developing integrin therapeutics to treat autoimmune, cardiovascular, metabolic, and other diseases. Karuna, whose founders worked at Eli Lilly and Takeda Pharmaceuticals, makes medicines to address neuropsychiatric conditions. Brazil’s Linx, a provider of software solutions to retailers in Latin America, filed its IPO plans. Three companies headquartered in Brazil completed IPOs in U.S. markets in 2018. Goldman Sachs, the lead underwriter for Linx and Karuna, also will lead the offering by Adaptive Biotechnologies. The Washington company creates immune-driven therapies for cancer, autoimmune and infectious diseases. Cambium Networks, which operates out of Illinois but is incorporated in the Cayman Islands, also registered. The company provides wireless infrastructure solutions for network operators. Cambium will continue to be controlled by private equity firm Vector Capital after the IPO. RealReal, the operator of an online marketplace for consigned luxury goods, is planning a public offering. The California company disclosed that it intends to use one percent of the IPO proceeds to fund RealReal Foundation, a non-profit charitable organization. South Mountain Merger was the latest blank checks new registrant. The company will focus its search for a target in the financial technology segment of the financial services industry. May closed with 29 new registrations, seven fewer than in April and four fewer than in May 2018. 2019’s five-month preliminary filings total is 113, which is five more than were filed from January through May 2018.

Withdrawals. MaxQ AI, which is incorporated in Israel, withdrew last week, opting not to pursue an IPO at this time. The developer of AI-based medical diagnostics never amended its August 2018 initial public registration. May’s six withdrawals were three more than in April and one more than last May. As of May 31, 22 companies have filed Forms RW in 2019 versus 14 in the same period last year.

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

Tuesday, June 04, 2019

Custody of digital assets, evolution of DLT top issues discussed at SEC’s FinTech Forum

By Amy Leisinger, J.D.

Investment management issues including the applicability of existing regulation and custody concerns with respect to digital assets, as well as distributed ledger technology (DLT) sparked lively discussion in the afternoon panels at the SEC’s FinTech Forum. According to the panelists, funds getting into digital assets need to remain vigilant with regard to the requirements of the Investment Company Act and the Advisers Act, and regulators must be diligent in their efforts to protect investors while avoiding stifling innovation. Separately, another panel explored developments in DLT and the potential for a shift in the numbers and types of public and private blockchains and for new combinations and interconnections.

Investment management. IM Director Dalia Blass opened the panel on issues facing asset management firms and investment advisers by noting that while the SEC staff recognizes the importance of innovation, stakeholders need to remember that the Investment Company Act and Advisers Act, as well as attendant regulations, still apply and should not be sacrificed to promote new technologies. At present, the director explained, the staff works to apply “tried and true” existing requirements concerning valuation, custody, and liquidity and to provide guidance regarding, and request comments on, compliance practices and challenges in connection with digital assets and blockchain technologies. Blass urged industry participants to engage with the SEC staff on potential concerns or solutions the governance of investments in cryptocurrencies.

Regulatory issues, challenges. According to Shearman & Sterling partner Jay Baris, the first thing to focus on when considering investments in digital assets is what the client is trying to accomplish and whether the client is a fund, bank, or other type of specifically regulated service provider. It is also crucial to determine the level of understanding the client has with regard to digital assets and underlying technologies; he noted; varying degrees of sophistication may warrant different approaches, Baris noted. John D’Agostino, managing director at DMS, agreed, noting that engaging in a digital asset class can involve a level of complexity that is good for private fund managers.

Deloitte partner Amy Steele also stressed the importance of regulatory considerations and applying traditional principles to digital assets. In particular, with regard to audits, asset “existence” can be a challenge, she explained; the asset is not tangible, and the only way to prove its existence is to go back to the blockchain, Steele noted. Rights can also raise issues with regard to ownership and control, according to Steele, and this can also necessitate specific blockchain review.

Steele also explained that auditors want to be comfortable that an asset custodian has controls in place to track assets and engage in reconciliation. Baris noted that custody can be a “vexing issue,” given the intangible nature of digital assets. He urged regulators to be wary of negative effects on innovation when dealing with custody regulations; the focus must be on principles because, when efforts are made to regulate technology, “a minute and half later, it will be outdated.” D’Agostino suggested, however, that custody is the “most solvable issue” and that, eventually, firms will get best practices. As digital assets and blockchain technology move toward increased encryption and more anonymity, it is important also to consider potential challenges with regard to anti-money laundering and “know your customer” requirements, he said.

The panelists concluded by noting that cryptocurrencies and blockchains are here to stay and urging industry participants and regulators to embrace technological changes and understand the risks while maintaining a dual focus on innovation and investor protection.

In prepared remarks, Office of Compliance Inspections and Examinations Director Peter Driscoll highlighted OCIE’s efforts to do just that. At the outset, OCIE staff seeks to understand what a given technology or digital asset is designed to do with recognition that markets spur innovations that help investors, he said. OCIE tracks new technology through exams, according to the director, and portfolio management and internal controls get evaluated. When examining a platform trading in digital assets, OCIE staff will assess if it needs to register as exchange, Driscoll stated. OCIE strives to embrace potentials for increased efficiencies and cost reductions, he concluded.

DLT innovations and trends. According to Christopher Ferris of IBM, governance of a permissionless, public blockchain system is the system itself with clients defining and developing governance. However, trust can be increased when a participant knows who he or she is dealing with, he explained; closed systems have identifiable transactions, and “proof of work” and even “proof of stake” are unnecessary. Similar benefits can arise in connection with semiprivate permissioned systems, Ferris noted.

Kevin Werbach of The Wharton School, University of Pennsylvania, suggested that, eventually, there may be no distinction between public and private, and permissioned and permissionless blockchains—just many variants in between. He also opined that something like an “internet” of permissioned blockchains relying on the same security could develop, with blockchains taking advantage of the benefits of each type. However, Todd McDonald of R3 argued that people may not build on top of a permissionless blockchain; like Bitcoin, the particular blockchain already does what it was designed to do, he explained. The panelists agreed that there is a proven benefit to maintaining open source—more eyes on the system means more eyes searching for potential problems, they opined.

The panelists also considered issues surrounding dispute resolution in connection with blockchains. Werbach noted that an arbitration or similar provision possibly could be built into a smart contract, and McDonald concurred that a smart contract could point back to the legal world: the main issue is to coordinate with an existing system while simultaneously trying to change it, he explained. Ferris agreed, suggesting that, moving forward, efforts will be made to more directly integrate blockchain technology with existing systems and separate blockchains with one another. This shift could assist in strengthening identity management and privacy, particularly with regarding to “zero-knowledge proof” of certain information, such as evidence to show you are over 21 without showing a specific age or birthdate, according to Ferris.

Blockchain technology can increase accuracy and efficiencies and decrease costs while still potentially reaching new customers, according to the panelists. Expect to see more blurred lines and integration as the technology continues to evolve, they concluded.

Monday, June 03, 2019

Current state of blockchain technologies, regulatory considerations explored at SEC FinTech Forum

By Brad Rosen, J.D.

Digital ledger technologies (DLT) have captured the world’s imagination over the past decade, observed Valerie Szczepanik, head of the SEC’s FinHub unit, in her opening remarks at the 2019 SEC FinTech Forum. She further noted that we are currently in a build-out phase and are seeing many blockchain-related projects starting to come to fruition. The event, which was hosted by the SEC's Strategic Hub for Innovation and Financial Technology (aka FinHub), attracted some of the nation’s leading experts to discuss the latest trends and developments impacted DLT and digital assets.

Capital formation considerations. The day’s first panel engaged in a lively discussion around capital formation issues in the digital space and was moderated by Jonathan Ingram, Chief Legal Advisor, FinHub, Division of Corporation Finance. The panelists included Joshua Ashley Klayman, Founder and Managing Member, Klayman LLC; Paul Brody, Principal, Ernst & Young; and Aaron Wright, Professor, Cardozo Law School.

In her remarks, Joshua Klayman noted that when digital assets are used for capital formation, the tokens can be structured precisely to the entrepreneur’s liking and requirements. The innovator’s interest doesn’t have to be diluted, nor does control have to be given up. Bespoke negotiations do not have to be entertained with each and every potential investor. With tokens, the entrepreneur is in a better position to say take it or leave it, and that can be very exciting. “The flexibility provided by tokens is tremendous,” observed Klayman.

Aaron Wright sees big interest around STOs (security token offerings which utilize DLT). With STOs, a startup is not limited from raising money from the two coasts, which is often the case now. For instance, he noted that an entrepreneur from Alabama could raise money in Alabama and get funding from his or her own users. In Wright’s view, this could potentially open up the floodgates for funding, and he noted that we have the tools to provide access to capital. “Simply, with STOs, there is the ability to raise lots of capital quickly . . . it’s like putting an investment banker in your pocket,” Wright observed. However, he cautioned that many challenges remain, especially around consumer protection concerns.

Using digital assets to achieve regulatory compliance. According to Paul Brody, digital assets can be used to achieve compliance objectives. He pointed to ERC protocols which can be employed on the Ethereum blockchain such that ownership can be controlled, transfer restrictions can imposed, and anti-money laundering issues can be addressed via the use of smart contracts. Wright concurred, noting that with the power of technology, rules, in effect, can be imposed upon assets. Wright pointed to smart contracts where law is being encoded to effectuate payment flows under legal agreements.

Trading and markets issues. The day’s second panel discussed issues relating to trading and markets in the digital asset space and was moderated by Elizabeth Baird, Deputy Director, Division of Trading and Markets. The panelists included David Forman, Chief Legal Officer, Fidelity Brokerage Services; Mark Weitjen, Managing Director, DTCC; and Neha Narula, Director, MIT Media Lab. The discussion centered around regulatory challenges involving offshore platforms and U.S. persons and disintermediation—the lack of traditional intermediaries in the digital asset space.

Locating risk—in the regulation or technology. According to Mark Weitjen, risk lies both in technology and in regulation. However, with blockchain technologies, redundancies and the consensus mechanism enhance security, in his view. In looking at DLT, or any new technology, Weitjen noted that DTCC asks how that technology delivers a solution, its security, its costs, and the associated risks.

A trustless technology? Baird posed the question whether blockchain technology is trustless and reduces counterparty risk. Most of the panelists expressed their discomfort with the concept. Narula said she was uncomfortable with the term “trustless.” Trust moves around, and you assume market participants are operating in good faith and are motivated by rationality, she observed. David Foreman indicated the concept of trustlessness is somewhat misleading. You have to trust someone, but you don’t need to trust the counterparty to a transaction. Participants should be able to determine the level of trust they are comfortable with, Foreman explained. He added that some participants are only comfortable with keeping their asset under the mattress.

A word about custody. Foreman also outlined the complex issues around digital asset custody. The correct approach depends where the customer is located, who the customer is, who you are, and where the assets are located, he noted. “It’s an alphabet of potential options—and not very efficient…it’s a minefield and easy to get in trouble,” Foreman concluded. He hopes to see progress in this area.

Friday, May 31, 2019

Commissioner Peirce shares thoughts on 25 years of ETFs

By Rodney F. Tonkovic, J.D.

SEC Commissioner Hester M. Peirce shared her thoughts on exchange-traded funds at the May 21, 2019 ETFs Global Markets Roundtable. Peirce's speech marked the 25 years since the first ETF was launched in 1993, and she took the occasion to share her views not only how ETFs can be used to facilitate further financial experimentation and innovations but also on how the SEC can fulfill its regulatory role without slowing any of these innovations.

ETFs are all grown up. Peirce, often called "CryptoMom," observed that, while ETFs have matured as an asset class since their 1993 launch, the SEC is "still smothering them with personalized attention as if they were infants." ETFs, she said, now have nearly $4 trillion in total net assets, but acquiring the necessary flexibility under the securities laws has required 300 separate exemptive orders. A 2018 rule proposal codifying these exemptions would level the playing field, she said, and she hopes that the proposal will be finalized in 2019.

"Indecision." Pierce also noted that taking 25 years to come up with a rule for "plain vanilla" ETFs does not bode well for, as an example, ETFs with a cryptocurrency angle. The SEC has been cautious in approving new types of ETFs, and she indicated that the Commission is perhaps overly concerned with the worthiness of these investments. This caution, however, makes it difficult for fund sponsors to plan the launch of a new product "with the great unknown of Commission timing lurking in the background," she said.

As an example of what she called "Commission indecision," Pierce offered the case of requests for exemptive relief for non-fully transparent actively-managed ETFs. The first ETF of this type was authorized on the day before this speech, eight years after the first applicant for exemptive relief to allow a non-fully transparent actively managed ETF publicly filed its application. It "took a considerable amount of time for the Commission to get comfortable," she remarked.

Another example is the Commission’s treatment of leveraged and inverse ETFs, also known as "geared" ETFs. No orders allowing the operation of geared ETFs have been issued since 2008. This moratorium, Peirce explained, seems to be a reflection of the Commission's concern that retail investors might be confused about the performance objectives of these funds. While these concerns are understandable, she continued, the disclosures being made by leveraged or inverse funds to have been "pretty unvarnished" and clearly lay out their investment objective, strategy, risks, and target audience. Moreover, an oligopoly has been created for ETF sponsors that obtained a leveraged or inverse ETF order before the moratorium took effect, and investors are left with limited options for portfolio diversification.

Bitcoin. Finally, Peirce said that she would like to see the Division of Investment Management entertain an exemptive application for an ETF or approve an exchange rule allowing for the operation of crypto ETFs or other exchange-traded products (ETPs). While the Commission has a number of concerns, she said, its role should not be that of arbiter of what constitutes an appropriate investment. Pointing to the disapproved Winklevoss Bitcoin Trust, she said that the Commission should have focused on how the exchange-traded wrapper would work rather than on the underlying characteristics of bitcoin. That said, SEC permission for a cryptocurrency ETP to trade would not be a seal of approval, and investors would still need to do their own homework.

Thursday, May 30, 2019

OCIE finds deficiencies in data-storage practices of brokers and advisers

By Anne Sherry, J.D.

The SEC’s Office of Compliance Inspections and Examinations issued a risk alert highlighting security risks identified in recent examinations of broker-dealers and investment advisers. OCIE examiners found that in storing electronic customer records and information in cloud-based and other network storage repositories, brokers and advisers did not always use the available security features. The risk alert provides several examples of effective practices.

The alert notes that the majority of network storage repositories offered encryption, password protection, and other security features, but these were not always utilized. These deficiencies could lead to violations of Regulations S-P (safeguards) and S-ID (identity theft red flags). Regulation S-P requires investment advisers and broker-dealers to have policies and procedures in place reasonably designed to protect customer information, while Regulation S-ID protects against identity theft and applies to investment advisers, broker-dealers, and investment companies.

Last September, the SEC for the first time brought charges for violations of Regulation S-ID. Voya Financial Advisers agreed to pay $1 million to settle the SEC's charges relating to weaknesses in their cybersecurity policies that resulted in the failure to detect and protect against a cyber intrusion that allowed access to the personal information of thousands of customers. The agency has also brought a number of enforcement actions for violations of Regulation S-P.

OCIE observed that some firms did not adequately configure the security settings on their network storage system to protect against unauthorized access and sometimes lacked policies and procedures addressing this security configuration. In some cases, firms did not ensure (for example, through policies and procedures or contractual provisions) that the security settings for vendor-provided storage were properly configured to the firms’ standards. And policies and procedures sometimes failed to identify the different types of electronically stored data and the appropriate controls for each data type.

The alert also gives several examples of effective practices noted in examinations. These include policies and procedures designed to support the installation, maintenance, and review of network storage systems; guidelines for security controls and baseline configuration standards; and vendor management policies and procedures. OCIE encourages brokers and advisers to review their practices, policies, and procedures and to actively oversee any third parties that provide network storage services with a view towards regulatory compliance.

Wednesday, May 29, 2019

Petition asks Supreme Court to clarify breadth of "in connection with" requirement

By Rodney F. Tonkovic, J.D.

A former racetrack operator charged with fraud by the SEC has asked the Supreme Court to consider whether a misrepresentation that does not affect a security's value can still be a violation of the antifraud provisions. In this case, the petitioner lied to induce a transaction involving the securities, but not about the value of the securities themselves. The petition urges the Court to clarify whether the "in connection with" requirement requires more than that a misrepresentation simply "touches" upon a securities transaction (Hall v. SEC, May 20, 2019).

Lied for loans. In 2015, the Commission charged Christopher J. Hall with fraudulently obtaining millions of dollars in margin loans from a brokerage firm where he and his company maintained accounts. At the time, Hall was the chairman and controlling shareholder of Call Now, Inc., a defunct publicly traded company that operated a horse race track in Texas. Between 1999 and 2008, Hall and Call Now borrowed millions of dollars using margin loans from their brokerage accounts and used the loan proceeds to operate the race track.

By 2009, the collateral in the accounts substantially diminished in value, so, on two occasions, the broker demanded additional collateral. To satisfy the margin calls, Hall offered to pledge Call Now stock to the broker, but claimed that he needed loans to unencumber shares that were pledged to other lenders. The brokerage firm then loaned Hall several million dollars, but he paid only one lender less than $1 million, and used the rest of the funds for his personal use.

Before the district court, Hall argued that the alleged misrepresentations were neither material or made "in connection with" the purchase or sale of a security, but this argument was rejected. In 2017, a jury found Hall, who admitted that he lied to get the loans, liable for securities fraud under both the Securities Act and the Exchange Act. A district court then denied the Commission's request for disgorgement, but ordered a permanent injunction against future violations, a 10-year officer and director bar, and a $225,000 civil monetary penalty; on reconsideration, disgorgement was also ordered. The 11th Circuit affirmed these sanctions.

Chance to clarify "in connection with" standard. In his petition for certiorari, Hall contends that his lies about the Call Now shares being encumbered was a "negotiating tactic." No misrepresentations were made about Call Now itself, or the value of its shares, he says. The Eleventh Circuit, however, "ignored" Hall’s arguments as to whether his conduct implicated the securities laws, stating that it lacked authority to consider Hall’s challenges to the sufficiency of the Commission’s evidence at trial because he had not filed a post-verdict motion for reconsideration or for a new trial in the district court. The first question presented by the petition concerns this issue: whether appellate courts have authority to consider challenges to issues of law raised in a pre-verdict FRCP 50(a) motion for judgment as a matter of law if the same challenges are not subsequently renewed in a post-verdict Rule 50(b) motion in the district court.

Regarding the securities issue, the petition asserts that this case presents the Court with the opportunity to clearly articulate the “in connection with” standard. According to Hall, there is ambiguity over the extent to which misrepresentations must affect the value of a security in order to satisfy the "in connection with" requirement and support a violation of the antifraud provisions. A Second Circuit decision, for example, concluded that where a misrepresentation involves a securities transaction but does not pertain to the security itself, there is no cause of action. The Eleventh Circuit, in contrast, has held prior to this case that the "in connection with" requirement is broad and that a misrepresentation does not need to be explicitly directed at the investing public or occur during the transaction. Indeed, the jury instructions below said that the requirement is met if the fraud "touches" upon the transaction.

The petition maintains that the Court has said (in Chadbourne & Parke LLP v. Troice (2014)) the “in connection with” requirement is not met unless it is material to a decision to buy or sell a security. In this case, Hall says, the misrepresentations had no impact on the brokerage's decision to accept the Call Now shares as collateral. The petition also took note of the Court's decision in 2002 in SEC v. Zandford, in which the Court concluded that the requirement was met when the fraud was directed at the securities themselves and coincided with their sales. The petition urges the Court to take up the case and articulate a standard stating that the fraud or misrepresentation must have a material effect on a party to buy or sell a security.

The petition is No. 18-1471.

Tuesday, May 28, 2019

PCAOB issues guidance on CAMs communications as compliance date nears

By Amanda Maine, J.D.

The PCAOB has issued new staff guidance on the communication of critical audit matters in the auditor’s report. The guidance purports to take a “deeper dive” on CAMs, which will be required for audits for fiscal years ending on or after June 30 for large accelerated filers.

New auditor’s reporting model. The PCAOB adopted a new auditor’s reporting model in June 2017 after several years of consideration, input, and roundtables. The new auditing standard requires the auditor to communicate in the auditor's report any critical audit matters (CAMs) arising from the current period’s audit of the financial statements. The Board defined a CAM as a matter communicated to the audit committee or that is required to be communicated to the audit committee that: (1) relates to accounts or disclosures that are material to the financial statements, and (2) involved especially challenging, subjective, or complex auditor judgment. These would be matters that, as explained by several PCAOB officials, “kept the auditor awake at night.”

Provisions of the new auditing standard related to the communication of CAMs will take effect for audits for fiscal years ending on or after June 30, 2019, for large accelerated filers; and for fiscal years ending on or after December 15, 2020, for all other companies to which the requirements apply.

New guidance. With the effective date for CAMs approaching, the PCAOB has issued new guidance on how auditors should communicate CAMs. The guidance refers to the “what” (the identification of a CAM), the “why” (the principal considerations that led the auditor to determine that the matter was critical), the “how” (how the CAM was addressed in the audit), and the “where” (the relevant financial statement accounts or disclosures).

The guidance contains examples to inform auditors how they should describe the principal considerations leading to a CAM determination. Using a goodwill impairment assessment as an example, the guidance recommends the auditor address issues such as what kind of valuation technique was used, if the valuation was based on subjective assumptions (such as revenue projections given a lack of operating history), underlying factors (such as market conditions, product demand, or new regulations), and the nature and extent of specialized knowledge, including using the work of a specialist, in addressing the CAM.

The guidance also describes considerations at play when describing audit procedures as part of communicating how a CAM was addressed in an audit. These might include the degree of auditor judgment involved in evaluating management assumptions, the testing of controls used in addressing risks related to the valuation assertion of assets acquired in an acquisition, and the nature and extent of a specialist’s involvement in performing the audit.

The guidance warns that the language used to describe how a CAM was addressed should not imply that the auditor is providing a separate opinion on the CAM. CAM communications should not simply duplicate public disclosures already made by the company, the guidance states. If a particular CAM is identified over more than one reporting period, the auditor should consider the specific facts and circumstances that existed during the audit when tailoring the communication of the CAM. The guidance also emphasizes that the auditor is not expected to provide information about the company that has not already been disclosed unless that information would be necessary to describe why a matter was considered a CAM.

Friday, May 24, 2019

SEC Commissioner Peirce advocates for periodically revisiting agency rules in remarks before accounting academics

By Brad Rosen, J.D.

SEC Commissioner Hester Peirce openly wondered what the SEC rulebook might look like if the agency did not automatically carry over its rules from one year to the next in a recent speech before the Center for Accounting Research and Education (CARE) conference held in Leesburg, Virginia. In remarks titled Sunsets, Russets, and Rule Resets, Peirce asserted that as the SEC writes its rules, the agency needs to be thinking of ways it can inject flexibility into the obligations it imposes to make them better able to change with the times.

The commissioner’s own private Idaho. Commissioner Peirce began her remarks by noting that the rules on Idaho’s state books sunset every year unless they are reauthorized. Usually they are, but this year, they were not, she observed. Peirce then turned her attention to the SEC’s rules, observing that the agency has accumulated a lot of regulations over the years, and she pondered what things might look like if SEC rules had to be similarly reauthorized annually. She concluded there would be fewer and simpler rules in place of the “complex tangle” now in place.

Nonetheless, the commissioner acknowledged that unlike the state of Idaho, “getting rid of antiquated rules at the SEC involves more procedural hurdles,” perhaps having the Administrative Procedures Act and other regulatory niceties in mind. Notwithstanding, Peirce called for the flexible application of SEC rules, as well as developing a culture of revisiting the agency’s rules on a periodic basis. She then turned to a number of “hot topics” where her lighter touch regulatory approach would be appropriate and yield meaningful benefits.

Sarbox, small players, and missed opportunities. The commissioner noted that the SEC recently moved to update Section 404(b) of the Sarbanes-Oxley Act which requires public companies to have their internal controls audited by an independent auditor. Specifically, the SEC proposed to allow certain small, low-revenue companies to opt out of the auditor attestation requirement which has proved to be quite costly for these market participants.

The commissioner observed that many small companies and their investors have expressed concern about the diversion of desperately scarce resources to the 404(b) audit. She also pointed to one small company CFO that told the SEC the auditor attestation would add 20 to 33 percent to his independent auditor bill.

Although Peirce views the recent proposal as a positive step for making SEC rules more flexible, an opportunity to make the rules simpler was missed last year when the Commission amended certain rules which defined a Smaller Reporting Company (SRC). At the time, amendments were adopted that expanded the pool of companies eligible for scaled disclosure. However, the SEC did not make complementary changes to the 404(b) exemption. According to Peirce, another opportunity to simplify requirements was similarly missed last week when the Commissioner adopted a limited definition for accelerated filers in connection with the auditor attestation requirement under 404(b).

Finalizing security-based swap rules mandated by Dodd-Frank. Another hot topic Commissioner Peirce identified was the recent SEC rule proposal regarding security-based swap markets. She noted the challenges of building a new regulatory framework for the security-based swap market in the U.S results from our domestic market being only part of a larger global market that developed mostly free of the burdens of potentially conflicting national regulatory requirements.

In Peirce’s view, U.S. and foreign regulators have had to work to determine where U.S. rules should end and those of overseas regulatory counterparts should begin. Peirce observed that the recent rule proposal is an attempt to lay out a workable framework that allows for an appropriate level of oversight of these large markets without imposing duplicative or conflicting regulation on global firms attempting to serve a global, sophisticated clientele.

Looking to early action in another jurisdiction. Peirce also observed that while international harmonization is important, sometimes one jurisdiction’s early action in an area helps other jurisdictions to think about how they address the same area. As an example, the commissioner looked towards the experience of Bermuda in connection with digital asset regulation to assess potential regulatory approaches in this realm. She observed that the Bermuda Monetary Authority recently released draft guidance for crypto custodial services which addresses how to store private keys for hot and cold storage while preserving necessary liquidity, what safeguards should be in place to prevent unauthorized access, and how to frame internal audit of transactions to ensure their integrity.

Lastly, Commissioner Peirce noted the SEC had much to learn from academics like those in attendance at the CARE conference. She concluded, “Given the value that research can have for our research agenda, we are always eager to hear ideas about how we can work more productively with academics.”

Thursday, May 23, 2019

NASAA adopts investment adviser information security model rule package

By Jay Fishman, J.D.

The North American Securities Administrators Association, Inc. (NASAA) has adopted an information security model rule package to enhance state-registered investment advisers’ cybersecurity and privacy practices.  The package consists of:
  1. A model rule requiring investment advisers to adopt policies and procedures regarding information security (both physical security and cybersecurity) and to deliver its privacy policy annually to clients;
  2. An amendment to the existing investment adviser NASAA model recordkeeping requirements rule mandating that investment advisers maintain records of their cybersecurity and privacy policies and procedures; and 
  3. Amendments to the existing investment adviser NASAA Unethical Business Practices of Investment Advisers, Investment Adviser Representatives, and Federal Covered Advisers and NASAA Prohibited Conduct of Investment Advisers, Investment Adviser Representatives and Federal Covered Investment Advisers Model Rule USA 2002 502(b) model rules, to include failing to create, maintain, and enforce the cybersecurity and privacy policies and procedures.   
Model rule package. The package was prompted by the current potential for information security breaches at investment adviser firms that could devastate the bottom line of any business, particularly a small business, as well as damage a firm’s reputation and a client’s trust in the investment adviser.

The Ohio securities commissioner and chair of NASAA’s Investment Adviser Section, added, “This is significantly important considering that 80 percent of the 17,500 state-registered investment advisers are one-to-two-person shops.”

Regarding the overall package’s importance, NASAA’s current President and Vermont Securities Commissioner Michael Pieciak, declared that “NASAA seeks to highlight the importance of data privacy and security in our financial markets along with the related need for investment advisers to have information security policies and procedures. The package does this by providing a basic structure for how state-registered investment advisers may design their information security policies and procedures, which we expect to create uniformity in both state regulation and state-registered investment adviser practices.”

Investment adviser section annual report. NASAA also issued its 2019 Investment Adviser Section Annual Report highlighting the many activities the organization undertook in 2018 to help small- and mid-size investment adviser firms continue to succeed and to understand and comply with state securities laws. The report provides information about investment advisers across the United States, including the demographics of the 17,543 state-registered investment advisers and 10,480 SEC-registered investment advisers; their business and fee structure; their clients; and the top advisory services they provide. The report also provides NASAA project group reports, outreach efforts, and the results of a continuing education survey.

Wednesday, May 22, 2019

Chamber of Commerce criticizes recent state fiduciary proposals, urges SEC to declare federal preemption

By Amanda Maine, J.D.

The U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness (CCMC) has written to the SEC calling on the Commission to reiterate that the federal securities laws would preempt recent state proposals seeking to establish fiduciary or best interest standards. A federal standard such as the SEC’s proposed Regulation Best Interest would better serve and protect investors compared to standards that differ on a state-by-state basis, according to CCMC.

State proposals. CCMC took aim at proposals in Nevada and New Jersey that would implement new uniform fiduciary standards of conduct for broker-dealers and registered investment advisers. According to CCMC, these proposals, should they become law, would be preempted by the National Securities Markets Improvement Act of 1996 (NSMIA).
Under NSMIA, regulatory requirements imposed by state law on SEC-registered advisers are preempted, except those that relate to fraud, notice filings, and Investment Advisers Act fees. In particular, CCMC highlighted text from NSMIA that prohibits states from establishing certain requirements “that differ from, or are in addition to” those enshrined in federal law.

The Nevada Securities Division proposed new regulations establishing fiduciary duties for broker-dealers and investment advisers in January 2019. CCMC noted that the proposal states that it is meant to be “interpreted and apply in harmony” with NSMIA but added that this statement alone would not prevent federal preemption in light of the requirements of the proposal. Because the Nevada proposal would result in new financial responsibility and record-keeping requirements for broker-dealers, they would have to endure the added expense of obtaining more insurance coverage, according to CCMC.

In addition, the proposal would require that broker-dealers make and keep records beyond those required by federal law, CCMC advised. “Virtually all recommendations would result in an ongoing obligation to monitor and advise clients,” even for a one-time fiduciary recommendation, CCMC said. This would require the collection and documentation of all relevant information about the client.

CCMC also criticized the Nevada proposal for deeming as fiduciary advice certain acts not related to the recommendation of securities, such as recommending other advisors. In addition, CCMC noted that the Nevada proposal would put the burden on the broker-dealer to prove that an exemption to the fiduciary exists, another burden that NSMIA preempts states from imposing, according to CCMC.

Similarly, the proposal put forth by the New Jersey Securities Bureau last month would impose a uniform fiduciary duty for broker-dealers, investment advisers, and investment adviser representatives, CCMC observed. In fact, the proposed standard explicitly states that it would go beyond the scope of the SEC’s proposed Regulation Best Interest: “Should the SEC adopt Regulation Best Interest, the Bureau’s proposed new rule will exceed this standard,” CCMC quoted from the proposal. State laws that exceed the SEC standard must trip NSMIA preemption, CCMC implored.

Regulation Best Interest. The Commission’s proposed Regulation Best Interest, which the SEC approved for comment in April 2018 and is expected to be put to a final vote in the near future, represents an effort to provide comprehensive regulation of investment advice that will preserve retail consumer choice, including for the brokerage “pay-as-you-go” model widely used by small-money investors, CCMC asserted. Fiduciary and best interest standards adopted state-by-state will likely materially conflict with each other and with federal standards, resulting in increased compliance burdens, risks, and costs, CCMC warned. Therefore, the SEC should reiterate that state fiduciary proposals such as those put forth by Nevada and New Jersey would be preempted by federal law under NSMIA, CCMC concluded.

Tuesday, May 21, 2019

Class action alleges Lyft misled investors in IPO

By Lene Powell, J.D.

In a new lawsuit in California’s Northern District, a family trust is alleging that Lyft Inc. misled investors in documents supporting its recent IPO regarding the company's national market share, safety issues regarding its bike sharing business, and labor issues, causing the share price to be artificially inflated and resulting in investor losses when the truth came out (Malig v. Lyft Inc., May 17, 2019).

IPO. Headquartered in San Francisco, Lyft operates a peer-to-peer marketplace for on-demand ridesharing, including access to motor vehicles, shared bikes, and shared scooters. According to the suit brought by Block & Leviton, Lyft offered 32.5 million shares via its March 28 IPO at a price of $72.00 per share, for total proceeds of $2.34 billion.

Misrepresentations. The action claims violations of Section 11 of the Securities Act for misrepresentations in the registration statement and prospectus. According to the complaint, Lyft’s statements about company’s business metrics, growth potential, and financial prospects were not as strong as presented in the offering materials.

This financial weakness was allegedly due to several reasons. First, to increase the Company's reported revenues and profits in the lead-up to the IPO, Lyft began charging higher "surge pricing" more often than it had previously been doing, but keeping a higher portion of the additional revenue without sharing a proportionate share with drivers. This led to decreased payment to drivers, disincentivizing them to drive for Lyft, and potentially damaging the business on a long-term basis. Lyft drivers in Los Angeles went on strike for 25 hours on March 25, 2019, just three days before the IPO.

In addition, Lyft allegedly failed to disclose that more than 1,000 of its rideshare bicycles had safety issues, which led to thousands of bicycles being taken out of service in New York, San Francisco, and Washington, D.C. following dozens of reported injuries and safety concerns.

Damages. According to the complaint, these misrepresentations and omissions materially and artificially inflated the share price at the time of the offering. As investors learned additional information after the IPO, the company's shares fell sharply from $72.00 to under $57.00 on April 15, 2019.

The complaint states that the claims are purely strict liability and negligence claims, and that the plaintiff expressly eschews any allegation sounding in fraud.

The case is No. 3:19-cv-02690.

Monday, May 20, 2019

CFTC Chairman Giancarlo lets his hair down in first installment of FIA Speaks podcast

By Brad Rosen, J.D.

CFTC Chairman J. Christopher Giancarlo recently sat down with FIA President and CEO Walt Lukken for the association’s newly launched podcast, FIA speaks. In a candid and engaging interview, the two industry leaders looked back at the chairman’s tenure at the agency, including his many accomplishments, as well as ongoing challenges for the agency and the industry. The chairman also shared some personal insights including how he acquired the “Crypto Dad” moniker, and the role music has played in his personal and professional life.

Becoming a commissioner and embracing Dodd-Frank. At the onset of the interview, Giancarlo shared his backstory and his unlikely path to becoming the Chairman of the world’s preeminent derivatives regulatory agency. “I never aspired to a Washington career” he recollected. After practicing law for 16 years, in 2000 Giancarlo went into business and was a key player in a company that built one of the world’s largest hybrid trading platforms for OTC derivatives, and then helped take that company public.

Then came 2008, and Giancarlo found himself at the center of the financial crisis. He noted, the response was passing and implementing the Dodd-Frank Act. Giancarlo was supportive of all elements of Title VII of the act which centered around the clearing mandate, data reporting mandate, and trading on licensed platforms. Despite his support for the reforms, Giancarlo still had differences with how the CFTC was implementing Dodd-Frank. As a result, Giancarlo reconsidered an opportunity to serve in government and was delighted when he was nominated to serve as a minority commissioner by President Obama in 2014, and then renominated to serve as CFTC Chairman by President Trump in 2017.

It’s all about the calibration. Responding to Luken’s surprise that as a Republican, Giancarlo supported all aspects of the G-20 reforms set forth in Pittsburg in 2009, the chairman noted that Congress had gotten it right with respect to Dodd–Frank. He indicated that that he has been working with these reforms from a commercial point of view, and looking to take the politics out of it. “It’s about calibrating – how do you get these rules to work that is suitable for market activity, he observed. The chairman continued, “ We operate in a global marketplace. We want to have the most optimal regulatory system in world.” Giancarlo, agreed that the KISS initiative is geared to assure that Dodd-Franks elements work practically and efficiently.

An agency that punches above its weight. When asked what makes the CFTC special in its role as one of the world's leading derivatives regulators, Giancarlo responded with the following: 
  • The agency reports to the Congressional Agriculture Committees. Ag folks have a long tradition of working together on a bipartisan basis. As a result, the CFTC is much less of a political agency; that flows down from the top.
  • The staff is sophisticated and highly expert in their areas of specialization.
  • The CFTC is the world’s only exclusive regulator of derivative markets. That may be a reason why U.S. has the largest.
  • Internationally, the CFTC is regarded as a premier regulatory agency. It trains other global regulators and it has a reputation as an extraordinary and leading governmental.
Some highs and some lows. Giancarlo said he wants to be remembered for making the case for having robust well-regulated derivative market at every opportunity. He noted well-functioning derivative markets are vital and essential for enabling stable interest rates as well as stable energy and food prices.

On the downside, Giancarlo pointed to the flat funding he has seen for the agency during his years as a commissioner. “Flat funding means you are a victim of attrition – when people leave you can’t fill that spot”, he observed. The Chairman noted that this cycle may have been broken, as agency funding has increased, although not everything the agency asked for was granted in the most recent round of appropriations.

The legacy of “Crypto Dad.” Giancarlo will certainly be remembered for his opening remarks before the Senate Banking Committee, when he abandoned his prepared statement, and instead shared experieces a recent family gathering, when the younger generation expressed their enthusiasm for virtual currencies. He shared that experience with the legislators and urged them to take cryptocurrencies seriously and not dismiss them out of hand. As a result, the Chairman gained some 46,000 twitter followers, as well as the nickname “Crypto Dad”.

Giancarlo also expressed his long-term bullishness for blockchain technologies. “It here to stay” he told Lukken. Specifically, he thinks blockchain innovations have greater potential in the developing world where payment systems and currencies remain problematic.

Getting the band back together. Giancarlo and Lukken concluded their discussion by talking about how music has shaped there lives, personally and professionally. Both are accomplished musicians. Giancarlo plays banjo and guitar and performs regularly. Once leaving the CFTC, the Chairman indicated he intends to play a lot more music and get the band back together. In fact, Giancarlo indicated that he is booked later in the summer to appear at the Stone Pony, a legendary venue on the Jersey shore where Bruce Springsteen played back in the day.

Chairman Giancarlo will be leaving the CFTC later this year. For him, the beat will go on.