Monday, 30 September 2019

Appellate court puts freeze on hearing requiring live testimony from CFTC commissioners

By Brad Rosen, J.D.

In yet another stunning development in a CFTC enforcement action against Kraft Foods, the CFTC has scored a victory of sorts, as a three-judge panel from the Seventh Circuit Court of Appeals granted its motion for a stay of proceedings. As a result, the district court struck an evidentiary hearing scheduled for October 2, where Commission Chairman Heath Tarbert, Commissioners Dan Berkovitz and Rostin Behnam, and Division of Enforcement Director James McDonald were expected to provide live testimony to justify and explain having made public statements despite a gag provision regarding a Kraft Foods/Mondelez International motion for contempt and sanctions. A status hearing in the lower court for September 27 was also cancelled. However, the CFTC’s victory may have come at a cost, as the appellate court has indicated that all papers in this case may become of public record, a development the agency is likely to strenuously oppose (CFTC v. Kraft Foods Group, Inc., September 26, 2019, per curiam).

The return of sunshine? Both the CFTC and the defendants have supported a cloak of secrecy that permeated both the settlement of the case and the subsequent contempt proceeding. Numerous pleadings and documents filed by the parties since the defendants’ August 16 contempt motion have been sealed from public view, including the CFTC’s 33-page petition for a writ of mandamus, as well as another memorandum concerning privilege. Additional sealed documents were filed by both parties as recently as this week. All this secrecy might be coming to an end as the Seventh Circuit denied the CFTC’s motion that all filings to be placed under seal.

In its order, the appellate panel stated, "All papers filed in this court will be placed in the public record on Tuesday, October 1, 2019, unless the parties show before then that a statute or recognized privilege requires secrecy," citing Herrnreiter v. Chi. Hous. Auth. (7th Cir. 2002) and Union Oil Co. of Cal. v. Leavell (7th Cir. 2000).

CFTC mandamus petition awaits resolution. The appellate judges—Frank Easterbrook, Ilana Diamond Rovner and Diane Sykes—also ordered the defendants and other parties-in-interest to file a response to the CFTC’s mandamus petition by October 7. As the CFTC’s petition for writ of mandamus is sealed, it is impossible to say what the basis of its claim is or the specific relief it is seeking. Generally, a writ of mandamus is a court order to an inferior court or government official to properly fulfill its official duties or correct an abuse of discretion.

The appellate panel also invited District Court Judge John Robert Blakey to respond to the CFTC’s petition if he so chooses pursuant to the Federal Rules of Appellate Procedure. If the district judge chooses to weigh in, that response is also due by October 7.

How we got here.
As this matter has seen many twists and turns, a brief recap is in order. On August 14, the parties entered into a consent order whereby they settled a CFTC enforcement action initiated in 2015 concerning the alleged manipulation of wheat prices. That consent order included an unusual "gag" provision that limited the parties’ rights to make most post-settlement public statements. On August 16, Kraft filed a motion for contempt claiming the CFTC breached the gag provision as a result of public statements made by the agency and three of its commissioners. That motion was retroactively sealed from public viewing together with a number of other filings in the case. In a resulting emergency hearing on August 19, the court ordered the CFTC’s chairman and other key members of the agency’s leadership to appear at an evidentiary hearing to provide testimony about their post-settlement public statements. That hearing was moved to October 2, but it is now cancelled as a result of the appellate court’s order.

The case is No. 19-2769.

Friday, 27 September 2019

Associate Enforcement director highlights cyber activities, initiatives

By Amy Leisinger, J.D.

In an SEC Historical Society Spotlight, Enforcement Associate Director and acting Cyber Unit Chief Carolyn Welshhans discussed emerging cyber issues with Morgan Lewis partner Ivan Harris. Among other things, the pair considered initial coin offerings, hacking and account intrusions, and cybersecurity controls. According to Welshhans, as ICOs and digital assets garner increased attention, cyber expertise is developing across the Commission. While the existing rules governing fraud and the goals underlying registration continue to apply, additional efforts to understand and analyze blockchain issues, virtual currencies, and cybersecurity concerns are being undertaken, she said.

ICOs and enforcement. Welshhans noted that the Cyber Unit was formed two years ago to provide for a more direct focus on cyber issues. With regard to potential violations in connection with ICOs and digital assets, the threshold inquiry is whether the platform, asset, or offer involves a security. According to the associate director, it is a mistake to think the Exchange Act and Securities Act and older regulations and case law cannot still apply to evolving products. The question of whether there a fraudulent activity has been committed and whether something is a security are still crucial to enforcement assessments, Welshhans said. Further, she explained, the need for registration and disclosure remains the same, particularly as part of the SEC’s mission to protect investors.

Harris asked Welshhans why many of the enforcement action brought in connection with ICOs involve only charges of registration failures under Section 5 and not fraud charges under Section 10(b). She responded that a variety of considerations go into how to bring these matters and that, sometimes, it can be difficult to trace digital assets. Further, she explained, several matters have involved ICOs where activity was ceased when the SEC became involved and money was returned investors. Collaboration with other Commission divisions and offices has been helpful in making enforcement determinations, Welshhans noted.

Cybersecurity. Cybersecurity is the responsibility of both government agencies and market participants, the associate director stated. Companies need to consider cyber threats when implementing controls and identifying cyber incidents, and the need to report under the internal controls provisions has not changed, Welshhans explained. The SEC may step in when a company does not have controls and policies and procedures in place to protect data, especially when the data goes to the heart of the business, she noted.

The SEC and its staff will not second guess good faith efforts to disclose and respond to events, according to the associate director, but the agency does need to ensure that the controls in place, as well as the timing and content of the response, were truly reasonable, Welshhans said. In some cases, controls and responses can be so ineffectual as to warrant enforcement, she opined. Ongoing investigations will not excuse nondisclosure, she concluded.

Thursday, 26 September 2019

High-frequency trader was ‘insider’ for purposes of short-swing trading

By Lene Powell, J.D.

A high-frequency trader who engaged in thousands of transactions in the stock of two companies during a single week and did not hold any shares for longer than a week was found to be an “insider” for purposes of the short-swing trading prohibition under Section 16(b) of the Exchange Act. Because the trader’s holdings exceeded the 10 percent beneficial ownership threshold during that week, he was barred from short-swing trading under the clear language of the statute. Therefore, the companies were allowed to proceed in their action to require the trader to disgorge short-swing trading profits of over $13 million (Avalon Holdings Corporation v. Gentile, September 24, 2019, Broderick, V.).

High-frequency trading. Between July 24 and July 31, 2018, Guy Gentile, the sole owner of trading firm MintBroker International, Ltd. and a resident of Puerto Rico, engaged in 2,331 purchase and sale transactions of common stock in Avalon Holdings Corporation, a publicly held corporation listed on NYSE. During that week, Gentile purchased approximately 2,325,244 shares and sold approximately 2,351,858 shares. Due to a spike in the stock price that week from $2.20 to $36.00, the defendants gained over $7 million in profits from these transactions. On July 31, the defendants sold 5,000 shares, reducing their ownership to less than 10 percent of all outstanding shares.

Similarly, the defendants engaged in several thousand purchase and sale transactions in the common stock of New Concept Energy, Inc. between June 29 and July 3, 2018, exceeding the 10 percent ownership threshold during that time and gaining approximately $6 million in profits.

Venue. The court first found that the defendants’ alleged trading of the companies’ stock on the NYSE provided a basis for venue in the Southern District of New York. In actions asserting violations of the Exchange Act, venue is governed by 15 U.S.C. § 78aa. The Second Circuit has held that the execution of relevant trades on the New York Stock Exchange is sufficient to establish venue in the Southern District of New York under § 78aa.

The court rejected the defendants’ argument that, since 2010, the “vast majority” of trading at the NYSE no longer takes place on the floor of the exchange on the corner of Broad St. and Wall St. in Manhattan, but rather in data centers located in northern New Jersey. Even if it were appropriate for the court to consider evidence from news articles, the articles did not unequivocally state that all the relevant NYSE operations had moved out of the district such that no “act or transaction constituting the violation” could have occurred there.

Short-swing trading. Next, the court found that the plaintiffs adequately established that the defendants’ trades fell within the short-swing trading prohibitions in Exchange Act Section 16(b). Although the defendants did not contest that they satisfied the definition of “insider”—a “person who is directly or indirectly the beneficial owner of more than 10 percent of any class of any equity security”— they argued that “Section 16(b) was clearly not designed to recover profits made from high-frequency trading positions by briefly-tenured shareholders with no connection to an issuer and no conceivable opportunity to obtain inside information.” The court found no support for this argument.

Assuming arguendo that the defendants did not have access to inside information during their brief period of beneficial ownership, this did not relieve the defendants of liability. Under precedent including the Second Circuit ruling in Donoghue v. Bulldog Inv’rs Gen. P’ship (2012), Section 16(b) imposes a “strict-liability rule” for disgorgement of profits, which operates without regard to whether the statutory fiduciaries were actually privy to inside information or whether they traded with the intent to profit from such information. Nor is any exception made for brief periods of 10 percent beneficial ownership.

The court quoted:
§16(b) operates mechanically, and makes no moral distinctions, penalizing technical violators of pure heart, and bypassing corrupt insiders who skirt the letter of the prohibition.
Accordingly, because the transactions fell within the terms of Section 16(b), the court denied the defendants’ motion to dismiss.

This is case No. 18-CV-7291 (VSB).

Wednesday, 25 September 2019

Software industry adds two more to 2019 IPO total

By John Filar Atwood

Six companies completed IPOs last week, including two prepackaged software companies. With the deals by Datadog and Ping Identity Holding, SIC 7372 has now tallied ten new issues for the year. Datadog’s $648 million offering was the industry’s second largest IPO of 2019 behind Uber’s $8.1 billion deal. Cancer treatment developer IGM Biosciences and autoimmune diagnostics company Exagen joined the list of the year’s health care new issuers. Both companies went public less than a month after they publicly registered. Envista Holdings completed the second IPO by a dental equipment and services (SIC 3843) company in the past two weeks. SIC 3843 previously had not produced an IPO company in the U.S. since at least 1998. The week’s other deal was completed by Apex Technology Acquisition, which raised $305 million to pursue a target in the software and internet technology industries. Apex is one of six 2019 blank checks new issuers headquartered in California.

New registrants. The week’s activity included four new registrations, one of which was filed by Innate Pharma, the third French company to file plans for a U.S. IPO this year. Innate is developing immunotherapies for the treatment of cancer. The IPO will be the company’s initial sale of shares in the U.S. Innate’s ordinary shares currently trade on the Euronext Paris market. Karat Packaging, a maker of disposable packaging products for restaurants and the foodservice industry, registered a $50 million offering. Karat’s customers include Chipotle, Applebee’s, Panda Express, and In-N-Out Burger. BellRing Brands, which is controlled by Post Holdings, plans to go public with a dual class share structure. The company makes PowerBar, Premier Protein, and other convenient-nutrition foods and drinks. Florida-based BI Acquisition filed a preliminary registration last week. The company plans to pursue a target in the metals, mining, and natural resources industries. BI Acquisition is controlled by Bedrock Industries, a privately-held mining company. BI’s sponsor has agreed to purchase $6 million of company units in a concurrent private placement.

Withdrawals. No companies opted to withdraw their pending IPO registration statements last week.

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, 24 September 2019

Debevoise & Plimpton’s Byungkwon Lim answers 10 questions on blockchain law

By Mark S. Nelson, J.D.

Byungkwon Lim is a partner at Debevoise & Plimpton LLP and is leader of the firm's Derivatives, Blockchain and Hedge Fund Practice Groups. Lim's practice includes advising technology firms on a variety of matters, including regulation, platform structure and offerings. Lim is admitted to practice in the Republic of Korea and New York

Lim spoke with Wolters Kluwer about trends and challenges in blockchain law and policy.

1. Your law firm biography indicates that you lead Debevoise’s Derivatives, Blockchain and Hedge Fund Practice Groups. How did you become interested in blockchain law? What advice would you give to an attorney who wants to represent clients in the blockchain space?

More than two decades ago, somebody told me that we would buy and sell everything on the Internet, and my reaction was simply “yeah, right.” Then, Amazon and so many other things have happened, and I became more and more curious about all new technologies, and blockchain and FinTech came my way almost by accident a few years ago. I am still working on many things I have been doing for a long time, but I am very excited and fascinated when I work on blockchain and technology matters.

I always suggest to lawyers and other service professionals working in the blockchain space that they should have some amount of knowledge and understanding of computer science—mostly the software side. Without that, it would be difficult to fully understand a legal or regulatory issue. For example, if you are tokenizing a security or issuing a security token on Ethereum, security law restrictions must be built into ERC 20 tokens (assuming tokens are fungible). As a lawyer, I will need to talk to you about what you need to write into the token codes and discuss with you how those lines in the code will execute in different conditions. This is true for any technology, whether it’s AI, big data analytics or self-driving cars.

2. The last roughly two years saw a great deal of enthusiasm that commercially viable blockchain solutions would soon emerge. Perhaps the volatility of the main blockchain solution to date—virtual currencies—has dampened that enthusiasm somewhat. What is the current state of the blockchain industry?

It really depends on what we mean by the “blockchain industry.” Blockchain is a technology, and the “blockchain winter” we saw last year just relates to the technology sector largely funded by those who own Bitcoin and other crypto assets. Corporations and sovereigns have been funding their projects differently, and we saw an increasing number of pilot projects using the technology last year. From early on, we have seen die-hard enthusiasts who preached that the world would transform in a matter of a few years. We still have those enthusiasts. But this technology cannot transform society overnight; we should just remember how long the Internet has taken to change every facet of our lives. But changes will come, and they will come faster than we think, simply because the pace of change in the society powered by every technology has been accelerating throughout history. We can pick anything we see—transportation, communication, or, more to our everyday life, stuff like home security. One last thing: for the record, I truly respect enthusiasts who believe in what they believe in and work tirelessly to achieve their goal. Many will fail, but some will not, and the world will owe gratitude to all of them.

3. A key challenge for the U.S. blockchain industry has been navigating the several existing federal regulatory regimes (e.g., securities, commodities, banking, and tax) that can apply to different aspects of blockchain activities. How likely is it that blockchain will ultimately require a new legal and regulatory framework?

Again, I view blockchain as a technology, which is neutral from a legal or regulatory perspective. I am not really sure if any new rule is necessary when a business enterprise uses it to manage its own supply chain, as Walmart has been reportedly experimenting with. On the other hand, trading, clearing and settling securities through blockchain would require a large scale modification of the current regulatory system. So, in some use cases, the current regulatory system will have to change. Such change may come in the form of a new rule or interpretation of the existing rule. It is not easy to change a rule, in whatever form it may take, so it is important for the industry and the regulator to engage each other to understand the objective of the relevant rule and the use case of the technology.

4. Questions have arisen about the need for additional federal or state laws to validate cryptographically signed documents such as smart contracts. How might existing laws, such as the federal Electronic Signatures in Global and National Commerce Act (E-Sign Act) and the Uniform Electronic Transactions Act (UETA), apply to smart contracts?

It depends on in what context a “smart contract” is used. Let’s say that you and I signed a contract on paper to exchange U.S. dollars and British pounds at different exchange rates depending on whether Brexit happens on October 31. Then we agreed to make the performance of this contract automatic by putting a smart contract on a blockchain. Come October 31, the smart contract will automatically transfer U.S. dollar and British pound amounts between our accounts. The smart contract doesn’t involve the formation of a valid contract. On the other hand, it is possible that we execute the same contract on a chain. In all likelihood, we will agree on the terms of the contract off-chain or on a website specifically designed for execution of this type of contract. In either case, it will be just a contract executed on the Internet, which can provide for a valid e-signing procedure. Although I am not really sure if this is realistic or not, it is possible that we open a joint address on the Ethereum blockchain, write a smart contract ourselves and send it to the chain for execution by miners. (The use of the word “execution” is a bit confusing, since it just means that the smart contract will be included in a block by a miner and that block becomes part of the chain.) Later, when conditions are met, the smart contract will be “executed” in a deterministic manner without any human intervention. In that case, we might face the issue of whether a contract (in a legal sense) was validly executed. Again, I am not sure how many of us could actually write a contract directly on the chain.

5. The SEC has perhaps taken the early spotlight among federal regulators due to the number of its blockchain enforcement actions dealing primarily with initial coin offerings, but the Treasury Department’s somewhat lesser known Financial Crimes Enforcement Network (FinCEN), also can play a big role in regulating blockchain activity through enforcement of its anti-money laundering (AML) regulations. What are blockchain firms already doing, or perhaps still need to do, in order to better comply with the Bank Secrecy Act and related know-your-customer (KYC) and AML requirements?

I cannot speak for all business enterprises that use blockchain in the money service business, but most of the enterprises that engage in money service business do generally comply with FinCEN rules and, if applicable, state money transmitter rules. There are, however, challenges. FinCEN’s 2019 guidance is more expansive than its 2013 guidance, and FinCEN will almost certainly implement new recommendations adopted by the Financial Action Task Force. The most complicated and possibly burdensome rule may be the travel rule. Many technology firms have been developing programs for enterprises to comply with the travel rule, but those programs need to be tested in a live environment in order to determine if they actually work as intended.

A more complicated and confusing area is data protection. Debate has been going on regarding how to apply data protection rules like the EU’s GDPR to blockchain based data structures, but there is no consensus even on the basic premise of whether blockchain can ever be adopted by a business enterprise in a manner to meet GDPR requirements. I recently read the European Parliament’s study paper on this topic, and I suggest others read it.

6. The SEC’s Division of Corporation Finance issued its “Framework” for digital assets in April 2019. So far, two no-action letters have resulted from that framework and both dealt with tokens that were to be part of functional blockchain platforms. In related events, two blockchain-related Regulation A offerings have been qualified. How effective has the Framework been in clarifying securities law requirements?

The industry largely agrees that the “Framework” is helpful in the sense that it provides an official confirmation of what the industry has believed to be factors the SEC staff would consider in analyzing an ICO. The flip side of this is that the Framework did not provide a safe harbor type guidance, which the industry was looking for. Since the Framework is based on the “Howey” decision and all subsequent court decisions, which are really fact-intensive, I am not sure if the SEC would be able to do anything else. Others will probably disagree with me, but I have thought that the Framework actually makes things more ambiguous. Let’s say that a developer got funded by a venture capital fund to build a platform, which goes live and functions as planned. The developer issues tokens, with which buyers can access the services provided by the platform. In issuing tokens, the developer says that it will use the proceeds to add functionality to the platform, improve it, and do other things to make the platform better using some of the token sales proceeds. The developer wants to limit the maximum number of tokens to be released. The market is excited about this, and many write blogs suggesting that this token is a must buy, and many people buy them for investment or speculative purposes. One could argue that this token is a security, but wouldn’t a business enterprise want to improve its product or introduce a new one? Should this token be treated as a security because there is a maximum amount to be released by the platform?

If we all step back a little bit, the fundamental issue is whether securities laws developed in an “analog” environment should be modified in a “digital” environment. It’s a policy question at a high level. Personally, I am not in the camp which argues that the rules need to be relaxed solely or even primarily in order to keep the blockchain industry in the U.S. That is one of many policy arguments—we do need to consider other policy goals like investor protection, the stability of the financial system and the integrity of the financial and other markets. But it is necessary for all participants to engage one another in a broad policy discussion.

7. SEC staff also have issued statements on custody of digital assets. What are some of the issues that blockchain firms and/or regulators still need to address regarding custody of digital assets?

Custody raises a number of complicated issues in part because of the current custody technology. Safe custody is all about safeguarding private keys. The best way is to have the private key related to an address which holds custodied assets of customers absolutely isolated from the world. It is more than cold storage in an off-line environment; it is better if no human being has access to it or knows what it is at all. So, the first question is how to demonstrate that the private key stored in an off-line device is indeed related to the particular address. Another question is how the custodian demonstrates to the world that the key stored in that device has been and is the only key that exists in the world. In other words, how can one demonstrate that the same key information (which is a string of alpha numerical digits) is not stored at a place not under the sole and exclusive control of the custodian? It’s proving the negative. Some technologies may prove it, but I don’t think they have been audited and certified. I am not sure if there is an ISO standard for blockchain related technology.

8. Several U.S. states have enacted digital token laws (e.g., Wyoming and Colorado). How do federal and state laws on blockchain either work together or conflict?

I have not really studied many state laws other than New York (for obvious reasons) and Wyoming. I have looked at Wyoming laws and rules and discussed them with some in the legislature and the banking department. It has been a great experience for me, and I hope that those in Wyoming I worked with feel the same. They spent a fair amount of time and resources to draft statutes and rules in a reasonably balanced manner. I don’t really see a conflict in the sense that Wyoming laws and rules are inconsistent with federal laws and rules, but if there are some and those are to be pre-empted by federal laws, then federal laws will of course apply in the inter-state context. I do believe that more states should be active in this area; the federal regulatory system would be better with better state systems. The two systems should not be mutually exclusive.

9. The U.S. is not the only would-be regulator of blockchain activities. What are some of the international issues affecting the development of blockchain solutions? Have there been any significant legislative or regulatory developments regarding blockchain outside the U.S.?

Based on my colleagues in our non-US offices, many countries have been implementing the adoption or modification of rules for blockchain. Of course, with more rules coming in all countries, it is getting pretty complicated to implement a platform or use technology in a business on a global basis. (Blockchain is meant to transcend geographic borders.) There are actually a number of good reports and studies coming out of the UK and the EU, which I suggest everybody in the industry read.

10. What do you expect could be the biggest developments for blockchain during the remainder of this year and into 2020?
Well, I wish I knew. But clearly Facebook’s Libra has forced many mainstream folks to seriously think about technology itself, use cases and regulation. These are all positive developments. I will not comment on whether Libra will go live next year. Because of Libra, more national central banks seem to be looking into central bank digital currencies. CBDC is a fascinating topic, and I am trying to read every study and paper on this topic.

Monday, 23 September 2019

Virginia adopts financial exploitation, cybersecurity, client privacy and mandatory arbitration rule amendments

By Jay Fishman, J.D.

The Virginia Securities and Retail Franchising Division has added certain broker-dealer and investment adviser rule provisions addressing financial exploitation of vulnerable adults; cybersecurity; client privacy; and mandatory arbitration, effective September 16, 2019.

Financial exploitation of vulnerable adults. Added to the broker-dealer and investment adviser unethical practice rules is a provision permitting a broker-dealer, agent, investment adviser, or investment adviser representative to delay a transaction and refuse disbursement from a vulnerable adult’s account when the financial institution suspects that the vulnerable adult has or is being financially exploited. Absent gross negligence or willful conduct, the broker-dealer, agent, investment adviser, or investment adviser representative will be immune from civil or criminal liability for reporting and submitting any information or records to the appropriate authorities based on a good faith belief that the transaction or disbursement may involve financial exploitation of the vulnerable adult.

Physical security and cybersecurity. Investment advisers registered or required to register in Virginia must create, implement, update, and enforce written physical security and cybersecurity policies and procedures reasonably designed to ensure confidentiality, integrity, and availability of physical and electronic records and information. The policies and procedures need to be tailored to the investment adviser’s business model that considers the firm’s size, services provided, and number of locations.

The physical security and cybersecurity policies and procedures must: (1) protect against reasonably anticipated threats and hazards to the security or integrity of client records and information; (2) ensure that the investment adviser safeguards confidential client records and information; and (3) protect the records and information from any harm or inconvenience that could befall clients if the records and/or information were released.

Additionally, the policies and procedures must cover at least five functions: (1) the organizational understanding to manage information security risk to systems, assets, data, and capabilities; (2) the appropriate safeguards to ensure delivery of critical infrastructure services; (3) the appropriate activities to identify the occurrence of an information security event; (4) the appropriate activities to take action regarding a detected information security event; and (5) the appropriate activities to maintain plans for resilience and to restore any capabilities or services that were impaired due to an information security event.

Investment advisers have to review their physical security and cybersecurity policies and procedures at least annually and modify them, as needed, to ensure their adequacy and ability to be implemented effectively.

Client privacy policy. Investment advisers must deliver upon the investment adviser’s engagement by a client, and on an annual basis thereafter, a privacy policy to each client that is reasonably designed to aid the client’s understanding of how the investment adviser collects and shares the client’s non-public personal information, to the extent permitted by state and federal law. The investment adviser must promptly update and deliver to each client an amended privacy policy if any of the policy’s information becomes inaccurate.
  • Registration. Added to the list of items investment adviser applicants must submit to the Division is a copy of the advisory firm’s physical security and cybersecurity policies and procedures, and a copy of the firm’s client privacy policy.
  • Recordkeeping. Investment advisers registered or required to register in Virginia must maintain and preserve records of their respective physical security and cybersecurity policies and procedures, and their client privacy policy. 
Unauthorized access to client records. Added to the investment adviser unethical practice rule is a provision mandating investment advisers and investment adviser representatives to notify the Division and the client of an unauthorized access to the records that may expose the client’s identity or investments to a third party, within three business days of the unauthorized access discovery.

Mandatory arbitration prohibition. Added to the investment adviser unethical practice rule is a provision prohibiting mandatory arbitration in any advisory contract.

Friday, 20 September 2019

House passes PCAOB whistleblower bill, government funding resolution

By Mark S. Nelson, J.D.

The full House passed a bill to establish a whistleblower program at the Public Company Accounting Oversight Board. The PCAOB bill was approved by voice vote, but it did draw some criticism because of its potential to upset the auditor-client relationship. Meanwhile, the House passed a continuing resolution that would fund financial regulators such as the SEC and the CFTC until Congress can enact comprehensive appropriations legislation.

PCAOB whistleblowers. The PCAOB Whistleblower Protection Act of 2019 (H.R. 3625), sponsored by Rep. Sylvia Garcia (D-Texas), would establish a whistleblower tip and reward program at the PCAOB. The bill is modeled after the Dodd-Frank Act whistleblower provisions applicable to the SEC.

House FSC Chairwoman Maxine Waters (D-Calif) noted that the PCAOB program will mirror the successful SEC program and help to ensure informative, accurate, and independent financial reports. House FSC Ranking Member Patrick McHenry (R-NC) emphasized that the amended bill includes a provision urging the PCAOB and the SEC to coordinate efforts in order to leverage the SEC’s expertise and to ensure that the program will be cost-effective.

The bill, however, drew criticism from Rep. Bill Huizenga (R-Mich) who warned that a separate PCAOB whistleblower program could threaten the auditor-client relationship. Specifically, he said audit personnel may seek bounties in a manner that could put the audit process at risk. The representative also questioned whether the PCAOB program would be redundant in light of the SEC’s whistleblower program and whether the PCAOB may have to divert resources to fund the program.

The bill’s sponsor, Rep. S. Garcia, replied that the PCAOB program was needed as evidenced by the many groups who urged passage of the bill. She also said the costs of the program would be offset by fees collected by the PCAOB. Earlier in the debate, Rep. Garcia emphasized that the post-Enron Sarbanes-Oxley Act reforms were the catalyst for the later SEC whistleblower program. The PCAOB program, she added, would help to ensure that investors continue to view U.S. markets as stable and transparent.

The bill would define "whistleblower" to mean any person, or two or more persons acting jointly, who provide information about violations of PCAOB or securities rules for audits or professional standards. A special rule would ensure that whistleblowers are protected from retaliation by their employers. Significantly, the definition does not specify to whom whistleblowers must report information about violations, a nod to the issues faced by the SEC regarding the Supreme Court’s interpretation in Somers that the Dodd-Frank Act provision for the SEC requires a report to the SEC in order to invoke the anti-retaliatory protections of the Dodd-Frank Act. The House has passed legislation (H.R. 2515) by a vote of 410-12 to reverse the holding in Somers.

Much like the SEC’s whistleblower program, a PCAOB whistleblower who provides original information to the PCAOB could receive between 10 to 30 percent of any monetary sanctions collected in an enforcement action. "Original information" would have the same meaning as the Dodd-Frank Act provision for the SEC. "Covered proceedings" would include those proceedings initiated after enactment and which result in monetary sanctions of more than $250,000.

Government funding. The Continuing Appropriations Act, 2020, and Health Extenders Act of 2019 (H.R. 4378) is a continuing resolution (CR) that would keep the government open through November 21, 2019 by extending funding for financial regulators at levels contained in the Consolidated Appropriations Act, 2019 ($1.675 billion for the SEC; $268 million for the CFTC). The House passed the CR by a vote of 301-123 and the Senate is expected to consider the bill soon.

“I regret that the Senate has not done its work. They have not passed a single appropriations bill,” House Majority Leader Steny Hoyer (D-Md) told members on the floor. House Appropriations Committee Chairwoman Nita Lowey (D-NY) told members the CR did not contain poison pill provisions. In a separate press release, Rep. Lowey stated that “[o]nce the CR is enacted and the Senate advances their appropriations process, Democrats will negotiate responsible spending bills that uphold our values and give working families a better chance at a better life.”

Ranking Member Kay Granger (R-Texas) tweeted her support for the CR and, in attached remarks, lamented that the appropriations process had broken down and threatened another government shutdown. She also noted that the CR continues funding for the Committee on Foreign Investment in the United States (CFIUS) which is tasked with, among other things, monitoring Chinese economic influence in the U.S.

Previously, Congress enacted the John S. McCain National Defense Authorization Act for Fiscal Year 2019 with its significant reform provisions for CFIUS. Subtitle A of Title XVII of the NDAA conference report contains the Foreign Investment Risk Review Modernization Act (FIRRMA), which expanded CFIUS’s authority to review mergers and acquisitions that involve foreign acquirers of U.S. businesses. Many of the new provisions were thought necessary because of strategic acquisitions in the U.S. by Chinese firms.

Thursday, 19 September 2019

Trulia’s impact lessens but is still being felt, Cornerstone finds

By John M. Jascob, J.D., LL.M.

The impact of the Delaware Chancery Court’s Trulia decision on merger and acquisition deals appears to have stabilized, according to a new report released by Cornerstone Research. Shareholders of public target companies challenged 82 percent of merger and acquisition deals valued over $100 million in both 2017 and 2018, up from just 71 percent in 2016, when Trulia was decided. Prior to Trulia, shareholders had litigated around 90 percent of M&A deals valued over $100 million.

In Trulia, the Delaware Chancery Court denied approval of a proposed “disclosure-only” settlement under which the companies would supplement the proxy materials disseminated before the shareholder vote on the transaction in exchange for the plaintiffs dropping their motion and releasing claims on behalf of the proposed class of stockholders. The Chancery Court found that “[n]one of the supplemental disclosures were material or even helpful” and thus provided no meaningful consideration for a release of claims. Cornerstone notes that Trulia resulted in increased judicial scrutiny of proposed settlements of stockholder merger litigation and diminished the acceptability of disclosure-only settlements in merger objection cases.

The report also found an easing of the shift from state to federal courts that began with Trulia. Between 2009 and 2015, 97 percent of litigated M&A deals had been challenged in state court. Post-Trulia, the number of state-court challenges fell to just 18 percent in 2017 before rebounding to 34 in 2018. A total of 49 large deals were litigated in state courts in 2018, up from 21 in 2017.

“The most notable trend at the state level occurred in the Maryland state courts, where 12 deals were litigated in 2018, compared to none in 2017,” said co-author Ravi Sinha in a news release. The number of deals litigated in the Delaware Court of Chancery, however, was just 13 in 2018, up from seven in 2017 but down from 37 in 2016. The Third Circuit was the most active federal court in 2018, with more than twice the number of challenged M&A deals over the prior year.

Trulia also resulted in a lower propensity to challenge M&A deals, the report finds. The number of lawsuits per challenged M&A deal has remained around three since Trulia, compared to the 2009-2015 average of 4.7 lawsuits per deal.

Wednesday, 18 September 2019

Clayton stresses importance of market price transparency, fostering small business growth

By Amanda Maine, J.D.

In an address at Central Michigan University, SEC Chairman Jay Clayton praised the role of the market on ensuring confidence in market prices. He also heralded the role of small business innovation and assured that the SEC is examining how to foster more entrepreneurial ecosystems beyond the traditional hot spots of the east and west coasts.

Market prices. Prices for stocks, bonds, and other assets should be generated by markets that are “transparent, information-rich, and fair,” Clayton said. Comparing prices to light houses, Clayton observed that they are non-excludable and non-rivalrous—he cannot keep others from using price information, and his use of price information does not affect others’ ability to use that information.

To give a more concrete example, Clayton cited mortgages. Two people with the same credit seeking a 30-year mortgage should pay the same amount, which should fairly reflect their credit relative to others with better or worse credit, Clayton explained. Investors, particularly Main Street investors, should be confident that that public company stock prices reflect the views of all investors, including “professional investors.” All investors benefit from the work of professional investors, which “economists adore,” Clayton quipped.

The availability of market prices is also important from the perspective of public company managers, Clayton said. When managers make decisions impacting the long-term outlook of the company, such as human capital, equipment, and research, they rely on metrics derived from public market-generated pricing information, according to Clayton. “Prices matter,” he said, including earnings multiples and cost of capital estimates. He emphasized that today’s prices impact long-term decisions.

Small business. Clayton then turned to what he called one of his favorite topics: small business capital formation. Clayton noted that 25 years ago, public markets dominated private markets. Today, he observed, private markets are outpacing the public markets. The SEC has an important role to play in the “creation and incubation” of small businesses, Clayton advised.

Clayton touted the establishment of the SEC’s Office of the Advocate for Small Business Capital Formation as an element of the Commission’s dedication to fostering small business growth. He also cited some geographically small but highly functioning networks and ecosystems for small business growth, including Silicon Valley, New York, the Route 128 Corridor, and Austin. These networks or “ecosystems” are vital to reducing the costs of information access, verification, contracting, the protection of rights, and the pursuit of remedies, Clayton said.

The SEC wants to expand the number of these ecosystems beyond the east and west coasts, Clayton stated. Currently 85 percent of venture capital is concentrated in Silicon Valley, Boston, and New York. However, Clayton noted that the Mississippi River Valley has hundreds of large public companies and prominent universities but only a handful of established capital firms. To address this, the SEC is examining how to foster more entrepreneurial ecosystems in non-coastal areas, Clayton said. He said he hoped that people will share their experiences and challenges regarding raising money for small businesses. “Let us know,” Clayton urged.

Tuesday, 17 September 2019

Controversial Volcker Rule amendments adopted prior to CFTC Sunshine Act meeting without public discussion

By Brad Rosen, J.D.

In his first open meeting as the 14th chairman of the CFTC, Heath Tarbert trumpeted the virtues of running the agency guided by the principles of unity, collegiality, and transparency. Towards that end, the Commission unanimously approved two final rules—one addressing position limits for security futures products (SFPs), and the other dealing public rulemaking procedures under Part 13 of the CFTC Regulations. The adoption of these rules was described as “housekeeping” undertakings during the course of the meeting.

Final rules on Volcker Rule amendments were dropped from the agenda. Despite talk of greater transparency and improving public visibility with regard to the CFTC’s rulemaking process, consideration of the highly controversial final rule on revisions to the Volcker Rule was removed from the agenda prior to the meeting. Notwithstanding a 3-2 split vote among the commissioners on the measure, the final rule was handled as a seriatim matter, and public comments were confined to prepared statements by the commissioners issued after the completion of the meeting. The original Volcker Rule is premised on the notion that banks should be barred from proprietary trading and from running hedge funds.

In support of the final revisions to the Volcker Rule, Chairman Tarbert stated that the initial regulations “have metastasized from Mr. Volcker’s original, simple vision to the degree where his distinction between proprietary and non-proprietary trading is hardly recognizable.” He also voiced concerns that the Volcker Rule may affect liquidity in the derivatives markets. Commissioner Brian Quintenz further noted that the final rule tailors and simplifies the Volcker Rule so as to enable banking entities to effectively provide traditional banking services to their clients in a manner that is consistent with the statute. Tarbert and Quintenz also issued a joint statement in support of interagency cooperation where they expressed their hope and expectation that banking regulators will work with the CFTC to address issues surrounding the supplementary leverage ratio (SLR) calculation, a matter that has impacted market liquidity.

In opposition to the final rule, Commissioner Rostin Behnam reiterated his concerns that the action would “encourage a return to the risky activities that led to the financial crisis, and perhaps further consolidate trading activity into a few institutions.” He added that while the proposed rule “merely threatened to kill Volcker through a thousand little cuts, the final rule goes for the throat.” He noted that the final rule significantly weakens the prohibition on proprietary trading by narrowing the scope of financial instruments subject to the Volcker Rule.

These concerns are echoed by Commissioner Dan Berkovitz as he stated, “The revised Volcker Rule will render enforcement of the rule difficult if not impossible by leaving implementation of significant requirements to the discretion of the banking entities, creating presumptions of compliance that would be nearly impossible to overcome, and eliminating numerous reporting requirements.”

Security futures position limit increase endorsed. All five commissioners enthusiastically supported the final rule addressing position limits and position accountability levels for security futures products. Those rules had not been substantively amended to account for market developments since they were first adopted in 2001. During that time period position limits on equity options had increased while the CFTC’s SFP position limits have remained unchanged. These updates to SFP position limits aim to provide regulatory comparability with equity options and minimize competitive disparity between the two markets. Commissioners Stump and Quintenz each issued statements on this final rule as well as the final rule addressing Part 13 amendments. Commissioner Berkovitz issued a separate statement on positions limits for SFPs.

Consensus on Part 13 amendments. All commissioners also supported amending the Part 13 regulations on public rulemaking by withdrawing the Part 13 rules, other than rule 13.2 which allows for or petitions for rulemaking. As the Administrative Procedures Act (APA) governs the Commission’s rulemaking process, most of the Part 13 rules were viewed as unnecessary and defunct. Moreover, the rules, which were adopted in 1976 shortly after the birth of the CFTC have not been touched in the 43 years since then. It was also noted that this rulemaking would not repeal or limit in any way the rights that the public has today in CFTC rulemakings under the APA. Commissioners Behnam and Berkovitz each issued separate statements on this final rule.

CFTC monitoring ongoing developments in the Middle East. Towards the conclusion of the meeting, Chairman Tarbert acknowledged the drone strikes over the weekend on a Saudi Arabian oil processing facility which accounts for one half of Saudi oil production and five percent of the world’s crude oil supply. He noted that as with any major market moving event, the CFTC immediately commenced monitoring impacted markets and will continue to do so as events unfold.

Monday, 16 September 2019

Panelists reflect on NASAA’s role in taking on Prudential at annual conference

By Jay Fishman, J.D.

The North American Securities Administrators Association, Inc. (NASAA) celebrated its 100th year as the states’ investor protecting umbrella organization by, among other things, relaying an egregious case of fraud from the late 1980s/early 1990s involving Prudential that ultimately propelled NASAA into becoming the most prominent “local cop on the beat” for protecting investors. The story serves as a reminder of NASAA’s role in combatting fraud, as it has more recently through a coordinated cryptocurrency crackdown.

New Jersey’s Securities Bureau Chief, Christopher Gerold, became NASAA’s new President for 2019-2020, and NASAA revamped its website to make it more investor-friendly.

Aside from the conference. Important NASAA events surrounding the conference that occurred in August/September 2019 included the following:
  • On August 7, NASAA updated its implementation of a coordinated cryptocurrency crackdown; 
  • On September 8, NASAA’s state investment adviser examinations uncovered rising cryptocurrency deficiencies; and
  • On September 11, the last day of the conference NASAA’s 2018-2019 President and Vermont’s Financial Regulation Commissioner Michael Pieciak testified before Congress’s House Subcommittee on Capital Markets, Securities, and Investment, urging that no further action be taken to expand the nation’s private securities markets until a more careful study of the impact on public markets and investor protection can be conducted. Pieciak stated that “NASAA is concerned that our current regulatory regime has gone too far in favoring private capital raising over public markets.” 
It therefore appears that new President Gerold’s concerns for 2019-2020 will involve, among other matters, cryptocurrency, the need to not expand U.S. private securities markets, and the impact that Regulation Best Interest will have on state securities regulation once the SEC rule takes effect in June 2020.

Regarding cryptocurrency and fintech, on October 29, 2019, NASAA will hold a fintech and cybersecurity symposium at the Spire Event Center in Washington, D.C., or virtually in your home or office. Find more details on NASAA’s website.

David and Goliath story. NASAA’s panel celebrating its 100-year anniversary, entitled “True David and Goliath Story: How State Securities Regulators Tackled a Wall Street Giant,” involved how NASAA brought down Prudential Securities Inc., forcing it to initially pay $330 million in a 1994 settlement and then much more money following a late 1980s scheme to swindle nearly 340,000 investors nationwide. The four panelists who were the most active advocates for the investors at the time opined that from its New York headquarters on Wall Street, Prudential was positively evil because it sent many brokers across the country with marketing materials falsely promoting Prudential’s limited partnership investments as “guaranteed” and “safe.” Many of the brokers were new to the job and had no idea they were selling the investors totally fraudulent products. Furthermore, throughout the time period NASAA was investigating the case, Prudential’s executives continuously denied any wrong doing and continued the scheme to wipe out investors’ entire life savings. Moreover, Prudential threatened and carried out the threat to destroy the working lives of those brokers who said they were going to report the fraud to the SEC and NASAA. Panelist Kurt Eichenwald, a journalist for the New York Times, who tenaciously worked around the clock to uncover the scheme, rose to prominence as a writer of corporate financial fraud books, including “The Informant” which became a 2009 motion picture.

He and the other three panelists—Matthew Neubert, the Arizona Corporate Commission’s Executive Director, and Nancy Smith and Wayne Klein who were New Mexico’s and Idaho’s Securities Directors at the time of the crime—all stated that this case made NASAA the prominent state investor protector because in the late 1980s, the SEC was only investigating matters where the victims were corporations, not individual retail investors, and did not, therefore, take a proactive role in this investigation.

When the story began, various state securities commissioners started getting complaints from a handful of their respective resident investors about the worthlessness of purchased Prudential limited partnership products. But later, when the commissioners realized this was a nationwide fraud, and that they individually were not equipped financially or staff-wise to go after Prudential, and that the SEC was not sufficiently addressing the issue, they reached out to NASAA to form a collective task force. In 1994, Prudential continued to deny any wrongdoing but agreed to a $330 million settlement which was immediately used to begin compensating the unfortunate investors. But NASAA said $330 million was not enough money to financially restore all of the 340,000 victims. As a result, for the first time ever, a company—Prudential—agreed to pay an open-ended amount of money which ultimately became the largest-ever settlement paid out at the time, $1.4 billion.

Friday, 13 September 2019

Financial planners join battle over SEC’s Regulation BI

By Mark S. Nelson, J.D.

XY Planning Network, LLC (XYPN) and Ford Financial Solutions, LLC have sued the SEC alleging that the recently effective Regulation Best Interest (Regulation BI) is legally infirm because it exceeded the SEC’s statutory authority, its adoption failed to comply with the law, and that the resulting final rule is arbitrary or capricious. XYPN is a financial planning firm that focuses on advising Generation X and Y clients. Regulation BI was adopted in June 2019, became effective September 10, 2019, and firms will be required to begin complying with the rule by June 30, 2020 (XY Planning Network, LLC v. SEC, September 10, 2019).

Same story as states. XYPN’s complaint, filed in the federal court in the Southern District of New York, tells a remarkably similar story to the complaint by eight state attorneys general filed days earlier. Both complaints lament that the distinctions between investment advisers and broker-dealers have become increasingly blurred and that Regulation BI does little to clarify those differences. Both complaints note that a majority of the Commission, in adopting Regulation BI, disregarded the recommendation of SEC staff who conducted the Dodd-Frank Act-mandated study that the Commission impose a uniform fiduciary duty without regard to the financial interests of a broker-dealer. And both complaints find fault in the Commission majority’s reliance on Dodd-Frank Act Section 913(f) (authority to "commence rulemaking") and other Exchange Act provisions to justify the adoption of Regulation BI rather than citing Dodd-Frank Act Section 913(g), which provides more specific rulemaking authority regarding the type of standard to be adopted.

Moreover, both XYPN’s and the states’ complaints recite that Dodd-Frank Act Section 913 was the result of compromise between the House and Senate versions of the legislation that was intended to give the SEC authority to increase the standard of conduct applicable to broker-dealers. XYPN said that historically broker-dealers were considered "intermediaries" rather than fiduciaries, while the states’ complaint explained that broker-dealers make "arms-length sales recommendations." That means broker-dealers generally must provide "suitable" recommendations under the Financial Industry Regulatory Authority’s Rule 2111. By contrast, XYPN said investment advisers historically have been fiduciaries, which the states’ complaint elaborated upon by saying investment advisers adhere to fiduciary principles of "trust and confidence," which the states’ complaint said embraces two components—a duty of care (including the suitability standard) plus a duty of loyalty (avoid or disclose conflicts).

Although XYPN’s complaint did not mention the now-defunct Department of Labor (DOL) best interest contract standard, the states’ complaint did note that the Fifth Circuit had credited Dodd-Frank Act Section 913(g)(2) as the basis for the SEC’s authority to regulate in the investment adviser space, as opposed to the DOL’s lack of such authority, in vacating and setting aside the DOL’s fiduciary rule.

The Fifth Circuit opinion explained further that the blurring of the distinction between investment advisers and broker-dealers, as noted by a "major securities law treatise," had been observed as early as 2006 in a study conducted by LNR-Rand which provided some of the impetus for the Dodd-Frank Act provisions on broker-dealers, including Section 913(g). With respect to the Section 913 study mandated by the Dodd-Frank Act, the treatise further noted that two SEC commissioners raised concerns about the recommendation in a public statement because, in part, the study lacked sufficient analysis. (See Loss, Seligman & Paredes, Securities Regulation, a Wolters Kluwer Legal & Regulatory U.S. publication, at Chapter 8.A.1.).

"Solely incidental." The Commission, in the context of Regulation BI, also addressed via an interpretive release several potentially confusing issues regarding Regulation BI and the Investment Advisers Act’s exclusion of certain broker-dealer activities. Advisers Act Section 202(a)(11) defines "investment adviser" to mean, among other things, any person who is compensated for engaging in the business of advising others about the value of securities. Advisers Act Section 202(a)(11)(C) excludes from this definition any broker-dealer who performs these services in a manner that is "solely incidental" to the conduct of the broker-dealer business and who does not receive "special compensation" for those services; this exclusion is known as the broker-dealer exclusion.

The Commission’s new interpretive release, issued the same day it adopted Regulation BI, states in relevant part: "We interpret the statutory language to mean that a broker-dealer’s provision of advice as to the value and characteristics of securities or as to the advisability of transacting in securities is consistent with the solely incidental prong if the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions."

XYPN’s complaint, but not the states’ complaint, further observed that the "harmful consequences" of Regulation BI could be "exacerbated" due to the interpretive release. Specifically, the complaint posits that the Commission’s interpretive release seeks to revive an expansive view of the Advisers Act’s catch-all provision allowing the Commission to exempt "such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order" (See Investment Advisers Act Section 202(a)(11)(H)). According to XYPN, the interpretive release, thus, runs afoul of a 2-1 decision by the D.C. Circuit in 2007 invalidating the Commission’s attempt to create an exemption for another set of broker-dealers beyond those mentioned in Advisers Act Section 202(a)(11)(C). The majority in that case consisted of Judge Judith Rogers (author of the opinion) and now-Supreme Court Justice Brett Kavanaugh; Chief Judge Merrick Garland dissented because he believed that Chevron required deference to the Commission's interpretation.

XYPN’s co-founder, Michael Kitces, had commented on proposed Regulation BI noting both that the proposed standard for broker-dealers would perpetuate the confusion that already existed among retail investors about what standards apply to investment advisers and to broker-dealers. The comment also posited that the SEC had elided the fact that, absent a narrow exception for "solely incidental" services, broker-dealers are required to register as investment advisers if they want to give investment advice to customers.

Standing. It is axiomatic that in order to bring suit in federal court a party must have standing to do so. XYPN asserted that its members could be harmed by the anti-competitive effects of Regulation BI. Put another way, XYPN claims its members, who take a "fiduciary oath" and are registered investment advisers, could, among other things, lose business if broker-dealers are able to market themselves as pursuing their customer’s best interest all the while adhering to a lower legal standard than is applicable to investment advisers.

The states’ complaint, by contrast, asserts that they could lose tax revenue from the taxable portions of their residents’ retirement accounts if broker-dealers are able to give conflicted investment advice under Regulation BI. The states also assert that they may incur "a greater financial burden" if they must assist retirees who have reduced financial means. Moreover, the states posit that they have a "quasi-sovereign" obligation to look out for their resident’s economic well-being.

The case is No. 19-cv-08415.

Thursday, 12 September 2019

House subcommittee examines whether private offering exemptions are barrier to IPOs and retail investment

By John Filar Atwood 

The rapid growth of private markets and the decline in IPOs over the past few decades have given rise to a number of legislative proposals aimed at improving investment opportunities for retail investors. The House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets met today to discuss some of those bills and whether private offering exemptions create a barrier to IPOs and retail investment.

Subcommittee Chair Carolyn Maloney (D-NY) noted that private markets are now more than twice the size of public markets—in 2018 issuers raised $2.9 trillion in exempt offerings compared to $1.4 billion through public offerings. This raises questions such as whether Congress should permit retail investors to participate in private markets, and whether private offerings are actually better investment opportunities or not, she said. The SEC has relaxed the rules around private markets for decades, and it is time to ask whether it has gone too far in deregulating, Maloney added.

Mike Pieciak, Vermont commissioner of Financial Regulation and past president of the North American Securities Administrators Association, testified that NASAA is concerned that the current regulatory regime has gone too far in favoring private capital raising over public markets. However, he does not believe the solution is to encourage retail investors to get into the private markets.

Definition of accredited investor. Pieciak is not in favor of the proposals in the Fair Investment Opportunities for Professional Experts Act that would expand the definition of “accredited investor,” allowing more investors to access exempt offerings. NASAA is deeply concerned over the lack of information about private markets, he said. Public information is essential to the proper functioning of the markets, so Congress should work to reinvigorate and grow the public markets rather than encourage retail investors to enter the private markets, he added. 

Elisabeth de Fontenay, a law professor at Duke University, said that research suggests that retail investors would do worse if they were allowed into private markets. In the private markets, there are unregistered, unregulated investments with poor return prospects, she noted. In response to questions from Alexandria Ocasio-Cortez (D-NY), she acknowledged that retail investors would not have access to a reasonable valuation in private market, would have no audited financial statements, and would not be notified if a private company is under investigation.
In de Fontenay’s view, legislative proposals should encourage more companies to go public. This may require reversing the provisions of the JOBS Act that allow companies to stay private indefinitely, she advised.

JOBS Act changes. Renee Jones, a law professor at Boston College, agreed with de Fontenay, stating that the most effective way for Congress to shore up shrinking public equity markets is to reverse the JOBS Act amendments to Section 12(g). Section 12(g) allows unicorns (private companies with greater than $1 billion in market capitalization) to delay an IPO indefinitely, allowing important companies to operate in secrecy, she stated.

Congress should at least impose minimum disclosure obligations for companies of a certain size with dispersed ownership patterns, Jones testified. This reform would increase pressure for an IPO or sale, and provide needed information for investors considering purchasing shares, she said.

Doug Ellenoff, a partner at Ellenoff Grossman & Schole LLP, said the he favors the proposal to broaden the definition of “accredited investor” but would not support any changes to the JOBS Act. Private markets and public markets exist for very different reasons and constituents, he noted, and regulators should ensure that both are operating well with minimum regulation. In his view, companies should be allowed to remain private if they so choose, regardless of their size.

Cost of being public. Ellenoff emphasized that the cost of being public is burdensome. A meaningful percentage of a company’s profits go to preparing initial disclosures, he noted, and that money is out of pocket before a company knows whether its offering will be successful.

Subcommittee member Trey Hollingsworth (R-Ind) related a story about the CEO of a newly-public Indiana company who told him that it is very costly to be a public company. The CEO estimated that his company was spending $12.5 million per year to be public. Hollingsworth said that newly public companies need a runway where costs increase as a company grows rather than being hit with the high costs immediately.

Report to Congress. Witnesses also discussed the merits of a bill that would require the SEC to submit a report to Congress about private securities offerings. Among other things, it would require the Commission to conduct an impact study before proposing or adopting any change to a rule regarding either exempt offerings or reporting requirements for public companies.

While several panelists supported the legislation, Ellenoff does not. He noted that the SEC has already begun an effort to harmonize the offering framework by issuing a concept release in June. Any legislation in this area might get in the way of the SEC’s efforts, he said, and encouraged Congress to just let the Commission do its job.

Wednesday, 11 September 2019

SEC proposes accountability requirements to speed CAT NMS Plan implementation

By Rodney F. Tonkovic, J.D.

The SEC has proposed amendments intended in part to facilitate the implementation of the national market system plan governing the Consolidated Audit Trail. Participating self-regulatory organizations would be required to file and publish complete implementation plans and progress reports. The proposed amendments also include financial accountability provisions establishing deadlines for four implementation milestones; if these deadlines are missed the amount of fee recovery available to the participants is reduced (Proposed Amendments to the National Market System Plan Governing the Consolidated Audit Trail, Release No. 34-86901, September 9, 2019).

The plan. On November 15, 2016, the SEC voted unanimously to approve a proposed national market system plan to create, implement, and maintain a consolidated audit trail that will allow regulators to track all activity throughout the U.S. markets in NMS securities. The plan was submitted by participating self-regulatory organizations in response to a requirement in Rule 613 of Regulation NMS.

Implementation status. Under the original deadlines in the CAT Plan, participants would begin recording and reporting data to the Central Repository by November 15, 2017. This and multiple other deadlines were not met, however, and the participants sought an extension, but the request was rejected by the Commission. According to a statement by Chairman Clayton on the CAT's status however, some progress has been made: the SROs began reporting certain data to the CAT; the SROs have published final specifications for the initial reporting of equities and options to facilitate broker-dealer reporting; and the SROs and the broker-dealer industry are working together to develop ways to conduct Large Trader Reporting.

"CAT needs to be implemented without further delays," said Chairman Jay Clayton. "The proposed amendments are designed to bring greater transparency and accountability to the implementation of the CAT." In the status report, Clayton also expressed his belief that "next six to twelve months will be critical for moving the CAT from concept to reality."

Proposed amendments. The proposed amendments are intended to ensure that the plan participants fulfill their obligations to deliver a functional CAT in a reasonable time frame, the proposal states. Participants would be required to develop a complete implementation plan (plus quarterly progress reports) with a detailed timeline and objective milestones. Each plan and progress report must be approved by the operating committee established by the CAT Plan and submitted to the participant's CEO, President, or equivalently situated senior officer. The formal and publicly-available progress reports are meant to increase accountability, and there would also be financial accountability if implementation milestone dates are not met.

Operational transparency. The CAT Plan does not currently have provisions requiring participants to provide public updates on implementation progress. To address this concern, the Commission proposes to amend Section 6.6 of the Plan by adding a new Section 6.6(c) requiring that:
  • Participants with the Commission, and make publicly available, a detailed implementation plan and ongoing quarterly progress reports. 
  • Each document must be submitted to the CEO, President, or an equivalently situated senior officer at each Participant and then approved by a supermajority vote of the Operating Committee. 
  • To the extent that any document is not approved by a unanimous vote of the Operating Committee, each Participant whose Operating Committee member did not vote to approve the document must separately file with the Commission, and make publicly available, a statement identifying itself and explaining why it did not vote to approve the document in question.
Financial accountability. To prevent additional delays, the Commission proposes to establish target deadlines for four critical implementation milestones. When the CAT Plan was approved, it provided for participants to recover implementation fees, costs, and expenses from their industry members. If participants miss the implementation milestones, the amount of CAT funding that they can recover from Industry Members will be reduced at regular intervals. The target dates and milestones, which are discussed in detail in the proposal are: 
  • April 30, 2020: Initial Industry Member Core Equity Reporting;
  • December 31, 2020: Full Implementation of Core Equity Reporting Requirements;
  • December 31, 2021: Full Availability and Regulatory Utilization of Transactional Database Functionality; and
  • December 31, 2022: Full Implementation of CAT NMS Plan Requirements. 
Comments should be received within 45 days following publication of this proposal in the Federal Register.

The release is No. 34-86901.

Tuesday, 10 September 2019

SEC advisory committee recommends ‘proxy plumbing’ changes

By Amanda Maine, J.D.

The SEC’s Investor Advisory Committee recently voted to approve a series of recommendations regarding the Commission’s rules on “proxy plumbing,” or the mechanics of communication and voting under the proxy rules. While the recommendation was approved by a distinct majority of the IAC, some members dissented due to some specific language used in the text and the recommendation to adopt with some changes the 2016 proposal on universal proxy.

Recommendation. The approved recommendation consists of four parts: (1) requiring end-to-end vote confirmations; (2) reconciliation of vote-related information; (3) conducting studies on investor views on anonymity and share lending; and (4) adopting the SEC’s proposed universal proxy rule with certain changes.

Regarding end-to-end vote confirmations, the recommendation notes that investors are currently unable to determine whether their voting instructions for shares they own are carried out and counted in votes. In implementing the confirmation requirement for end-users, the SEC should require that confirmations indicate that proxies and/or voting instructions were received and implemented, or if not, give a reason as to why not. Confirmations could take any reasonable form, including electronic delivery or delivery through the system already developed by proxy servicing firm Broadridge Financial Solutions.

A duty to cooperate in regular reconciliations is driven by routine errors and mismatches in the system in place today, according to the recommendation. The SEC should therefore require every participant in the proxy system to cooperate with the others to reconcile ownership and voting information on a regular basis. The recommendation advised that costs associated with this requirement would fall over time as the process becomes more routine.

The staff should study the reasons for and the extent to which customers of intermediaries actually want to remain anonymous (that is, to not be “non-objecting beneficial owners” or “NOBOs”) to the companies in which they own stock, the committee recommended. A second study should examine the extent to which share lending contributes to errors, over-votes, or under-votes, as well as whether the effect of share lending on voting entitlements is effectively disclosed to investors. Both studies would inform further monitoring or rulemaking by the Commission.

Finally, the IAC recommended that the SEC move forward on implementing a universal proxy to allow shareholders to vote for the combination of nominees they wish to represent them. The committee offered suggestions to revise certain aspects of the Commission’s 2016 proposal, including revisiting what percentage of shareholders dissidents should be required to solicit to be able to use universal proxy and addressing the issue of incumbents that may refuse to serve if elected to a split slate.

Objections. While most committee members approved of the recommendation, some members dissented. Professor J.W. Verret of Antonin Scalia Law School at George Mason University expressed his dissatisfaction that the recommendation did not address the role of proxy advisory firms. According to Verret, the proxy system is so interrelated that the issue of proxy advisors should have been considered as part of the recommendation. He also was disappointed that the recommendation did not consider revising the rules on shareholder proposals, some of which are “conflicted and politically motivated,” Verret lamented.

Verret and Lydia Mashburn of the Cato Institute also expressed concern about the universal proxy recommendation. Verret said that what the committee is recommending goes further than the IAC’s previous recommendation, which encouraged the SEC to remove barriers to universal proxy, not mandate them.

Mashburn also took issue with some of the language included in the recommendation: “We do not believe private actors will improve the system without SEC intervention.” Mashburn disagreed with this characterization and said she could not put her name on it. However, she indicated that she was in favor of the recommendations regarding confirmations and reconciliation.

Professor John Coates of Harvard Law School, who chaired the Investor-as-Owner subcommittee that developed the recommendation, agreed that there is work yet to be done regarding shareholder proposals and proxy advisory firms to improve the proxy system. However, he added that wanted to recognize that those issues may involve some tricky policy issues and political tradeoffs that may make it hard to progress in those areas and may need to be worked through in the form of a comment process.

Monday, 9 September 2019

FASB proposes guidance to ease transition in benchmark reforms

By Lene Powell, J.D.

With trillions of dollars in loans, derivatives, and other contracts expected to move away from LIBOR and other benchmarks toward alternative reference rates, the Financial Accounting Standards Board (FASB) has issued a proposed Accounting Standards Update (ASU) that would provide temporary optional guidance to ease the potential burden in accounting for, or recognizing the effects of, reference rate reform on financial reporting.

“The FASB is committed to providing stakeholders with the guidance they need to ease the process of migrating away from LIBOR and other interbank offered rates to new reference rates,” said FASB Chairman Russell G. Golden. “The Board’s proposal will address operational challenges they have raised and ultimately help simplify the process while reducing related costs.”

Migration from LIBOR. Responding to concerns about structural risks of LIBOR and other interbank offered rates, regulators around the world have been working on reform initiatives to identify alternative reference rates that are more observable or transaction-based and less susceptible to manipulation. In late July, IOSCO issued a statement emphasizing the need to move away from LIBOR and identifying specific topics for LIBOR users to consider, including risk-free rates (RFRs), infrastructure, conventions, fallbacks, term rates, regulatory dependencies, communication, and international engagement. The SEC and CFTC have also stressed the need to switch to alternative reference rates.

Proposed FASB guidance. Given the significant volume of contracts and other arrangements like debt agreements, lease agreements, and derivative instruments that reference LIBOR and other interbank offered rates, benchmark reform poses significant operational challenges in terms of the need to modify existing contracts. As FASB explained in a fact sheet, certain accounting issues may arise. For example, changes in a reference rate could disallow the application of certain hedge accounting guidance, and certain hedge relationships may not qualify as highly effective during the period of the market-wide transition to a replacement rate.

The proposed guidance, “Facilitation of the Effects of Reference Rate Reform on Financial Reporting,” would:
  • Simplify accounting analyses under current GAAP for contract modifications if qualifying criteria are met;
  • Allow hedging relationships to continue without dedesignation upon specified changes in the critical terms of an existing hedging relationship due to reference rate reform;
  • Provide optional expedients for existing fair value hedging relationships for which the derivative designated as the hedging instrument is affected by reference rate reform;
  • Provide temporary optional expedients for cash flow hedging relationships affected by reference rate reform. 
The proposed amendments would be:
  • Applicable to all entities, subject to meeting certain qualifying criteria;
  • Limited to contracts and hedging relationships that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform;
  • Elective, not required;
  • Temporary; the amendments would not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022. 
Next steps. FASB encouraged stakeholders to review and comment on the proposed ASU by October 7, 2019.

Friday, 6 September 2019

IAA recommends tweaks to FINRA proposals to amend IPO rules

By Amy Leisinger, J.D.

The Investment Adviser Association has submitted comments to the SEC on the Financial Industry Regulatory Authority’s proposal to amend FINRA Rules 5130 and 5131 governing purchases and sales of initial public offerings. According to IAA, the proposed changes would remove certain barriers to capital formation and increase the availability of new issues. However, the organization contends, certain conditions in the proposed changes to exemptions are overly narrow, and FINRA should modify them to remove quantitative thresholds.

In its comments, IAA notes that FINRA’s IPO rules are designed to ensure that broker-dealers make fair offerings of securities and that they and other insiders do not take advantage of their positions for their own benefit. However, the organization explains, IAA members’ clients may not currently meet the requirements of foreign investment company exemption from prohibitions on investment and are sometimes restricted in their ability to invest in new issues on behalf of foreign plan clients. The proposed changes would address these concerns, IAA states.

Quantitative thresholds. IAA takes issue, however, with the quantitative thresholds in the proposed foreign plan exemption, specifically the requirement that a foreign plan have at least $10 billion in assets and 10,000 participants to qualify. According to IAA, some of its members come close to, but do not meet, these thresholds, and prohibiting these entities from investing in new issues on behalf of foreign plan clients would not serve the policies underlying the rule. Further, the organization contends, a specific minimum of assets and clients is not necessary to show that a foreign plan lacks a concentration of interest, and the other conditions of the proposed exemption are sufficient to prevent manipulation or abuse.

IAA also urges FINRA to remove the quantitative thresholds from the foreign investment company exemption. The proposal would create alternatives to the current requirement that no person owning more than 5 percent of a foreign investment company’s shares be a restricted person—that the company has 100 or more direct owners or 1,000 or more indirect owners. However, according to IAA, none of these three quantitative tests is necessary to demonstrate that a foreign investment company is widely held. Quantitative tests are not used to ensure that a U.S. investment company is widely held, and they should not be deemed necessary for a foreign public fund, the organization states. The conditions that the fund is listed for sale to the public and was not formed for the purpose of investing in new issues are sufficient to achieve the objectives of the rule, IAA concludes.

Thursday, 5 September 2019

Hearing to determine CFTC’s contempt in Kraft Foods matter continued until October

By Brad Rosen, J.D.

In this closely watched case, Judge Sharon Johnson Coleman of Northern District of Illinois granted the CFTC’s emergency motion filed on August 28, 2019, under seal, to continue a previously scheduled hearing for September 12, 2019 to October 2, 2019. The deadline for submitting for prehearing briefs was also extended. As the agency’s motion was filed under seal, it is not publicly available and the basis for the CFTC requesting the continuance is unknown. On August 30, 2019, the defendants Kraft Foods Group, Inc., Mondelez Global LLC filed responses to the CFTC’s filing, which similarly were under seal and unavailable to the public (CFTC v. Kraft Foods Group, Inc., August 30, 2019, Coleman, J.).

Judge Blakey, the presiding judge in the case, is scheduled to conduct the evidentiary hearing on October 2nd where CFTC Chairman Heath Tarbert, Commissioners Rostin Behnam and Dan Berkovitz, and Division of Enforcement Director James McDonald will be required to appear, testify, and be subject to cross examination.

Relief granted to the CFTC and recent developments. In addition to continuing the evidentiary hearing to October 2, 2019, Judge Coleman also granted the additional relief requested in CFTC’s emergency motion:
  • Leave to file an oversized brief;
  • The briefing deadline for the motion for contempt, sanctions, and other relief has been extended to September 23, 2019; and
  • The court entered the CFTC’s emergency motion to vacate the minute order dated August 19, 2019 entered by the court.
In other developments, on September 30, 2019, CFTC General Counsel Daniel J. Davis, and Deputy General Counsel also filed appearances in the case on behalf of the Commodity Futures Trading Commission.

A strange trip its been. The genesis of the current dispute goes back to August 14, 2019, when Kraft, Mondelez, and the CFTC entered into a consent order whereby it was agreed that the defendants would pay $16 million to resolve CFTC claims they manipulated wheat futures prices. That consent order was unusual in two respects. First, Kraft, Mondelez, and the CFTC (as a full Commission) were limited in their ability to speak publicly about the case. Moreover, the order was void of any factual findings or conclusions of law, which is out of the ordinary in these types of regulatory settlements.

What happened next was even more unusual. On August 15, 2019, the CFTC issued a press release, a statement about the case where the agency boasted that the penalty was valued at three times the defendants’ gain from the alleged wrongdoing, among other things. Additionally, CFTC Commissioners Behnam and Berkovitz issued a joint statement freely sharing their thoughts about the settlement and its policy implications. They claimed the gag provision did not apply to them.

Not surprisingly, Kraft and Mondelez took issue with the CFTC and commissioner public statements. On August 16, 2019, they filed an emergency motion for contempt and sanctions charging the CFTC with deliberately violating the consent order. In an initial hearing on August 19, 2019, Judge Blakey ordered key CFTC officials to appear at the evidentiary hearing (now set for October 2, 2019) to provide further explanation with regard to the various public statements made.

Developments in this highly unusual case will remain closely watched by regulatory and criminal attorneys across the country.

The case is No. 15-cv-02881.

Wednesday, 4 September 2019

Kokesh casts no doubt on prior rulings on disgorgement in SEC enforcement proceedings

By Rodney F. Tonkovic, J.D. 

A Second Circuit panel has affirmed a district court judgment ordering the payment of disgorgement. The court rejected the appellant's argument that the district court lacked the authority to impose disgorgement after Kokesh v. SEC and denied challenges to the remedies calculations (SEC v. de Maison, August 30, 2019, per curiam).

Pump-and-dump scheme. Angelique de Maison was part of a ring of individuals charged taking part in a pump-and-dump scheme involving a microcap company. According to the Commission, de Maison's husband, Izak Zirk de Maison F/K/A/ Izak Zirk Engelbrecht, orchestrated a scheme starting with the installation of associates as officers and directors of Gepco Ltd., a publicly traded microcap issuer, while he secretly ran the company and illegally transferred shares to the associates. The de Maisons then manipulated the market for Gepco's stock, with Angelique seeking out investors to purchase unregistered securities in two fraudulent issuers.

The Commission first brought this action in 2014. After an amended complaint was filed in July 2015, settlements were reached late that year with several of the defendants, including de Maison. Under the terms of the judgment and consent, de Maison agreed to pay disgorgement and a civil penalty, and the Commission moved for relief in January 2018. In July 2018, the district court ordered de Maison to disgorge $4,240,049.30, plus prejudgment interest, and to pay a third‐tier civil penalty of $4,240,049.30.

Kokesh argument rejected. On appeal, de Maison's principal argument was that, after Kokesh v. SEC, the district court lacked the authority to impose disgorgement. She asserted that disgorgement is historically rooted in equity and that equitable relief does not include penalties. Kokesh, de Maison said, held that disgorgement in the securities context is always a penalty and is thus no longer an authorized remedy.

The panel rejected this argument. While a panel is not bound by the decision of a prior panel where an intervening Supreme Court decision casts doubt on the earlier ruling, that was not the case here. The panel noted that the Supreme Court in Kokesh explicitly said that was not opining on whether courts have authority to order disgorgement in SEC enforcement proceedings. Concluding that Kokesh did not disturb Second Circuit precedent on disgorgement in SEC enforcement proceedings, the panel stated that de Maison's argument must await consideration by an en banc court or by the Supreme Court.

Disgorgement affirmed. De Maison then challenged the district court's calculation of the disgorgement amount. Here, de Maison made several arguments regarding where the proceeds of the illegal sales went, but the court said that all this was a "collective distraction." De Maison, the court said, confused what made the gains "ill-gotten" in the first place: the fact that she was selling unregistered securities and was not a registered broker‐dealer.

The judgment of the district court was accordingly affirmed. The ruling is by summary order and is without precedential effect.

The case is No. 18-2534.