Friday, March 17, 2023

Katten lawyers Johnjerica Hodge and India Williams lead firm’s newly launched practice focused on ESG risk and investigations

By Brad Rosen, J.D.

In this third installment of The ESG Ready Lawyer, Katten Muchin Rosenman partners Johnjerica Hodge and India Williams speak about leading the firm’s recently reconstituted ESG Risk and Investigation practice, the passion they bring in providing counsel around a host of thorny ESG issues, as well as the role they play in advancing ESG educational efforts.

Hodge and Williams also describe Katten’s approach in partnering with clients by adopting ESG policies that promote sustainability and mitigate risk in a manner that creates long-term and sustainable value, and how they go about achieving those objectives. The pair also give their views on how best to navigate the increased politicization of ESG matters, as well as the value of conducting DEI (diversity, equity and inclusion) audits.

You can read this installment of The ESG Ready Lawyer here.

Thursday, March 16, 2023

SEC unveils suite of new cybersecurity rules for securities markets

By Suzanne Cosgrove

The SEC proposed new rules Wednesday that would require all securities market entities to establish, maintain and enforce written policies and procedures to address cybersecurity risks, and to assess the effectiveness of those policies and procedures at least annually, including whether they reflect changes in cybersecurity risk over the period covered by the review (Cybersecurity Risk Management Rule for Broker-Dealers, Clearing Agencies, Major Security-Based Swap Participants, the Municipal Securities Rulemaking Board, National Securities Associations, National Securities Exchanges, Security-Based Swap Data Repositories, Security-Based Swap Dealers, and Transfer AgentsRelease No. 34-97142, March 15, 2023).

The rules would impact participants at all levels of the securities industry, the SEC said, including most broker-dealers, clearing agencies, major security-based swap participants, the Municipal Securities Rulemaking Board (MSRB), national securities associations, national securities exchanges, security-based swap data repositories, security-based swap dealers and transfer agents.

The proposed “Rule 10” regulations would compel financial firms to immediately notify the SEC of a significant cybersecurity incident by providing a written electronic notice of the event and report detailed information about the incident to the Commission on Part I of a proposed reporting vehicle, called Form SCIR. The new form is designed to collect information about cybersecurity incidents, as well as the covered entity’s efforts to respond to and recover from them.

In addition, the firms would be required to publicly disclose summaries of their cybersecurity risks and the significant cybersecurity incidents they experienced during the current or previous calendar year on Part II of the proposed Form SCIR – filing the form with the Commission and posting it on its website.

As part of the proposal, the Commission also included amendments to existing clearing agency exemption orders that would require the retention of records needed under the new cybersecurity requirements.

If adopted, the rules would set standards for market entities’ cybersecurity practices, said SEC Chair Gary Gensler in a statement. “The nature, scale, and impact of cybersecurity risks have grown significantly in recent decades. Investors, issuers, and market participants alike would benefit from knowing that these entities have in place protections fit for a digital age,” Gensler added.

The SEC has published a cybersecurity Fact Sheet that summarizes the 530-page proposal and highlights key Rule 10 recommendations. “This proposal would help promote every part of our mission, particularly regarding investor protection and orderly markets,” Gensler said.

The big picture. In an apparently related action, the SEC Wednesday also reopened the comment period on proposed rules and amendments related to cybersecurity risk management and cybersecurity-related disclosure for registered investment advisers, registered investment companies and business development companies.

The investment adviser rules were proposed by the Commission last year, on February 9, 2022, and the original comment period ended on April 11, 2022.

The Commission said the reopened comment period will allow interested persons additional time to analyze the issues in light of other regulatory developments, including whether there would be any effects of other Commission proposals related to cybersecurity risk management and disclosure.

Too much paperwork? In a strongly worded reaction to the proposed Rule 10 and Form SCIR, SEC Commissioner Hester Peirce agreed that there are heavy reputational and financial costs associated with cybersecurity breaches. “Addressing this challenge constructively requires the Commission to work with firms in a way that helps them shore up cyber-defenses and minimize the consequences of cyberattacks,” she said.

But Peirce said she would not support the current proposal. “The Commission stands ready, not with assistance but with a cudgel to wield if the firm fails to comply with a complicated reporting regime, even if the firm resolves the incident by avoiding significant harm to the firm or its customers,” she said.

“This proposal demonstrates that our priority is to create even more legal peril for a firm in this situation, legal peril that will distract employees of the firm from mitigating the immediate threat to the firm and its customers as they navigate the aggressive deadlines and open-ended information demands of the Commission,” Peirce said.

Commissioner Mark Uyeda also raised concerns about the proposed regime. Requiring covered entities to provide written notice immediately and file a form within 48 hours of an incident “would demand immediate attention from management all in the midst of responding to a breach and alerting other authorities, including law enforcement. And for what purpose? The SEC does not have a cyber response team that could immediately respond to seal the breach and provide technical assistance.”

Uyeda also objected that the SEC did not use its express authority under Dodd-Frank to test whether the proposed disclosures to investors would be effective. It is possible, he said, that customers who already receive voluminous disclosures from their broker-dealers may simply ignore the additional cybersecurity disclosures.

Finally, Uyeda wondered why the new proposal was not informed by public comments received on a similar proposal from the Division of Investment Management. Along with that 2022 proposal are two other new proposals that overlap with the newly proposed cybersecurity rules. “It is crucial that there is a clear regulatory framework to address cybersecurity,” Uyeda wrote. “While the proposals acknowledge the possibility of potential overlap, they fail to address those concerns and simply ask commenters to specifically identify areas of duplication and costs. A preferable approach would have been to propose a set of coordinated rules and to consider those costs and benefits both individually and as a package.”

This is Release No. 34-97142.

Wednesday, March 15, 2023

SEC challenges holding that ALJ proceedings are unconstitutional

By Rodney F. Tonkovic, J.D.

The SEC has filed a petition for certiorari challenging a circuit court decision that could upend the Commission's enforcement regime. In May 2022, the Fifth Circuit held that the Commission's administrative proceedings violated the petitioners’ Seventh Amendment right to a jury trial and that Congress unconstitutionally delegated to the SEC the power to decide which proceedings should remain in-house and which should be brought in the courts. With the Fifth Circuit having facially invalidated provisions of federal statutes, the SEC urges the Court to review the decision. The holding is not only in conflict with over a century of precedent, the petition contends, but it may also have significant adverse effects for a host of federal agencies that bring proceedings seeking civil penalties (SEC v. Jarkesy, March 8, 2023).

The long journey. The story begins ten years ago: in March 2013, the Commission accused hedge fund manager George R. Jarkesy with defrauding investors in two hedge funds and steering millions in fees to a broker-dealer. Jarkesy's co-respondents settled, but Jarkesy challenged the proceeding in the district court in D.C., arguing that the settled order included findings that he had violated the securities laws. He sought to stay the administrative proceeding for Due Process violations arising from the SEC’s alleged prejudgment of the case.

The district court concluded that it had no concurrent jurisdiction to consider the challenge, and the D.C. Circuit agreed that Congress intended for Jarkesy’s claims to go through the administrative process before being appealed to an appellate court. The proceedings resumed, and the Commission eventually affirmed the ALJ’s conclusion that Jarkesy and his investment adviser committed securities fraud and ordered penalties and disgorgement totaling almost $1 million, along with barring Jarkesy from various activities. Jarkesy then challenged the proceedings in federal court.

Fifth Circuit holds unconstitutional. In May 2022, a 2-1 panel of the Fifth Circuit Court of Appeals vacated and remanded the decision against Jarkesy. The panel held that the administrative proceedings suffered from three independent constitutional defects, the first two of which each provided a standalone basis for vacating the SEC’s decision:
  1. The petitioners were deprived of their constitutional right to a jury trial;
  2. Congress unconstitutionally delegated legislative power to the SEC by failing to provide an intelligible principle to guide its exercise of that power; and
  3. The statutory removal restrictions on SEC ALJs violate Article II by depriving the President of adequate control.
A majority of the Fifth Circuit denied the SEC a rehearing en banc.

Grant cert and reverse. The petition maintains all three of the circuit court's holdings warrant review and that the Court should grant certiorari and reverse. Each holding is highly consequential, the SEC says, and calls longstanding practices at the SEC—and other agencies—into question.

First, the appellate court erred in holding that Congress violated the Seventh Amendment by authorizing the SEC to bring administrative proceedings seeking civil penalties. Congress has broad authority to assign adjudication of "public rights" to entities other than Article III courts, and there is a long line of Supreme Court precedent holding that administrative proceedings like the SEC's seeking civil penalties qualify as matters involving public rights. The court's reasoning was flawed, the petition says, because Congress may assign a matter involving public rights to an agency even where the Seventh Amendment would require a jury in a federal court. Plus, Congress’s decision to allocate some securities enforcement proceedings to courts does not stop it from allocating others to agencies.

The SEC next argues that the panel erred in holding that Congress violated the nondelegation doctrine by giving the SEC the power to bring fraud actions in-house. The Commission's decision to pursue either an administrative or judicial remedy is a core executive function, the petition says, not an exercise of legislative power. The decision whether and where to pursue an enforcement action involves the execution rather than the making of law, and the Court has never suggested otherwise, the SEC says.

Finally, the SEC argues that the court erred in holding that the two layers of removal protection granted to SEC ALJs is unconstitutional. SEC ALJs can only be removed by the SEC Commissioners if the Merits System Protection Board finds good cause, and SEC Commissioners and MSPB members can only be removed by the President for cause. The circuit panel held that the two-layer for-cause protection for PCAOB members that the Supreme Court held unconstitutional in Free Enterprise Fund v. PCAOB (U.S. 2010). But, the petition says, unlike the board members in Free Enterprise Fund, the SEC ALJs perform adjudicative functions, and the power of the President to remove quasi-judicial officers can be limited; the SEC's removal standard is also less stringent than the PCAOB standard at issue.

Read the Docket. This case, and others before the Court may be referenced in the latest version of the Supreme Court Docket, a regular feature of Securities Regulation Daily. Issued opinions, granted petitions, pending petitions, and denied petitions are listed separately, along with a summary of the questions presented and the current status of each appeal.

The petition is No. 22-859.

Tuesday, March 14, 2023

New York AG sues to block KuCoin crypto trading platform, argues ETH is both security and commodity

By Lene Powell, J.D.

New York Attorney General Letitia James has filed an enforcement action in New York state court seeking to stop cryptocurrency trading platform KuCoin from operating in New York. The action charges KuCoin with failing to register as a securities and commodities broker-dealer and falsely representing itself as an exchange (People of the State of New York v. Mek Global Limited d/b/a KuCoin, March 9, 2023).

“KuCoin operated in New York without registration and that is why we are taking strong action to hold them accountable and protect investors,” said James.

Alleged violations. According to the complaint, KuCoin is a cryptocurrency trading platform that operates through and mobile phone applications. KuCoin was founded in September 2017 and is headquartered in the Republic of Seychelles. It is owned and operated by Mek Global Limited, based in the Republic of Seychelles, and PhoenixFin PTE Ltd., based in Singapore.

The Office of the Attorney General (OAG) alleges that KuCoin violated the law in at least three ways:
  • KuCoin sold, offered to sell, purchased and offered to purchase cryptocurrencies that are commodities and securities without being registered with OAG as a commodity broker-dealer or a securities broker or dealer, in violation of New York law.
  • KuCoin issued and sold “KuCoin Earn,” a security in which KuCoin pooled investors’ cryptocurrencies to generate income for both itself and investors. KuCoin issued and sold this product to New Yorkers without registering as a securities broker or dealer.
  • KuCoin wrongfully represented itself as an “exchange” without appropriate registration or designation in violation of New York law.
According to OAG, KuCoin also failed to comply with a subpoena issued by OAG to provide more information about its digital asset trading activities in the state. KuCoin has already been found to be operating without proper licensure in several jurisdictions including the Seychelles, Canada, and the Netherlands.

OAG alleges that KuCoin violated New York Executive Law (“Executive Law”) § 63(12) and the New York General Business Law (“GBL”) (“the Martin Act”) §§ 352-c(3), 359-e (2), 359-e(3) and 359- e(14)(b, j, and l).

ETH and other tokens are securities … AND commodities? Significantly, OAG argues that ETH, the native cryptocurrency on the Ethereum blockchain and one of the largest cryptocurrencies, is both a commodity and a security.

OAG says the action is one of the first times a regulator is claiming in court that ETH is a security.

OAG also alleges that KuCoin’s own token, KuCoin Earn, is a security. Further, OAG argues that LUNA and its sister token, UST, are commodities and securities. LUNA and UST are virtual assets created by Terraform Labs as an “algorithmic stablecoin” project.

Penalties and undertakings sought. The OAG seeks a court order to stop KuCoin from misrepresenting that it is an exchange, prevents the company from operating in New York, and directs KuCoin to implement geo-blocking based on IP addresses and GPS location to prevent access to KuCoin’s mobile app, website, and services from New York.

OAG also seeks an accounting of fees received, restitution and disgorgement, and costs.

Other NY AG crypto actions. OAG noted previous actions to enforce New York laws in the cryptocurrency industry and protect New York investors, including actions against crypto platforms CoinEx, Nexo, Celsius, and BlockFi Lending.

“One by one my office is taking action against cryptocurrency companies that are brazenly disregarding our laws and putting investors at risk,” said James.

The case number for People of the State of New York v. Mek Global Limited d/b/a KuCoin was unavailable at time of publication.

Monday, March 13, 2023

Conservative Free Enterprise Project challenges Apple Inc.’s current DEI policies

By Suzanne Cosgrove

In a pushback against recent corporate inclusion and diversity initiatives, conservative shareholder activists from the Free Enterprise Project Friday submitted a proposal at the Apple Inc. shareholder meeting that challenged what they characterized in a tweet as “the value of their (Apple’s) woke Diversity, Equity & Inclusion (DEI) policies.”

“DEI is overtly bigoted against men, white people and straight people by falsely assuming that they are inherently—and irredeemably—racist and sexist oppressors,” stated Ethan Peck, an associate with the National Center for Public Policy Research’s Free Enterprise Project, in a statement released by the group on Friday.

In response, Apple’s board of directors stated the group’s resolution “mischaracterizes Apple’s commitment to inclusion and diversity by suggesting that our policies promoting these goals are discriminatory. Contrary to the proponent’s claims, Apple does not tolerate discrimination or harassment of any kind.”

Apple shareholders backed the company on Friday and voted against the Free Enterprise Project’s proposal.

Apple audit underway. In its shareholder resolution, titled a “Civil Rights and Non-Discrimination Audit Proposal,” No. 5 in Apple’s proxy statement, the National Center for Public Policy Research had argued “there is much disagreement about what non-discrimination means.”

That disagreement and the resulting controversy creates reputational, legal, and financial risk, the group claimed, not just for Apple, but for other companies, including Bank of America, American Express, Verizon and others, according to the group’s proxy filing. In the development of its audit recommendation, Apple should consult both civil rights and public interest law groups, the group said.

But a proposal to conduct an audit is redundant, Apple replied. The company said Apple already engaged a team from Covington & Burling, LLP, led by former U.S. Attorney General Eric Holder, to examine civil rights impacts related to Apple’s people, services, customers and communities.

Part of a bigger picture. The Free Enterprise Project’s latest shareholder initiative is part of a wave of anti-DEI measures. A law firm called the American Civil Rights Project sued Starbucks Corp. on similar grounds last year, also on behalf of the National Center for Public Policy Research, arguing that Starbucks and its executives violated their fiduciary duties in adopting the DEI policies that allegedly illegally discriminated based on race by incentivizing officers to establish a more diverse workforce and supply chain.

And the recent shareholder action follows a vote in Congress earlier this month to disapprove a U.S. Department of Labor rule that would allow ERISA fiduciaries to consider environmental, social and governance (ESG) factors when making investment decisions. The anti-DEI legislation was introduced in the Senate by Sen. Mike Braun (R-Indiana) and a companion bill was sponsored in the House by Rep. Andy Barr (R-Kentucky).

As reported by Securities Regulation Daily, the resolution to disapprove H.J. Res. 30, which was brought under the Congressional Review Act, was expected to encounter a presidential veto. The Biden administration has stated it strongly opposes the resolution.

Friday, March 10, 2023

Mayer Brown’s Anna Pinedo testifies on fostering capital formation

Mayer Brown’s Anna Pinedo, co-author of Wolters Kluwer’s Corporate Finance and the Securities Laws, was recently tapped to testify before the House Committee on Financial Services on the topic of fostering markets. She said that in her 30-year career handling securities offerings she has watched IPOs lose their luster while small and mid-sized companies fled to the private markets. Added regulation from Sarbanes-Oxley and Dodd-Frank, plus the lack of an “ecosystem” to support these companies, has meant that IPOs have been left to larger, more seasoned companies better able to fare in the market. In her testimony Ms. Pinedo called for legislation that deals with the market problems small companies face and noted the particular importance of a bill that would expand the availability of well-known seasoned issuer status.

View Ms. Pinedo's testimony here.

Industry blames geopolitics, pandemic for ‘rising risks’ in global commodity derivative markets

By Suzanne Cosgrove

Members of the U.S. House of Representatives’ Agriculture Committee heard testimony Thursday from Dan Berkovitz, a former CFTC commissioner, as well as from speakers from derivative exchanges and the Futures Industry Association about the wide post-pandemic price swings of 2022 and 2023.

Questions posed by the congressmen put a particularly bright light on the CFTC as the legislators sought to make sense of the dramatic rise, then fall, of energy prices and other related products that have impacted farm producers. Several legislators asked if speculators were behind the volatility, and if current margins imposed on derivatives contracts by the exchanges were sufficient.

The last CFTC reauthorization was in 2008 and lapsed in 2013, an issue addressed by Chairman Rostin Behnam in testimony before the U.S. Senate Committee on Agriculture, Nutrition, & Forestry on Wednesday and reported by Securities Regulation Daily. At the Thursday hearing, U.S. House Rep. David Scott (D.-Georgia), chairman of the Agriculture Committee, indicated he supported a CFTC reauthorization push.

Confluence of events. Recent market volatility, Berkovitz said, was spurred by a number of factors, including increased demand for commodities as the U.S. and other economies recover from the shutdowns that took place during the pandemic, Russian’s invasion of Ukraine, central bank tightening of interest rates, China’s COVID policies, and extreme weather events.

He noted that in addition to the actual contracts available for trade, the exchanges have tools to help endure market prices, and volatility reflectS “the true forces of supply and demand.” Those tools include margin levels, speculative position limits, daily price limits and trading halts–all protections against manipulation, fraud and disruptive trading practices.

“None of these tools, however, can insulate market participants from price changes due to the basic forces of supply and demand,” Berkovitz said.

Nonetheless, through the market volatility related to the pandemic in March 2020, and the Russian invasion of Ukraine in 2022, “futures markets continued to function amid tremendous stress in the financial system,” said Alicia Crighton, co-head of Goldman Sachs’ global futures business and chair of the Futures Industry Association.

Exchanges chime in. Before the war, Russia and Ukraine contributed about 25 percent of total global wheat exports, noted Derek Sammann, senior managing director and global head of commodities at CME Group. Following Russia’s invasion of Ukraine, wheat market prices increased 70 percent from their January 2022 levels. He said in March 2022 the CME saw the largest daily price move in wheat, with implied prices rising 26 percent, compared with a 7.1 percent price limit in wheat futures, forcing the contract to temporarily stop trading.

At that point, CME worked with the CFTC to get expedited approval to increase price limits and later implement a “dynamic” price limit mechanism in wheat that allowed the price limit to adjust with volatility and restore trading more quickly following limit-trading events, Samman said.

Christopher Edmonds, chief development officer for Intercontinental Exchange (ICE), agreed that the combination of market events that took place in 2022 has been unique. In prepared remarks, he noted the Russian invasion of Ukraine significantly reconfigured global energy supply. But he added that while ICE recognizes energy markets remain volatile, the exchange does not support the recent imposition of a market correction mechanism, or price cap, by the European Union.

ICE does not believe the mechanism will achieve its primary objective of lowering energy prices, Edmonds said, because it undermines the ability of the commercial market to transfer and manage their risk.

“Clearing members are intermediaries,” Crighton said. “We act as the first and the last line of defense in fostering stability in cleared derivatives markets.”

Thursday, March 09, 2023

Goldsmith Romero outlines how the CFTC should approach climate financial risk

By Rodney F. Tonkovic, J.D.

In a keynote address at the ISDA's 2023 ESG Forum, CFTC Commissioner Christy Goldsmith Romero talked about her priority to promote market resilience to climate risk. Romero shared her thoughts on how to best promote climate risk resilience, and she took the opportunity to announce five new proposals to promote market integrity and resilience; the proposals would also implement recommendations by the Financial Stability Oversight Council. The remarks, delivered on March 7, 2023, were titled "A Thoughtful Approach to the Daunting Challenge of Climate Financial Risk."

A daunting challenge. Goldsmith Romero began by outlining the challenges posed by climate change. Initially, she said, the players were world leaders, scientists, and environmentalists, but not participants in the financial world or its regulators. The industry was slow to accept the idea that there was financial risk from climate change, but this is now well-established, and participants in the financial markets are now major players in the climate change story.

Promoting market resilience. When she was confirmed as a Commissioner in March 2022, Goldsmith Romero stated that one of her highest priorities would be to identify and mitigate risks that could threaten market integrity and resilience. After many discussions on climate matters, Goldsmith Romero announced in September 2022 her "priority to promote market resilience to climate-related risk, and to see the CFTC as a critical player in the story of climate change."

It is critical, Goldsmith Romero said, for the CFTC to understand the role that derivatives markets play to promote climate risk resilience. She also called for a whole-government approach to the matter to engage with the issue and to better leverage experience, expertise, and resources across the agencies.

Five proposals. Goldsmith Romero announced five proposals for action by the Commission:
  • Proposal 1: The Commission should enhance its understanding of the use of derivatives markets to manage climate-related financial risk by creating a new category that identifies Environmental/Climate-Related products that are trading in derivatives markets. Goldsmith Romero noted that the Commission currently lacks a method for determining what is an environmental/climate-related product and that creating such a category would help it to understand and monitor how derivatives markets are promoting resilience to climate risk.
  • Proposal 2: The Commission should follow a similar oversight and approach to Environmental/Climate-Related products as those adopted for digital assets. There is "no reason to reinvent the wheel," Goldsmith Romero said, and the CFTC should use essentially the same approach for ESG products as it does for digital assets.
  • Proposal 3: The Commission should conduct consumer education of Environmental/Climate-Related products. A greater public understanding of environmental/climate-related products, plus standard definitions of, for example, "green" or "sustainable," would help inoculate the public against wild assertions and hyperbole. There is also a need for greater understanding about carbon credits, Goldsmith Romero said.
  • Proposal 4: The Commission should develop a “Heightened Review” framework for any self-certified environmental/climate-related products (including those relating to carbon credits), just as it did with derivatives on digital assets. As it did with digital assets, Goldsmith Romero said that the CFTC should provide guidance on the steps that an exchange should take before self-certifying that products comply with the Commodity Exchange Act. The Heightened Review could also include steps more targeted at concerns in the carbon credit markets.
  • Proposal 5: The Commission should increase market intelligence to monitor and surveil markets to promote integrity and resilience to climate risk. Increased market intelligence would also help ensure that derivatives markets are providing appropriate price discovery, Goldsmith Romero said.
Finally, Goldsmith Romero observed that she had previously proposed that the Commission increase its law enforcement resources to combat greenwashing and other forms of fraud. Here, she emphasized that: "As a 20 year federal law enforcement official, I take the position that greenwashing is one type of fraud." To that end, she said, the Commission should develop a specialized group of expert enforcement staff.

Wednesday, March 08, 2023

Dem, GOP lawmakers collide over demands for SEC’s climate regulation

By Mark S. Nelson, J.D.

Fifty-one Congressional Democrats constitute the latest group of lawmakers to press their views with the SEC on climate risk disclosures for public companies. Democrats this week urged the SEC not to weaken the final version of the agency’s forthcoming climate risk disclosure regulation, while GOP lawmakers last month urged the SEC to heed warnings about the agency’s “partisan” agenda and regulatory overreach while cautioning of legal challenges to come if the agency adopts a final rule that approximates the version of the regulation proposed almost a year ago.

Scope 3 third rail. As of the date of publication of this story, the SEC had received 16,086 public comments consisting of individually-identifiable comment letters (4,472) and generic form letters (11,614); SEC commissioners and other agency officials have held 240 meetings with various individuals and interest groups. For purposes of perspective, those numbers pale in comparison with the millions of public comments submitted regarding a 2011 petition for rulemaking that asked the SEC to require public companies to disclose their political spending habits, a topic Congress has in recent years repeatedly barred the SEC from addressing by prohibiting annual appropriations for such rulemaking.

By way of further background, a number of possible topics may be under consideration by the SEC as it finalizes the climate risk disclosure rule, some of which are suggested by the proposal itself, while others have been raised by public comments. Examples of areas the final rule may address include the degree to which climate disclosure will be made in notes to financial statements versus the management’s discussion and analysis, whether disclosures will be filed or furnished, the costs of preparing disclosures, uncertainties about some types of disclosure (e.g., scenario analyses) that may require additional work to render data useful to investors, and which standards will predominate in an American climate disclosure rule.

On this latter topic, the SEC’s proposal leans heavily on standards published by the Task Force on Climate-Related Financial Disclosures and the Greenhouse Gas Protocol, but European standards driven by the International Sustainability Standards Board will likely have a global impact on public company climate disclosures (within the past year, SASB was incorporated into IFRS Foundation, which created the ISSB).

Democrat lawmakers’ recent letter to the SEC specifically addressed another topic the SEC may be mulling as it finalizes the climate risk disclosure regulation—Scope 3 emissions, or what might be considered the proverbial electrified third rail of climate disclosure. The Democrats’ letter said overall that they want the SEC to move forward with a “strong climate disclosure rule without delay.” While the letter worried about the SEC potentially raising the threshold for disclosure (the proposal pegged the threshold at 1 percent of the specified line-item financial metric), the letter was even more concerned about the prospect that the SEC could weaken or even eliminate Scope 3 emissions disclosures from the final regulation.

Democrats cited an S&P global report for the statistic that 90 percent of oil & gas company emissions fall into the category of Scope 3 emissions. “Not requiring Scope 3 emissions disclosures would enable these and other companies with similar types of emissions patterns to hide the vast majority of their exposure to climate risk from regulators and investors,” said the Democrats’ letter. “For many companies and sectors, a greenhouse gas inventory that omits Scope 3 would be materially misleading to investors” (a footnote to the quoted passage cited an As You Sow press release and a comment letter submitted to the SEC by a group of 75 investors).

With respect to what investors want regarding Scope 3, Democrats said the vast majority of institutional investors’ comments on the SEC’s proposal urged the SEC to keep Scope 3 emissions disclosures in the final regulation. Democrats also noted that Scope 3 emissions disclosures will likely become “inevitable” because of forthcoming European rules and investor demand (the letter noted that ISSB’s global baseline standard includes Scope 3 emissions).

As for potential legal challenges to a final SEC climate risk disclosure regulation, Democrats urged the SEC to not be intimidated by the Supreme Court’s opinion in West Virginia v. EPA, in which a conservative majority invoked the major questions doctrine to strike down an EPA climate regulation. That case can be read both narrowly or broadly, with potentially far-reaching consequences under the broader view of the court’s holding. The letter from Democrat lawmakers said the SEC has authority to require standardized public company disclosures, including on climate risk. The letter cited multiple authorities for the proposition that the SEC’s climate risk “…rulemaking is well within the Commission’s authorities and long-standing practice of requiring standardized disclosures of investor-led, decision-useful information, and thus should not be reasonably at-risk under the Major Questions Doctrine.”

Major questions doctrine. Republican lawmakers also have recently offered their views to the SEC ahead of the adoption of its final climate risk disclosure regulation. Last month, House Financial Services Committee Chair Patrick McHenry (R-NC), joined by Rep. Bill Huizenga (R-Mich), who chairs the House FSC's Subcommittee on Oversight and Investigations, and Sen. Tim Scott (R-SC), Ranking Member of the Senate Banking Committee, emphasized their belief that the proposed climate risk disclosure regulation exceeds the SEC’s statutory authorities.

The trio warned that, under West Virginia v. EPA, the SEC may lack Congressional authority to issue a final regulation mandating that public companies make disclosures about their climate risks. “Congress did not intend for the SEC to be an arbiter of business strategies, much less the determining body for climate policies,” said the Republicans’ letter. “This abuse of the rulemaking process, and blatant partisan efforts to circumvent the legislative process, are outside the bounds of the SEC’s mission and authority.”

The letter also criticized current SEC Chair Gary Gensler for, in the drafters’ view, deviating in recent rulemakings from a more principles-based approach to public company disclosures to a more prescriptive approach. In the climate context, the letter cited a Politico report for the notion that the SEC may be considering rolling back some parts of the climate risk disclosure regulation in light of the possibility of future legal challenges to the final version of the regulation.

Moreover, the Republican lawmakers demanded that the SEC respond to a wide-ranging information request, including for data on the impact the climate risk regulation may have on energy prices, how the SEC plans to address First Amendment issues regarding compelled speech, whether the SEC coordinated with other federal regulators or non-governmental organizations or with the White House Climate Policy Office, the legal advice received or considered by the SEC’s Office of the Chair and its Office of General Counsel regarding the SEC’s authority to issue the climate risk disclosure regulation, the names of SEC officials and employees working on the climate risk regulation, and whether SEC officials or employees used non-government devices when working on the climate risk regulation.

Tuesday, March 07, 2023

McDonald’s board didn’t ignore red flags about harassment

By Anne Sherry, J.D.

When McDonald’s head of human resources—the person specifically charged with promoting a culture of inclusion and respect—repeatedly engaged in sexual harassment, it threw up “the most vibrant of red flags,” the Delaware Court of Chancery observed. But a stockholder complaint did not support an inference that the defendant directors failed to respond to these warnings, nor that they breached their fiduciary duties by terminating the company’s CEO without cause after learning he had engaged in an inappropriate relationship with a subordinate. The chancery court accordingly dismissed the complaint for failure to state a claim (In re McDonald’s Corporation Stockholder Derivative Litigation, March 1, 2023, Laster, J.).

Scandals. The complaint revolves around two recent corporate governance scandals at McDonald’s. First, in 2018, a wave of coordinated complaints to the EEOC alleged widespread sexual harassment and retaliation at the company. Workers across ten cities held strikes, and U.S. Senator Tammy Duckworth (D-Ill.) sent an inquiry about the reports to the then-CEO, Stephen Easterbrook. The allegations culminated in the “brutal” revelation in December 2018 that McDonald’s Global Chief People Officer—and head of HR—had engaged in multiple acts of sexual harassment and had been warned about his alcohol consumption at company events.

Then, in November 2019, McDonald’s terminated Easterbrook after learning that he had engaged in a relationship with an employee. Easterbrook had insisted that this was his only personal relationship with an employee and that it consisted only of texts and video calls, and no physical contact. Wanting to avoid litigation over a close case, the board terminated Easterbrook without cause, entitling him to severance. When the company learned that Easterbrook had had multiple physical sexual relationships with employees while he was CEO, it sued him to claw back the severance payments. Easterbrook later agreed to repay $105 million.

Fiduciary duties. According to the derivative complaint, McDonald’s directors breached their fiduciary duties by ignoring red flags of sexual harassment. Then, they approved a no-cause termination of Easterbrook to avoid a lawsuit that could expose their failures of oversight of the harassment issues.

In the court’s reasoning, though, the directors did not ignore the red flags or show a total failure of oversight. McDonald’s engaged the Rape, Abuse & Incest National Network (RAINN), the largest anti-sexual-violence organization in the U.S., to advise the company on preventing sexual misconduct and harassment. It also revised its policies and training programs, provided more resources and support to franchisees, and ended a policy requiring mandatory arbitration of harassment and discrimination claims. Because of these efforts, the court could not infer that the director defendants acted in bad faith, a necessary predicate to a red-flags claim for breach of the duty of oversight.

The court also held that the business judgment rule protected challenged board decisions, including the decision to terminate Easterbrook without cause. Even if the director defendants made a bad decision by not investigating Easterbrook’s misconduct more thoroughly, this does not mean they breached their duties. Directors are liable to make mistakes, even when acting diligently, loyally, and in good faith. The directors did not face a threat of liability for their response to the issues of sexual harassment and misconduct, and they could have believed in good faith that an amicable termination of Easterbrook was in the company’s best interests.

Dismissal. Finally, the court addressed a procedural matter: whether the motion to dismiss should be converted to a motion for summary judgment because the defendants relied on matters outside of the pleadings. Rather than meaningfully engage with the complaint, the directors argued from 93 exhibits totaling 1400 pages.

The defendants countered, however, that when they produced books and records, they did so under a confidentiality agreement that deemed the full production incorporated by reference into any subsequent complaint. Therefore, they argued, they merely relied on documents that the complaint had incorporated by reference. While the company engaged in “questionable redaction practices,” including redacting partial sentences, the facts of the case still did not warrant conversion. Among other things, it would not be reasonable to infer that the redacted information could affect the outcome of the motion to dismiss.

The case is No. 2021-0324-JTL.

Monday, March 06, 2023

Investor Advisory Committee advances plan to update, improve customer account statements

By Suzanne Cosgrove

The SEC’s Investor Advisory Committee has submitted a series of recommendations aimed at standardizing and enhancing monthly and quarterly customer account statements, noting Commission rules governing the statements’ form and contents have remained largely unchanged for almost 30 years.

The committee approved the recommendations at Thursday's meeting, and they were published on the IAC’s public website on Friday, opening them up to consideration by the Commission.

In introducing its proposal, the IAC said regulators see the review of account statements as a key component of smart money management. The ability of an investor to review their securities account statements is “a critical tool” in the identification of inaccuracies, fraud and financial exploitation.

In addition, registered investment advisers – a rapidly growing industry group that was the focus of another panel session of the IAC’s meeting on Thursday -- are not currently required to send their clients account statements. “Even when accounts statements are provided, the rules do not require that the information that must be included on a brokerage account statement be presented in any particular format or with any minimal level of clarity,” the committee said.

Regulators, industry associations and firms have published guides for investors puzzled by their account statements, “but these guides are lengthy and often are overly general because of the potential variations in client account statements,” the committee added.

Gensler on custody. In a pre-session statement, SEC Chairman Gary Gensler did not directly address possible changes in customer account rules but highlighted a recently proposed safeguarding rule for investment advisers that would expand the current 2009 custody rule.

The SEC’s current custody rule covers a significant amount of crypto assets, Gensler said. “Advisers, in complying with the current custody rule, are required to safeguard investors’ crypto funds and securities with qualified custodians.”

However, “based upon how crypto trading and lending platforms generally operate, investment advisers cannot rely on them today as qualified custodians,” Gensler said. “To be clear: just because a crypto trading platform claims to be a qualified custodian doesn’t mean that it is,” he said.

“When these platforms fail—something we’ve seen time and again—investors’ assets often have become property of the failed company, leaving investors in line at the bankruptcy court,” Gensler said.

Supporting innovation. In presenting the recommendations to IAC members, Christine Lazaro, professor of clinical legal education at St. John's University School of Law, said it became evident to the committee that the rules governing account statements needed review. The recommendations were intended to support innovation, she said. But while there is room for enhancement, “we need to understand what investors are looking for,” she added.

In fact, the first of the nine recommendations from the IAC’s Disclosure Subcommittee advises the SEC or FINRA to survey investors to better understand the utility of account statements, including how investors use them and what information they view as important in their decision-making process.

Following the survey, other recommendations included determining what amendments to the current FINRA Rule 2231 are needed to align account statement requirements with what investors see as important content, and with respect to the formatting and presentation of the statements.

The SEC and FINRA also should consider standardizing certain core terminology and the use of a standardized table that highlights information such as fees paid and returns for the period and year-to-date, the subcommittee said.

In addition, because there is no direct requirement for registered investment advisers to provide account statements, the SEC should propose and adopt a rule requiring advisers to provide either directly or through their custodians account statements, no less frequently than quarterly, to advisory clients and prescribe the content of such statements. The latter recommendation is consistent with the SEC’s recent proposal to require private fund advisers distribute a quarterly statement of performance and fees that follows a standardized format, the subcommittee noted.

Finally, the subcommittee recommended continuing to offer paper as a default statement delivery method – on the assumption that elderly account holders would prefer it, although that point was subject to committee debate. For investors who opt for electronic delivery, the committee said the SEC and FINRA should encourage the use of embedded links and other technology to enhance disclosure.

Commissioner comments. In prepared comments on the committee’s recommendations, SEC Commissioner Hester Peirce said she was “generally supportive of efforts to enhance the utility and value of account statements in helping investors make informed decisions,” but she had a few reservations. In particular, she said a paper default for the delivery of account statements seemed “anachronistic.”

Another consideration, Peirce said, is how to achieve greater consistency across firms’ account statements “without impinging on firms’ ability to develop effective and unique ways of presenting information.”

“More generally, I would like to encourage firms to experiment with electronic delivery methods that facilitate greater investor understanding of the information,” Peirce said. “Doing so will be easier absent a paper-delivery mandate.”

The committee approved the recommendations at Thursday's meeting, and they were published on the IAC’s public website on Friday, opening them up to consideration by the Commission.

Friday, March 03, 2023

Boards act on 37% of majority-backed ESG proposals, investors say

By Anne Sherry, J.D.

Majority-supported environmental, social, and governance shareholder proposals are still rare, representing less than a tenth of overall ESG proposals, but their prevalence is growing. However, proponents responding to a survey by the Principles for Responsible Investment (PRI) believe that only 23 percent of these proposals are being fully implemented, and another 14 percent partly implemented. Corporate inattention to proposals that receive majority support can create compliance, legal, or operational risks, PRI posits.

Chart. The report includes a comprehensive chart showing the status of majority-supported proposals since 2022, including the company, resolution name, percentage of shareholder support, and whether both the proponent and the company believe the company is taking action on the proposal. Where applicable, PRI links to publicly available information showing the company’s response. For example, the chart shows that a proposal that Canadian retailer Loblaw Companies disclose supply chain audits received 72 percent support. While the proponent does not believe the company adequately responded, the company asserts a partial response as seen on its human rights policy webpage.

Why it matters. PRI says that paying attention to proposals that receive majority support is a sign of good shareholder relations and governance. Conversely, ignoring shareholders’ preferences can damage investor engagement. If corporate boards are unresponsive, it is unlikely that shareholders can achieve meaningful progress on systemic sustainability issues through the proposal process.

While majority support on a proposal is not legally binding, inaction is a red flag for investors. As PRI notes, “many institutional investors recognize proxy voting as a part of their fiduciary duty” because the corporate response can affect shareholder returns. This isn’t even limited to majority-supported proposals: Glass Lewis, the UK Investment Association, and the International Corporate Governance Network all expect boards to engage with shareholders when just 20 percent of shareholders vote against board recommendations.

Inaction can also be seen as a governance failure in jurisdictions where directors owe fiduciary duties to shareholders. PRI says that inaction can be a sign of a captured board that is beholden to the CEO or management. Companies with captured boards, especially those that do not have ESG expertise, may fail to mitigate the risks that arise from environmental or sustainability factors.

Recommendations. Looking ahead to the 2023 proxy season, PRI recommends that investors define what constitutes issuer inaction. Companies should show some meaningful progress on majority-supported proposals within the first year. Investors should be wary of disclosures that make it sound like the company is acting, but that lack any solid commitment or change. PRI cites ISS’s voting guidelines, which warn that companies may disclose that they have discussed a majority-supported resolution with shareholders. “Investors should think critically about whether such efforts, when used to delay action or commitment, are justified when over half of the company’s voting shares have already weighed in favour of a proposal,” PRI suggests.

To spur action on majority-supported proposals, investors should communicate directly with companies to clarify what actions they expect by the next annual meeting. If the company’s actions are inadequate, an investor can employ the “escalation strategy” of holding the board accountable by voting against all directors or targeting the board chair or key members of governance and oversight committees. Investors may also consider nominating alternative directors or engaging companies on improving shareholder access.

Thursday, March 02, 2023

Jones Day lawyers Giles Elliott and Howard Sidman describe firm’s global reach, capabilities and impact in the ESG realm

By Brad Rosen, J.D.

Thus far in 2023, ESG controversies continue to dominate the legal headlines in light of the increased politicization of these issues in the U.S. The wrangling comes from both sides of the aisle, at the state and federal levels. Against this backdrop, law firms have been orienting their practices to respond to increasing demand for ESG expertise. The global law firm of Jones Day is certainly no exception as it seeks to provide counsel to a diverse clientele in connection with increased ESG risks and challenges, as well as ESG-related opportunities which have never been greater as organizations worldwide seek to transition to a less carbon-intensive economy.

In this second installment of The ESG Ready Lawyer, Jones Day partners, Giles Elliott and Howard Sidman describe their firm’s ESG-related undertakings which are driven by the varied needs and wide range of issues faced by its clients. Elliott and Sidman also provide some recollections and insights about their own journeys in and around the world of ESG.

During the interview, Elliott and Sidman also share their observations in connection with:
  • Building a multidisciplinary, global team of lawyers to address ESG risks and opportunities across multiple jurisdictions and borders;
  • Advising clients on a variety of transactional and financing matters including cutting edge renewable energy and carbon capture transactions, public and private reporting obligations, along with investigations and litigation related to efforts by NGOs;
  • Providing counsel to clients in connection with the growing number of so-called anti-boycott laws passed by a number of states, along with increased attention on these issues from state attorneys general; and
The role played by Jones Day in successfully representing a plaintiff in the landmark U.S. Supreme Court decision in West Virginia v. EPA, a ruling which places greater limits on the authority of administrative agencies, and some potential implications of that case.

Additionally, both Elliot and Sidman share their insights regarding the marked recent increase in ESG-related investigations and litigation around the world.

You can read this second installment of The ESG Ready Lawyer here.

Wednesday, March 01, 2023

Crypto law firm steps up suit against SEC, demands clarity on Ethereum

By Lene Powell, J.D.

A small crypto-focused law firm is fighting to keep its lawsuit alive demanding that the SEC take a public stand on the Ethereum crypto network and Ether token. In a new filing, the law firm urged the court to deny the SEC’s motion to dismiss, arguing that due process requires the SEC to give fair notice of conduct that is forbidden or required with regard to crypto assets (Hodl Law, PLLC v. SEC, February 27, 2023).

“The SEC continues to assert its jurisdiction over a trillion-dollar industry for which it admittedly has no congressional authorization and no desire to engage in any rulemaking or even constructive dialogue with industry participants,” said Fred Rispoli, attorney for Hodl Law Cali, in a statement to Securities Regulation Daily.

Rispoli is the managing attorney for both Hodl Law, the Arizona firm that filed the lawsuit, and Hodl Law Cali, the California firm representing Hodl Law.

The SEC did not respond to a request for comment by time of publication.

Request for declaratory relief. Hodl Law PLLC is seeking declaratory relief to clarify the legal status of Ethereum and Ether under the federal securities laws.

The firm sued the SEC last November, arguing it is at risk of imminent harm because the SEC may exert jurisdiction over Ethereum and Ether and bring enforcement actions relating to lack of securities registration. The firm is concerned it might have legal liability because it transacts on the Ethereum Network and uses the Ether digital currency unit (DCU) for various purposes.

The SEC has moved to dismiss, arguing that Hodl Law has not shown any “actual or imminent injury” or hardship, only a hypothetical concern that it may be violating federal securities laws. According to the SEC, the court lacks subject matter jurisdiction to hear the claim due to a lack of “case or controversy,” standing, and ripeness. The SEC also argues the claim does not meet Administrative Procedure Act (APA) requirements for review of agency actions.

Are Ethereum and Ether securities … or not? Fundamentally, the firm says it is just trying to find out if the SEC considers Ethereum or Ether a security or not.

“Hodl Law is simply asking the Court to determine—identically as the SEC has asked courts to determine in over one hundred federal cases previously regarding other DCUs [digital currency units] and networks—whether the Ether DCU and Ethereum Network fall within the Securities Act.,” the firm wrote in a memorandum in opposition to the motion to dismiss.

The firm added that it will stop using the Ethereum Network and Ether DCU if such use constitutes unregistered securities transactions under the Federal Securities Act of 1933 (the “Securities Act”).

As evidence of regulatory uncertainty, the firm said that SEC Chair Gary Gensler recently stated in an interview with New York Magazine that “everything other than bitcoin” is a security—seemingly reversing previous statements by SEC officials that the Ethereum Network and Ether DCU are not securities.

In that interview, Gensler stated, “Everything other than bitcoin …you can find a website, you can find a group of entrepreneurs, they might set up their legal entities in a tax haven offshore, they might have a foundation, they might lawyer it up to try to arbitrage and make it hard jurisdictionally or so forth … But at the core, these tokens are securities because there’s a group in the middle and the public is anticipating profits based on that group.”

Regulation by enforcement. Hodl Law asserts that it has standing and that its claim is ripe. First, the firm argues that the SEC has no jurisdiction over the Ethereum Network and Ether DCU and cannot point to any statute or regulation conferring such authority.

Yet the SEC has brought enforcement actions against other crypto entities. The firm says the SEC is testing its authority by bringing lawsuits instead of by adopting regulations.

“[T]he SEC has zero regulations, zero rules and zero intent to engage in public rulemaking regarding which DCUs it considers securities,” Hodl Law states.

Risk of immediate harm. According to the firm, this potential for enforcement action raises the risk of immediate harm if the SEC decides to target the Ethereum Network and Ether DCU. Once the SEC targets a particular crypto token with an enforcement action, the market value of that token plummets, the firm said. As an example, the firm said the XRP token lost 50 percent of its value less than 24 hours after the SEC brought an enforcement action against XRP’s creator, Ripple Labs.

Hodl Law firm says it “suffers the certainty” that the value of its Ether DCUs will be wiped out if the SEC initiates any enforcement lawsuit alleging security status. Moreover, the value of other DCUs that Hodl Law utilizes for transactions over the Ethereum Network would likewise be crushed. The firm also uses the Ether DCU to purchase digital property in the metaverse to offer services, build its brand and strengthen its reputation as a digital asset-based firm. The firm’s transactional practice of law involves the use of the Ethereum Network and its smart contract functionality, the firm said.

Any loss in value of the Ether token if the SEC exerts jurisdiction would be a “taking” of that value, said the firm.

Risks for lawyers. Hodl Law raised the further concern that if the Ethereum Network and Ether DCU are subject to the Securities Act, Hodl Law could face disciplinary action by the state bar for violating federal law in connection with simply adhering to the rules of professional conduct regarding client payments and even custody of client property.

“The professional livelihood of any lawyer at the firm would be at stake,” wrote Hodl Law.

Constitutional rights. Hodl Law also argues that enforcement against its secondary use of the Ethereum Network and Ether DCU would violate its First and Fifth Amendment rights. The firm says that one of its uses of the Ethereum Network and Ether DCU is engaging in constitutionally protected commercial speech in a digital metaverse on an Ethereum Network-based application.

APA and the major questions doctrine. The firm also cited to a legal doctrine much in the news lately: the major questions doctrine. In West Virginia v. EPA, the Supreme Court recently held that a federal agency “must point to clear congressional authorization when it seeks to regulate a significant portion of the American economy.”

Here, Hodl Law asserts that the market capitalization of Ethereum alone is in the hundreds of billions of dollars. The firm states that the SEC, in statements by agency officials, has disavowed jurisdiction over the Ethereum Network and Ether DCU. Under these circumstances, the APA simply cannot apply where the agency seeking its protection has no administrative role, said the firm.

Alternatively, the SEC’s actions permit judicial review under the Administrative Procedure Act, the firm argued. It asserts that the SEC has not cited a statute that precludes judicial review of whether any digital asset is a security under the Securities Act. The court may also determine that the SEC has reached a “final agency action” sufficient for judicial review, said the firm.

Leave to amend. Hodl Law requested leave to amend its complaint if the court determines jurisdictional issues are present.

Declaratory relief appropriate. In conclusion, the firm argued that the court should exercise its discretion under the Declaratory Judgment Act.

“Ultimately, given that the SEC’s only attempt at regulating the nascent digital asset space has been by lawsuit, we continue to struggle with the SEC’s attempt to dismiss this action, given we are only following the SEC’s admitted “policy” of getting answers to its beliefs on security status for digital assets—by lawsuit,” said Rispoli.

The case is No. 22-cv-01832-L-JLB.

Tuesday, February 28, 2023

Eversheds Sutherland examines the current state of the Chevron doctrine

By Jamie Cain and John Coffron, Eversheds Sutherland

Recent Supreme Court decisions have put the Chevron doctrine on the ropes, which could have a big impact on federal agency rulemaking in 2023, according to Eversheds Sutherland. In this Strategic Perspective, the firm provides an overview of the doctrine and looks at AHA v. Becerra and West Virginia v. EPA and the potential impact the cases may have on rulemaking from financial regulators like Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission.

Monday, February 27, 2023

Attorney general sues CoinEx for failing to register as a broker-dealer

By Suzanne Cosgrove

New York Attorney General Letitia James has sued the cryptocurrency platform CoinEx for falsely representing itself as a crypto exchange and failing to properly register the company with U.S. regulators or with the state of New York, a violation of New York’s Martin Act (People Of The State Of New York, by Letitia James, Attorney General Of The State Of New York, v. Vino Global Limited D/B/A CoinEx, February 22, 2023).

The enforcement action seeks to permanently stop CoinEx from operating in New York through its website and mobile apps and directs CoinEx to implement geo-blocking based on IP addresses and GPS location to prevent access to CoinEx’s mobile app, website, and services from New York.

In addition to offering services on its website, a CoinEx application is available for downloading on mobile phones through marketplaces like the Apple and Google Play stores. CoinEx advertises that its platform supports spot, margin, futures, and other derivatives trading.

Tokens described as securities. “The days of crypto companies like CoinEx acting like the rules do not apply to them are over,” said Attorney General James in a press release. “My office will continue to protect New York investors and ensure our state’s laws are followed.”

Founded in December 2017 by its CEO, Haipo Yang, with headquarters in Hong Kong, CoinEx is a currency trading platform that allows investors to buy and sell virtual currencies, including, but not limited to, Flexa's AMP, LBRY's LBC, Terraform Labs' LUNA, and Rally's RLY tokens—tokens that the attorney general characterized as securities and commodities.

The CoinEx website states its users can “directly trade with third-party payment partners to buy cryptocurrency at a mutually agreed price and payment method” and touts its ability to support “more than 60 fiat currencies for buying mainstream cryptocurrencies.”

Investigation documented. In an affidavit filed with the court, Brian Metz, a senior detective with the New York OAG's Criminal Division, verified that he was able to create an account with CoinEx using a computer with a New York-based IP address in October 2022 that allowed him to buy and sell digital tokens for a fee paid to CoinEx. Metz said on the date of the affidavit, February 19, 2023, the website, and his account remained accessible.

In addition, although CoinEx is based in Hong Kong, Metz found that CoinEx's terms of service, downloaded on May 31, 2022, indicated it was operated by Vino Global Limited, an entity incorporated in the State of Colorado. Haipo Yang was listed on the document as Vino Global’s “incorporator.”

This week’s action is one of a series of crypto-related enforcements pursues by the New York attorney general. They included a lawsuit she filed in January that alleged Alex Mezvinsky, a co-founder of the lending platform Celsius Network LLC, made false and misleading statements about Celsius’s safety to encourage investors to deposit billions of dollars in digital assets onto the platform. The New Jersey-based Celsius filed for bankruptcy in July.

The case is No. 450503/2023.

Friday, February 24, 2023

Court finds that Oregon securities laws do not apply to notes sold by defendant

By John Filar Atwood

An Oregon district court judge has granted defendants’ motion for summary judgment against allegations of securities violations under the Oregon Revised Statute on the grounds that Oregon’s securities laws do not apply to the transactions in question. In a case involving an unpaid promissory note and amended note between the plaintiff and defendants, the court determined that neither party was in Oregon during the negotiations and plaintiff’s attempts to otherwise prove a connection to Oregon were not persuasive. The court also granted plaintiff’s request for summary judgment on a breach on contract claim, and defendants’ request for summary judgment on fraudulent transfer claims (Sound Foundation v. SCI Fund II, LLC, February 17, 2023, Hernandez, M.).

In January 2017, Derek Sivers, the founder of plaintiff Sound Foundation, agreed to make a short-term loan to defendant SCI Fund II, LLC that was represented by a promissory note. The terms of the note were negotiated between Sivers’ father, who lived in Oregon, and defendant Herbert Wilkins, a managing director for SCI Management, Inc.

Sivers assigned his interest in the note to Sound Foundation, a foreign company registered in the Cook Islands. At all times relevant to the promissory note transactions Sivers lived outside the U.S.

In June 2017, Wilkins asked Sivers to extend the loan, and Sivers agreed to amend the note to extend repayment until December 2018. The defendants failed to repay the note by the extended deadline and the plaintiff subsequently filed suit.

Securities claims. Among the allegations brought by Sound Foundation was that Wilkins made material omissions of fact in violation of Oregon securities law when selling the note and the amended note to Sivers. The defendants countered this claim by arguing that: 1) Oregon securities law does not apply because the notes were not bought or sold in Oregon, 2) the notes are not securities as a matter of law, and 3) Wilkins made no material misstatements or omissions of fact as a matter of law. The court found the first of the three arguments to be persuasive, so did not address the other two.

The judge noted that Oregon law applies to persons who sell or offer to sell a security either when “[a]n offer to sell is made in this state” or “[a]n offer to buy is made and accepted in this state.” Further, an offer to buy or sell is made in Oregon “whether or not either party is then present in this state, when the offer: (a) [o]riginates from this state; or (b) [i]s directed by the offeror to this state and received at the place to which it is directed.”

The parties focused their arguments on whether an offer to sell or buy the notes “originated” in Oregon. The court determined that Oregon securities laws govern if an offer to buy or sell a security arises or is initiated in Oregon, even if neither party is in Oregon when the offer is ultimately made.

Three connections to Oregon. In this case, the court noted, Sivers was living outside the U.S. when he offered to buy the note. Wilkins resided in Maryland and did not travel to Oregon to execute the notes. Instead, plaintiff relied on three other connections to Oregon: Sivers’ father was located in Oregon and facilitated the investment as the agent of Sivers; Sivers intended to invest in Oregon companies; and the notes themselves contemplate existence in Oregon.

The plaintiff relied on State v. Jacobs, in which the Oregon Court of Appeals stated that “the Oregon Securities Law applies if there is sufficient evidence from which the trier of fact could conclude that the offers to sell... originated in Oregon.” The court determined that Jacobs does not apply in this case.

In Jacobs, the court stated, the defendant was an out-of-state agent acting on behalf of Oregon residents who were the sellers of the investment. The agency relationship and the actions of the sellers in Oregon were key to the Oregon Court of Appeals’ decision, the court found. Here Sivers’ father, the Oregon connection, was an agent and not a principal and was an agent of the lender (buyer), not the borrower (seller), the court stated. Jacobs does not provide a basis to impute the father’s Oregon connections to Wilkins, the court concluded.

Based on this reasoning, the court concluded that none of the three Oregon connections on which the plaintiff relied is sufficient to show that the Oregon securities laws cover the transactions at issue. The father’s role in the process, however substantial, was insufficient to meet the statutory requirements, the court ruled.

Oregon law applies to sellers of securities when either the offer to sell is made in Oregon, or the offer to buy is made and accepted in Oregon, the court said. The statute is precise on this point, and the facts here do not meet either set of requirements, the court determined.

On the first point, the court stated that it is undisputed that Wilkins was not in Oregon for the negotiation or execution of the notes. The Oregon connection of Sivers’ father cannot be imputed to Wilkins to satisfy the origination requirement, the court held. On the second point, the court found no evidence that any offer by Sivers to buy the notes was accepted in Oregon, as Wilkins was in Maryland when he negotiated and executed the notes. The court said that even if it were to conclude that the offer to buy the initial note was made in Oregon by the father on behalf of his son, this would still be insufficient under the statute as the offer to buy must be both made and accepted in Oregon for Oregon securities law to apply.

The court also found that the other two Oregon connections on which plaintiff relied did not bolster its case. Nothing in the statutory language or the caselaw supports plaintiff’s contention that the location of the companies for which the investment was destined is in itself relevant in assessing the applicability of the Oregon securities statute, the court stated.

Choice of law clause. Finally, the court noted that plaintiff pointed to no caselaw holding that a choice of law clause in a note should be considered in determining whether the offer to buy or sell originated in a particular state. That evidence may be relevant when evaluating personal jurisdiction, but it does not point to the location of an offer or acceptance, the court held.

Having already determined that the other Oregon connections on which plaintiff relied are insufficient, the court stated that the choice of law clause is insufficient on its own to show that the note originated in Oregon. To hold otherwise would allow the clause to trump the statute and defeat the intent of the Oregon Legislature, the court concluded. Because the Oregon securities laws do not apply to the notes, the court ruled that the defendants are entitled to summary judgment on plaintiff’s securities claims.

The case is No. 3:20-cv-01190.

Thursday, February 23, 2023

Post-IPO SPAC fined for lax internal controls

By Mark S. Nelson, J.D.

The SEC brought a settled administrative enforcement case against African Gold Acquisition Corp., a special purpose acquisition vehicle or SPAC, for the company’s failure to adhere to federal securities law requirements pertaining to internal controls. The company’s CFO allegedly misappropriated over $1 million from an account that was to be used to fund the company’s search for a suitable acquisition target. The company resolved the SEC’s charges for more than $100,000 and without admitting or denying the SEC’s findings (In the Matter of African Gold Acquisition Corp., Release No. 34-96960, February 22, 2023).

According to the SEC’s order, African Gold Acquisition Corp. was a publicly-traded post-IPO SPAC that failed to maintain adequate internal accounting controls, internal control over financial reporting, and disclosure controls and procedures. Following its IPO, the company had $1.5 million in an operating bank account that was to be used to fund the search for an acquisition target.

However, the company also had broadly delegated most financial matters to its CFO, who had, among other things, the authority to approve cash payments up to $50,000, an authority that the SEC alleged the CFO used to pay himself $1.2 million. The SEC also alleged the CFO managed vendor payments in order to hide his withdrawals from the company’s operating bank account (the CFO, however, did not have access to the trust account that held the funds raised by the company’s IPO). Significantly, the company generally did not have expenses above $50,000, except for the expenses incurred for its IPO. The CFO also gave false information to the company’s accountants and its outside auditor.

As a result of improper payments made by African Gold Acquisition Corp.’s CFO, the SEC alleged that the company’s Forms 10-K for three quarters spanning the second half of 2022 and early 2023 materially misstated the amount of cash the company had available to fund its search for an acquisition target.

The SEC charged that the company violated numerous Exchange Act provisions and related rules that require public companies to maintain adequate internal accounting controls, ICFR, and DCP. The company, without admitting or denying the SEC’s findings, agreed to cease and desist from further similar violations and to pay a civil money penalty of $103,591.

John T. Dugan, Associate Director for Enforcement in the SEC’s Boston Regional Office, commented via press release on the need for SPACs to follow the same rules that other public companies follow. “This settled order with African Gold demonstrates that SPACs must comply with basic Exchange Act requirements, just like any other publicly traded company,” said Dugan. “The fact that African Gold did not discover the misappropriation of its funds for more than a year, when certain vendors refused to provide further services due to unpaid invoices, clearly indicates that the company neglected to comply with basic internal control requirements.”

Cooper J. Morgenthau, African Gold Acquisition Corp.’s former CFO, was previously charged by the SEC with fraud and with violations of assorted books and records rules. Morgenthau also has pleaded guilty to one count of wire fraud related to a scheme to embezzle more than $5 million from the two SPACs. The criminal case was brought in the federal court in Manhattan.

The release is No. 34-96960.

Wednesday, February 22, 2023

Key takeaways from DAAG Miller speech on compliance

By Mark S. Nelson, J.D.

The DOJ’s Deputy Assistant Attorney General Lisa H. Miller recently told an audience at the University of Southern California Gould School of Law that corporate resolutions are “not ‘free passes,’” while also noting the many incentives the DOJ has put forth to coax corporations to be more proactive in their compliance programs with any eye to self-reporting suspected wrongdoing. In her remarks, Miller also offered some observations about key developments in 2022’s corporate cases.

Looking ahead in 2023. According to Miller, international corruption will remain a high priority for the DOJ in 2023. She described these cases as “challenging and resource intensive.” Miller also noted the many “carrots” that the DOJ has now presented to companies to encourage self-reporting. Miller said the carrots “have never been juicier.”

On that last point, Miller reiterated that corporate resolutions should not be considered “free passes” and that companies should carefully mull the DOJ’s recent changes to its Corporate Enforcement Policy (CEP).

By way of background, the DOJ’s Kenneth A. Polite, Jr., Assistant Attorney General, gave a speech at Georgetown Law in mid-January 2023 in which he outlined recent changes to the Criminal Division’s Corporate Enforcement Policy (CEP). The revisions follow-up on other changes that established a presumption that the DOJ would decline to prosecute a corporation if certain criteria are met coupled with efforts to have all DOJ divisions adopt similar policies. Polite, however, emphasized that a declination or DPA or NPA is not an easy default but must be earned, and that all companies begin such process with zero cooperation credit.

As for the latest changes, Polite first said that, among other things, even when aggravating factors exist and the presumption of a declination is unavailable, prosecutors still may decline to prosecute if: (1) the company’s voluntary self-disclosure was made immediately upon learning of an allegation of misconduct; (2) at both the time of the misconduct and the time of the disclosure, the company had an effective compliance program and system of internal accounting controls that led it to identify and voluntarily disclose the misconduct; and (3) the company provided extraordinary cooperation and undertook extraordinary remediation.

Second, Polite said that where a company otherwise fully complied and cooperated, but a criminal resolution is warranted, prosecutors could recommend to a sentencing court that the company get 50 percent to 75 percent off the low end of the U.S. Sentencing Guidelines fine range, except in the case of a criminal recidivist.

Miller suggested that the revised CEP gives companies a compelling reason to make voluntary self-disclosures of suspected wrongdoing. Miller explained that the DOJ’s guidelines are intended to benefit “good corporate citizens” but are balanced to ensure that companies can enter high-risk markets, make acquisitions of risky companies, and then cooperate, remediate, and disclose any wrongdoing.

“A final note: while these revisions just came out, last year’s resolutions show how we carry out the division’s stated principles in practice,” said Miller. “Companies that do not self-disclose egregious and pervasive misconduct are more likely to be required to plead guilty and face steep monetary penalties…”

Moreover, Miller said that the DOJ's Criminal Division is mulling additional tweaks to its corporate policies. She said the areas under consideration include possible changes to the DOJ's framework for evaluating corporate compliance programs to better account for the use of personal devices and third-party messaging applications. These apps typically offer strong encryption and/or the potential for messages to be ephemeral such that they leave little or no trace that would reveal their contents.

In September 2022, the SEC suggested a pathway to civil liability in this context when 15 broker-dealers and an affiliated investment adviser agreed to pay a combined $1.1 billion to settle charges that they had violated the recordkeeping provisions of the federal securities laws by allowing employees to pervasively use off-channel communications. Gurbir S. Grewal, Director of the SEC’s Division of Enforcement, remarked via press release that “[o]ther broker dealers and asset managers who are subject to similar requirements under the federal securities laws would be well-served to self-report and self-remediate any deficiencies.”

Messaging apps are not the only area the DOJ may be looking into. Miller said the department also was considering changes to how it evaluates executive compensation policies.

Looking back at 2022. With respect to 2022, Miller said that the DOJ charged 280 individuals and obtained 340 convictions. The agency also concluded seven corporate resolutions that generated penalties of $2.3 billion.

Miller’s remarks covered a wide swath of DOJ activity but, for purposes of securities practitioners, her comments on the DOJ’s Market Integrity and Major Frauds Unit are likely the most relevant. Miller summarized the key points from the DOJ’s JPMorgan matter in which three former directors attempted to manipulate gold and silver futures contracts via spoofing. In addition to holding individuals accountable, that matter also produced a parent-level DPA that required JPMorgan to pay $920 million.

Miller explained that the JPMorgan matter was an example of the DOJ’s parallel goals of holding individuals responsible and pursuing corporate entities when an institution’s liability derives from individuals’ conduct.

The DOJ, Miller said, also pursued similar cases that involved kickbacks and commodities insider trading, pump-and-dump schemes, securities fraud, and crypto fraud. In the case of crypto fraud, Miller had this to say: “Crypto markets can be volatile yet alluring to many. There has been some speculation as to how cryptocurrencies should be classified and regulated, but from our vantage point, a grift is a grift.”

Other DOJ highlights from 2022, Miler said, included the 1MDB bribery scheme, in which Goldman Sachs agreed to pay $2.9 billion as part of a global resolution with U.S. and foreign regulators. Another high-profile case was that of Glencore International AG, which allegedly engaged in “one of the most pervasive FCPA schemes” that also became the largest criminal enforcement of commodities price manipulation conspiracy in oil markets. A Glencore U.S.-based entity agreed to plead guilty to benchmark manipulation as part of the resolution of the case.

Tuesday, February 21, 2023

OCC agrees to pay a total of $22 million in SEC, CFTC settlements

By Suzanne Cosgrove

The Options Clearing Corporation (OCC) has agreed to pay $22 million in penalties, $17 million to settle SEC charges that it failed to comply with its SEC-approved Stress Testing and Clearing Fund Methodology rule and another $5 million in a settlement with the CFTC for parallel offenses made between 2019 and 2021 (In the Matter of the Options Clearing Corporation Respondent, Release No. 34-96945, February 16, 2023; In the Matter of: The Options Clearing Corporation, CFTC Docket No. 23-06, February 16, 2023).

Gensler comments. "OCC is the sole registered clearing agency for exchange listed option contracts in the United States," said Chairman Gary Gensler in a statement released Thursday. "Today’s action by the SEC reinforces the importance of OCC’s compliance with risk management policies and procedures designed to meet its obligations to our financial system."

"OCC plays a critical role in our financial markets, and the fact that they violated the very rules designed to ensure the stability and efficiency of those markets is, in a word, troubling," said Gurbir S. Grewal, Director of the SEC’s Division of Enforcement.

The Chicago-based OCC was designated a systemically important financial market utility in 2012 under the Dodd-Frank Act. In its filing, the SEC noted disruptions in OCC operations, or its failure to manage risk, could result in costs to not only OCC and its members, but also to the broader U.S. financial ecosystem.

CFTC weighs in. In a separate release, CFTC Acting Director of Enforcement Gretchen Lowe said the Commission’s action showed derivatives clearing organizations “must not only establish policies and procedures designed to manage their risks, but also implement, maintain, and enforce those policies and procedures.”

The orders announced Thursday were the second ones for OCC in recent years. Both the SEC and the CFTC initiated actions against the derivatives clearing organization in September 2019 for violations related to risk management procedures. The SEC imposed a $15 million penalty in its settled action that year.

SEC and Reg SCI. In this week’s order, the SEC listed about a half-dozen violations related to the management of operational risk, including failure to enforce written policies and procedures, failure to comply with its margin methodology and policy, failure to modify its Comprehensive Stress Testing System and neglecting to provide timely notification to the SEC of these failures as required by Regulation SCI.

Regulation SCI (Regulation Systems, Compliance and Integrity) requires self-regulatory organizations like registered clearing agencies to take corrective action in the case of systems disruptions, systems compliance issues and systems intrusions--and to notify the Commission if any of those events take place.

OCC’s response. The clearing corporation did not admit or deny the regulators’ findings in its settlements. However, in a statement, OCC indicated it resized its Clearing Fund in 2021 and corrected implementation errors. OCC also agreed to complete additional remedial efforts according to the terms of the SEC and CFTC agreements.

The releases are Nos. 34-96945 (SEC) and 23-06 (CFTC).