Friday, 29 November 2019

NYC comptroller expresses ‘strong opposition’ to SEC proxy proposals

By Joanne Cursinella, J.D.

In a strongly worded letter to the Commission, the comptroller of the City of New York criticized recent proxy proposals and called for longer comment periods. According to the letter, the comptroller wrote to the SEC to provide preliminary comments in strong opposition to the proposal, "Amendments to Exemptions from the Proxy Voting Rules for Proxy Voting Advice" (the "Proposal"), and to request that the SEC extend the comment period from 60 to 120 days so that interested parties the time necessary to prepare responsive comments. He also opposed the concurrently issued proposal, "Procedural Requirements and Resubmission Thresholds under Exchange Act Rule 14a-8" (the "Shareholder Proposal Rule"), and requested a similar extension of its comment period.

The Commissioners voted 3-2 to approve issuing the proposals for comment on November 5, 2019.

Remedy for nonexistent problems? The proposals seek to remedy problems that do not exist and will radically tilt an already uneven playing field further in favor of corporate management and away from investors, who actively and responsibly exercise longstanding rights to cast informed proxy votes and to submit shareowner proposals to hold companies accountable for runaway CEO pay, excessive risk taking, and irresponsible and harmful business practice, the comptroller claimed, calling them a two-pronged attack on rights—proxy voting and shareowner proposals.

In his role as the proxy voting fiduciary for the New York City Retirement Systems (NYCRS), the comptroller stated that in response to the "steady drumbeat" from corporate management and their lobbyists for the regulation of proxy advisory firms in recent years, evaluation criteria with respect to any potential regulation has been clear and consistent: "We oppose any SEC or other regulatory actions that would compromise the independence of research, reduce the amount of time we have to review research in advance of our portfolio companies’ annual meetings, or that would otherwise impose additional costs on our participants and beneficiaries in terms of either added burdens on staff resources or additional compliance costs imposed on our advisors," which paying clients would ultimately bear.

In light of the harm and costs that the Proposal is likely to impose on investors, and the benefits it will bestow upon the corporate management "who have aggressively lobbied for it," the comptroller said, investors are left to wonder what problems that the SEC is seeking to remedy here.

Quality of advice. According to the comptroller, instead of improving the quality of the proxy advisors’ research, the Proposal is likely to have the opposite effect. By giving companies (at least those that file their proxy statement at least 25 days before the annual meeting) at least three business days to review the proxy research report and two business days of notice before the report is issued, the advisers will have less time to collect, verify, analyze, and present data and provide their research and present data and provide their research reports to clients well in advance of the annual meeting.

Insidious conflict of interest. While proxy advisory firms should and do have procedures in place to mitigate any potential conflicts of interest, the comptroller could not imagine a conflict of interest more "insidious" than the one created by a proposal that would grant a company that is the subject of proxy voting advice the right to review and provide feedback on that advice. FINRA Rule 2241, which the SEC approved, he commented, explicitly prohibits stock analysts from sharing draft research reports with target companies (other than to check facts after approval from the firm’s legal or compliance department) in order to "help protect research analysts from influences that could impair their objectivity and independence," he pointed out.

Long-term. "We recognize our responsibility to vote proxies with diligence and integrity, and in the best long-term interests of our participants and beneficiaries." the comptroller said. "We do not want company management interposed between us and our research service providers, and this is even more problematic if it involves additional cost and delay, giving us less time for our due diligence on each proxy vote." Therefore "[W]e strongly oppose the proposed rule as unnecessary, costly and harmful not only to investors, but also to the promotion of fair and efficient markets," he concluded.

Wednesday, 27 November 2019

Dueling motions argue whether sports betting pools are securities

By Rodney F. Tonkovic, J.D.

Defendants charged by the SEC with operating a fraudulent sports betting scheme denied the accusations, arguing that betting pools are not securities. The motion to dismiss says that gambling contracts rest on the outcome of a game and are not based on any concrete asset and that to hold otherwise would disrupt the legal gambling industry in Nevada. The Commission counters that established precedent conclusively shows that the contracts are securities (SEC v. Thomas, November 19, 2019).

The scheme. The Commission filed a complaint in August 2019 alleging that two convicted felons, John F. Thomas and Thomas Becker, engaged in a $29 million sports betting investment scheme impacting over 600 investors from more than 40 states. Thomas and Becker raised funds by offering investments in six entities founded by them offering pooled investment contracts promising shares in profits generated from a proprietary sports betting system. The majority of the investors' money, however, went to fund Thomas and Becker's lifestyles, pay commissions to brokers and agents, or make Ponzi-like payments to other investors. The Commission alleged that the defendants violated the antifraud provisions of the securities laws (Claims 1 and 2), the registration provisions of Securities Act Section 5 (Claim 3), and the broker-dealer registration provisions (Claim 4).

Motion to dismiss. One of the six entities, Wellington Sports Club, LLC moved to dismiss the first three claims for relief. The crux of the motion's argument is that the sports betting contracts at issue are not securities. The defendants assert that district courts in Nevada and in the rest of the Ninth Circuit have consistently held that sports gambling and other wagers are not within the scope of the securities laws. The investor in a gambling contract, the motion says, never gains an interest in an underlying asset because these contracts rest on the outcome of a game and have no tie to established financial markets.

The defendants also declare that pooling funds for gaming purposes is "omnipresent in and essential to the economy of Nevada" and eliminating such betting would "fundamentally alter legalized sports gambling." Gambling coincidentally resembles securities in that chance has a role in financial gain, but to conclude that it is thus a security would grant the SEC carte blanche to regulate activities having no connection to the securities markets and would render meaningless provisions of the U.S. Code that govern legal gambling.

The motion argues further that the complaint fails to identify any specific misrepresentations and never identifies a client (out of 600), date, or amount with enough specificity for the defendants to ascertain on what the Commission's case will be based. According to the motion, the complaint points generally to over four years of financial records and concludes that only a portion of the funds received went to sports betting. In the alternative, the motion asks that the court order the Commission to amend the complaint to identify specific misrepresentations, parties, and transactions.

The SEC's answer. In response, the Commission maintains that the investment contracts in this case are securities. Arguing that the cases cited by the defendants are unrelated, the Commission says that Howey governs here: in return for an investment, investors received contracts specifying that their funds, pooled with money from other investors, would be used to place bets and that they would all share in the profits generated by the betting. The contracts are securities, the Commission flatly states, and, moreover, the defendants do not contest any of the complaint’s allegations demonstrating that they offered investment contacts that meet the Howey test.

The Commission then addresses and rejects the argument that the SEC lacks jurisdiction because gaming is a regulated industry. First, the Unlawful Internet Gambling Enforcement Act, for example, expressly states that an activity is not a bet or wager if it is governed by the securities laws. And, the fact that gambling, or any other industry, is subject to one regulatory regime does not mean that it is not subject to any others. The Commission noted here that it has brought enforcement actions against similar betting contracts.

The Commission then explains that investment contracts for sports betting are not "outside" of the reach of the securities laws, particularly the registration provisions. First, investors making a decision to pool their money with others and relying on the defendants to bet on their behalf deserve the financial data and other information that a registration statement provides. And, while the defendants argued that it would be difficult and expensive to register, that is not an excuse, the Commission said.

Finally, the complaint provides sufficient notice for the defendants to prepare an answer. The complaint alleged the specific misrepresentations and when they were made, the Commission says. Also, since the SEC does not need to show reliance, it does not need to identify specific victims in order to state a claim. The Commission concluded its opposition by reiterating its allegations and asserting that it pleaded all the elements necessary to establish violations.

The case is No. 2:19-cv-01515.

Tuesday, 26 November 2019

Bipartisan bill would bring managed stablecoins within definition of ‘security’

By Mark S. Nelson, J.D.

The bipartisan Managed Stablecoins Are Securities Act of 2019, sponsored by Reps. Sylvia Garcia (D-Tex) and Lance Gooden (R-Tex), would address worries these lawmakers have about the entry of Facebook’s proposed Libra virtual currency into the cryptocurrency markets. The bill was first floated as a discussion draft at an October 2019 hearing of the House Financial Services Committee at which Facebook CEO Mark Zuckerberg had appeared as the sole witness. A press release formally announcing the bill said it would help protect consumers by subjecting stablecoins to regulatory oversight.

House FSC hearing. At the House FSC’s October hearing, Reps. Gooden and Garcia asked about how Libra would be managed and why it is not currently expected to be based in the U.S. Zuckerberg told Rep. Gooden that Facebook’s Calibra digital wallet subsidiary and other relevant Facebook platforms (e.g., What’s App and Facebook Messenger) are U.S. products and that reserves held by the Libra Association (Libra’s governing body) would be "primarily" U.S. dollars. Representative Gooden observed that he was less against Libra than he was previously, but that it remained difficult to back "something so big" if it is based outside the U.S.

Representative S. Garcia, following up on a question by Rep. Jesus "Chuy" Garcia (D-Ill), asked Zuckerberg directly whether Libra was a stablecoin. Zuckerberg agreed that it was a stablecoin. In later questioning, Rep. S. Garcia asked how the Libra Association would be able to maintain a one-to-one ratio that ensures stability when the association likely would have to use a basket of global currencies, such as euros, yen, and U.S. dollars, but without being backed by the full faith and credit of the U.S. Zuckerberg said he believed that the association would be able to do this and that was the "default" plan.

Stablecoin defined. The Managed Stablecoins Are Securities Act (H.R. 5197) would amend the definition of "security" contained in the Securities Act, the Exchange Act, the Investment Company Act, and the Investment Advisers Act to explicitly include the term "managed stablecoin" and to clarify that an item is a security regardless of its form. The bill would then add new definitions to the Securities Act for the terms "digital asset" and "managed stablecoin." A sense of Congress in the bill posits that managed stabelcoins are investment contracts and, thus, are securities.

The term "digital asset" would have several key characteristics: (1) it would be an asset, contract, agreement, or transaction (including a representation of an economic, proprietary, or access right); (2) a digital asset must be stored in a computer-readable format; and (3) a digital asset’s transaction history must be recorded in a distributed ledger or other type of digital ledger or structure. A digital asset, the bill states, may be a managed stablecoin and a security.

As a preliminary matter, a "managed stablecoin" must not be a digital asset that is a registered security under Section 8(a) of the Investment Company Act. To be a managed stablecoin, a digital asset must otherwise satisfy at least one of two criteria:
  • The digital asset’s value is determined by the value of a reference pool or basket of assets (including digital assets) that is managed by one or more persons; and/or
  • One or more holders of a digital asset are entitled to consideration or assets in exchange for the digital asset in an amount fixed in significant part by the value of a reference pool or basket of assets (including digital assets) that are managed by one or more persons.
The portion of the Exchange Act’s definition of "security" that states what is not considered a security would be revised to clarify that the term "currency" means "sovereign currency," presumably to distinguish legal tender from virtual currencies, a distinction that could require still further clarification if central banks around the world were to adopt their own digital currencies. The bill also would authorize the SEC to further refine the meaning of "digital asset" and "managed stablecoin" via regulation.

Executive compensation. A related discussion draft published by Michael F. Q. San Nicolas, the delegate from Guam, would limit companies’ ability to issue securities if their leaders are, among other things, paid in managed stablecoins. Specifically, the proposal would direct the SEC to require stock exchanges to bar the listing of an issuer’s security if, following registration of the security, the issuer or its executives or directors: (1) received managed stablecoins as compensation; (2) bought or sold a managed stablecoin; or (3) were affiliated with a person who bought or sold a managed stablecoin after the security was registered. Delegate San Nicolas’s discussion draft borrows the definitions of "digital asset" and "managed stablecoin" from the proposed Managed Stablecoins Are Securities Act.

Delegate San Nicolas also queried Zuckerberg at the October House FSC hearing on Libra. Specifically, the delegate had asked about whether Libra, an asset-backed currency, could manage a basket of fluctuating currencies. The delegate also asked more pointedly, who is responsible if Libra fails? Zuckerberg replied that the delegate’s concerns had been considered in developing Libra but that some economists would argue the basket of currencies approach is more stable than focusing on a single currency. Zuckerberg also said the Libra Association would have reserves and that the Financial Stability Oversight Council would be involved in discussions about Libra.

Monday, 25 November 2019

Division of Corporation Finance launches new shareholder proposal response procedures

By John Filar Atwood

The Division of Corporation Finance officially began its new Rule 14a-8 shareholder proposal response procedure yesterday with replies to no-action requests from Oshkosh Corp. and QUALCOMM Inc. The staff posted a chart indicating that it will allow both companies to exclude the subject proposals from their proxy materials. Oshkosh received its response in writing, while QUALCOMM received the first oral response of the 2019-2020 proxy season.

The staff officially announced the new approach in September, indicating that it would respond to some no-action requests orally instead of in writing. At a recent industry conference, Deputy Director Shelley Parratt said the staff plans to update the new chart once or twice each week. In her view, the chart will make it easier to track the staff’s work on Rule 14a-8 no-action letters.

In public appearances over the past year, Division Director William Hinman indicated that the new procedure was born out of necessity following the early 2019 government shutdown. Faced with a large backlog of no-action requests after the shutdown ended, the staff responded orally to many of them to ensure that companies got their responses expeditiously. The system worked well, and the staff decided to adopt it on an ongoing basis.

Written responses. Under the new approach, the staff will continue to respond in writing to many letters, as evidenced by the Oshkosh entry on the new chart. The staff said that one instance in which it will issue a response letter is when it believes doing so would provide some value, such as more broadly applicable guidance about complying with Rule 14a-8.

The new chart indicates whether the staff responded to a request in writing or orally. In a "Staff’s Response" column on the chart, the staff will indicate whether it agreed, disagreed, or expressed no opinion on whether the company may omit the shareholder proposal in question.

The staff has provided clarifying language along with the chart that addresses cases in which a company’s request asserts multiple regulatory bases for exclusion. If the staff concurs that the proposal may be excluded, the decision will be based on one of the bases asserted by the company and the staff will not address the others. If the staff denies a company’s request for exclusion when multiple bases are asserted, the staff will not concur with any of the bases asserted by the company.

Oshkosh. The staff received a request from Oshkosh that it be allowed to omit a proposal received from John Chevedden. The proposal requests that Oshkosh’s board of directors adopt a requirement that director nominees be elected by the affirmative vote of the majority of votes cast at an annual meeting of shareholders, with a plurality vote standard retained for contested director elections.

Chevedden went on to request that a director who receives less than a majority vote be removed from the board immediately. The proposal allows that if this director has key experience, he or she can transition to work as a consultant. In addition, if the board deems it critical to have this person as a director, then the board can reappoint the director to the board on a temporary basis and report the basis for its decision.

Oshkosh sought to exclude the proposal based on either Rule 14a-8(i)(2) or Rule 14a-8(i)(6). The staff concurred that the company could use (i)(2) as a basis for exclusion. Rule 14a-8(i)(2) states that a shareholder proposal may be omitted from a company’s proxy materials if it would cause the company to violate state law. Oshkosh successfully argued that the proposal, as it relates to incumbent directors, is directly contrary to the Wisconsin Business Corporation Law because there is no action the company or its board could lawfully take to effect immediate removal of a director under Wisconsin law.

QUALCOMM. J. Michael Schaefer submitted a proposal to QUALCOMM asking that the company adopt cumulative voting for future shareholder meetings to permit shareholders the option of voting their shares cumulatively, rather than regularly, for election of directors. QUALCOMM requested, and was granted, permission to exclude the proposal under Rules 14a-8(b) and (f).

Rules 14a-8(b) and (f) permit exclusion if the proponent fails to establish the requisite eligibility to submit the proposal within the required time following the receipt of the company’s request for proof of such eligibility. QUALCOMM advised the staff that although Schaefer provided documentation, he failed to show that he owned the shares continuously for one year as required by the rule. Moreover, the company noted that the shares were actually owned by Schaefer’s sons and not by Schaefer himself.

Friday, 22 November 2019

SEC staff issues staff accounting bulletin on credit losses

By Amy Leisinger, J.D.

The SEC staff has published a new staff accounting bulletin to update existing guidance with respect to methodologies and supporting documentation for measuring and accounting for loan losses. In the bulletin, the staff discusses the documentation that it would normally expect registrants engaged in lending transactions to prepare and maintain to support estimates of expected credit losses for loan transactions.

Measuring losses. According to the staff, at each reporting date, an entity should record an allowance for credit losses on assets measured on an amortized cost basis and a liability for credit losses on certain off-balance-sheet exposures. The allowance for credit losses is an estimate of current expected credit losses considering available information relevant to assessing the collectability of cash flows, the bulletin notes. In establishing the estimate, a registrant should consider historical experience, current conditions, and reasonable forecasts that affect collectability, according to the staff.

Systematic methodology. The staff states that a registrant should have a systematic methodology to determine its provision and allowance for credit losses. The allowance methodology should be influenced by specific factors relevant to the entity, including organizational structure, strategies, risk assessments, and loan portfolio complexity. However, according to the bulletin, each registrant should have a methodology that, among other things: (1) identifies relevant risks; (2) involves consideration relevant data; (3) addresses expected credit losses of all existing loans and measures them in a pool when similar risk characteristics are involved; and (4) includes a logical means to consolidate loss estimates so that the allowance for credit losses can be recorded in accordance with GAAP. Management should periodically review the propriety of methodologies, the staff explains.

Policies and procedures. Further, the staff notes that registrants use variety of policies, procedures, and control systems tailored to their own businesses. However, the staff believes that, for an allowance methodology to be effective, a registrant’s policies and procedures to maintain an appropriate allowance for credit losses should likely address: (1) the responsibilities of the personnel that determine the allowance; (2) the methods used in developing the allowance; (3) a description of the systematic methodology; and (4) how internal controls ensure that the allowance is in accordance with GAAP. The bulletin also notes that a registrant’s policies and procedures should describe the approach used to pool loans based on similar risk characteristics, methods used to determine the contractual terms of financial assets, and the means by which historical data and historical credit loss information is used, among other things.

Documentation. The staff also expects a registrant to maintain documentation to support its measurement of expected credit losses and to demonstrate that the loss measurement methods and assumptions used to estimate the allowance are determined in accordance with GAAP. According to the bulletin, a registrant also should demonstrate in documentation the relevance and reliability of data in making its determinations. The staff also notes that allowance-for-credit-losses summaries should include the economic forecasts used, the estimate of the expected losses, and a summary of the current allowance for credit losses balance.

Validation. The staff expects a registrant’s systematic methodology to include procedures to assess the continued reliability of the methods, data, and assumptions used to make estimations. To verify conformance to GAAP, the bulletin suggests that it would be appropriate for management to establish internal control policies, which may call for independent review. The staff also states that management should support its validation process with documentation of the specific procedures performed and any changes made as a result of the process.

Thursday, 21 November 2019

Chairman Tarbert: ‘I want the United States to lead’ on blockchain and digital assets

By Lene Powell, J.D.

In a CNBC interview and opinion piece in Fortune magazine, CFTC Chairman Heath Tarbert made the case that the U.S. must remain a leader in fintech in order to ensure U.S. prosperity. Noting the recent example that the Libra Association chose to set up in Switzerland instead of the U.S., Tarbert said that principles-based regulation is the best way for U.S. regulators to mitigate risks yet facilitate critical innovation and maintain a leadership role.

"I think whoever ends up leading in this technology will end up writing the rules of the road for the rest of the world, and my emphasis is on making sure that the United States is a leader," said Tarbert.

Tarbert has made similar statements in the past. The Chairman has also previously stated that if the United States does not lead on this front, someone else will.

"Digital assets" not "cryptocurrency." On a terminology note, Tarbert says he never uses the term "cryptocurrency" and instead uses the term "digital assets." Bitcoin and other digital assets are not legal tender, they are not money, and they are not currency, he said. The CFTC has recognized such assets as commodities, and futures markets are currently trading Bitcoin futures, but that does not make it a "currency."

This marks something of a departure from current CFTC terminology, which has extensively referred to "virtual currency" and "cryptocurrency" in consumer advisories and brochures as well as a primer, backgrounder, and guidance.

U.S. needs to lead. According to Tarbert, ensuring that America remains a global fintech leader will be essential to our future prosperity. CNBC commentator Andrew Ross Sorkin observed that if any digital assets reached "escape velocity," it could upend the idea of a monopoly that the U.S. or any government has on currency. For example, said Sorkin, if Libra were to truly take off, billions of people would start operating with it virtually overnight.

So where does the U.S. stand in the ranking? In Tarbert’s view, the U.S. is not at the top, but probably not at the bottom. He noted that the Libra Association chose to set up in Switzerland, and his understanding was that Singapore would have been the second choice. As to what would accelerate the adoption of digital assets, Tarbert said a key development would be if countries started accepting them as legal tender, for example to pay taxes. He said we haven’t seen that yet in the U.S. and we are "far from that at this stage," but we are starting to see that in other countries.

On the question of whether there are "different forces fighting each other" in the U.S. government over cryptocurrencies, and whether Treasury Secretary Steven Mnuchin and President Trump have misgivings, Tarbert responded that he didn’t think there was any space between Mnuchin and himself. He does share concerns about anti-money-laundering, terrorist financing, and financial stability. But for commodities that are regulated by the CFTC, the agency wants to create an environment where these markets have integrity, the CFTC can regulate them, and they are able to innovate.

Tarbert stressed that fintech potential lies not only in digital assets, but also in the blockchain technology underlying it. Currently, it is being used primarily for digital assets. Ultimately, however, he could see it overtaking the internet, or being used in parallel to the internet, and powering other types of transactions besides financial.

Principles-based regulation. In the Fortune opinion piece, Tarbert urged that a principles-based approach is the best way to govern these emerging markets. Avoiding detailed, prescriptive rules and relying more on high-level, broadly-stated principles to set standards for regulated firms and products allows for flexibility and enables the CFTC to stay ahead of technology developments. It also allows for innovation, letting companies be responsible for finding the most efficient way of satisfying standards.

So what does principles-based regulation look like? Tarbert gave the example that the CFTC does not have formulaic rules for derivatives clearinghouse operational systems but rather outlines core principles that derivatives clearinghouses must follow in mitigating potential risk. According to Tarbert, this has allowed each of the three clearinghouses currently handling digital assets to adopt a different method of facilitating Bitcoin transfers and addressing the risk of loss. In working with CFTC front-line staff to comply with the CTFC’s core principles governing operational risk and the allocation of losses, the clearinghouses were able to determine which specific arrangements are commercially viable, yet the arrangement ensured that systems developed under sound regulation.

Adjusting the framing somewhat from comments by former Chairman J. Christopher Giancarlo that advocated a "do no harm" and "light touch" regulatory model, Tarbert emphasized strongly that principles-based regulation is not the same as "light touch" regulation. Tarbert noted that the CFTC has brought more than a dozen enforcement actions in this area against scammers and entities offering unauthorized derivatives. The CFTC has also recently brought actions for violations of its core principle obligations, he said.

Given the fast-evolving technology and product offerings in this space, favoring a principles-based approach over prescriptive rules does allow for greater flexibility. But laying out fewer specifics in detailed rules can also mean fewer safe harbors, more uncertainty, inadvertent violations, or even complaints of "rulemaking by enforcement." Nevertheless, the CFTC has repeatedly stressed that "the door is open" to market participants to meet with staff, particularly through the LabCFTC program, which was recently elevated to an independent office reporting directly to the Chairman. The CFTC has certainly set the stage for a lively conversation and potential leadership role in this area.

Wednesday, 20 November 2019

Kraft says au contraire to CFTC’s mootness theory, stage set for court status hearing

By Mark S. Nelson, J.D.

Kraft Foods Group, Inc. and Mondelez Global LLC (collectively Kraft), urged a federal court in Chicago to view skeptically the CFTC’s assertion that contempt proceedings initiated by Kraft against the CFTC are now moot or entirely constrained by sovereign immunity. The CFTC and Kraft had reached an agreement to settle the CFTC’s enforcement case against Kraft via a consent order but Kraft objected to the CFTC’s and individual CFTC commissioners’ public statements following announcement of the consent order, which contained a provision purporting to limit what Kraft or the CFTC could say publicly about the settlement. Following a fast-tracked appeal to the Seventh Circuit, the district court vacated the consent order and scheduled a hearing for November 20, 2019 at which the CFTC and Kraft are expected to deal with a variety of unresolved issues as the case once again heads toward trial (CFTC v. Kraft Foods Group, Inc., November 18, 2019).

Consent order vacated but not forgotten. The court recently vacated the consent order between the CFTC and Kraft following the Seventh Circuit’s grant of mandamus in favor of the CFTC. Kraft, however, does not see the contempt proceeding that it initiated as complete and now disputes the CFTC’s assertions of mootness and sovereign immunity.

Specifically, Kraft countered by asserting, among other things, that CFTC attorneys tried to get the gag provision removed from the consent order because CFTC commissioners might be limited in speaking about the settlement if that provision remained in the consent order. "Those requests demonstrate the CFTC knew that Defendants intended Paragraph 8 to reach such statements," Kraft told the court. Kraft further asserted that the CFTC falsely represented to the court that it and Kraft had reached an agreement, a theory Kraft said is underscored by the CFTC’s later public efforts to explain why individual commissioners could nevertheless speak publicly about the consent order.

With respect to mootness, Kraft argued that the consent order may have been vacated, but that the court could still reprimand the CFTC for the agency’s conduct during the consent order’s lifetime. Put another way, Kraft argued that the consent order was vacated because of the CFTC’s own conduct.

Potential remedies for CFTC conduct. Kraft also sought to turn the words of Commissioners Dan Berkovitz and Rostin Behnam against the CFTC, noting that the joint statement by Berkovitz and Benham suggested a limit to any penalties the CFTC could obtain. "The $16 million penalty and injunctive relief that the Commission has obtained in this consent order is as much as the Commission could reasonably expect to obtain if it were to prevail at trial," said Commissioners Berkovitz and Benham at the beginning of their separate public statement on the consent order.

At a later point in its briefing, Kraft would combine the Berkovitz-Benham statement with a similar assertion made by the Commission. "The Consent Order results in a $16 million civil monetary penalty—nearly three times the unlawful profit the Commission alleged the Defendants obtained," said the Commission. Kraft said the Commission’s reference to "three times the unlawful profit" implied that the agency had obtained the maximum amount possible and, thus, suggested a ceiling.

According to Kraft, the court could impose a variety of sanctions against the CFTC for the agency’s alleged violations of the consent order. Specifically, Kraft said the court could:
  • Find that the CFTC violated prior court orders and acted in contempt of court and make findings about the acts that constituted the CFTC’s contemptuous conduct (Kraft urged this result even if the CFTC would not be subject to financial penalties);
  • Order appropriate relief, including either a compensatory contempt remedy or a litigation sanction that caps Kraft’s liability going forward at the $16 million amount agreed to in the vacated consent order (alternatively, Kraft said the court could bar the CFTC from presenting evidence that a higher amount should be imposed on Kraft, if the CFTC won at trial); and
  • Award Kraft its attorney’s fees for prosecuting the contempt proceeding, an award Kraft said would not be barred by principles of sovereign immunity.
Kraft, however, acknowledged that some remedies would be out of reach. As a result, Kraft said the court could not impose punitive or criminal relief, bar commissioners from making additional statements, or order a contempt award that would violate sovereign immunity. Still, Kraft said it believed that its request for relief from the CFTC would not run afoul of any of these potential limits.

The case is No. 15-cv-2881.

Tuesday, 19 November 2019

Commissioners Jackson and Lee explain support for non-transparent ETFs

By Amy Leisinger, J.D.

The SEC has acted on four applications relating to a new type of exchange-traded fund providing less transparency. Unlike more standard ETFs, these funds will not provide full daily transparency of the exact securities in their portfolios and will instead provide "proxy" portfolios reflecting holdings. While ultimately supporting the actions, Commissioners Robert Jackson and Allison Herren Lee wrote separately to express concern that in times of stress, ordinary investors in non-transparent ETFs may not be able to get a fair price for their shares. While the SEC staff has provided conditions for these four applications designed to protect investors, future applications that do not address the potentially serious liquidity problems associated with the structure of nontransparent ETFs should give the Commission pause, they said.

Non-transparent ETFs. Precidian, Blue Tractor, Fidelity Beach Street, Natixis, and T. Rowe Price plan to introduce and operate actively managed ETFs that would not be required to disclose their portfolio holdings on a daily basis. Like other ETFs, the funds would issue shares redeemable in large aggregations only, and secondary market transactions would occur at negotiated market prices rather than at net asset value. Certain affiliated persons also would be permitted to deposit securities into, and receive securities from, the funds in connection with the purchase and redemption of creation units.

However, the applicants maintained that operating the funds as fully transparent would cause them to be susceptible to "front running" by others, which could harm the funds and their shareholders. According to the firms, non-transparent ETFs would allow investors to access to strategies more akin to those available through mutual funds while simultaneously taking advantage of the traditional benefits of ETFs, including lower costs and taxes and intraday liquidity.

On a daily basis, each fund would publish a basket of securities and cash designed to closely track its daily performance while not specifically detailing the fund’s portfolio. The "proxy" portfolio would serve as a tool for market participants to identify arbitrage opportunities and estimate the value of the fund’s holdings. The proxy portfolio also would allow market participants to gain exposure to the performance of the fund’s holdings so that it could serve to hedge a position in the fund’s shares.

Commissioners’ statement. Commissioners Jackson and Lee noted that the Commission has historically required ETFs to ensure that the market price for their shares does not substantially deviate from the value of underlying holdings and that authorized participants ensure that balance by consistently examining the value of the ETFs’ assets. With these new ETFs, the authorized participants will have access to "proxy" portfolios that provide enough information to keep the share prices in line with asset values, and the funds will establish thresholds for tracking error and bid-ask spreads, they said.

"These protections, combined with the Commission’s previous approval of one other non-transparent ETF—creating the need for competition that can help protect investors—convinced us that we could support these actions," the commissioners explained.

However, the commissioners noted, without those protections, in the event of limited liquidity, non-transparent ETFs come with the risk that ordinary investors will face wider spreads and find prices that do not accurately reflect share value. Jackson and Lee stated that they would be skeptical of non-transparent funds focused on different asset types without these protections in place and suggested that the Commission keep "close watch" over whether additional disclosure regarding the risks of non-transparent ETFs would be appropriate.

"[W]e look forward to hearing from the market about the limits of the nontransparent ETF model—and how we can make sure disclosures give investors the information they need about these funds," the commissioners concluded.

Monday, 18 November 2019

Icahn loses ‘novel’ bid to inspect books and records to aid proxy contest

By Mark S. Nelson, J.D.

A post-trial opinion by a Delaware vice chancellor rejected as not the "right case" Carl Icahn’s attempt to invoke Delaware’s books and records statute to demand that Icahn be allowed to inspect a company’s books and records for "questionable, but not actionable" board deliberations that could then be communicated to other shareholders regarding a potential Icahn-led proxy contest. The case arose out of the proposed merger of Occidental Petroleum Corporation and Anadarko Petroleum Corporation. Icahn-affiliated entities were large investors in Occidental, which Icahn suspects of having arranged merger financing that was too costly (High River Limited Partnership v. Occidental Petroleum Corporation, November 14, 2019, Slights, J.).

On-again, off-again merger takes hold. Occidental and non-party Chevron each wanted the same thing: Anadarko. An early bid by Occidental was rejected and, for a while, replaced by a mostly stock deal offered by Chevron. As bidding progressed, Anadarko was initially cool to a renewed offer by Occidental, but a revised Occidental offer with more cash and less stock resulted in an agreement to merge the roughly equal Occidental and Anadarko.

Icahn, the well-known activist investor, had taken a sizeable stake in Occidental soon after the Occidental-Anadarko merger was announced. But Icahn was unhappy with the structure of the merger and sought to bring a proxy contest to oust the Occidental board, alleging that Occidental had entered into one bad deal after another in order to finance the merger. Icahn also sought to invoke Delaware’s books and records law to obtain merger documents that he believed would aid his impending proxy contest.

Not the "right case." Vice Chancellor Slights began his analysis by rejecting Icahn’s back-up theory for inspecting Occidental’s books and records, concluding that the trial record did not show a credible basis that Occidental’s board engaged in mismanagement or wrongdoing. Specifically, the court said Icahn failed to allege that Occidental’s board was conflicted, disloyal, or acted in bad faith. Rather, the court said Icahn’s theory was more akin to a disagreement with the Occidental board’s exercise of business judgment, a theory that, by itself, Delaware books and records cases find insufficient to justify a demand.

The court then turned to Icahn’s "novel" theory that an activist investor should be able to obtain a company’s books and records for the purpose of communicating with other shareholders about a proxy contest. The court distinguished both precedents cited by Icahn. First, the court explained that in Tactron, Inc. v. KDI Corporation (Del. Ch. 1985), a judge concluded that the shareholder could inspect books and records for the purpose of obtaining "logistical" information that would allow the shareholder making the demand to contact other shareholders, a purpose that was analogized to the inspection of a shareholder list. The demand in Tactron, however, was denied regarding less logistical items such as board minutes. The court here found there was nothing logistical about Icahn’s demand.

Icahn also argued that High River Ltd. Partnership v. Forest Labs., Inc. (Del. Ch. July 27, 2012), a bench ruling by then-Master in Chancery (now Superior Court Judge) LeGrow, suggested that a books and records demand can be proper in the context of an impending proxy contest. That case involved an Icahn affiliate seeking books and records regarding whether a company had implemented previously negotiated governance changes in advance of a renewed Icahn proxy contest.

Vice Chancellor Slights observed that Master Legrow had limited her bench ruling to the facts of the case, but she nevertheless suggested that documents "necessary, essential and sufficient" to an imminent proxy contest could justify a books and records demand. Vice Chancellor Slights also echoed Master Legrow’s concern that clarification was needed in this corner of Delaware’s books and records law. But the vice chancellor concluded that Icahn’s latest attempt to use a books and records demand in the proxy setting was not the "right case" by which to deliver that clarity because the documents Icahn requested regarding Occidental concerned information that was widely publicized and, thus, were not "necessary and essential."

Still, Vice Chancellor Slights hinted in the introductory portion of his opinion that such a "right case" might exist: "It may well be that, in the right case, this court might endorse a rule that would allow a stockholder to receive books and records relating to questionable, but not actionable, board-level decisions so that he can communicate with other stockholders in aid of a potential proxy contest."

What is a proper purpose? Delaware books and records litigation under DGCL Section 220 can seem rather simple on the surface, but it often branches into more esoteric subtopics. To provide examples of proper purposes, Vice Chancellor Slights repeated a citation to a treatise noted by Icahn’s briefing in the case (see footnote 62 in the opinion). Specifically, the court cited Edward P. Welch, Robert S. Saunders, Allison L. Land, and Jennifer C. Voss, co-authors of Folk on the Delaware General Corporation Law Sixth Edition (2019), a Wolters Kluwer Legal & Regulatory U.S. publication, which lists nearly 20 purposes credited by Delaware courts.

The Folk treatise begins its lists of proper and improper purposes by noting that DGCL Section 220 defines "proper purpose" to mean " a purpose reasonably related to such person's interest as a stockholder." The treatise also explains that the right belongs to the stockholder plaintiff and often depends on the facts and circumstances. Moreover, the treatise quotes at length from a case positing that the proxy setting is especially ripe for abuse of DGCL Section 220 because of the compressed time frame of "an impending or ongoing proxy contest" and that any demand must be "narrow."

The case is No. 2019-0403-JRS.

Friday, 15 November 2019

Telegram insists Gram tokens are currency

By Rodney F. Tonkovic, J.D.

Accusing the SEC of "regulation by enforcement," Telegram Group Inc. has filed an answer in the Southern District of New York denying all charges related to an alleged unregistered digital token offering. The Commission filed an emergency action and obtained a temporary restraining order against the company on October 11, 2019, asserting that the digital tokens were securities being sold in violation of the registration provisions of the Securities Act. The answer asserts that the Commission has failed to provide clear guidance and is operating in an ad hoc manner that contradicts precedent and public statements by SEC officials (SEC v. Telegram Group Inc., November 12, 2019).

Grams. Telegram Group Inc. and its wholly owned subsidiary TON Issuer Inc. (collectively, "Telegram") own and operate a mobile messaging app called Telegram Messenger. In January 2018, Telegram began to raise capital to launch a blockchain called the "Telegram Open Network" or "TON" which would "host a new generation of cryptocurrencies and decentralized applications, at a massive scale." Telegram raised $1.7 billion from 171 initial purchasers via agreements for the purchase of digital-asset securities called "Grams," which would be created upon the launch of TON. Before the restraining order, Telegram had committed to deliver the Grams to purchasers in conjunction with TON's launch on October 31, 2019. Upon delivery, purchasers would then be able to resell the Grams on the open market.

SEC says it's a security. Accusing Telegram of avoiding the securities laws by labelling its product as a currency, the Commission alleged that Grams are securities and were being sold in violation of the registration provisions of Sections 5(a) and 5(c). In addition to the temporary order halting the resale of Grams, the Commission seeks permanent injunctions, disgorgement with prejudgment interest, and civil penalties.

Lack of guidance. In its answer to the complaint, Telegram denied each and every allegation in the complaint, even those "contained in all headings, titles, captions, footnotes or charts." The company did admit some uncontested details, such as the fact that it did not file any registration statement because "none was, is or will be required." Grams are a currency, not securities, Telegram emphatically stated.

Telegram asserts that its private placement to highly sophisticated, accredited investors was conducted pursuant to valid exemptions to registration under Regulations D and S. The crux of Telegram’s defense is that it was not provided sufficient notice that its actions would violate the Securities Act. According to Telegram, based on public comments by SEC officials, it believed in good faith that its private placement was in compliance. For example, Chairman Clayton has stated that it is possible to conduct an ICO without triggering the registration requirements. But, there has been no formal rulemaking, interpretation, or other action from which developers like Telegram can glean guidance.

As a result, the Commission's enforcement to date has been arbitrary, Telegram says. Here, the answer quotes a Congressman who accused the Commission of "regulation by enforcement" rather than by clear guidelines, an approach which was also been criticized by Commissioner Peirce. The company also points out that Bitcoin and Ethereum are presumed not to be securities while similar cryptocurrencies are deemed to be securities. Telegram also attempted to receive guidance and feedback directly from the Commission and voluntarily produced documents and engaged in discussions. Instead of working out any issues, the answer implies, the Commission instead initiated its enforcement action.

In addition to these defenses, Telegram maintains that the Commission lacks extraterritorial authority over any transactions between it and foreign purchasers. In addition, the company states that it is not subject to the jurisdiction of the court. Telegram asks that the claims be dismissed in their entirety and with prejudice.

The case is No. 19 Civ. 9439.

Thursday, 14 November 2019

Chamber of Commerce questions effects of bill to reform private fund industry

By Amy Leisinger, J.D.

The U.S. Chamber of Commerce has released a study exploring the economic effects of legislation introduced by Sen. Elizabeth Warren (D-Mass) on the private fund industry. Private equity firms make substantial contributions to the economy, and legislation such as the Stop Wall Street Looting Act imposing tax increases and additional liabilities on private funds that invest in businesses would ultimately harm the American workforce and the businesses that rely on private fund capital.

"Private equity firms make valuable, long-term investments in U.S. companies, supporting over 26 million U.S. jobs and driving economic growth by contributing over $475 billion in annual tax revenues," U.S. Chamber Center for Capital Markets Competitiveness Executive Vice President Tom Quaadman noted.

The legislation. Among other things, the Stop Wall Street Looting Act (S. 2155/H.R. 3848) would impose additional leverage caps on private equity firms and tax private equity profits at ordinary tax rates as opposed to those applicable to capital gains. In addition, private equity firms would be held liable for debts and other obligations of their underlying companies. In addition, the legislation changes bankruptcy law to place additional focus on workers’ interests in the bankruptcy process. The legislation is designed to bring greater transparency to the private fund industry while also enhancing related investor protections.

According to a press release issued by Sen. Warren, the bill would "empower[] workers and investors" and help to protect markets regarding high risk forms of debt.

Economic concerns. In its report, the Chamber of Commerce notes that the private equity funds created by private equity firms invest in various companies and play a major role in their development. These companies employ millions of people in the U.S., and, as such, the private fund industry drives economic growth and supports the American workforce. In addition, the report states, the firms contribute billions in annual federal and state and local tax revenue and support investments by pension funds and public retirement systems.

However, according to the report, the Stop Wall Street Looting Act would impose significant restrictions, liabilities, and tax increases on the private fund industry, including by capping private equity leverage and taxing profits at ordinary tax rates. In its study, the Chamber of Commerce found that these changes could cause a loss in the range of 6.9 million to 26.3 million jobs and decrease combined tax revenues from $109 billion to $475 billion per year.

Further, the report continues, the increased restrictions and enhanced liabilities could disincentivize business formation and growth and impose risks for private equity managers and investors. Discouraging private equity investment in companies could result in increased business failures, as well diminished returns for private equity investors, according to the report. Because most taxes in private equity are paid by business partners on their individual tax returns, the increased taxes act as a tax on efforts of those who help grow businesses, the Chamber of Commerce opines.

Increasing restrictions, risks, taxes, and liabilities could potentially drive participants out of the industry, leaving firms seeking private equity financing unable to find necessary capital, the report concludes.

Wednesday, 13 November 2019

SEC Investor Advisory Committee debates securities offering reforms

By Lene Powell, J.D.

In a panel of the Investor Advisory Committee, speakers spiritedly discussed a recent Concept Release on securities offering reform that raises issues for capital formation, investor protection and market integrity.

Concept Release. In June 2019, the SEC issued a Concept Release on Harmonization of Securities Offering Exemptions. Jennifer Zepralka, Chief of the SEC Office of Small Business Policy, explained that the release broadly reviewed the available exemptions to the registration requirements and examined the state of registered versus deregistered offerings.

According to the release, significantly larger amounts of new capital have been raised in deregistered offerings in recent years. An estimated $2.9 trillion has been raised in exempt offerings in 2018, compared to $1.4 trillion raised in registered offerings. In 138 specific requests for comment, the release explores whether overlapping exemptions are confusing for issuers trying to navigate the most efficient path to raise capital; whether there are any gaps in the framework that may make it difficult for companies to find the right exception from registration at key stages of their business cycle, and looking whether integration could help issuers to transition from one exempt offering to another and ultimately to a registered public offering.

The comment period closed on September 24, and the SEC has received more than 150 letters so far. The most popular topic for comment has been the definition of "accredited investor."

Risks of easing restrictions. Several speakers explored risks to investors and the markets that may arise from relaxing restrictions in securities offerings.

According to Renee Jones, associate dean of academics and professor at Boston College Law School, new transaction exemptions created by Congress and the SEC and the past 15 years have strayed dramatically from their statutory and traditional bases. This trend towards increasingly relaxed conditions for exemption has created new risks for investors. Further, the expansion of these exemptions has also created unfortunate spillover effects that have spread to all corners of the economy, and have impacted the welfare of corporate employees, consumers and even broader society.

Jones also took issue with several "flawed" premises. In her view, it has not been adequately shown that retail investors would likely gain superior returns if allowed to invest more easily and privately offered securities. Jones also believes it a "strange" assumption that there is an inherent conflict between the objectives of investor protection and capital formation, when comprehensive disclosure is the hallmark of efficient capital markets and transparent security markets have served as the engine of the U.S. economy and are the envy of the world. Moreover, the lack of information transparency has been associated with serious economic problems, including poor investment decisions, even by sophisticated investors, misallocation of capital and increased opportunities for misconduct and fraud.

According to Andrea Seidt, Ohio Securities Commissioner, private offerings have been and remain the most common source of state enforcement action, and a recent paper showed that this was the case not just in Ohio but across the nation. Companies take advantage of the relaxed filing reporting requirements to perpetrate fraud, with minimal pre or post sale disclosure. Exemptions have become so attractive that most companies to very little or no upside to going public at all, and retail investors have not been all that interested in the private or quasi private deals that the JOBS Act has made available to them—possibly in part due to financial capacity, as half of American households have less than $10,000 in savings.

Yet proposals are being discussed to make these exemptions even more attractive. Seidt believes this would cause public markets to shrink even further, since companies will be able to stay private and gain the same access to capital as public companies with none of the cost. Further, Seidt believes that "Mom and Pop investors might get fleeced," though this is not definite, due to the lack of data as to how investors on the whole actually fare in private markets.

According to Tyler Gellasch, Executive Director, Healthy Markets Association the concept release is a continuation of a decades long trend where Congress and the commission have created exemptions and exceptions from a regulatory framework, and these changes have siphoned off trillions of dollars from capital from the public markets and the private ones. Two thirds of offerings are outside of the public realm, and there are 500 companies in the private markets valued at more than a billion dollars.

Without basic information on securities, it's impossible to make for even the most sophisticated investors in the world to make informed decisions about where and how much to invest, said Gellasch. The consequence of reduced disclosure requirements has led to many IPOs significantly underperforming. This has ramifications for investors and the economy. For example, this year, one company went from a predicted valuation of $120 billion dollars to an IPO of $80 something, and yesterday was trading under $45 billion. That's a $75 billion range for one company in what it's worth, over the course of a few months. This was because the company had to make more disclosure following the IPO, and as investors started asking questions and learning things, the valuation dropped. There were similar valuation issues with WeWork and Peloton.

"If you're an investor and you can choose anywhere in the world to invest, do you really want to invest in IPOs when they've got that track record over the last 10 years?" Gellasch asked.

Gellasch also noted that the securities laws were adopted not just for investor protection, but so the government can gain basic information about companies, such as whether they are paying their taxes or violating laws.

Promoting capital formation. In the view of Sara Hanks, CEO, Crowd Check, Inc., it is just too hard for small companies to go public, given information and filing requirements. Hanks believes that more companies might go public if were an entry level reporting tier, possibly based on regulation, that they could comply with until they could move to a higher level of reporting at the time of their choosing. She recommends to shift regulation from the time of offer to the time of sale, and that there should be no prohibitions on general solicitation anywhere in the exempt offering framework.

As to the accredited investor definition, Hanks recommends:
  • Keep the existing financial qualification, but index it to inflation from now on;
  • Add accreditation by means of a securities specific educational qualification, such as holding CFA designation or certain FINRA licenses;
  • Add accreditation by reference to a specific test developed for private investors; and
  • Add accreditation by chaperone.
According to Catherine Mott, CEO, Founder and Managing Partner, BlueTree Capital Group, LLC, entrepreneurs can get tripped up by regulations. They are focused on how to raise capital at the lowest cost and protect their ownership and might not always be aware of the potential for unintended consequences due to the form of offering they choose. For example, after an entrepreneur in Jacksonville, Mississippi raised $500,000 in startup capital via a crowdfunding portal, he learned that he could not raise an additional $3 million from venture capitalists because he raised the capital under a Rule 506(c) offering. Venture capitalists will not invest in a 506(c) offering, and this entrepreneur could not go back and change the offering to a 506(b) offering. Thus, his ability to grow his enterprise and add the 10 jobs he intended to add was lost.

Mott believes that offerings policy should not be driven by "unicorns" which are outliers that don’t reflect the majority of angel and VC funding. In particular, she believes that the general solicitation rules need to be modernized and demo days should be carved out. Further, the Angel Capital Association recommends creating a definition of qualified private sale that covers sales of minority positions in private companies with limited trading volume.

Tuesday, 12 November 2019

SEC’s Enforcement Division is staying the course after recent court decisions

By John Filar Atwood

The decision by the Supreme Court in Kokesh v. SEC, the High Court’s grant of certiorari in Liu v. SEC, and the ruling in SEC v. Gentile will not deter the SEC’s Enforcement Division from pursuing appropriate cases, according to Division Co-Director Steven Peikin. At the Practising Law Institute’s securities regulation conference, Peikin and Co-Director Stephanie Avakian said that they have not backed off from bringing any cases because of legal challenges or risks.

In 2017, the Supreme Court held in Kokesh that disgorgement is a penalty and therefore is subject to a five-year statute of limitations. In Liu, the High Court will address the question left open in Kokesh about whether the SEC can seek disgorgement as "equitable relief" for a violation of the securities laws. The Third Circuit recently reversed the district court’s decision in Gentile, finding that a penny stock bar and an "obey the law" injunction are not penalties. The court cautioned the SEC to ensure the injunctions it seeks are narrowly tailored and serve a preventive purpose.

Peikin said that although Gentile was initially a setback, the Third Circuit’s reversal was welcome. Although the decision requires properly tailored injunctive relief, the staff intends to continue to pursue "obey the law" injunctions, he noted.

King & Spalding’s Carmen Lawrence said that she was surprised by the ruling in Liu. Her prediction about which way the Supreme Court will decide is that the Court will limit the SEC’s disgorgement authority.

Peikin said that he hopes Lawrence’s prediction is wrong because disgorgement is a very important remedy for the Enforcement Division. Avakian agreed, noting that the staff has tried to keep a running tally of what Kokesh has cost the Commission in disgorgement. The current ballpark estimate is $1.1 billion, she said.

Digital assets. The co-directors also discussed areas of focus for the Division and cited digital assets and cybersecurity. In the cryptocurrency space, Avakian said that her sense is that there are fewer initial coin offerings and that entities are trying to find other exemptions for the issuance of tokens.

Avakian said the Division generally has seen two types of misconduct with initial coin offerings: straight-up frauds where issuers did not actually provide what they said they would and regulatory violations such as touting. The staff saw a drop in the regulatory violation cases in the last fiscal year, she said.

Peikin discussed the three token registration cases that the Division settled this year against Paragon Coin, AirFox, and Gladius Network. In these cases, the staff required the issuers to make a rescission offer for the issued tokens, he noted.

In an action against, the Division did not require rescission, but Peikin said that involved very unusual circumstances. The underlying tokens were fixed and non-transferable, he noted, so the staff felt that rescission did not make sense. In addition, the tokens did not lose value after the offering, he said.

Some observers have suggested that perhaps the sanctions were a little light. Peikin reiterated the Division’s procedure for determining penalties, which is to consider duration of the offer, the amount raised, efforts to target U.S. investors, and the size of penalties in other recent cases. He believes there has been a steady progression of sanctions over time and advised that if an entity creates a platform for the exchange of tokens, it is responsible for complying with the federal securities laws.

Cybersecurity. In the area of cybersecurity, Avakian discussed the division’s case against Altaba, formerly known as Yahoo!. The company failed to disclose a major data breach resulting in the unlawful acquisition of hundreds of millions of its users’ data. Altaba paid a $35 million penalty. Avakian described this as an "extreme disclosure failure," and advised that the division is not looking to pursue actions where there is a good faith effort at disclosure.

Peikin said that the Division’s cyber enforcement also involved a few risk disclosure cases this year, notably those against Facebook and Mylan. These were episodic, facts-and-circumstances cases, he said, and do not represent a trend.

Avakian added that the Facebook case was a situation where one group within the company knew of the breach, but another group was responsible for the disclosure of it. The take away from the Facebook matter is that companies should have a process in place to ensure that these two groups can come together and provide adequate disclosure.

Monday, 11 November 2019

A week of spoofing by newbie trader results in $500,000 fine

By Brad Rosen, J.D.

The CFTC issued an order filing and settling charges against Mitsubishi Corporation RtM Japan Ltd., a company incorporated under the laws of Japan, with its main office in Tokyo, for engaging in multiple acts of spoofing contracts on the New York Mercantile Exchange for platinum and palladium futures. The order found that RtM Japan engaged in this spoofing activity through an inexperienced trader who utilized a trading platform located in RtM Japan’s Tokyo office. The order requires RtM Japan to cease and desist and imposes a civil monetary penalty of $500,000. The order also notes that company promptly suspended the trader from trading upon learning of the spoofing activities (In the Matter of Mitsubishi Corporation RtM Japan Ltd., November 7, 2019).

Spoofing trader lacked experience. According to the order, for an approximate one-week period, from April 5, 2018 through April 13, 2018, the company, thorough one of its traders, engaged in spoofing in connection with various precious metals futures products traded on the NYMEX and thereby violated Sections 4c(a)(5)(C) and 6c(a)(5)(C) of the Commodity Exchange Act. The order also found that the trader in question had no trading experience and was placed on the precious metals as part of a training rotation. Furthermore, the order found that during the trader’s time on the desk, the novice trader placed multiple orders for futures contracts with the intent to cancel the orders before their execution.

A typical spoofing scheme. The order found that the trader typically first placed a large order with the intent to cancel it before execution (the spoof order). Soon thereafter, in the same market, the trader entered a smaller order which the trader intended to execute (the genuine order), while the spoof order rested. In many instances, the trader received a partial or complete fill on the genuine order, and then cancelled the spoof order before it was filled. At times, the trader layered the spoof orders, entering multiple genuine orders in conjunction with spoof orders. The trader engaged in this spoofing activity in order to test how the market would react.

Cooperation and remediation led to reduced penalties. The order found that RtM Japan cooperated with the Division of Enforcement’s investigation and engaged in proactive remedial measures, including implementing an electronic trading monitoring system to screen for suspicious trades and retaining a third-party expert to develop and implement a comprehensive risk assessment for precious metals trading. Moreover, the company overhauled its training program and conducted relevant training sessions and seminars on market misconduct in the U.S. futures markets. According to the order, this cooperation and remediation is reflected in a reduced civil monetary penalty.

Director comments. James McDonald, the CFTC’s Director of Enforcement, had this to say about this matter: "Today’s enforcement action shows, once again, that the Commission will aggressively pursue spoofing in our markets. It also demonstrates that participants who allow their employees to test the markets for training or other inappropriate purposes will be held accountable when employees do not trade lawfully."

Parallel CME disciplinary action. The CME Group’s Market Regulation Department independently conducted a parallel investigation, and also announced a disciplinary action brought against RtM Japan based upon substantially the same set of facts as set forth in the CFTC order. The company agreed to pay a fine in the amount of $250,000 as part of its settlement with the exchange.

The order is CFTC Docket No. 20-07.

Friday, 8 November 2019

SEC advisory committee examines ESG disclosures

By Amanda Maine, J.D.

The SEC’s Investor Advisory Committee heard from industry and academic representatives on the role environmental, social, and governance (ESG) disclosures play in investment decisions and the difficulties of quantifying ESG data for investors. Some of the panelists said that SEC action on ESG disclosures could improve their consistency and as a result, their comparability to the benefit of investors.

Need for ESG disclosures. The panelists agreed that the disclosure of ESG information is necessary regardless of whether investors are specifically seeking that information. Professor Satyajit Bose of Columbia University said that studies have shown a robust correlation between sustainability measures in corporations and financial performance. He also noted that while the numbers on sustainability investment are highly correlated with financial operating performance, market performance is a different matter. This suggests that it can take many years of sustainability investment before the market recognizes it, Bose said.

Michelle Dunstan, a portfolio manager at AllianceBerstein (AB), said that her firm incorporates ESG analysis in all its portfolios, not just those with an ESG mandate. She described AllianceBernstein as having a three-pronged approach to ESG. The prongs include "portfolios with a purpose" that target specific ESG goals for investments, as well as how the firm measures up to its own ESG policies. The other prong relates to portfolios with no explicit ESG mandate, she said. However, ESG considerations are still taken into account in these portfolios, Dunstan explained. For example, with heavy carbon emitters, analysis will examine if a carbon tax applies to a company or if one might be imposed in the future.

Where to get ESG data. Dunstan also emphasized the importance of engaging with companies on ESG matters. AB cannot rely solely on ESG rating firms; its representatives meet with management and boards of directors to discuss their approaches to dealing with ESG, she explained. She added that AB has its own ESG specialists as well as ESG training programs for its analysts.

Jonathan Bailey, head of ESG Investing at Neuberger Berman, also stressed the need for multiple sources of insight on ESG. He said that his firm seeks dialogue with companies, as well as NGOs and academics, to inform their decision-making regarding ESG investing. Like the other panelists, Neuberger Berman analysts examine ESG disclosures whether or not "sustainable" is in the portfolio’s name. He also advised that when it comes to ESG matters, the focus is on disclosure and not making a normative judgment about a company’s ESG policies.

Rakhi Kumar, head of ESG Investments and Asset Stewardship at State Street Global Advisors, described how State Street measures ESG through its R-Factor scores (Responsibility Factor), which leverage multiple data sources and aligns them to widely accepted, transparent materiality frameworks to generate a unique ESG score for listed companies. Kumar said that State Street also uses data from third party sources and integrates R-Factor data and specialized data to provide its clients insights about their holdings at the fund level.

Need for SEC action? Some of the panelists cited a need for standardization and consistency as a reason for SEC action on ESG disclosures. Commissioner Allison Herren Lee noted that the Commission last issued guidance related to climate issues in 2010 and that a lot has changed since then. Bailey described the current state of ESG disclosures by public companies as "patchy and inconsistent." He also said that he has heard from management who privately say they have collected the necessary data internally, but would prefer not to share it with investors over concerns relating to the actions of competitors and possible legal ramifications.

Jessica Milano, vice president and director of ESG Investment Research at Calvert Research and Management, said that any ESG disclosure framework must not rely on boilerplate disclosures because that would not be useful to investors. She said she supports a combination framework that takes into account different industry sectors, such as those of the Sustainability Accounting Standards Board (SASB). For example, a company in the consumer finance sector (such as a credit card company) may face environmental impacts mainly related to the energy uses of the facility, the disclosure of which would not be material. In contrast, disclosures related to personal data go to the core of the business and is material to investors.

Committee discussion. Committee member Barb Roper of the Consumer Federation of America asked about the definition of materiality when it comes to ESG disclosures. Bailey responded that SASB provides a framework for minimum standards, but his firm has clients that may have different expectations based on their portfolio choices. Dunstan agreed, advising that what is material can be a different decision based on the same information depending on how much weight a client attaches to it. She added that that her firm looks at materiality not only on a company level but also at a portfolio level to study the cumulative effects of a particular risk.

Committee member Prof. J.W. Verret of Antonin Scalia Law School at George Mason University thanked the panel for its input but lamented that there were no panel members who are skeptical of SEC involvement over ESG matters. Forced ESG disclosure can actually be counterproductive and harmful, including requiring the disclosure of proprietary information or increasing the regulatory and litigation risks that a company can face, according to Verret. As for materiality, Verret said that the appropriate denominator is not global; it should be particularized to a company. He also took aim at investment advisers and pension funds who use ESG as a means to advance a personal political preference.

Thursday, 7 November 2019

Division of Corporation Finance will roll out new no-action letter procedures this month

By John Filar Atwood

The Division of Corporation Finance is already receiving no-action requests for the 2020 proxy season, so the new approach to responding to those inquiries is underway, according to Shelley Parratt, a deputy director in the division. In remarks at Practising Law Institute’s conference on securities regulation, she said that the process will involve some oral responses from the staff, as well as a new chart tracking the staff’s no-action positions that will be posted on the Commission’s website.

Parratt said that the chart will indicate the company’s name and whether the staff granted, denied or chose not to comment on its no-action request. The staff currently plans to update the chart once or twice each week, she added.

In some cases, the staff will notify companies and proponents of its decision by email, and then later the same day make the decision publicly available in the chart, she said. While some responses will be oral, others will still receive a letter. Any staff response letters will be linked in the chart, she noted.

September announcement. The new approach, which was announced in September, involves responding to some no-action requests orally instead of in writing. In the summer, division director Bill Hinman discussed the plan, stating that if the staff "gets out of the way," it could lead to improved engagement.

The announcement has generated a considerable amount of uncertainty among stakeholders, but Parratt reassured them that the three possible positions—grant, denial, or declining to express a view—is what the staff has always done. Moreover, she believes that chart will make it easier to track the staff’s work on no-action letters.

Morrison and Foerster’s Martin Dunn concurred that in the September announcement the staff just reiterated the same three options that have always existed. He noted that if the staff decides not to state a view, it simply means that it is not getting involved and the parties are free to litigate the matter. He said that he hopes that declining to state a view does not become the norm this proxy season.

Dunn, who spent a number of years working with no-action letters at the SEC, thinks that oral advice makes sense from a time-management perspective. He cited instances in which proponents submit a lot of letters on an issue, many of which do not advance the matter. It can take up a lot of the staff’s time to maintain those files, he noted, and oral advice would eliminate that.

Concerns about the approach. Dunn does have one concern about oral no-action advice. If the staff calls the proponent, and then calls corporate counsel, how can counsel be sure that the two parties heard the conversation the same way, he said.

Elizabeth Ising, a partner at Gibson Dunn and frequent author of no-action requests, said that she is not too worried about the staff delivering decisions orally. She is concerned about the instances in which the staff issues no decision. Clients are not going to like the uncertainty, she noted, and having to decide whether or not to litigate the matter.

Glass Lewis. Dunn noted that proxy adviser Glass Lewis has decided to take a hard line with respect to the new no-action approach. It recently released its policy stating that in cases where the staff states no view, Glass Lewis will recommend against the company’s governance committee.

Glass Lewis went a step further, stating that if no-action advice is given orally, it expects to see disclosure about it in a company’s proxy. If there is no written record, Glass Lewis plans to give a negative recommendation on the company’s governance committee.

On this point, Stephen Brown, a senior adviser at the KPMG Board Leadership Center, recommended that companies disclose oral no-action advice or the staff’s decision to take no position somewhere in their proxy statements. It is a good idea to demonstrate to investors that the company has gone through the process and heard from the staff, he said.

Wednesday, 6 November 2019

Peirce favors digital assets safe harbor, suggests improvements to enforcement program

By John Filar Atwood

SEC Commissioner Hester Peirce plans to propose that the Commission create a safe harbor for entities that want to develop digital asset networks. In a keynote address at Practising Law Institute’s conference on securities regulation, Peirce said she envisions a two- to three-year period during which a token issuer would be allowed to develop a network without the force of laws bearing down on them.

Peirce lamented that there is no workable regulatory framework for crypto assets. The SEC should not be dictating whether a digital asset network will be a success because it does not have a framework in place, she said.

She acknowledged that the agency has issued crypto asset guidance, and there have been some instructive enforcement actions. The problem is that they do not offer a way forward for people that want to operate in the digital asset space, she said. An entity that has raised private funds and wants to launch a network cannot issue tokens for fear that they might be securities, she added.

Under Peirce’s proposal, entities that want to start a digital asset network would have to disclose certain basic information, such as a description of the tokens, the number of tokens they plan to issue, and whether the principals have a criminal background. After that, she believes people should be able to transfer tokens back and forth. If the network is fully functional at the end of the initial few years, she proposes that it be allowed to continue to operate without being subject to the federal securities laws.

Peirce intends to propose a non-exclusive safe harbor that network operators do not have to use it they do not want to. She said that she plans to present her proposal to the Commission "soon," but does not know whether it will get the support of the other commissioners.

Enforcement improvements. Peirce also discussed the SEC’s enforcement program and offered four suggestions for how to improve it. First, she said that to strengthen the program the Commission should look for rules that need to be written, rewritten or adjusted.

She cited the example of the advertising rule, which was adopted in 1961, but is scheduled to be updated with proposals released at today’s SEC open meeting. Under the advertising rule, the Commission brought an enforcement action against a radio show host who went off script and expressed his own positive opinion of an investment adviser. Peirce questioned whether the agency should be spending its limited enforcement resources to stop harmless testimonials.

A second recommendation to improve the enforcement program offered by Peirce was to resolve certain problems through the Office of Compliance and Inspections examination process instead of through enforcement referrals. It could assist the ultimate goal of getting better protection for investors, she noted. She admitted that one drawback of this proposal is a lack of transparency since the resolution of the matter might not become widely known.

Peirce also suggested that the SEC could improve the enforcement program by being more sensitive to the far-reaching implications of the actions it takes. Specifically, she does not believe that the consolidated audit trail (CAT) may not be good for investors.

CAT criticism. In her view, the CAT would provide too much information and data to the government. It is a privacy issue, she said, adding that too much gathered information could assist cyber criminals. She noted that in order to be effective, the SEC has to gather some data, but she would rather respect the privacy of investors.

Her final recommendation was for the Commission to acknowledge the valuable role of self-regulation. She clarified that she was not talking about SROs, which she views as quasi-governmental organizations. Peirce would like to see the industry regulate itself where individuals hold colleagues and customers accountable. The industry needs to develop an internal sense of right and wrong, she stated. This is not possible if the SEC micromanages every enforcement issue, she concluded.

Tuesday, 5 November 2019

CFTC sued for failing to provide information on its “secret settlement” in Kraft case

By Brad Rosen, J.D.

In yet another strange and bizarre development in connection with the CFTC’s ill-fated resolution of its market manipulation enforcement action against Kraft Foods Group and Mondel─ôz Global, New York law firm Kobre & Kim has sued the agency in the Southern District of New York. The law firm alleges that the Commission refused to respond to its Freedom of Information Act (FOIA) request seeking information with regard to the attempted settlement of that case. Kobre & Kim asserts its request will shed light on the unusual and unprecedented terms the agency agreed to in its attempted settlement of the matter, which included a “gag” provision by which the parties agreed to make no public statements about the case, other than those already in the public record (Kobre & Kim LLP v. CFTC, October 31, 2019).

Seeking to solve the mysteries around the CFTC-Kraft settlement. At the onset, Kobre & Kim raises a central question which is at the core of its FOIA complaint and quest for documents: “[W]hy did the CFTC, the nation’s principal regulator of commodities and derivatives markets, try to conceal the factual and legal bases for its litigation settlement with Kraft Foods Group Inc. and Mondel─ôz Global LLC … and agree never to discuss that settlement in public?” Some other public policy-oriented concerns raised by the law firm include:
  • The CFTC has left the public in the dark about how the CFTC applied its anti-manipulation authority to a fact pattern it litigated for over four years. Beyond seeding concerns across the industry over arbitrary enforcement, the CFTC’s actions threaten to chill legitimate market behavior while failing to deter potential misconduct in the future.
  • Unless and until the CFTC provides a full accounting of the attempted Kraft settlement, the public cannot have reasonable confidence that the agency is discharging its core mission of fostering open, transparent, and competitive markets.
  • The CFTC’s secret settlement in the Kraft case, like its handling of other recent market manipulation cases, is a disservice to the industry the CFTC oversees. This is the latest example of the CFTC obfuscating the law on market manipulation by pressing legal theories that are inconsistent with what the courts have articulated and using its leverage to secure private settlements purportedly validating the CFTC’s own theories. 
The CFTC’s ill-fated market manipulation enforcement efforts. The complaint provides a comprehensive survey of the CFTC’s efforts over the years to assert its anti-manipulation enforcement authority, as well as the obstacles it has encountered. It notes that the Kraft matter was the first litigated case brought by the CFTC under Section 6(c)(1) of the Commodity Exchange Act (CEA), as amended by the Dodd-Frank Act and implementing Commission Rule 180.1.  

The Kraft case took on heightened importance following the CFTC’s loss in another market manipulation case, CFTC v. DRW Investments, LLC, in November 2018. Following a bench trial in the DRW case, the judge rejected the CFTC’s theory of manipulation, stating that it was “only the CFTC’s Enforcement Division that has persisted in its cry of market manipulation, based on little more than an ‘earth is flat’-style conviction that such manipulation must have happened because the market remained illiquid.” In a stinging rebuke to the CFTC in that matter, the court also observed, “It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product.” Kobre & Kim represented the defendants in that litigation.

The central importance of the Kraft case. According Kobre & Kim’s complaint, following the court’s rejection of the CFTC’s manipulation theory in DRW, the industry was at a loss regarding what the CFTC would (or would not) deem to be manipulation in the future. Many in the industry were looking to the Kraft case for that guidance.  Kobre & Kim asserts that the CFTC responded to its defeat in DRW by further obscuring the law and abandoning its four-year litigation against Kraft in favor of a settlement in which the defendants ultimately paid $16 million to resolve the matter, but where the Commission made no public findings of fact or conclusions of law.

According to the law firm, the CFTC’s agreement not to make any public statements about the case in the future as part of its resolution ensured that large swaths of the rationale for the settlement would remain insulated from public oversight. In effect, the Kobre & Kim contends that the CFTC negotiated a private resolution that left the industry without any intelligible guidance and with a potential misimpression that the legal theories asserted against Kraft had a sound legal basis. 

Legal claims and relief requested. According to the four-count complaint, the CFTC’s violation of FOIA includes its:
  • failure to comply with statutory deadlines;
  • failure to conduct a reasonable search;
  • improper withholding of agency records; and
  • failure to produce reasonably segregable information. 
As part of its relief, Kobre & Kim is seeking: an order for the Commission to immediately process the FOIA request; an order requiring the agency to conduct searches reasonably calculated to identify all records responsive to the request; a declaration that Kobre & Kim is entitled to disclosure of the records sought by the request; and attorney fees and costs reasonably incurred in pursuing the action.

CFTC officials did not respond to a request for comment on this lawsuit. As is practice in these types of matters, the Department of Justice will respond to the complaint.

The case is No. 19-cv-10151.

Monday, 4 November 2019

Pre-suit communication was a demand letter in the guise of an informal letter

By Rodney F. Tonkovic, J.D.

A letter that a shareholder argued was simply making suggestions to a company board had enough "legal bite" to constitute pre-suit demand, the Delaware Court of Chancery found. The shareholder claimed that his letter was simply an informal suggestion that the board look into its compensation practices, but the court said that the content of the letter looked enough like a demand for it to be construed as a pre-suit litigation demand for purposes of Rule 23.1 (Solak v. Welch, October 30, 2019, McCormick, K.).

The letter. The suit was brought a shareholder of Ultragenyx Pharmaceutical Inc., a biopharmaceutical company incorporated under Delaware law. In April 2018, Ultragenyx filed an updated compensation policy within its definitive proxy statement filed with the SEC. In June 2018, the shareholder sent a letter to the Ultragenyx Board of Directors suggesting that the board take immediate action to address excessive director compensation and other compensation practices and policies. The letter referred to a recent Delaware Supreme Court case in which the court said that shareholder ratification of an equity incentive plan does not foreclose review for breach of fiduciary duty. The letter did not expressly ask the board to initiate litigation (and contained a footnote to the effect that it was not to be considered a demand) but stated that the shareholder would pursue all available remedies if there was no response within 30 days.

In October 2018, the board responded, stating at the outset that it understood the letter to be a demand pursuant to Rule 23.1. The board then explained that it conducted an investigation with the assistance of counsel and described the approach used to set Ultragenyx's compensation policies. The response also said that the board unanimously resolved that it would neither change the compensation policy nor authorize commencement of a civil action.

This derivative action commenced in November 2018, based on the board’s allegedly excessive non-employee director compensation practices. The complaint asserted three causes of action: breach of fiduciary duty, unjust enrichment, and corporate waste. Eight of the directors serving at the time of the complaint were named as defendants. Ultragenyx moved to dismiss under Rule 23.1(a).

Demand. At issue was whether the shareholder's letter constituted a pre-suit demand on the board. The shareholder argued that the letter was simply an informal attempt to educate the board and encourage it to make changes to the compensation policies. The court disagreed.

The shareholder maintained that because the letter did not expressly demand that the board commence litigation, it could not be construed as a pre-suit litigation demand. The court cited precedent holding that pre-suit communications do not have to expressly demand litigation to constitute pre-suit demand. In this case, the letter articulated the need for "immediate remedial measures," proposes remedial action, and requested that the board take such action. While the letter said that it was not a demand, the court remarked that "these strong overtures of litigation very much make it look like one."

The court went on to note other factors that led to the conclusion that the letter constituted a demand. First, the fact that the complaint in this action was a near-copy of the letter weighed heavily in favor of deeming it a pre-suit demand. The remedial measures requested in the letter also resembled action commonly achieved through derivative litigation. The court noted in addition that a very similar letter by the same plaintiff had been had been held to constitute a pre-suit demand by a New York state court.

Finally, the court found in conclusion that the complaint did not plead with the required particularity that demand was wrongfully refused. The complaint failed to allege any facts supporting an inference that the demand was wrongfully rejected and did not even acknowledge the board's response. The court accordingly granted the motion to dismiss.

The case is No. 2018-0810.